Class_Notes07_Market_Efficiency_2013 (1).pdf - Market...

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1 Market Efficiency How “smart” are markets? Goals Examine what is meant by market efficiency Examine the implications of an efficient market Examine how efficient markets might be © 2008, Sandeep Dahiya and Lee Pinkowitz. Do not copy or use these notes without permission. Slides 1-21 are covered in the Market Efficiency lecture video (32:43 long)
2 Market Efficiency Efficient Markets Hypothesis (EMH) states that asset prices fully reflect all available information A market is said to be efficient if, on average , the prices at any point in time reflect all the available information. DOES NOT mean that all prices are always correct. Could possibly be over/undervalued assets at any point in time. HOWEVER, in an efficient market there is no way to systematically identify which stocks are overvalued or undervalued.
Market Efficiency Some Intuition Suppose the price of Federated American Materials Associated (FAMA) is currently $100. What if an announcement was made today (day zero) that the price of FAMA would DEFINITELY be $200 in eight days. What would happen to the price of FAMA?
3 WHY? Let’s take a look at how prices are determined in a market.
How Are Market Prices Determined In order for a transaction to take place, you need BOTH a buyer and a seller At a particular price, why would someone buy a stock?
Why would someone sell at that SAME price?
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5 Market Efficiency FAMA Example FAMA is worth $100 and it is announced that it will DEFINITELY be worth $200 in about one week. What happens to the price. Consider the incentives of someone who wants to buy FAMA to profit from this. Would they be willing to pay $100 today for an investment that would be worth $200 in about one week? It seems that most investors would jump at this chance and thus want to buy for $100. In order to buy the stock though, it MUST be the case that someone is willing to sell it to them. Since the sellers also know the information, would they be willing to sell FAMA for its “current price” of $100?
6 Market Efficiency FAMA Example No one who owns FAMA would be willing to sell for $100 when they could wait for eight days and get $200 per share. Thus, in order for the stock of FAMA to trade at all, buyers and sellers must agree on a price at which they are both willing to trade. The most likely price given the information is $200.

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