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What Are the Characteristics of an Efficient Capital Market?

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  • Written By: John Lister
  • Edited By: O. Wallace
  • Last Modified Date: 11 April 2014
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A capital market can be defined narrowly as the market for investors to trade securities, and widely as the market for companies and governments to raise money or capital. An efficient capital market is one where prices change rapidly in response to changes in demand and supply, thus producing "fair" prices at any time. As well as information, an efficient capital market will usually require liquidity through a large enough collection of traders to accurately influence prices.

The capital market consists of securities, both debt products such as bonds and equity products such as stocks. It is usually defined as securities where the issuer will have more than a year to return the initial payment. This means short term securities such as Treasury bills are instead traded on a different type of market, usually called a money market.

There are two main forms of the capital market. The primary market is the one in which companies and governments create and sell the securities, often via an underwriter. The secondary market is the one in which traders buy and sell those securities among themselves, meaning the investor who ultimately redeems a debt security or receives dividends on stocks is often not the investor who originally paid money to the issuer.

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An efficient capital market is usually defined by the availability and accuracy of information about the securities and their prices. Economic market theories are usually based on the idea that every trader has full information about the securities available and the price demanded, along with any other details that could be relevant such as past market behavior, the performance of the company issuing the stock, or the likelihood of a debt security issuer repaying the money as promised. The more efficient a capital market, the closer the real situation is to this hypothetical situation. The idea is that the more efficient the market, the more informed the judgments and decisions of investors, and thus the money is allocated in the most productive way overall.

One classification gives three levels of efficiency. A weak efficient capital market is one where only information about the past is reflected in security prices. A semi-strong efficient market is one where the publicly available current information is known by all investors and reflected in prices. A strong efficient market is one where all information is known by investors, even information that is not publicly available; this is effectively the situation assumed by market theories but unlikely in the real world.

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