International Journal of Innovative Management, Information & Production Volume 2, Number 3, September 2011

ISME International2011 ISSN 2185-5439

PP. 40-48

INFORMATION EFFICIENCY OF STOCK MARKETS

HUIWEN ZOU
School of Management Fuzhou University Fujian Province, 350108, P. R. China zhw_zc@yahoo.com ABSTRACT. The efficiency of a stock market is principally measured by its information efficiency which is closely related to the information in stock markets. However, there is no uniform definition of information from the economy perspective since different researchers may have various opinions on the information of stock markets. In this research, a comparatively strict definition of information in Economics is presented. Based on this definition, the optimal conditions to reach the maximum information efficiency of stock markets are derived. The conclusion is: only when the markets operation and information transmission mechanisms are fully effective, and its information completeness degree is optimal, will the information efficiency of stock markets be optimal. Based on the conclusions, the information efficiency of reality stock markets is studied and the corresponding supervision countermeasures are suggested. Keywords: Information Definition; Stock Market; Information Efficiency

1. Introduction. The fundamental significance of the stock market lies in that it can efficiently allocate society's capital resource to promote the overall socio-economic development through its inherent market functions. The effectiveness of the basic capital resource allocation function of a stock market depends on the maturity degree of the market. Market efficiency is one of the metrics to evaluate the maturity degree of the market. The market efficiency can be differently understood based on different standing points: in macro sense, it can refer to functionality efficiency (Samuelson, 1965; Merton, 1992; Dow and Gorton, 1997), insurance efficiency (Arrow and Debreu, 1954), Tobin (1984) or pricing efficiency (Samuelson, 1975); in micro sense, it may refer to operational efficiency (O`Hara, 1995) or the information efficiency (Fama, 1970). The functionality efficiency of a stock market is defined as the efficiency of service provision of the stock market for the economic operation. The services include, providing direct financing to reduce corporate financing costs, creating premise for information gathering and outlet for the information spreading, aiding the macroeconomic control, guiding the flow of social capital to optimize the capital allocation, offering more effective corporate management structures, and promoting more rational use of assets and more effective redistribution of income. The insurance efficiency is: the stock market can provide insurance for the future delivery of goods and services for economic entities, the efficiency of which is referred to as insurance efficiency. If stock price is made based on rational expectations of future cash flows, then the stock market prices the company's securities unbiasly, the efficiency of which is referred to as pricing efficiency. Operational efficiency

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of stock markets refers to the efficiency a stock market executes the transactions for investors. Information efficiency, also known as the effectiveness of market information, that is how much stock price has sufficiently absorbed and reflected all available information. For high information efficiency, no investor can continuously gain excessive Indeed, the above stock market efficiencies in various senses are organically correlated logically and functionally (Shi, 2001): the operational efficiency provides the micro-foundation for information efficiency; information efficiency is a prerequisite for markets to achieve pricing efficiency; pricing efficiency and insurance efficiency is a necessary condition for stock markets to realize functionality efficiency, which plays a key role for effectively allocating social resources and redistributing social income. Through analysis above, essentially, the information efficiency of stock markets is the most important. So far, researches focusing on the information efficiency (Hua and Lu, 2001; He and Gao, 2001; Jin et al., 2000) have different understandings on information, which, however, are all extensions of information but not the intension. Moreover, few existing researches apply formal mathematical model to investigate the information efficiency. In this paper, we will derive a more strict definition of information in sense of economic with mathematical method. Within our information definition, we derive optimal conditions for maximizing information efficiency in the stock markets, based on the which, we suggest corresponding supervision strategies. 2. Definition of information in Economics. So far, there is no universally accepted definition on the information in sense of economic (Chen, 1998). Marsac (1959), Chen (1998) points out the posterior conditional distribution based on observed signals is generally different from the prior distribution and such probability difference is the consequence of information access. Arrow (1977), Chen (1998) believes that information is observation results based on which the probability changes according to the principle of conditional probability. The later scholars make great efforts to agree on one viewpoint (Chen, 1998): information in the Economics, in essence, is probabilistic knowledge difference caused by difference among market participants and event states in economic. Inspired by this viewpoint, we consider that the economic information should include three aspects: the observed signal, the degree of consistency between signal and the natural state and recognition of the natural state implied by this consistency degree. In the following the three aspects are separately discussed, based on which a strict definition of economic information is presented. Assume the set of economic environment states is , i.e. the set of all the natural states of factors and events which directly or indirectly influence the market. Market participants have a common objective prior probability with regard to the state of natural environment, it is represented by a given probability distribution P on . When is infinite, because k =1 P(k ) =1, which is series convergence, lim P( k ) = 0 holds,
k

