Question

Critically explore the concept of efficient markets and discuss to what extent financial markets such as the equity and foreign exchange markets are informationally efficient. Support your answer with relevant examples. (20marks)

Answer 1

The efficient market hypothesis is a concept which says that the market price of a stock reflects all the information about the stock. There are different forms of efficient market hypothesis such as weak form hypothesis, semi-strong form and the strong form of efficiency. The weak form of efficiency says that market price reflects all the historical information of the stock so analyzing price patterns might not help generate excess return. The semi-strong form says that all the publicly available information is in the stock price so fundamental analysis might also not help consistently generate excess return and the strong form of efficiency says that people with insider information can not generate excess return because all the information has already been adjusted in the price. The market in the short-term are very volatile so saying that market prices are always efficient would not be correct thing, they can be affected by a large number of factors but market prices in the long term are closer to the intrinsic value of the stock. If in a market the number of participants is large then the price of the stock would be closer to its intrinsic value and the market would be more efficient. The equity market is normally less informationally efficient then the foreign exchange market because the number of participants in the foreign exchange markets are large but both markets are not always efficient, the price does fall in line with the intrinsic value in the long-term. It is often seen that when earnings beat estimate price soar even to the point where the price is not justifiable so markets in the short-term are not informationally efficient.