Concept
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Efficiency in a financial context refers to the fact that the specified prices reflect all available information regarding the particular instruments, making it impossible for participants to outperform the markets over time. The Efficient Market Hypothesis (EMH) states that: “asset prices fully reflect all available information. A direct implication is that it is impossible to ‘beat the market’ consistently on a risk-adjusted basis since market prices should only react to new information or changes in discount rates (the latter may be predictable or unpredictable).” Though the theory is by no means watertight, it draws our attention to an important aspect of price setting in the global financial market: that prices are driven upward or downward to the point at which the available information reflects an equilibrium price.
In practice, let’s look at an example below:
If two different exchanges, the NYSE and the LSE, offered the same stock ABC Ltd on their platforms, and the NYSE sold ABC Ltdstock for $10, but the LSE sold ABC Ltd stock for $10.50, it could be assumed that the market could simultaneously buy up the cheaper ABC stock on the NYSE and sell it for more on the LSE.
This buying of shares on the NYSE would –through forces of supplyand demand –drive up the price of ABC Ltd on the NYSE, while the selling of ABC Ltd on the LSE would drive down the price on that exchange. This would go on until the prices find equilibrium. This example –which is an example of arbitrage -gives a good indication of the efficiency of the market in practice.