2. Market Efficiency

Question 1

If financial markets are efficient what do prices tell us?

Answer 1

They tell us about the profitability of the corporate sector. They contain all relevant information

Question 2

Types of efficiency

Answer 2

1. Weak form efficiency- info comprises of all past and current prices
2. Semi-strong form efficiency- information set includes all available info
3. Strong form efficiency- information set includes all info including inside info

Question 3

Describe the random walk model

Answer 3

The random process according to which the asset price evolves must satisfy the restriction that the expectation of next period’s price, conditional on information available today, equals today’s price

Question 4

What do competitive markets imply about profits?

Answer 4

There are zero profits. Stock prices offer the same RoR as the rest of the economy

Question 5

What is the best predictor of tomorrow’s price according to the random walk model?

Answer 5

The best predictor is today’s price

Question 6

What is meant by geometric brownian motion?

Answer 6

Asset returns are normally distributed with mean u (drift) and variance (volatility)

Question 7

What is the Grossman- Stiglitz paradox?

Answer 7

If info is costly to collect then it is impossible for prices to reflect all available info. Either there are no transaction costs in which case markets are efficient or prices dont reflect all information

Question 8

What is the no trade theorem?

Answer 8

If we assume all traders are speculators then a trader’s willingness to buy ir sell reveals their private info. Other traders use this info to adjust the price. Now there is no incentive to buy so there is no trade and thus prices dont reflect all info

Question 9

What is the solution to the no trade theorem?

Answer 9

In reality people still trade, the solution is to introduce noise traders who buy and sell for other reasons like needing liquidity