The financial markets context
The financial markets context

This free course is available to start right now. Review the full course description and key learning outcomes and create an account and enrol if you want a free statement of participation.

Free course

The financial markets context

2 Perfect and efficient markets

Before we consider whether financial markets are indeed efficient in the sense of offering fair prices, we need to look more closely at the definition of an efficient market. The best starting point for this is the concept, in general economic theory, of a perfectly competitive market (or perfect market for short). In a perfect market, there would be no barriers or even temporary delays to the formation of perfectly fair prices, that is, prices would instantaneously and universally reflect all available and relevant information. What conditions would have to be met in order to produce this ideal state of affairs? Here are the most important.

  • There are so many individual buyers and sellers in the market that no one participant (or group of participants acting in concert with each other) can manipulate prices.

  • All participants can gain all the information on which to base their purchases at no cost and as soon as it is available.

  • There are no barriers to entry or exit.

  • There are no transaction costs. This is a very wide concept in the context of financial markets. It embraces the following factors:

    • stamp duties;

    • broker's commissions;

    • exchange fees;

    • tax regulations affecting (a) the relative attractiveness of different investments or (b) the timing of purchases and sales;

    • accounting practices that affect either the relative attractiveness of different transactions or cause significant differences in the timing of the recognition of profits and losses;

    • regulatory constraints, for example, preventing particular classes of investor from purchasing specific types of investment;

    • adverse impact on market prices of an attempt to buy or sell. This could apply, for instance, if it became known that a prominent investor was trying to dispose of a large holding in a particular investment.

In the real world, no investment market quite meets all of the above conditions, because there are delays in the dissemination of information as well as transaction costs and taxes. If the markets are not actually perfect, then just how imperfect are they? Are they still sufficiently close to the status of perfect markets that it is still impossible to profit systematically (and not just occasionally and coincidentally) from mispricings that offer excess returns?

Random walk theory

Research into the workings of the stock market began by examining this question in its simplest form: are there patterns in share prices, so that future movements can be predicted from past history? The earliest relevant research (Bachelier, 1900) looked not at stock-market prices but at commodity prices and concluded that there were no discernible trends in historic prices. In the 1950s and 1960s these findings were extended to the stock markets, as successive research studies suggested that there was little or no correlation between successive movements in share prices. This observation was called the random walk theory, as it likened the progress of share prices to the walk of a drunken man; you cannot predict the direction of his next step from the last one.

Observers of the random walk in share prices naturally sought to explain their findings in terms of the efficiency with which new information was incorporated into prices. They reasoned that if there were delays as new relevant information became disseminated through the market, the price of the affected share would not move instantaneously to the new equilibrium level reflecting the information, but would trend towards the new level over time. This might happen gradually or quite rapidly, but would still not be instantaneous. If this were the case then there would be periods (immediately following the release of new information) when price trends could be discerned. This in turn would mean that excess returns could be made, either by buying shares before the price had finished moving up to the new equilibrium level justified by good news, or by selling before the price had finished moving down to the new equilibrium level justified by bad news. The fact that these early studies found no such trends or correlations was seen as powerful support for the argument that the markets were efficient. It seemed to be the case that at any point in time, all available information was reflected in the price: the next move could not be predicted from the last one, as the next piece of news would not be genuine news if it was already implied in past prices. This finding was the central feature of what became known as the Efficient Markets Hypothesis (EMH) – the theory that the major stock markets, in particular those of the USA and UK, while not perfect, are at least efficient.

B821_2

Take your learning further

Making the decision to study can be a big step, which is why you'll want a trusted University. The Open University has nearly 50 years’ experience delivering flexible learning and 170,000 students are studying with us right now. Take a look at all Open University courses.

If you are new to university level study, find out more about the types of qualifications we offer, including our entry level Access courses and Certificates.

Not ready for University study then browse over 900 free courses on OpenLearn and sign up to our newsletter to hear about new free courses as they are released.

Every year, thousands of students decide to study with The Open University. With over 120 qualifications, we’ve got the right course for you.

Request an Open University prospectus