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What an efficient market is, and what makes one
In an efficient market, prices adjust quickly and rationally to new information, so investors cannot consistently earn returns above what the risk justifies. Efficiency is a matter of degree: more participants, better disclosure, easy arbitrage and low trading and research costs make a market more efficient.
Before this: What the financial system does, and what makes it work well
On the exam
- Describe market efficiency and related concepts, including their importance to investment practitioners
- Contrast market value and intrinsic value
- Explain factors that affect a market’s efficiency
Describe market efficiency and why it matters, contrast market value and intrinsic value, and explain what affects a market's efficiency. Expect: which change would make a market more efficient; what an abnormal return is; whether a small mispricing is worth trading after costs.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
What is an efficient market?
An informationally efficient market is one where asset prices reflect new information quickly and rationally. If the price already holds what is known, nobody can reliably profit from that knowledge.
Two words carry the definition. Quickly means the price adjusts at once, not over the following weeks. Rationally means it moves to the right level, not past it. In practice efficiency is a spectrum. A heavily followed index stock sits near the efficient end, and a thinly traded share in a small market sits further from it. The same market can move along the spectrum over time.
What counts is the unexpected part of the news. If a company reports earnings of exactly what everyone predicted, nothing new has arrived and the price has no reason to move. If it beats the forecast, the price moves by the value of the surprise.
The yardstick for “beating the market” is the abnormal return : the actual return minus the return you would expect given the security’s risk.
Efficiency says that, on average and after costs, nobody can earn a positive abnormal return from information already in the price. That is why it matters: if the market is efficient, beating it is hard and low-cost passive investing is attractive. If it is not, skilled active investment has room to work. An active investor trades to try to beat a benchmark. A passive investment approach simply holds the market, usually through an index fund.
Regulators care too. Efficient prices steer money to the companies and projects that investors value most, which supports economic growth.
How does market value differ from intrinsic value?
Memorize
Market value is the price at which the asset can be bought or sold right now. Intrinsic value (also called fundamental value) is what investors would pay if they fully understood the asset’s characteristics. You can only estimate it, for example by discounting expected cash flows.
- Market value Memorize the price at which it can be bought or sold now
- Intrinsic value Memorize the value investors would place on it with a complete understanding; only ever an estimate
- Intrinsic above market looks undervalued, active investor buys
- Intrinsic below market looks overvalued, active investor sells or shorts
- Roughly equal market is efficient, passive investing makes sense
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In an efficient market the two are close, so the gap is small. An active investor who thinks intrinsic value is above the price is betting that the price will move up toward it. If the analyst’s estimate is far from the price of a heavily followed share, the first suspect is the estimate: a discount rate that is too low for the risk, or cash flow forecasts that are too hopeful.
What makes a market more or less efficient?
Four things matter: who trades, what they know, what stops them and what it costs.
- Market participants Memorize more investors and more analyst coverage, so mispricings are found and traded away
- Information and disclosure Memorize timely, accurate, equally available to all
- Limits to trading Memorize arbitrage and short selling impeded, efficiency falls
- Costs Memorize prices are efficient within the bounds of what it costs to trade on them
- Transaction costs Use it commissions, spreads, price impact
- Information-acquisition costs Use it research, data, analysts
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| Factor | More efficient when | Example |
|---|---|---|
| Market participants | many active, competitive traders and analysts | large-company shares in a deep market, against a small frontier market |
| Information and disclosure | timely, accurate and equally available to all | rules against selective disclosure and insider trading |
| Limits to trading | arbitrage and short selling are easy | a short-selling ban slows the fall of overpriced shares |
| Trading and information costs | low | a mispricing smaller than the cost of trading on it survives |
Participants. More investors and more analysts mean any mispricing is spotted sooner. Opening a market to foreign investors usually raises efficiency for exactly this reason. Thin trading does the opposite.
Information. Prices can only reflect information that reaches the market. Disclosure rules, an active financial press and rules against selective disclosure and illegal insider trading all help.
Limits to trading. Arbitrage is a set of trades that earn a riskless profit from a price difference, such as buying an asset where it is cheap and selling it where it is dear. Arbitrageurs close pricing gaps, so anything that hinders them weakens efficiency. Short selling (selling borrowed shares) lets investors act on overvaluation, not only undervaluation. Restrictions on it make it harder to correct overpriced shares. Regulators sometimes argue that short selling can exaggerate falls, but the evidence is that restrictions let prices drift from intrinsic value.
