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Financial market efficiency

There are several concepts of efficiency for a financial market. The most widely discussed is informational or price efficiency, which is a measure of how quickly and completely the price of a single asset reflects available information about the asset's value. Other concepts include functional/operational efficiency, which is inversely related to the costs that investors bear for making transactions, and allocative efficiency, which is a measure of how far a market channels funds from ultimate lenders to ultimate borrowers in such a way that the funds are used in the most productive manner. Three common types of market efficiency are allocative, operational and informational. However, other kinds of market efficiency are also recognised. James Tobin identified four efficiency types that could be present in a financial market:

  1. Information arbitrage efficiency Asset prices fully reflect all of the privately available information (the least demanding requirement for efficient market, since arbitrage includes realizable, risk free transactions) Arbitrage involves taking advantage of price similarities of financial instruments between 2 or more markets by trading to generate profits. It involves only risk-free transactions and the information used for trading is obtained at no cost. Therefore, the profit opportunities are not fully exploited, and it can be said that arbitrage is a result of market inefficiency. This reflects the semi-strong efficiency model.
  2. Fundamental valuation efficiency Asset prices reflect the expected flows of payments associated with holding the assets (profit forecasts are correct, they attract investors) Fundamental valuation involves lower risks and less profit opportunities. It refers to the accuracy of the predicted return on the investment. Financial markets are characterized by predictability and inconsistent misalignments that force the prices to always deviate from their fundamental valuations. This reflects the weak information efficiency model.
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