Equilibrium in Financial Markets - Concepts and Two Views About Financial Markets Flashcards
What is the informational efficiency and the fundamental efficiency?
Infomational efficiency means that prices rapidly reflect all the available information and it is not possible to predict how prices will evolve - information absorved very quickly and prices react almost instantly.
Fundamental efficiency means prices rapidly and correctly reflect all the available information - prices will be the best estimate af the intrinsic value of the security and can be used by managers to estimate the firm’s cost of capital
Is it possible to predict how prices will evolve if they are informationally efficient?
If prices are informationally efficient, stock returns follow ab random walk, so it won’t be possible to predict price evolution, and we cannot use past or future information to beat the market because the current price already reflects it.
What are the 3 informational efficiency versions according to the information reflected in the prices?
-Weak form: current price reflects all past public information
-Semi-strong form: current price reflects all past and present public information
-Strong form: current price reflects all public and private information
Why is it hard to test the strong form of informational efficiency?
Because private information is only available to insiders and even if they’ll pass that info to the price and this will give insights to the public, insiders with that kind of information normally can’t trade
What would happen if prices were easily predictable?
We could obtain a capital gain and investors, trying to explore that, would create pressure for prices to adjust, making the opportunities disappear
What is the only kind of information that influences the prices if markets are informational efficient?
If the market is informationally efficient, prices already reflect past and future info, so the only kind that will affect prices is new unexpected information.
If markets are efficient, returns should be random, but is returns are random does that mean that markets are efficient?
they might, but the randomness might also be due to high competition
What is the efficiency paradox?
The markets can be viewed as a self-corrected mechanism. If investors detect an anomally, like small stocks outperforming large stocks, they’ll buy more, prices will increase and they’ll get rightly priced
In an informationally efficient market, what strategies are more valued?
-Randomly diversifying across stock, carrying little to no informational cost and execution costs
-Minimizing trading
Can inverstors beat an informationally efficient market? what are their odds?
Half the investors will beat the market, but not in the long term. Although, a large group might beat the market consistently over long periods due to shear luck
In a fundamentally efficient market the market price is an unbiased estimate of the true value of the investment. What are the implications of this?
- Doesn’t require market price=true value, just so errors in the market price be unbiased
-50/50 chance of stock to be undervalued/overvalued at any point and the deviations are random
-investors shouldn’t be able to find under or overvalued stocks using any strategy
What does the view about financial markets - Mechanisms of Market efficiency (MOME) says?
The prediction of the efficiency hypothesis is that, even though information is not immediately and costlessly available to all participants, markets act as if it were
Regarding the MOME view, what are the 4 mechanisms that work to incorporate the information in the market prices with progressively decreasing efficiency?
1) Universally-informed trading - market prices immediately reflect information that all traders know because it informs all traders
2) Professionally-informed trading - information less widely known but public, incorporated into price through trading made by professionals
3) Derivatively-informed trading - inside info known by just a few traders impacts the prices slowly and uninformed traders learn by observing (trade and price decoding)
4) Uninformed trading - info known by no one might impact prices (investors only have expectations)
What is the level of market efficiency dependent on in the MEMO view?
-How many traders learn the new information
-Which depends on the cost structure of the market for information - the lower the costs, the wider the distribution, more effective are the operative efficiency mechanisms and the more efficient is the market
What 3 categories are the informations costs devided into?
-costs of producing or acquiring information
-costs of processing information
-costs of verification of the quality of information