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econ423lec7

# econ423lec7 - The Plan for Today Homework Quiz#2 The...

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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 box2 Homework Quiz #2 box2 The Efficient Markets Hypothesis box2 Homework #3 Distribution box2 Importance of Expectations in the Financial System. box5 Expectations of returns, risk, and liquidity impact asset demand box5 Inflationary expectations impact bond prices box5 Expectations affect financial institution operation box2 To better understand expectations, we examine the efficient markets hypothesis . box5 Framework for understanding what information is useful and what is not Market Efficiency Efficient Market Hypothesis box2 Recall that the rate of return on a security can be written as: box5 What part of this equation is unknown at the time of purchase? box2 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 box2 The efficient market hypothesis views the expectations of future prices as equal to optimal forecasts using all available information. box2 This implies that: box2 In equilibrium, box2 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 box2 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. box2 Or, a security’s price fully reflects all available information in an efficient market.

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econ423lec7 - The Plan for Today Homework Quiz#2 The...

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