(here P( ) P({}) ). For example 1 |k = 1, 2, } k (k + 1) meets the requirement. When is finite, assume {k | k 1, 2, , m} , we can expand = = {P(k ) =

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into = { k | k = 1,2, } by defining P( k ) = 0, k = m + 1, m + 2, . By doing so, we only consider as infinite in the following. In the economic sense, this assumption means that the market participants have known the objective probability distribution on natural states, and have "roughly" ordered the objective probabilities where less objective probability is "roughly" put in the back. It should be noted that such order is not necessarily monotonous. Define signal mapping : S , ( ) = s . s is signal participants observe when natural state is . Typical signals include price, cost, volume etc. S is the set of all possible values of , referred to as signal type set of participants. We assume that the participants assign each element of S with a subjective prior probability, i.e. P ( 1 ( s )) > 0, s S , where 1 ( s ) = { | , ( ) = s} . This assumption is reasonable as long as the participants are confident with their observed signal. Based on the property of probability, for 1 ( s ) , P( ) P( 1 ( s )) holds. Therefore if 1 ( s ) and P ( ) = 1 , P ( 1 ( s )) = 1 holds. Assume: (i) P ( 1 ( s )) = 0 when P( ) = 0 , because {} = implies 1 ( s ) = ; (ii) P( 1 ( s1 )) P( 1 ( s2 )) when P(1 ) < P( 2 ) , where ( i ) = s i , i = 1,2 ( s1 = s 2 is possible), namely, a signal corresponding to natural state with larger possibility is assigned with a larger subjective prior probability. These assumptions are relatively reasonable. From the economic perspective, these assumptions denote that market participants have subjective (priori) knowledge on the possibility of natural states based on the observed signal. These assumptions also mean participants set the subjective probability of natural state as positive, and such setting satisfies monotonicity and boundary conditions of the objective probability. If participants receive signal s S , they infer whether each state belongs to 1 ( s) and assign the state with a posterior probability: P ( ) / P ( 1 ( s )), 1 ( s ), P ( ) > 0; (1) P ( | s ) = 0, 1 ( s ), P( ) > 0; 1, P ( ) = 0 In (1), the first equation is derived from the definition of conditional probability. The second equation is because such conditional event is impossible. The third equation holds because P( ) / P( 1 ( s )) is of 0 / 0 type; then according to the monotonicity assumption (ii), P( 1 ( s )) scales down as P ( ) decreases, so we can assign it with 1. From an economic sense, formula (1) denotes that market participants have a new subjective (a posterior) knowledge on the probability of natural states according to the observed signal, and determine the value of such probability according to the ratio of objective probability of natural state to subjective prior probability , meeting boundary conditions. Define the degree of consistency of signal ( ) = s to natural state : d S R (real set) [1 P ( 1 ( s ))]P ( ) / P( 1 ( s )), 1 ( s ), P( ) > 0; d ( , s ) = P ( | s ) P ( ) = 1 ( s ), P( ) > 0; (2) P( ), 1, P( ) = 0

