econ423lec7

econ423lec7 - 6/26/2009 The Plan for Today Homework Quiz #2...

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6/26/2009 1 FINANCIAL MARKET EFFICIENCY JUNE 26 TH , 2009 Lauren Heller Econ 423, Financial Markets The Plan for Today b Homework Quiz #2 b The Efficient Markets Hypothesis b Homework #3 Distribution b Importance of Expectations in the Financial System. b Expectations of returns, risk, and liquidity impact asset demand b Inflationary expectations impact bond prices b Expectations affect financial institution operation b To better understand expectations, we examine the efficient markets hypothesis . b Framework for understanding what information is useful and what is not Market Efficiency Efficient Market Hypothesis b Recall that the rate of return on a security can be written as: b What part of this equation is unknown at the time of purchase? b This implies that the expected return on a security can be written as: R = P t + 1 - P t + C P t R e = P t + 1 e - P t + C P t Efficient Market Hypothesis b The efficient market hypothesis views the expectations of future prices as equal to optimal forecasts using all available information. b This implies that: b In equilibrium, b The efficient market hypothesis would then imply that: P t + 1 e = P t + 1 of R e = R of R e = R * R of = R * Efficient Market Hypothesis b In English: Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return.
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econ423lec7 - 6/26/2009 The Plan for Today Homework Quiz #2...

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