Which one of the following is considered a necessary precondition by Richard Roll for markets to become efficient?

Correct option is D

Richard Roll argued that for markets to become truly efficient, the presence of traders who make a living by ‘beating the market’ through trading is a necessary precondition. These traders, often referred to as arbitrageurs or informed traders, play a crucial role in ensuring that market prices reflect all available information.

Roll's view aligns with the idea that markets do not become efficient automatically but are driven towards efficiency by active market participants who exploit price inefficiencies for profit. These traders engage in arbitrage and informed speculation, eliminating mispricing and ensuring that asset prices adjust to reflect true values.

Information Booster:

• Price Correction Mechanism – Traders who actively exploit mispriced securities ensure that prices adjust quickly, helping markets move towards efficiency.

• Liquidity Providers – By continuously buying and selling assets, these traders enhance market liquidity, reducing bid-ask spreads.

• Arbitrage and Rational Pricing – Arbitrageurs eliminate price discrepancies across markets, ensuring that no significant arbitrage opportunities persist.

• Incorporation of New Information – Informed traders respond to news and data faster than others, pushing prices to reflect the latest available information.

• Efficient Allocation of Capital – By correctly pricing assets, these traders direct capital to its most productive uses.

• Testing the Market’s Efficiency – If skilled traders fail to consistently earn excess returns, it supports the idea that the market is already efficient.

Additional Knowledge:

(a) Costless trading

• While costless trading would make markets more efficient, it is not a necessary precondition. Even with transaction costs, markets can still achieve efficiency if informed traders actively participate.
• Real-world markets always have some trading costs, yet they remain relatively efficient due to competition among traders.

(b) Free access to and flow of information

• Although free information is important, it does not guarantee efficiency. Information must be actively interpreted and acted upon by traders to impact prices.
• In some markets, even with limited information access, prices remain efficient due to arbitrageurs' ability to infer missing details.

(c) Prices approximate a random walk

• A random walk in prices is an outcome of market efficiency, not a precondition.
• Even in inefficient markets, prices can sometimes exhibit random walk behavior due to other factors like noise trading.

Conclusion:

Richard Roll emphasized that traders who make a living by ‘beating the market’ through trading are essential for market efficiency. Their participation drives price corrections, enhances liquidity, and ensures that new information is reflected in asset prices, making markets more efficient.