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im10 - Chapter 10 Information and Financial Market...

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Chapter 10 Information and Financial Market Efficiency Overview Financial markets as efficient markets is one of the key ideas that students should take away from the course. The basic idea will initially seem counterintuitive to many students, but eventually most come to see the logic of it. Most students seem to believe that being knowledgeable about the workings of the stock and bond markets is sufficient to ensure an investor high returns. They will probably need to be convinced that the sort of stock-picking advice given on television business programs or in newspaper financial columns is largely without value. The investment strategy implications of the efficient markets hypothesis are sure to prove of great interest to many students. A key point to stress is that asset prices determined in an efficient market provide valuable information to savers and borrowers. The prices of assets traded in markets that are highly liquid and where information costs are low—the market for T-bills, for example— reflect all available information about the fundamental value of the assets. Whether the stock market or the markets for less than the highest grade corporate bonds are efficient is subject to debate. The chapter presents a thorough discussion of the arguments concerning the efficiency of the stock market in the context of an analysis of the causes of the crash of October 1987. When financial markets are not efficient problems of excessive price fluctuations and inefficiencies resulting from high information costs arise. When information costs are high, savers and borrowers must devote considerable resources to research and monitoring. In fact, because of the inefficiencies of high information costs, financial markets are unable to perform fully the role of matching savers and borrowers. Financial intermediaries exist to reduce information costs for savers and borrowers. This point is important. Stress it because it leads naturally into the discussion of financial intermediaries in the following chapters. Outline I. Rational Expectations A) Expectations of asset values by participants in financial markets determine market prices and changes in market prices. B) When market participants use all available information, market prices becomes signals for financial and economic decisions. C) When the market price of a financial instrument equals its present value, savers and borrowers can be sure that the price communicates information about market participants’ expectations of value. D) When market participants have adaptive expectations, their expectations of changes in prices or returns change gradually over time as data on past prices or returns become available.
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51 Hubbard • Money, the Financial System, and the Economy, Sixth Edition E) Most economists believe market participants have rational expectations and use all information available to them.
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