Liquidity and the convergence to market efficiency

Nicara Young, Christo Auret
  • Investment Analysts Journal, June 2018, Taylor & Francis
  • DOI: 10.1080/10293523.2018.1483791

The liquidity of a financial market has a mixed influence on the market's degree of efficiency.

What is it about?

Financial market efficiency has been characterized in terms of two philosophies. The first characterization is the absence of trading profits above those expected based on the risk profile of an asset or portfolio. The second is the state of conformity of asset prices to their underlying or fundamental values. We have shown for the first time in a South African context, that both of these market efficiency designations are influenced by the liquidity (or turnover) of the market in which they trade - but interestingly, in opposite directions.

Why is it important?

The study achieves the following: It introduces a measure of market efficiency unique in the South African literature; it provides insight into how market efficiency has evolved over time and how it is influenced by the critical factor of liquidity; and it demonstrates that market efficiency tests are most comprehensive when incorporating both meanings of the term. The above achievements are important for both academics and finance practitioners, as they bring us closer to understanding the fundamental characteristics and drivers of market functions, which in some cases can present opportunity for exploitation of market inefficiencies when they arise.

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