L4- Market Efficiency Flashcards
Valuing the NPV of loans that are
granted at rates that are different from the market rate equation
Cheap rate - ∑ annual coupon interest/1.market rate^t - face value/1.market rate^n
As an example, suppose you have obtained a loan at a cheap rate of 3%
when the market rate is 5%. You borrow 10,000 at the cheap rate, at
annual coupon interest payments of 300 (3% of 10,000), and agree to
repay the face value of 10,000 in year 10.
The NPV of this transaction is
10, t=1
NPV = 10, 000 − ∑ 300/1.05t − 10,000/1.05^10 = 1, 544.4
Would you normally expect that financing decisions have zero NPV
Yes
If financing yields a positive NPV to the borrower…
It yields a negative
NPV to the lender
When do non-zero NPVs arise in financing decisions?
Non-zero NPVs of financing typically arise in the context of government loans, which are granted to encourage certain investments.
What issue does market efficiency address in the context of financing?
addresses the issue that the market may not always be able to value financial assets
correctly
What is the random walk model in stock price movements?
–stock price movements are unpredictable, –Information becomes embedded into prices very quickly.
What is the formula for the random walk model?
P(t) = E[P(t-1)/1+r|information set t]
What does the weak form of the Efficient Market Hypothesis (EMH) assume about the information set?
The weak form of the EMH assumes that the information set contains only price information up to time t.
What does the semi-strong form of the Efficient Market Hypothesis (EMH) assume about the information set?
The semi-strong form of the EMH assumes that the information set contains all public information up to time t.
What does the strong form of the Efficient Market Hypothesis (EMH) assume about the information set?
The strong form of the EMH assumes that the information set contains all information, both public and private, up to time t.
EMH Evidence and Examples on slides
Limits to arbitrage in financial markets?
–Prospect theory
–Anchoring
–Overconfidence
–Confirmation bias
–Herd Behaviour
–Inefficient Markets
What’s Prospect Theory
the hurt of losses is greater than the pleasure of gains
What’s Anchoring
over-reliance on past information, past doesn’t= future
What’s Overconfidence
(subjective confidence in own judgment greater than the objective confidence
What’s Confirmation Bias
selecting data to confirm existing beliefs, whilst disregarding contradictory data
What’s Herd Behaviour
mimicking the action of others (can be irrational)
What’s Inefficient Markets
prices do not reflect rationally the available
information
Lessons for Managers When Market are Efficient
–Markets are memory-less
–Trust market prices
–Learn from market price movements
–No financial illusions
–Do-It-Yourself alternative
–Stocks generate cash flow benefits only
Characteristics of inefficient markets
–Trading opportunities
–Repurchasing or issuing mispriced stock
–Bubbles?
Characteristics of Common Stock
–“Owners”
–Residual claim
–Voting rights
–Venture capital
–IPOs (initial public offerings)
LOOK AT EXAMPLES
