A Market Microstructure View of the Informational Efficiency of Security Prices

Abstract

Do equity prices efficiently reflect fundamental information, as the efficient markets hypothesis (EMH) suggests? The author challenges financial academicians’ widely held acceptance of the EMH. In a frictionless environment, information acquisition and trading would be costless, transaction prices would reflect information perfectly, prices would follow random walks, and the EMH would be validated. But markets are not frictionless. Academic research commonly invokes an assumption that informed investors have homogeneous expectations. But, given the enormity and complexity of information sets, investor expectations differ. Taking an intraday, microstructure focus, the author explains that price discovery in a nonfrictionless, divergent-expectations environment is a protracted, dynamic process that accentuates intraday price volatility and introduces return autocorrelations. This counters the EMH. He stresses the importance of instituting a market structure that further enhances the operational, and therefore informational, efficiency of a security market.

TOPICS: Security analysis and valuation, portfolio theory, statistical methods, exchanges/markets/clearinghouses

Key Findings

• ▪ Given the enormous size and complexity of information sets, equally informed investors form different expectations of stocks’ risks and returns. Consequently, shares do not have unique fundamental values that can be known by research analysts. Rather, prices must be discovered in a marketplace, and the efficiency with which this task is performed depends on how orders are handled and turned into trades (i.e., market structure matters).

• ▪ In a frictionless, zero-trading-cost market, security prices depend on two factors: risk and return. In a nonfrictionless market, three factors matter: risk, return, and liquidity. Illiquidity is closely associated with price discovery being a noisy, dynamic process.

• ▪ High-frequency, intraday data show that intraday price volatility is markedly accentuated and that stock returns are autocorrelated (i.e., share prices do not follow random walks). These properties of intraday price formation are manifestations of price discovery being a noisy process, and they explain why share prices can be informationally inefficient.