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w4reading_1 - ACCG 329 Lecture 4: The Informational...

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Unformatted text preview: ACCG 329 Lecture 4: The Informational Efficiency of Capital Markets By Egon Kalotay Macquarie University, North Ryde March 15, 2009 Ver:1.1 1 Fundamentals Economists joke: An economist is strolling down the street with a companion when they come upon a $100 note lying on the ground. As the companion reaches down to pick it up, the economist says, Dont bother ...if it were a real $100 note, someone would already have picked it up! Having to talk about market efficiency for a single lecture is something of a challenge. ...At a first glance there seems nothing to it ... A capital market is said to be efficient if it fully and correctly reflects all rel- evant information in determining security prices. Formally, the market is said to be efficient with respect to some information set ...if security prices would be unaffected by revealing that information to all participants. Moreover, effi- ciency with respect to an information set implies that it is impossible to make economic profits by trading on the basis of the information set, Malkiel [1992] Information Sets are usually distinguished in the following manner; Weak Form Efficiency : The information set includes only the history of prices or returns themselves. Semi-Strong Form Efficiency : The information set includes all information that is known to all market participants, that is, publicly available information. Strong Form Efficiency : The information set includes all information known to any market participant. Given the relative ease of entry and frictionless nature of trade in financial as- sets, it would seem that competition amongst greedy sophisticated players is sufficient to ensure that no market participant can systematically make eco- nomic profits on the basis of information contained in the defined information sets. Seems sensible enough ...! Testing this appealing intuition however is fraught with all manner of prob- lems. We will get back to these ...even before one considers issues of testing, it is worth considering some implications of, and misconceptions about market 1 efficiency. 1.1 What Market Efficiency Does and Does Not Imply Smooth Adjustment of Prices or Randomness ? It is commonly believed that market efficiency implies that security price changes should be smooth and orderly. Campbell, Lo and Mac Kinlay [1997] argue that the mis-conception of efficiency implying smooth and orderly price adjustment stems from the reasoning that a number obtained by discounting a future expected cash flow stream cannot possibly be random. The discounted present value model can be reconciled with randomness in the following manner ... The key result is the Law of Iterated Expectations ....
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This note was uploaded on 08/13/2011 for the course ACCG 329 taught by Professor Egonkalotay during the Three '09 term at Macquarie.

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w4reading_1 - ACCG 329 Lecture 4: The Informational...

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