2-Financial Markets Page 31 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 31selling a security that is not in inventory (a short position). There are
three types of risks associated with maintaining a long or short position
in a given security. First, there is the uncertainty about the future price
of the security. A dealer who has a long position in the security is con-
cerned that the price will decline in the future; a dealer who is in a short
position is concerned that the price will rise.
The second type of risk has to do with the expected time it will take
the dealer to unwind a position and its uncertainty. And this, in turn,
depends primarily on the rate at which buy and sell orders for the secu-
rity reaches the market (i.e., the thickness of the market). Finally, while
a dealer may have access to better information about order flows than
the general public, there are some trades where the dealer takes the risk
of trading with someone who has better information^6 This results in the
better-informed trader obtaining a better price at the expense of the
dealer. Consequently, in establishing the bid-ask spread for a trade, a
dealer will assess whether the trader might have better information.
Some trades that we will discuss below can be viewed as “information-
less trades.” This means that the dealer knows or believes a trade is
being requested to accomplish an investment objective that is not moti-
vated by the potential future price movement of the security.Market Price Efficiency
The term “efficient” capital market has been used in several contexts to
describe the operating characteristics of a capital market. There is a dis-
tinction, however, between an operationally (or internally) efficient mar-
ket and a pricing (or externally) efficient capital market.^7 In this section
we describe pricing efficiency.
Pricing efficiency refers to a market where prices at all times fully
reflect all available information that is relevant to the valuation of secu-
rities. That is, relevant information about the security is quickly
impounded into the price of securities. In his seminal review article on
pricing efficiency, Eugene Fama points out that in order to test whether
a market is price efficient, two definitions are necessary.^8 First, it is nec-
essary to define what it means that prices “fully reflect” information.
Second, the “relevant” set of information that is assumed to be “fully
reflected” in prices must be defined.(^6) Walter Bagehot, “The Only Game in Town,” Financial Analysts Journal (March-
April 1971), pp. 12–14, 22.
(^7) Richard R. West, “Two Kinds of Market Efficiency,” Financial Analysts Journal
(November–December 1975), pp. 30–34.
(^8) Eugene F. Fama, “Efficient Capital Markets: A Review of Theory and Empirical
Work,” Journal of Finance (May 1970), pp. 383–417.