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Lesson 1 of 7 · 14 min

What an efficient market is

In an informationally efficient market, prices absorb new information quickly and rationally, so market value sits at or near intrinsic value and nobody can earn superior risk-adjusted returns, after all costs, on a consistent basis.

In short

An informationally efficient market is one where prices react quickly and rationally to new information, so they reflect all past and present information.
In an efficient market, consistent superior risk-adjusted returns net of all expenses are not achievable, so a low-cost passive strategy is preferred; in an inefficient market an active strategy may win after costs.
'Quickly' cannot be faster than the shortest time needed to execute a trade. Efficiency is a continuum, not a yes/no label.
Prices should react only to the unexpected (surprise) part of a news release; what was anticipated is already in the price.
Market value is the price at which an asset can be traded now; intrinsic value is what it would be worth to investors with a complete understanding of it (often the PV of expected cash flows), and it can only be estimated.
Efficient markets produce informative prices, which steer capital to its best uses (allocative efficiency). That is why regulators care too.

Prices that reflect information

An informationally efficient market (or simply an efficient market) is a market in which asset prices respond to new information both quickly and rationally. If that holds, today's price already reflects everything that was known yesterday and everything that has just been released.

Practitioners care because efficiency decides how many profitable trading opportunities exist. If a market is efficient, nobody can consistently earn superior risk-adjusted returns net of all expenses. Superior here means higher than the asset's risk would justify (a positive abnormal return).

In that world, a passive strategy (buy and hold a broad market portfolio, no attempt to beat it) is the sensible default, because it avoids the trading and research costs of active management. In a markedly inefficient market, an active strategy may beat a passive one even after all its costs.

This is why a careful manager-selection process starts by asking where an inefficiency comes from and why it should last. A track record of past active returns tells you little unless you can explain why the market will keep allowing them.

Governments and regulators care as well. Efficient markets give informative prices: prices that accurately reflect what is known about fundamental value. Since prices decide which firms and projects get funding, informative prices channel scarce capital to its most valuable uses (allocative efficiency) and support economic growth.

Efficiency does not mean prices are always 'right' with hindsight. It means that, given what is known now, the price is an unbiased best guess, so nobody can reliably profit by second-guessing it.

How quick is quick, and what moves the price

Information enters prices through trades. So the time a price needs to absorb news can never be shorter than the shortest time a trader needs to execute a transaction. In very liquid markets such as major currencies and developed equity markets, researchers have studied efficiency over intervals as short as a minute or less.

If the adjustment is slow enough that many traders can profit with little risk, the market is relatively inefficient. Because speed varies, efficiency is best seen as a continuum from completely efficient to completely inefficient.

In an efficient market, prices react only to the part of a release that investors had not already anticipated: the surprise. If everyone expected a profit of EUR 200 million and the company reports exactly that, there is nothing new to price.

When a surprise arrives, investors revise their expectations of the asset's future cash flows, risk or required return. Those who now think the price is too high for the risk sell (or sell short); those who think it is too low buy. The new price is the one that balances these revised opinions.

Illustrative: good news lifts a share's value from 50 to 55. In an efficient market the whole move happens at once. A slow drift (underreaction) or an overshoot that later reverses (overreaction) would be predictable, and predictable moves are profit opportunities an efficient market does not leave lying around.

Market value versus intrinsic value

Market value is the price at which an asset can be bought or sold right now. Intrinsic value (also called fundamental value) is the value investors would put on it if they fully understood its investment characteristics. It is often defined as the present value of all expected future cash flows.

For a bond, a full understanding would cover the coupon, principal and payment dates, the indenture terms, default risk, market liquidity and market variables such as the term structure and the relevant risk premiums. Intrinsic value is always an estimate: models such as the dividend discount model all need judgement about the size, timing and riskiness of future cash flows, and the more complex those cash flows, the harder the estimate.

If investors believe a market is highly efficient, they generally accept the market price as a good measure of intrinsic value. If they think it is relatively inefficient, they may build their own estimate. Gaps between the two are the raw material of active investing: buy what trades below estimated intrinsic value, sell or short what trades above it.

Market value is where supply meets demand: low enough for at least one buyer and high enough for at least one seller. Because value-relevant information arrives continually, intrinsic value estimates keep changing, and so do market prices.

Reading the gap between the two values
Situation	Label	Active investor's response
Intrinsic value > market value	Undervalued	Buy
Intrinsic value < market value	Overvalued	Sell or sell short
Intrinsic value ≈ market value	Fairly valued	No active trade; the typical case in an efficient market

The same cash flows give very different intrinsic values depending on the discount rate. The market prices this asset at 75, which implies 8%. An analyst who discounts at 6% finds 100 and calls it 'undervalued'; in an efficient market the likelier story is that the analyst has underestimated the risk.

Formula

Intrinsic value (general idea): $V_0 = \sum_{t=1}^{N} \frac{E(CF_t)}{(1+r)^t}$
Present value of the expected future cash flows, discounted at a rate $r$ that reflects their risk. A higher $r$ (more risk) gives a lower value.

Worked examples

Example 1 Which part of the news moves the price?

Analysts widely expect Fjordline Shipping to report annual profit of NOK 2.0 billion, and its share price already reflects that. At 07:00 the company reports profit of exactly NOK 2.0 billion and, in the same release, announces that it will cut its dividend by half, which nobody had predicted. If the market is efficient, what should the share price react to?

Example 2 When is the news fully in the price?

For weeks the press has reported that competition authorities may block a planned merger of two retailers, and the target's share price has been swinging with each report. One morning before the open, the authority announces that it has approved the deal without conditions. If the market is efficient, when does the price fully reflect the approved deal?

Example 3 Undervalued, or an error in the estimate?

A security is expected to pay EUR 6 a year forever, and the cash-flow forecast is reliable. It trades at EUR 75 in a market you consider efficient. Your model, using a 6% discount rate, gives an intrinsic value of EUR 100. What is the most likely conclusion?

On the exam

Expect definitional items (efficient market, market vs intrinsic value, under- vs overvalued), questions on when an efficient price fully reflects news, and on whether active or passive investing suits an efficient market.

Thinking prices react to the whole announcement. Only the unanticipated part moves an efficient price.
Mixing up the labels: intrinsic value above market value means undervalued, not overvalued.
Treating intrinsic value as known. It is always an estimate and depends heavily on the assumed risk.
Concluding that an efficient market makes active returns impossible on any single trade. It rules out consistent superior risk-adjusted returns after costs.

Check yourself

Q1In an informationally efficient market, a share price is most likely to react to:
Q2An analyst estimates a share's intrinsic value at EUR 42. It trades at EUR 48. The share appears to be:
Q3An asset pays EUR 4.50 a year forever. Using a 7.5% discount rate, its intrinsic value is closest to:
Q4Cash-flow forecasts are reliable and the market is considered efficient, yet an analyst's value is 15% above the price. The discount rate used is most likely:
Q5Compared with an inefficient market, a highly efficient market most likely favours:
Q6The time a price needs to incorporate new information in an efficient market must be at least as long as:

0/6Check yourself

Answer the 6 questions: +10 XP for each one you get right first time.

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