Costs. Two kinds of cost sit between a mispricing and the profit from it. Transaction costs are the commissions, bid–ask spreads and price impact of the trade. Information-acquisition costs are what it costs to find and analyze the information in the first place. A market is “efficient” within the bounds of these costs. A gap that is smaller than the cost of trading on it is not an opportunity, so it can survive.
When is a mispricing worth trading?
Only when the expected gain is bigger than the round-trip cost.
Here is the intrinsic value estimate, the market price and the round-trip trading cost as a fraction of the price.
An analyst estimates a share's intrinsic value at 41.00. It trades at 40.70, and round-trip trading costs are 1.00% of the price. Acting on the estimate gives a net gain per share closest to:
(41.00 − 40.70) − 0.01 × 40.70 = -0.107
Net gain per share after costs-0.107
- 41−40.7−(0.01×40.7)=-0.107
- 41ENTER40.7−0.01ENTER40.7×−-0.107
ENTER enter (on the HP, puts the number on the stack)
Try this 0 of 3
- Slide the market price until the dot turns green
- With the worked example's prices (41.00 and 40.70), find the highest cost that still makes the trade pay
- Set up checkpoint 2: value 63.00, price 62.40, costs 1.5%
Not worth trading: the EUR 0.30 gap is smaller than the EUR 0.407 round-trip cost, so acting would lose EUR 0.107 a share. The mispricing survives.
Grey band: prices where the gap is smaller than the cost. Dashed zone (illustration): with 12 analysts watching, a price can stray about EUR 0.10 beyond the band before someone notices. More analysts, a narrower zone.
Show working
Gap = |41.00 − 40.70| = 0.30
Round-trip cost = 1% × 40.70 = 0.4070
Net gain = 0.30 − 0.4070 = −0.1070 per share, so the trade does not pay after costs.
Band edges (where the gap equals the cost): 41.00 ÷ (1 + 0.01) = 40.59 and 41.00 ÷ (1 − 0.01) = 41.41.
Break-even cost = 0.30 ÷ 40.70 = 0.74% of the price.
- 41−40.7−(0.01×40.7)=−0.107, the net gain per share after costs
- 41ENTER40.7−0.01ENTER40.7×−−0.107, the net gain per share after costs
ENTER enter (on the HP, puts the number on the stack)
Exam tip If the stem gives a percentage cost, take it of the price, not of the gap. Then compare cost against gap.
Go deeper Why markets cannot be perfectly efficient
If prices already reflected everything, nobody would pay for research, and then prices would stop reflecting new information. Grossman and Stiglitz made this point: for markets to stay efficient, information must earn a return. So a market is efficient when, after deducting the costs of research and trading, active investing earns only a fair return for its risk. Before costs, the work of finding information is rewarded.
Go deeper Efficiency is not the random walk
A random walk says price changes are independent of one another. Market efficiency does not require that. Prices could follow predictable patterns that reflect changing risk and still be efficient. What efficiency rules out is a pattern that earns a consistent abnormal return after risk and costs. Another practical gauge is how long prices take to adjust: the faster, the more efficient.
Memorize this
MemorizeWhat raises efficiency
| Factor | More efficient when |
|---|---|
| Participants | many active investors and analysts |
| Information | timely, accurate, equal access (disclosure rules) |
| Limits to trading | arbitrage and short selling are easy |
| Costs | trading and research costs are low |
Memory hook Who trades, what they know, what stops them, what it costs.
Know it cold Efficient = prices reflect new information quickly and rationally. A degree, not an on/off switch.
MemorizeValue and returns
| Term | Meaning |
|---|---|
| Market value | the price now |
| Intrinsic value | estimated true worth |
| Abnormal return | actual − expected (risk-adjusted) return |
Memory hook Price is what you pay, intrinsic value is what you get, abnormal return is what you beat.
Know it cold Only the unexpected part of news moves an efficient price.
