Market efficiency is a fundamental assumption of in a market where prices of instruments trading on market floors reflects their perceived true economic value to the investors. There are three forms of market efficiency VIZ:
Strong form of market efficiency
Semi strong form of market efficiency
Weak form of market efficiency
Investors cannot consistently beat the market in an efficient economy as prices fluctuate randomly. One cool concept that investors and other financial engineers love to believe is the concept of theoretical fair value.
Theoretical fair value assumes that somehow somewhere out there, there exists real value of commodities. This concept of theoretical fair value makes investors and financial engineers happy because, they believe that lots of money awaits them as they believe to buy very low and sell very high. The only serious problem they however face is how to find the true economic value of instruments.
This problem has however been relieved by yet another model called (CAPM) capital assets pricing model. CAPM is a controversial and highly debated theory whose applicability cannot be verified in practice. The formula to calculate it is:
E(rs) = r + [E(rm) - r]βs
Where E(rs) is the expected return on the market portfolio, which is the combination of risky assets, r represents risk free asset, and βs is called the asset beta. The beta measures unavoidable risk (systematic risk). It is not my intention to fully discuss CAPM in this article as I will give it full treatment while discussing ‘derivatives’.
One cannot possibly appreciate the concept of derivatives without firstly gaining full understanding of CAPM.
All the above concept of theoretical fair value of instruments can only hold true if the market is efficient. Like I explained before, market efficiency deals with how investors and other consumers of financial information and other information incorporate these information into prices of tradable commotidies.