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Obviously, 1 d ( , s ) 1 . When d ( , s ) = 0 , P( | s ) = P( ) . This means the signal s can hardly help participants to identify whether state {} appears. When 1 d ( , s ) < 0 , it must hold that P ( | s ) = 0 and d ( , s ) = P ( ) . It indicates that participants observe the signal s but believe 1 ( s ) . If { } is a realized state (the probability { } appears is P ( ) ), such belief is an opposite recognition of observed signal on the realized state. The closer is d ( , s ) to 1 , the stronger is the degree of the opposite recognition. Especially, when d ( , s ) = 1 , P ( ) = 1 , which means appearance of state { } is an inevitable event, while observed signal s result in an absolutely opposite recognition on the realized state { } . When 0 < d ( , s ) 1 , P ( | s ) > P ( ) . This indicates that observed signal s can help recognition on the state { } to some extent. Notice that 0 P( ) 1 and 0 P( | s ) 1 , hence the closer is d ( , s ) to 1, the more P ( ) reaches 0 and the more P ( | s ) reaches 1. This means the more state { } is a small probability event; the more correct of the recognition on the state { } based on the observed signal s. This conclusion is relied on the previous monotonicity assumption (ii): P( 1 ( s )) decreases as P ( ) decreases. Especially, when P( ) = 0 as well as P ( | s ) = 1 , d ( , s ) = 1 holds and vice versa. In essence, the market participants recognize the real situation of natural states based on the difference between subjective posterior probability (based on the observed signal) and objective natural states probability. Such recognition may be consistent with or contrary to the real situation. Based on the above analysis, we give a formal definition of information as follows: Definition of Information. for given space ( , S , P , , d ), when d ( , s ) > 0 , the increased recognition degree on the state { } appearance caused by observed signal s is known as information (positive information); when d ( , s ) < 0 , the opposite recognition degree on the state { } appearance induced by observed signal s is known as noise (negative information). With terms in information theory, the significance of d ( , s ) can be re-explained as follows: d ( , s ) = 0 denotes observed signal s does not convey any information of natural state { } ; d ( , s ) > 0 means observed signal s represents information of natural state { } to some extent; d ( , s ) < 0 indicates observed signal s reflects negative information of natural state { } to some extent. The closer d ( , s ) is to 1 , the stronger information of natural state { } observed signal s conveys. The closer d ( , s ) is to 1 , the stronger noise of natural state { } observed signal s conveys. In sense of information theory, above assumptions on ( , P ) denotes that the information source of stock markets is open for all market participants (information users). The process of market participants' observing signal ( ) = s S is an information transmission and reception process. The process of market participants' assigning state with a posteriori probability P ( | s ) is an information judging process. 3. Information Efficiency and Practical Study of Stock Markets.

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3.1. Information Efficiency of Stock Markets. To improve the information efficiency of stock markets, we should let the prices of stock fully reflect all information relate to pricing and guide investors to reasonably anticipate relevant information, so that stocks' prices can dynamically approach to their intrinsic values. Here the stock's price is one of the observed signals and the stock's intrinsic value is determined by the natural state. If the observed stock price accurately reflects information of the natural state, it faithfully reflects the intrinsic value of the stock. Based on this idea, we redefine information efficiency of stock market based on our definition of information in section 2. Assume the set of stock market participants is N, s.t. | N |= n . For participant i N , let Si , i and di separately denote its signal type set, signal mapping and coincidence degree. Define S = i =1 Si with its member s ( s1 , s2 , , sn ) S , where si Si , i =, n . Hence = 1, 2,
n

for ( , s ) S , d ( , s) = (d1 ( , s1 ), d 2 ( , s2 ),L , d n ( , sn )) . Assume B =

n i =1

[1,1] R n and f is a strictly monotonically increasing continuous

function determined by information transmission mechanism of market on B: f B R y = f ( x1 , x2 , , xn ) s.t. | f ( x) | 1 , x B

(3)

Let D denote completeness degree of information in the stock market. D can be determined by following mapping: (4) F : S R D F= f (d ( , s )) f (d1 ( , s1 ), d 2 ( , s2 ),L , d n ( , sn )) = ( , s ) = Because of the strict monotone of f , the stronger information on natural state { } signal s conveys, i.e. the better consistency between signal ( ) = s and natural state { } ), the greater is the completeness degree of information in the stock market. Proposition 2.1. Assume si S i , lim di ( , si ) , i = 1, 2,, n are all finite. For
P ( ) 0

specified f , the necessary and sufficient condition for maximizing the information completeness degree D is: for all s S , it holds (5) lim di ( , s= 1, i 1, 2, , n = i)
P ( ) 0

Proof: Define Dmax = max {= max f ( x) f (1,1, ,1) . D} , f max =

d ( , s )B

xB

Sufficient condition. Assume formula (5) holds. Because 1 d i ( , si ) 1 , i = 1, 2, , n and f is a strictly increasing function, it holds that = f (d1 ( , s1 ), d 2 ( , s2 ),L , d n ( , sn )) f max , d ( , s ) B D f max . On the other hand, D and therein Dmax= f (d1 ( , s1 ), d 2 ( , s2 ),L , d n ( , sn )) Dmax , and because of (5) and f being continuous, it holds that = lim f (d1 ( , s1 ), d 2 ( , s2 ),L , d n ( , sn )) Dmax f max
P ( ) 0

