Question

(a) Identify and explain ONE incentive and ONE limitation for arbitrageurs to promote market efficiency.

(b) Sam had dinner in a restaurant yesterday and found Mr. Li Ka Ka, the Chairman of Cheung Kung (a listed property company), sat next to him. He overheard Mr. Li saying that Cheung Kung wil acquire another small property developer with an attractive price very soon. Sam bought shares of Cheung Kung on the next day. Two days later, Cheung Kung announced the acquisition and Sam gained 20% in one week from the investment. The market dropped 2% in the same period. Explain why the above case does NOT violate semi-strong form efficient market.

Answer 1

a) The incentive for arbitrageur to promote efficiency in market is by exploiting inefficiencies in the market which causes one asset price to rise in one location while fall in another can lead to risk-free profits for arbitrageur. E.g. If a security X is Priced at $100 in Location A and $105 in location B, arbitrageur will buy X in location A and sell in location B making a risk free profit of $5.

The limitation for arbitrageur to promote efficiency in the market is the capital that the arbitrageurs use for their operations is often leveraged and if Security prices moved against the arbitrageurs for a very long time then arbitrageurs will not be able to sustain operations once there capital is exhausted as a result of need to repay debts.e.g. If arbitrageur borrows $100 for purchasing a security X at 5% rate of interest, the selling price must be above 105 at the end of the period. Also, if selling price remains lower than $105 the next period then arbitrageur will incur a loss of $5.

b) The given example reinforces the hypothesis of Semi-strong form off efficient market which states that it is possible for individuals to gain excess returns over the market returns which are in possession of Material Non-public information (MNPI). In the given example, Sam uses the Material Nonpublic information obtained during dinner from Mr. Li. In the process he is able to gain 22% more return then the market (Sam' s excess return over market = 20% - (-2%) = 22%. Such a scenario is not possible in Efficient markets as no amount of Technical Analysis or Fundamental Analysis can lead to consistent excess returns for a strongly efficient market.Hence, in our case Sam made excess returns purely on the basis of MNPI and hence is aligned to semi-strong efficiency in the markets.