Lecture 9 Market Efficiency

Question 1

What are the two standard assumptions of the Traditional Finance Theory?

Answer 1

Standard assumptions:
- Investors and managers resemble the Homo Economicus
- Markets are perfect and informationally efficient

Question 2

Efficient Market

Answer 2

A market in which prices always “fully reflect” available information

Question 3

Out of which two efficiencies exists Informational efficiency?

Answer 3

Allocative efficiency
Operational efficiency

Question 4

How does the price adjustment of new information imply of the EMH?

Answer 4

Price adjustments after the arrival of new information are immediate and correct

Question 5

What are the two interpretations of the EMH then?

Answer 5

Prices reflect fundamental values
It is not possible to systematically achieve abnormal returns

Question 6

Arbitrage

Answer 6

The strategy of buying something in one place and selling it in another place at the same time, in order to make a profit from the difference in price.

Question 7

What do EMH proponents do when there is mispricing?

Answer 7

Arbitrageurs buy and sell the same or essentially similar securities at advantageously different prices and as a result push prices back to their fundamental value.

Question 8

What are three limits to Arbitrage?

Answer 8

Fundamental risk
Noise Trader risk
Implementation issues

Question 9

What entails fundamental risk?

Answer 9

Substitute securities are rarely perfect

Question 10

What entails Noise trader risk?

Answer 10

Mispricing may increase and force liquidation

Question 11

What entails the implementation issues?

Answer 11

Transaction costs (commission, tax, bid-ask spread, price impact)
Short-sale constraints (regulation, fees, lacking stock lending supply)
Information costs (detecting)
Resources (money, collateral)

Question 12

What is the one-way statement of the free lunch?

Answer 12

Prices are right is no free lunch, but no free lunch doesn’t mean prices are right

Question 13

How can you test if price is right?

Answer 13

Law of one price - identical assets should have identical prices

Question 14

rights issue

Answer 14

Issue of rights to a company’s existing shareholders to buy a proportional number of additional shares at a given price within a fixed period.
- Rights are mostly tradable
- Deep discount for distressed firms

Question 15

What are advantages of rights issues relative to conventional issues?

Answer 15

• No wealth transfer to new shareholders
  -Higher success rate
• Lower issue costs (less marketing efforts)

Question 16

What is the disadvantage of rights issue relative to conventional issues?

Answer 16

Signal of urgency

Question 17

Which two components does the joint-hypothesis problem have?

Answer 17

Informational efficiency of the market
Asset pricing model specification

Question 18

What are the three forms of efficiency and what do they entail (Fama 1970)?

Answer 18

Weak - Historical trading info -Technical analysis
Semi-strong - public info - Fundamental analysis
strong - Insider info - Insider trading

Question 19

Inter-Dependency of the three forms of efficiency

Answer 19

A circle within a circle within a circle called from in to out: weak - semistrong - strong form

Question 20

Anomaly

Answer 20

Deviation from an established rule

Question 21

What is the Anomaly in Finance?

Answer 21

Market Inefficiency

Question 22

A bubble

Answer 22

A bubble is an upward price movement over an extended period that then implodes