Question

What does it mean to be market efficient? What is the link between perfect markets and efficient markets? You see that the price of IBM is such that you expect it to earn 20% over the next year. Can you conclude that the market is inefficient? What types of markets are more likely to be inefficient? Given that a stock price is the PV of the firm’s cash flow, discuss the positions taken by a true believer, firm believer, mild believer and non-believer of the EMT ---- in terms of what/how they believe an investor can exploit the market. How does risk (standard deviation) grows with the holding period in a random walk?

Answer 1

Market efficiency refers to the degree to which market prices reflect all available, relevant information.

The Efficient market hypothesis is a theory in financial economics that states that asset prices fully reflect all the available information.

A perfect market is one in which there are never any arbitrage opportunities because assets are priced with total efficiency. And in an efficient market all the relevant, efficient information is reflected through the market prices.

Yes, the market will be inefficient because the statement that the price of IBM is such that 20% increase is expected, does not give much information about the asset's true value, does not provide the public with information.

The markets in which the asset market prices do not reflect the true value are inefficient markets.

A true believer has faith in the strong form version of Efficient Market Hypothesis (EMH), he believes that the current stock prices account all the public and non public information, and that investors cannot make returns on investment exceed normal markets returns, regardless of information retrieved and research done.

A firm believer has faith in the semi-strong version of EMH, that all the public information is accounted for calculation of stock's current price, investors cannot use technical or fundamental analysis to gain higher returns in market.

A mild believer has faith in the weak form of EMH, it suggests that today's stock prices reflect all the data of past prices and that no form of technical analysis can be effectively used by investors to make decisions.

Risk reduces with growth in holding period