Chap3 Questions - X (i.e., such that E [ Y | X = 1] = E [ Y...

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THE ECONOMICS OF FINANCIAL MARKETS R. E. BAILEY Exercises for Chapter 3 Predictability of prices and market efficiency 1. In the following table the probabilities of an asset’s payoffs are given, according to whether the “information” available to the investor takes on the value 1 or 2. Information, X : Asset Payoff, Y : Y = 0 Y = 1 Y = 3 X = 1 0 1 4 1 4 1 2 X = 2 1 4 1 4 0 1 2 1 4 1 2 1 4 1 (a) Suppose that the investor does not know the value of X . What is the expected payoff on the asset? (b) Suppose that the investor knows that X = 1 . What is the expected payoff on the asset (i.e., calculate E [ Y | X = 1] )? What is the expected payoff if X = 2 (i.e., calculate E [ Y | X = 2] )? (c) Verify that E [ E [ Y | X ]] = E [ Y ] in this example. (d) Using the above framework, construct an example (by altering the probabilities) such that the expected payoff on the asset does not depend on the value of
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Unformatted text preview: X (i.e., such that E [ Y | X = 1] = E [ Y | X = 2] = E [ Y ] ). 2. Suppose that the rate of return on the stock of XYZ plc is observed to follow a martingale process. Explain what this means in terms of the properties of the rate of return over time. What can be inferred from this observation about the efciency or inefciency of the market for the stock of XYZ plc? 3. If every appraisal of asset market efciency depends on a model of asset prices, what criteria should be used to choose the model? 4. Discuss the theoretical and empirical signicance of the hypothesis that stock market prices follow a random walk. 5. Discuss the strengths and weaknesses of event studies in appraising asset market efciency. *****...
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