Asset Markets

Evaluate the following statement. "Speculation and market efficiency are fundamentally incompatible. Moreover, since we can never determine whether an observed change in the price of an asset is due to speculative factors or fundamentals, we can never establish that financial markets are efficient."

A: Compatibility of Speculation and Market Efficiency

If we define speculation broadly to mean exposure to risk, then all asset holders are speculating whether they want to or not. In this sense, speculation is clearly compatible with market efficiency. If we define speculation to mean a conscious attempt to seek out capital gains accompanied by a willingness to bear the resulting risk, speculation and market efficiency are still compatible. Market efficiency means that market participants use all the information available to them in making their decisions---they do not throw information away. A speculator, bearing additional risk in the expectation of capital gains, is using all information available. The only difference between a speculator and a non-speculator is the willingness to bear additional risk chasing potential capital gains. It should be noted, of course, that whether or not one is a speculator by this second definition depends on one's intentions. Intentions are impossible to quantify, so this definition cannot be used to construct hypotheses that can be tested using data. And by the first definition everyone is a speculator, so that too cannot be used to form testable hypotheses. This all suggests that the term "speculation" is fuzzy and not very useful in economic analysis.

B: Observed Asset Prices vs. Fundamentals

One might think that if market participants use all available information the observed market prices of assets will reflect the fundamental factors determining those prices---i.e., will correctly reflect the "true" present value of the future earnings from the assets. The problem is that available information is typically subject to interpretation and, even though market participants use that information as best they can, they may make wrong decisions. Asset prices will then not reflect what, in retrospect, will turn out to be a true measure of the present value of the future earnings of assets. Thus, we can never know whether currently observed asset prices reflect "the market fundamentals" because no one can observe these fundamentals. The market will be efficient when all information is being used. The problem is that information is not perfect.

It is thus impossible to determine whether markets are efficient by analyzing currently observed asset prices. To test for efficiency we must have a theory as to what the fundamentals in the market are. But a test constructed in this fashion could now fail either because the asset market in question is inefficient or because our theory of the fundamentals is wrong. Alternatively, our test could indicate that the market is efficient because our wrong theory of the fundamentals compensated for the failure of market efficiency.

Market efficiency should be seen as a useful working hypothesis. If participants do not throw profit opportunities away, markets will be efficient. If they do throw profit opportunities away market behavior becomes incoherent and beyond rational analysis. Like utility maximization, efficient markets is a precondition for useful economic analysis of asset pricing.