Therefore Dmax = f max , i.e. the information completeness degree D achieves maximum. Necessary condition. Assume D achieves maximum, i.e. Dmax = f max . Proof by contradiction: If for a certain i , lim di ( , si )= a < 1 holds. Notice that when
P ( ) 0

(1 k , P(k ) 0 holds, so for = a) / 2 > 0 , K 0 > 0 , when k > K 0 ,

it holds

that: di (k , si ) < a + = (1 + a ) / 2 < 1 . Define b = si ), , di (K0 , si ) < 1 . It holds that max (1 + a ) / 2, di (1 , si ), di (2 , {

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di (k , si ) b < 1 , k = 1, 2, Then d ( , s ) B , D = f (d1 ( , s1 ), d 2 ( , s2 ), , d n ( , sn )) f (1, 1, b,1, ,1) holds. Thereby Dmax f (1, ,1, b,1, ,1) < f (1, 1,1,1, ,1) = f max which is contrary to the condition. Hence lim di ( , si= 1, i 1, 2,L , n . Proof completed. ) =
P ( ) 0

Note 2.1. Proposition 2.1 illustrates the information completeness D achieves maximum when the information on natural state {} observed signal s transmits reaches maximum. Further, we assume that the mapping f is f * when the market information transmission * mechanism is fully effective, (i.e. f , f max f max ). If the information completeness degree D achieves maximum for f * , then for any f, the information completeness degree D achieves maximum. Note 2.2. When {k | k 1, 2, , m} , according to the previous prescription : = = P (k ) = 0 , k = m + 1, m + 2, , condition of proposition 2.1 is automatically satisfied and therein the information completeness degree D achieves maximum. Define Dr = max { f (d (1 , s )), f (d (2 , s )), , f (d (m , s ))} and generally we have P( k ) > 0 , k = 1, 2, , m . Therefore d ( k , s ) < 1 , k = 1, 2, , m, s S . Hence Dr < f max = Dmax . This means that the practical maximum of information completeness degree D is less than the theoretical one when the number of considered state of nature is inadequate. Assume value range of f is R f and g is a strictly increasing continuous function determined by operation mechanism of market on R f
g : R f R z = g ( y ) , s.t. | g ( y ) | 1, y R f
d (k , s )B

(6)

Let E I denote information efficiency of the stock market. E I can be determined by the following mapping: (7) G : S R, = G ( , s ) g= g ( f (d1 ( , s1 ), d 2 ( , s2 ),L , d n ( , sn ))) EI = ( D) So the information efficiency of the stock market is determined by the completeness degree of market information, transmission mechanism of market information and operation mechanism of markets. Proposition 2.2. When information transmission and operation mechanisms of a market are fully effective, as well as the information completeness D achieves maximum, information efficiency E I of the stock markets will achieve maximum. Proof of proposition 2.2 is similar to proposition 2.1. 3.2. Study of Information Efficiency in Practical Stock Markets. According to the above analysis, within our information framework, the condition for maximizing information efficiency E I of a stock market is: 1) the relevant information are fully disclosed and uniformly distributed to participants, i.e. there is no information asymmetry; 2) information transmission and operation mechanisms of the market are sufficiently effective; 3) market participants make rational judgments on the information; 4) the information completeness

