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09Class1 - Efficient markets Efficient markets is an idea...

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 Efficient markets Efficient markets is an idea from finance. A. Definition A stock market is efficient if stock prices accurately reflect all publicly available information. One implication of an efficient market is that stocks are not overvalued or undervalued. (From your textbook on page 39) B. Rationale for market efficiency Why might one expect the stock market to be efficient? Investors have a motivation to make the stock market efficient. If a stock is undervalued it will be discovered and bought which will drive up the price to where it is no longer undervalued. Similarly investors will avoid overvalued stocks which will drive the stock price down to where it is no longer overvalued. 1
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C. Brief history of the efficient market hypothesis. In the 1980s MBAs were taught financial markets are efficient since this is what their professors believed. Since 1990 more and more experts question market efficiency. Convincing examples have been shown of where the market appears to be inefficient: stock market crash of 1987 / Internet stock valuations of the late 1990s Now market efficiency is believed to be only approximately true. It is believed that stocks may be overvalued or undervalued but that it is not easy to find these stocks, even with a course in financial statement analysis. 2
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D. Rationale for market inefficiency. Why should one expect that markets are somewhat inefficient? Two answers: 1. Counter to the rationale for market efficiency. A. It is true that if the market is inefficient in a major way that we would expect traders using financial statement analysis to find undervalued stock and buy them which would make the market more efficient. B. However, if the market is completely efficient then it doesn’t pay for traders to work to find undervalued stocks since they don’t exist. This lack of searching for undervalued stock would make the market less efficient.
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