Question

Intermediate Macroeconomics:

1.  Use the Efficient Market Hypothesis to explain why there are no arbitrage opportunities in financial markets. Can you think of an instance in which the Efficient Markets Hypothesis would fail?

Answer 1

The best trading strategy under the efficient market hypothesis is to buy and hold. This means buying a large bundle of stocks and just hold them irrespective of the presence of bad times or good. Market participants use the best available information when they attempt to have an analysis of the stocks. This indicates that when there are no arbitrage opportunity available in the market, price of a security should be equal to its fundamental value which in a way, imply that it is equal to the discounted sum of future returns. Theory indicates that if there is an arbitrage opportunity to gain from buying and selling, this opportunity is quickly harnesses so that on average, there are no mismatch in the price and the fundamental price.

There are anomalies as well, that show that price of a security can deviate from its no arbitrage value. One example is the overpricing of the Internet stocks as argued by Ofek and Richardson. The market hypothesis failed in the recent recession of 2008. Government's bailout of hedge fund LTCM and other massive bailouts of 2008 and 2009, suggest that the important assumptions of the efficient market hypothesis failed in the process