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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 10 Information and Financial Market Efficiency.

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1 Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 10 Information and Financial Market Efficiency

2 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Types of Expectations Adaptive expectations: market participants change expectations gradually over time. Rational expectations: market participants use all information available to them.

3 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Characteristics of Markets with Rational Expectations Market price equals the best guess of the present value of expected future returns, or the asset’s fundamental value. Expectation of the asset’s price, P e, equals the optimal price forecast, P f. Difference between the actual price and the expected price equals a random error.

4 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Efficient Markets Hypothesis When traders have rational expectations and when the cost of trading is low, equilibrium price = optimal forecast of fundamental value. Prices will change in reaction to changes in expected future returns, or in risk, liquidity, or information costs.

5 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Figure 10.1 Flow of Information in an Efficient Financial Market

6 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Determining an Asset’s Expected Price P t = D e t+1 + P e t i Where: P t = price of financial assets at time t D e t+1 = expected periodic return on the asset for time t + 1 i = interest rate, adjusted for the asset’s risk P e t+1 = expected price of the financial instrument at time t + 1

7 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Table 10.1 Signals for Savers and Borrowers in an Efficient Market

8 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Investment Strategies Investors should hold a diversified portfolio. Buying and selling individual assets regularly is not a profitable strategy. Don’t analyze past price trends or use “tips” in financial publications.

9 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Actual Efficiency in Financial Markets Some analysts have discovered pricing anomalies that allow above-normal returns. Mean reversion: stocks with high (low) returns now, get low (high) future returns. Stock prices may be more volatile than efficient markets hypothesis predicts.

10 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Possible Causes of Stock Market Crash of 1987 Relatively uninformed traders pursued trading strategies with no superior information. Some stock market assets had prices higher than their fundamental values. Computer-generated orders to buy or sell many stocks at the same time may have played a role.

11 Copyright © 2008 Pearson Addison-Wesley. All rights reserved Costs of Inefficiency in Financial Markets When price changes do not reflect shifts in value, prices contain less information. Inefficient markets cause higher information costs. Inefficiency lowers output since resources aren’t allocated efficiently.


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