Chapter 1
Energy Markets as Efficient Markets
1.1 The âEfficient Market Hypothesisâ
Are energy markets efficient markets? In what sense can a commodity market be considered efficient? And what are the trading implications of market efficiency? These are the questions we would like to answer in this introductory chapter. The third question, in particular, has a strong impact on the overall meaning of the book, but obviously, before discussing the trading implications of market efficiency we need to define the concept formally and to try to understand if energy markets can be considered efficient in some sense.
The theoretical origins of the Efficient Markets Hypothesis (EMH) are connected with pioneering studies of modern financial economics. The first formal definition and in depth analysis must surely refer to the studies of Roberts (1967) and Fama (1970). Whenever we say that a market, a financial market particularly, is efficient we basically refer to efficiency in the informational sense. In fact, in a competitive market, asset prices dynamically reflect relevant information flows and consequently a certain market is more informationally efficient if it is able to reflect more relevant information in its asset prices. Information is thus relevant if it can predict future price dynamics. According to Fama's original definition, a capital market is said to be efficient with respect to a certain information set if security prices would be unaffected by revealing that information to all market participants. Hence, the description of the information set is the base for the definition of market efficiency.
The classic taxonomy of the information set exposed by Roberts (1967) characterizes three different forms of market efficiency: weak, semistrong and strong.
In weak form market efficiency the information set considered includes only the history of prices themselves. If the market we are considering is efficient in the weak form, revealing the whole history of security prices to market participants wouldn't impact their behaviour in the market. In other words, future prices cannot be predicted by analyzing prices from the past. Under this framework, price realizations are time independent of each other. Knowing last price realization or the whole history of prices wouldn't change the ability to predict future prices. This form of market efficiency has strong mathematical and trading implications and will be discussed throughout the chapter.
In its semistrong form, the information set includes all the so-called âpublicly available informationâ, while in the strong form of market efficiency private information is also considered as a part of the available information set. Under these two frameworks, price adjustments to new information should be immediate and of a reasonable size. Consistent upward or downward adjustments after the initial change should be interpreted as informational inefficiencies.
Independently of the nature of the information set used for the definition of a particular market efficiency form, it is clear that the only way information should be reflected in prices is through real market transactions. Hence, even if the information flow is huge and fast in its development but the frequency of effective transactions is not proportional, the market efficiency paradigm loses its importance. In other words, a market can be efficient only if it is sufficiently liquid, otherwise the information flow cannot be reflected in price signals. Market efficiency is strictly connected to perfect competition between a wide universe of market operators (no single one of which is able to impact price dynamics). If this were not the case, information would be uploaded into prices as discrete packages resulting in sizable price jumps. Often energy or other commodity markets suffer when liquidity problems arise and this is something that has to be seriously considered when testing for market efficiency.
1.1.1 Trading Implications
The efficient market hypothesis has aroused interest in the public debate not because of its theoretical appeal, but mainly for its trading implications. In fact, if the disclosure of a certain information set to market participants does not affect their price forecast, no extra profits can be extracted on the basis of that information set. In t...