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Financial Literacy | Efficient Financial Market (Part2 | Chapter4)

June 5, 2017

 

PART2 | KEY PRINCIPLES OF FINANCE

 

CHAPTER4 | EFFICIENT FINANCIAL MARKET

 

 

Before we jump into the efficient financial market theory, let’s first visit one key concept:

 

ARBITRAGE.

 

You may have heard of this word, but what does it exactly mean?

 

Let’s say, you buy a brand new iphone7 on Ebay at $500. Simultaneously, you sell the iphone7 on Amazon at $600. Even after including the $50 shipping cost, you still made a profit of $50 through this trade. And what you have done here is called an arbitrage. And people who take the advantage of arbitrage opportunities by capturing the price discrepancies of a same product are called arbitragers.

 

As you can see, arbitrage opportunities provide risk-free profits to the market participants. And if the market were to be less efficient, more arbitrage opportunities would arise.

 

By the way, if there is a chance to make a profit without taking any risk, would someone be willing to take that chance?

 

The answer is obviously “YES”.

 

As long as people can make a profit, someone would continue to make the same transaction until the arbitrage opportunity disappears.

 

Let’s go back to our iphone7 example.

 

If the price of an iphone7 is lower on Ebay than it is on Amazon, people like you would buyiphone7 from Ebay, and sell it on Amazon to generate profits. As more and more transactionstake place, it will eventually affect the price of an iphone7 on both websites. The price of iphone7 would rise on Ebay as demand is high, and fall on Amazon as supply is high. This price movement will continue until there is no more arbitrage opportunity.

 

Now, the market is “efficient” as no more arbitrage opportunities exist and we have arrived to an equilibrium price, or point.

 

In modern financial world, most transactions are done electronically and seldom require physical settlements between two parties. In other words, transaction costs are minimised. Therefore, taking arbitrage profits became much handier. In fact, there are a lot of computer programs and systems constantly searching for arbitrage opportunities across different asset classes, and quickly materializing the profits.

 

These arbitragers are moving fast and juicing those arbitrage opportunities that the modern financial markets are generally “efficient”.

 

As mentioned, as there are so many professional arbitragers in the market, personal investors, who are being treated with higher transaction costs than institutional investors and lack sophisticated infrastructures, rarely have opportunities to take any arbitrage.

 

Even if you see some arbitrage opportunities even after considering the transaction costs, you are highly likely taking additional risksthat you are unaware of. In other words, they were not real arbitrage opportunities.

 

This is an important assumption in finance, and based on this efficient market theory, consistently earning higher returns than expectedin a risk versus return trade-off is almost impossible.

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