Market Efficiency for Financial Futures and Options

Abstract

The world-wide collapse in share prices of October, 1987, has caused commentators to claim that share markets and other financial markets are not efficient, and that the existence of financial futures and options markets tends to destabilise prices of shares and other financial assets. Both ideas are wrong. The first reflects a misunderstanding about market efficiency. Market efficiency means that price equals value. Value depends on the expectation of investors about the future. If investors change their expectations, values of shares or other assets change, and prices must change too. Major shifts in assessment of the economic situation will lead to major changes in asset prices. Market efficiency requires that prices should change, but it does not imply that they will change in a steady, still less a predictable, way. Occasionally, a panic can happen, as it did in this case, but the evidence favours the view that financial markets are normally efficient. The idea that futures and options markets tend to destabilise cash market prices is also wrong.