Chap 14_Efficient Markets

Chap 14_Efficient Markets - Efficient Markets Click to edit...

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M G M T 50 5, Fa ll 20 RWJ, Chapter 14 Click to edit Master subtitle style Efficient Markets
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M G M T 50 5, Fa ll 20 RWJ, Chapter 14 Definition A Market is “efficient” if prices reflect available information about assets. Expected return on the investment corresponds exactly to the risk taken. i.e. Price = (Present) Value
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M G M T 50 5, Fa ll 20 RWJ, Chapter 14 Sufficient Conditions for Efficiency Rational Investors Investors’ expectations are correct, on average. i.e. the probability distribution of expected prices is the same as the distribution of actual prices. Investors act to maximize Utility Competition between Investors Frictionless Markets No Transaction Costs, taxes, etc. Information is costless and available to all investors.
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M G M T 50 5, Fa ll 20 RWJ, Chapter 14 Capital Markets vs. Other Markets Characteristics of Capital Markets Many buyers and Sellers All investors have similar access to information Many close substitute products Low Transactions costs Easily divisible These characteristics are unique to capital markets. They are the most likely to be efficient. Other markets, such as the used car market or the real estate market are very unlikely to be efficient .
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M G M T 50 5, Fa ll 20 RWJ, Chapter 14 Implications of Efficient Markets In an efficient market, there are no mispricings. Any price movements would be random and investors cannot expect to make abnormal returns. If prices reflect value, then funds are being allocated to the best firms/projects. Poorer projects will have lower value and hence get lower levels of funding. Uninformed investors are more likely to participate in risk-taking investments.
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M G M T 50 5, Fa ll 20 RWJ, Chapter 14 Will anyone collect “costly” information? For markets to be efficient, it is necessary to have investors who constantly look for even the smallest mispricings and trade on it (arbitrageurs). If no one collects information and trade on them, then no one can know whether the security is priced correctly or not (Grossman and Stiglitz, 1980) So, we re-define efficiency as follows: A market is "economically efficient" if prices reflect information to the point where the marginal costs of collecting the information does not exceed the marginal benefits of acting on the information.
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M G M T 50 5, Fa ll 20 RWJ, Chapter 14 Fama’s Classification of Efficiency Weak-form Efficiency Cannot predict future prices/returns from past prices/returns. Technical Analysis should not work, Semi-Strong form Efficiency Prices reflect all public information Even Fundamental Analysis should not work. Strong-Form Efficiency
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Chap 14_Efficient Markets - Efficient Markets Click to edit...

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