Analyze the most significant driver in an efficient market a

Analyze the most significant driver in an efficient market and whether or not you would characterize the U.S. markets as efficient. Provide support for your position.

Solution

Greetings,

The level of sophistication of the investors in the marketplace is the most important factor in determining the market efficiency. Market efficiency refers to a situation where there are no free profits, information affects the prices instantly and all investors have similiar opportunity to transact (there is no information asymmetry).

More the institutional investors in the market, the higher will be the level of efficiency in the market. It is because of the infrastructure they own. They will not let mispricing exist even for nano seconds as ALGOs are designed in such a way that as soon as mispricing is identified, they will hit the trade without any human intervention. This will keep the markets efficient and anyone working in such a market will earn only normal profits (zero alpha).

Eugene Fama derived the efficient market hypothesis. He classified market efficieny into three parts -

A market is said to be weak form efficient if asset prices fully reflect a past data and patterns. It means technical analysis (the study of past prices, volume and other patterns) would not help reaping super normal returns. Most of the markets in the world are weak form efficient.

A semi strong market means a market where all the new information comes instantly and asset prices also respond instantly to it such that market participants have no time to adjust. So fundamental analysis is useless here. It means study of underlying characteristics of an asset, industry or economy analysis will earn you only normal profits. Only insider information can help here.

Strong form of market efficiency says that even insider information can\'t help you to achieve super normal profits. It means markets already discount the worth of insider information as well.

Most if the developed nations like US, UK etc claim to be strong form efficient, but in reality no economy in the world is strong form efficient. They are semi strong efficient. Insider information can always help you to achieve super normal profits. But insider trading hurts the financial markets and confidence of investors is lost. So most of the economies have stringent regulations against insider trading.