- Market participants Memorize more investors and more analyst coverage, so mispricings are found and traded away
- Information and disclosure Memorize timely, accurate, equally available to all
- Limits to trading Memorize arbitrage and short selling impeded, efficiency falls
- Costs Memorize prices are efficient within the bounds of what it costs to trade on them
- Transaction costs Use it commissions, spreads, price impact
- Information-acquisition costs Use it research, data, analysts
-
- Market value Memorize the price at which it can be bought or sold now
- Intrinsic value Memorize the value investors would place on it with a complete understanding; only ever an estimate
- Intrinsic above market looks undervalued, active investor buys
- Intrinsic below market looks overvalued, active investor sells or shorts
- Roughly equal market is efficient, passive investing makes sense
-
Quick example
A share earns 10.2% in a year when its expected return, given its risk, was 7.5%. 10.2 − 7.5 = 2.7%.
- 10.2−7.5= 2.7
- 10.2ENTER7.5− 2.7
ENTER enter (on the HP, puts the number on the stack)
Quick example
Intrinsic value estimate 88.00, price 85.50, round-trip cost 1.2% of the price. Gap 2.50; cost 0.012 × 85.50 = 1.026. Net +1.474 per share.
- 88−85.5−(0.012×85.5)= 1.474
- 88ENTER85.5−0.012ENTER85.5×− 1.474
ENTER enter (on the HP, puts the number on the stack)
How it is asked
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Which change makes a market more efficient?
A market opens to foreign investors, or bans short selling, or loses analyst coverage.
More participants and lower costs raise efficiency. Opening to foreigners does. Trap: a short-selling ban looks "calming" but blocks arbitrage.
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Worth trading after costs?
Intrinsic value INR 520, price INR 512, round-trip cost 2%. Trade?
Gap 8; cost 0.02 × 512 = 10.24. Cost beats gap, so not profitable.
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Over- or undervalued?
The analyst estimates intrinsic value at 55 for a share trading at 58.
Intrinsic below market: overvalued.
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What moves the price on news?
A company reports earnings exactly in line with consensus. Price reaction?
Nothing was new, so no move. Only the unexpected part counts.
Exam traps
- Equating efficient with 'prices are always right'. Efficiency means no consistent, risk-adjusted, after-cost advantage from information, not that price equals value at every instant.
- Forgetting that only the unexpected part of news moves prices. Good news that was already expected leaves the price unchanged.
- Treating restrictions on short selling as making markets more efficient. They limit arbitrage and slow the correction of overpriced shares.
- Ignoring costs. A gap between price and estimated value smaller than round-trip trading costs is not an opportunity.
Checkpoint
4 exam-style questions. About 90 seconds each.
1Which of the following changes would most likely make a market more informationally efficient?
2An analyst estimates a share's intrinsic value at USD 63.00. The share trades at USD 62.40 and round-trip trading costs are 1.5% of the price. Acting on the estimate would most likely:
3In an efficient market, a company's earnings announcement most likely moves its share price:
4An analyst's discounted cash flow estimate of intrinsic value is 20% above the market price of a heavily followed large-company share. Before concluding the market is mispricing the share, the analyst should most likely check whether:
Key takeaways
- Efficient market: prices adjust quickly and rationally to new information.
- Abnormal return = actual return − risk-adjusted expected return.
- Market value is the price. Intrinsic value is an estimate of true worth. Active managers bet on the gap.
- Efficiency rises with more participants, better disclosure, easier arbitrage and short selling, and lower costs.
Quick example
A share earns 10.2% in a year when its expected return, given its risk, was 7.5%. 10.2 − 7.5 = 2.7%.
- 10.2−7.5= 2.7
- 10.2ENTER7.5− 2.7
ENTER enter (on the HP, puts the number on the stack)
Quick example
Intrinsic value estimate 88.00, price 85.50, round-trip cost 1.2% of the price. Gap 2.50; cost 0.012 × 85.50 = 1.026. Net +1.474 per share.
- 88−85.5−(0.012×85.5)= 1.474
- 88ENTER85.5−0.012ENTER85.5×− 1.474
ENTER enter (on the HP, puts the number on the stack)
Questions about this lesson?
Where this comes back
- Weak, semi-strong and strong-form efficiency Market Efficiency
Questions candidates ask
What is an efficient market in CFA Level 1?
A market where prices react quickly and rationally to new information, so investors cannot consistently earn abnormal returns, after risk and costs, using that information.
What is the difference between market value and intrinsic value?
Market value is the current price. Intrinsic value is what the security would be worth if everyone fully understood it. It can only be estimated.
What makes a market more efficient?
Many participants, timely disclosure, easy arbitrage and short selling, and low trading and research costs.
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