FMI SECOND PARTIAL.docx - 11 MARKET EFFICIENCY Stock prices also reflect expectations about how economy will do in the future Recall that P 0= D K e g

FMI SECOND PARTIAL.docx - 11 MARKET EFFICIENCY Stock prices...

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11. MARKET EFFICIENCY Stock prices also reflect expectations about how economy will do in the future. Recall that: P 0 = D K e g therefore, for a given D, stock price is high when either K e is small or g is large. Current stock prices reflect expectations about future risk and opportunities. If people perceive a company/country to be safe, then, this company/country’s stock prices will rise. If people perceive a company/country to grow fast in the future, then, this company/country’s stock prices will rise. Stocks are not the only financial assets that reflect expectations about the future. All financial assets do. A bond spread is the difference between the bond’s yield and the yield on benchmark bond. Spreads (just as stock prices) contain information about the market’s expectations that a particular bond issuer will pay back the The fact that Italy’s yield is higher than Germany’s indicates that, according to the market, Italy’s default probability is higher than that of Germany. Market expectations are useful only If prices are efficient . - Market efficiency is the degree to which prices of financial securities reflect fundamental values of those securities and also the extent to which they adjust to new information. - The efficient market hypothesis (EMH) is a statement that financial markets are informationally efficient. - If markets are financially efficient, no one can consistently achieve risk-adjusted returns in excess of the market. Weak efficiency : According to this type of EMH, all past prices of a stock are reflected in today’s stock price. Semi-strong efficiency : this form of EMH implies that all public information is embedded in a stock’s current share price Strong efficiency : this is the strongest version which states all information, whether public or private, is accounted for in a stock price. Not even insider information could give an investor an advantage. Arbitrage: investment strategy that generates risk free returns and requires a zero-net investment. An example would be two identical stocks selling for different prices in different exchanges, in which case an arbitrage would involve buying the stock on the exchange where it costs less and selling it on the exchange where it costs more. Rationale behind EMH: Arbitrage opportunities cannot survive for long. When an unexploited profit opportunity arises (yielding abnormally high returns), investors will rush to buy until the price rises to the point that the returns are normal again. Hence, all unexploited profit opportunities will eventually be eliminated. The fact that arbitrage opportunities will be eliminated quickly forms the basis of EMH. Not every investor has to be aware of every security and situation.
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