Equilibrium in Financial Markets - Concepts and Two Views About Financial Markets

Question 1

What is the informational efficiency and the fundamental efficiency?

Answer 1

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

Question 2

Is it possible to predict how prices will evolve if they are informationally efficient?

Answer 2

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.

Question 2

What are the 3 informational efficiency versions according to the information reflected in the prices?

Answer 2

-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

Question 3

Why is it hard to test the strong form of informational efficiency?

Answer 3

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

Question 3

What would happen if prices were easily predictable?

Answer 3

We could obtain a capital gain and investors, trying to explore that, would create pressure for prices to adjust, making the opportunities disappear

Question 4

What is the only kind of information that influences the prices if markets are informational efficient?

Answer 4

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.

Question 5

If markets are efficient, returns should be random, but is returns are random does that mean that markets are efficient?

Answer 5

they might, but the randomness might also be due to high competition

Question 5

What is the efficiency paradox?

Answer 5

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

Question 5

In an informationally efficient market, what strategies are more valued?

Answer 5

-Randomly diversifying across stock, carrying little to no informational cost and execution costs
-Minimizing trading

Question 6

Can inverstors beat an informationally efficient market? what are their odds?

Answer 6

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

Question 6

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?

Answer 6

• 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

Question 7

What does the view about financial markets - Mechanisms of Market efficiency (MOME) says?

Answer 7

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

Question 7

Regarding the MOME view, what are the 4 mechanisms that work to incorporate the information in the market prices with progressively decreasing efficiency?

Answer 7

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)

Question 8

What is the level of market efficiency dependent on in the MEMO view?

Answer 8

-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

Question 8

What 3 categories are the informations costs devided into?

Answer 8

-costs of producing or acquiring information
-costs of processing information
-costs of verification of the quality of information

Question 9

What are the main conclusions taken form MOME?

Answer 9

-Only has implications on the notion of informational efficiency - assumes that there are no disagreements among investors who have the same information - homogeneous expectatios
-Deals with relative efficiency - how quickly new information is reflected in the price
-Informational efficiency is a relative concept, imperfect when the costs are significant, and even if public info is too complex and fificult to understand it may never impact the market prices
-Markets can rapidly adjust without producing a correct equilibrium -> models of heterogeneous expectations

Question 9

The Miller model is a good example of a model considering geterogeneous expectations. What are its assumptions?

Answer 9

-Investors have heterogeneous expectations - they are optimistic or pessimistic
-investors are risk averse
-there are restrictions on short sales

Question 10

Why are pessimistic investors be excluded from the Miller model?

Answer 10

due to the short sale restrictions. There will be overvaluation and pessimists won’t be able to express their pessimistic view

Question 10

What are the possible reasons for disagreement regarding the heterogeneous expectatios models?

Answer 10

-gradual information flow
-limited atention
-heterogeneous priors

Question 10

What are the implications of the Miller model in terms of efficiency?

Answer 10

-Equilibrium price may be different from the asset’s intrinsic value in the long run -> informational efficiency and fundamental market inefficiency - due to the rapid impact of information on prices

Question 11

What are the main arguments contradicting the heterogeneous expectations model and the implications of the Miller model?

Answer 11

• Just because prices are difficult to predict doesn’t mean the market is efficient - prices may not reflect the fundamental value; there are a lot of non-rational investors
  -Because it’s difficult for an investor to get returns higher than the market, that doesn’t make the market efficient - may be due to arbitrage; investors are able to beat the market (even if for luck)