"Can financial markets ever be considered to be truly efficient; given that insider trading is prohibited in a number of jurisdictions? Further, what might have been the pitfalls and the benefits of relaxing insider trading prohibitions?

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AC32820 – Financial markets and institutions assignment

Total word count - 1984

Assignment Question:

"Can financial markets ever be considered to be truly efficient; given that insider trading is prohibited in a number of jurisdictions? Further, what might have been the pitfalls and the benefits of relaxing insider trading prohibitions in the context of the recent (and on-going) difficulties and uncertainties in financial markets?"

This report has been undertaken to consider whether financial markets can ever be truly efficient, with specific relation towards insider trading and the connotations different proposals on the regulation of this activity could have on the on-going difficulties and uncertainties in the financial markets at present.  

To explain some of the fundamental terms this report will be discussing; A financial market is any market place that allows traders to buy and sell financial assets such as bonds, shares, commodities, currency’s and derivatives. They are typically defined by having transparent pricing, basic regulations on trading, costs and fee’s and market forces determining the prices of securities that trade. Examples of financial markets include the New York stock exchange (NYSE) and the forex markets. Insider trading defines the buying and selling of securities by someone who has access to material, non public information about the security. A controversial example of this was the Kenneth Lay Enron scandal in which Mr. Lay used his inside knowledge as a company director to sell his shares in the company just prior to the company filing for bankrupt [1].

At present, there are three main types of market efficiency; Allocative efficiency (production and distribution), Operational efficiency (market micro structure) and informational or pricing efficiency (Efficient market hypothesis). ‘A market is said to be perfectly efficient if it is simultaneously alllocatively, operationally and informationally efficient‘[2].

Types of Market efficiency

Allocative Efficiency -The role of the markets in a competitive economy is to allocate the limited resources it has available in the most productive way, this means that the highest bidder for the resources gets to use them. When this happens a market is said to be allocatively efficient. Financial markets duty is to allocate all the investable resources in a way which is allocatively efficient.

Operational efficiency -This is a market condition where participants can perform transactions at a price which equates fairly to the actual costs required to provide them. In other words, the market operates in a competitive environment with market-makers and brokers earning normal profits (not abnormal profits) on their activities. In a strict theoretical sense, this implies that the transactions costs of making a market are zero, however in reality this is not the case as markets wouldn’t exist if the people who operated them were not rewarded for doing so.

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Informational efficiency (EMH) - In this situation, current market prices ‘instantaneously and in an un biased manner fully reflect all relevant available information’, this being the efficient market hypothesis. Due to it being difficult to conceive how a market could be operationally and allocatively efficient, without being informationally efficient, this has resulted in a situation where market efficiency has loosely or widely been used interchangeable with informational efficiency. However, due to insider trading being prohibited in many jurisdictions, the question still remains whether a market can really be truly efficient as insiders will obviously have better information than the ...

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