A financial market (including money and capital markets) is said to be efficient when (a) the prices of its assets are determined and governed competitively by the free play of natural forces of demand for and supply of funds; (b) it operates at the least cost level; (c) it is free from wasteful use of resources; and (d) its resources are allocated in the most socially productive purposes.
There are various forms of efficiency as discussed below:
1. Valuation Efficiency:
When the market price of a financial asset is equal to its intrinsic value (or investment value), it achieves valuation efficiency. The intrinsic value of an asset is the present value of the future stream of cash flow associated with the investment in that asset.
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The present value is obtained by discounting the future cash flows at an appropriate rate of discount. The valuation efficiency can be achieved only when the financial markets are perfectly competitive.
2. Functional or Operational Efficiency:
A financial ancient (a) when it minimizes administrative and transactions costs; (b) when it provides maximum facilities and conveniences to the borrowers and lenders while performing the function of transmission of resources; and (c) when it ensures a fair return to financial intermediaries for their services.
3. Allocation Efficiency:
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A financial market has allocation efficiency if it is able to channelise its resources into those investment projects or uses where marginal efficiency of capital (after adjusted for risk differences) is the maximum.
4. Information Arbitrage Efficiency:
If a person can make huge gains by using commonly available information, the financial market is said to be inefficient. Thus, the degree of efficiency and the degree of gains from the use of commonly available information are inversely related.
Under the conditions of perfect competition, such gains are not possible at all because the prices in such a market already reflect fully all the relevant and available information and no body can know anything which is not already known.
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5. Full Insurance Efficiency:
Insurance efficiency refers to the degree of hedging against future contingencies. The greater the possibility of hedging and reducing risk, the higher will be the efficiency of the market.