Financial Market Efficiency

Question 1

what do changes in financial assets signal?
- buying a 10% share means you get 10% share of future firms profits

Answer 1

• todays price is equal to all the profits that the firm will make in all periods after today:
• todays price reflects:
• expectation of discounted future profits
• future profits = sell it tomorrow at p1 and dividends you receive discounted

Question 2

if the market is efficient what do prices inform us about - and why is this important

Answer 2

the profitability of the firm –> if people think its profitable they will buy more and the price will increase
- this is important for the efficient allocation of resources
- profitable firms can sell their share for higher prices, make more money and use this for investments, the firm grows
- get rids of inefficient firms that arent able to raise money - forced out of market

Question 3

when are markets efficient?

Answer 3

• fully and correctly reflects all relevant information in the prices
• therefore there is no way to beat the market because there are no undervalued or overvalued securities available - you cant beat the market
• impossible to make abnormal profits by using the set of info to formulate buying and selling decisions

Question 4

what are the 3 degrees of market efficiency?

Answer 4

1. weak form efficiency
2. semi strong form efficiency
3. strong form efficiency

Question 5

what is weak form efficiency

Answer 5

• information included in prices is made up of all past and current prices
• past info is only info needed to predict current prices
• follow a buy and hold strategy - because we know that prices increase over time
• future price changes only a result of new info (technology)

Question 6

what is semi strong form efficiency

Answer 6

• information set includes all publicly available information (newspapers, reports)
• stocks adjust quickly to absorb new public information so that an investor cannot benefit

Question 7

what is strong form efficiency

Answer 7

• the information set includes ALL information - (available and private info)
• asset prices reflect inside info too
• no investor, including a corporate insider, would be able to profit above the average investor even if he were privy to new insider information

Question 8

what is the martingale model?

Answer 8

a martingale is a stochastic process where the expected value of the next observation, given the information available at the present time, is equal to the current observation
- if I think tomorrows price in expectation is todays price = martingale

• Market prices fully reflect all available info
• If announce 10% increase - people buy - increases demand - prices rise to absorb this announcement - until you can no longer make profits

Question 9

what does a martingale model imply?

Answer 9

expected rate of return = 0

Question 10

what are the 3 models that describe the relationship between expected future prices and current prices?

• models that describe movement in prices over time

Answer 10

1. submartingale model
2. random walk
3. geometric brownian motion

Question 11

what is the submartingale model?

Answer 11

• profits grow over time so so do prices
• prices grow at a constant rate
• expected price tomorrow = todays price + growth
• average rate of return = growth rate of prices
• process tends to exhibit a trend

Question 12

what is the random walk model

Answer 12

• price tomorrow = price today + error term
• error term is identically and independently distributed across time
• price changes are unpredictable

future price movements of an asset are unpredictable and can be thought of as a sequence of random upward or downward steps
so the best predictor over tomorrows price is todays price

Question 13

what is the geometric brownian motion

Answer 13

The process includes a drift component, which represents a trend or expected average return, indicating that the price tends to move in a particular direction over time
- mean = drift
- variance = volatility = magnitude of price changes can vary over time
- asset returns are normally distributed

Question 14

what is the grossman stiglitz paradox
- questions EMH

Answer 14

• The Grossman-Stiglitz paradox challenges the efficient market hypothesis (EMH), which assumes that financial markets incorporate and reflect all available information
• if markets are efficient then there is no incentive to collect information if all information is already represented in the prices = this would be costly - no profits made
• but if nobody invests in information acquisition then how can the markets reflect all information
• market is efficient = no one seeks info
• people seek info = markets are inefficient - profits to be made - info can increase price

Question 15

what is the no trade theorem
- challenges the notion of perfect market efficiency in the absence of asymmetric info

Answer 15

• if markets are perfectly efficient and all participants have access to the same information, then there would be no trades in the market and the prices will not change to reflect all available information
• there is no incentive to buy or sell because no profitable opportunities
• nobody disagrees about the assets value - no trade
• The no trade theorem highlights the role of information asymmetry in markets and suggests that trade activity is essential for market efficiency (for prices to adjust with new info)
• solution = noise traders that buy and sell for other reasons - trades can take place