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degree D achieves maximum. However, in the practical stock market, the information contains noise, the information collection const money and time, and different participants may possess different capabilities in information collection and analysis, therefore the information owned by market participants is incomplete and asymmetrical, i.e. d ( , si ) < 0 for some i N , . Hence information efficiency E I of practical stock markets cannot achieve maximum. In practical stock markets, information asymmetry among different stakeholders is ubiquitous. For instance, institutional investors possess more information than individual investors; investors close to information sources possess more information than those far away from sources of information. Moreover the information is time sensitive. Investors who first receive bullish information can mobilize capital in time to preemptively buy cheap stock, while participants who later receive information only follow the trend and purchase stock with prices already raised. On the other hand investors who receive bearish information earlier can sell stocks earlier to avoid loss, while participants receiving information later can only close positions with loss or get hooked. There is significant difference between investors asynchronously receiving information, therefore speculative gains by making use of information may far exceed the normal investment return. If the market is flooded with such opportunities, imbalance between supply and demand can never be eliminated and prices continuously rise or drop and the market is unstable. A more severe problem is, by taking advantage of their considerable capitals and superiority to access information, market manipulators purposely generate noise in the stock market and therein change the investors expectations. They can further generate irrational market bubble by using of the herd behavior, excessive reaction and self-reinforcing mechanism of the market. By doing so, they impair the market's overall information completeness degree, and thus result in information inefficiency. When manipulators exist, the model of information efficiency in stock markets is: E I = wE I + (1 w) E I where w denotes the capital weight of market manipulators, s.t. 0 < w < 1 ; denotes reduction coefficient of information efficiency caused by the noise of market manipulation s.t. <1 ( <0 is possible), which means 1 (>0) is the expanded coefficient of information inefficiency caused by noise. Let E I = E I E I = (1 ) wE I denote the loss of market information caused by noise. Obviously, the larger the capital weight w of market manipulators is, the larger is the expanded coefficient 1 > 0 creating inefficient of information, then the greater is the loss of information efficiency in market. Especially, when 1 > 1 / w , E I < 0 holds, i.e. information efficiency in market is of negative Particularly, in China's stock markets, because information asymmetry and incompleteness is more severe, and irrational investment and manipulating behavior floods the market. Moreover, because securities are generally of low intrinsic value, pursuit of short-term speculative gains becomes the main drive of security transactions, which increase the stock market's risk and degree of non-rational bubbles. Hence in China's stock market, abnormal fluctuations in security price is more frequent and the market is harder to achieve stable dynamic equilibrium.

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4. Supervision Methods for Improving Information Efficiency. According to discussions in section 3, the information efficiency of a stock market is positively correlated to its operation mechanism, its information transmission mechanism and the information on natural state {w} observed signal s transmits. The improvement of operational efficiency has been investigated by a lot of literatures and thus not discussed here. The second condition involves the information disclosure. Here the information disclosure does not only refer to disclosure of financial information of listed companies, but also should include disclosure of natural states of all factors and events directly or indirectly impacting the market. Also the information disclosure is required to be reflected by observed signal (such as stock price, trading volume, etc). To fulfill such information disclosure, first, the listed company should disclose not only its complete financial information, but also its business status, investment status, competitive status, capital and dividend status and status of the industry it belongs to. Secondly, the relevant state departments and the media should fully disclose the macroeconomic information related to stock markets, and increase new indicators to clearly illustrate these information if necessary. Finally, both institutional investors and capable individual investors should be willing to pay the cost for mining and judging information related to the stock markets; also they should transmit these information to the stock markets through the medium of stock price. By doing so, managers and ordinary market participants can have more rational understanding on the intrinsic link between the information and stock price, and thus are more enthusiastic on investment. In addition, we should establish a good formation mechanism of stock price to avoid price manipulation, so that stock price can more accurately reflect the intrinsic value of stock. Moreover, we should strictly supervise the market and strengthen punishment on information distortion and market manipulation. 5. Conclusion. In this research, we formally define the information in sense of economy. Based on the information modeling, a stock market's information efficiency E I is optimal when its transmission and operation mechanisms are sufficiently effective and its information completeness degree D reaches maximum. Optimal information efficiency of a stock market can ensure high effectiveness of the stock market and form a long-term stable dynamic equilibrium on the stock price. In real stock markets, the real information efficiency values vary for the degrees of the information completeness and symmetry, as well as the rationality degree of market participants. When degrees of information asymmetry and incompetence and participant irrationality are pretty high, the information efficiency will be greatly impaired. The consequence is abnormal volatility in security price are more frequent and the market is very difficult to achieve stable dynamic equilibrium. In this research, from the perspectives of listed companies, state departments, media and investors, we discuss feasible supervision countermeasures for real stock market to make information efficiency approach the optimal value. Acknowledgment. Supported by the Humanities and Social Sciences Foundation of Ministry Education of China (07JA790096).

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