Tuesday, 2 May 2017

Costs of trading, illiquid markets and costs associated with gathering and analyzing information affect security prices.

Two securities that should trade for the exact same price in an efficient market may trade at different prices for various reasons:

  1. If the costs of trading on the mispricing (to make a profit) for the lower cost traders are greater than the potential profit.
  2. In such cases, these prices are still "efficient" within the bounds of arbitrage.  The bounds of arbitrage are relatively narrow in highly liquid markets (e.g., U.S. T-bills), but wider in relatively illiquid markets.
  3. There are always costs associated with gathering and analyzing information.  Net of information acquisition costs, the return offered on a security should be commensurate with the security's level of risk.  If superior returns can be earned after deducting information-acquisition costs, the market is relatively inefficient.

Factors Contributing to and Impeding a Market's Efficiency

Market participants:   
The greater the number of active market participants (investors and financial analysis) that analyze an asset or security, the greater the degree of efficiency in the market.

Information availability and financial disclosure:
The availability of accurate and timely information regarding trading activities and traded companies contributes to market efficiency.

Limits to trading:
The activities of arbitrageurs, who seek opportunities to trade on mispricings in the market to earn arbitrage (riskless) profits, contribute to market efficiency.

Transactions costs and information acquisition costs:
Investors should consider transaction costs and information-acquisition costs in evaluating the efficiency of a market.

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