Capital Market Efficiency

Market efficiency is important for everyone because markets set prices. In particular, stock markets set prices for shares of stock. Currency markets set exchange rates. Commodity markets set prices of commodities such as wheat and corn. Setting correct prices is important because prices determine how available resources are allocated among different uses.

Cost of Information

While market efficiency is desirable, there are three limitations in achieving that ideal: the cost of information, the cost of trading, and the limits of arbitrage.

Let us assume that markets are fully efficient, that is, they instantaneously reflect new information in prices. If that is the case, then no investor or market participant has any incentive to generate or report new information because the value of that information is zero. That is, when a company announces its earnings, no one wastes time trying to analyze that information because the price already reflects it. There is no value in even reading the corporate announcement, But if no one has any incentive to react to new information, then it is impossible to reflect new information in prices.

The implication of this is that markets can't be fully efficient because no one has the incentive to make them so. Market participants must be compensated in some way for making the market more efficient. Arbitrageurs and speculators must get something in return. Thus, instead of achieving instantaneous adjustment to new information, prices can adjust to new information only with a time lag. This time lag allows market participants to earn a reasonable return on their cost of obtaining and processing the information. If the return is abnormally high, it will attract more information processors, leading to a reduction in time lag.

Cost of Trading

Like the cost of information, traders incur costs brokerage costs, and other related costs. When the cost of trading is high, financial assets are likely to remain mispriced for longer periods than when the cost of trading is low. In essence, like with the cost of information, the arbitrageurs or er traders must get an adequate return after accounting for costs to engage in an activity that make market more efficient. To the extent that trading activity is limited, prices will not reflect all available information.

Limits of Arbitrage

Wwe implicitly assumed that arbitrageurs have an unlimited amount of capital to take advantage of mispriced assets. That is not true.Just like everyone else, arbitrageurs have a limited amount of capital, which they devote to the most profitable strategies or to the -most egregious mispricings while ignoring the remaining mispricings. The problem of limited capital becomes more severe in a bull market. Though there are potentially more mispricings in a bull market, the arbitrage capital is even more limited because most investors want to ride the market.