2Market Efficiency•Efficient Markets Hypothesis (EMH)states thatasset prices fully reflect all available information•A market is said to be efficient if,on average,the prices at any point in time reflect all theavailable information.–DOES NOTmean that all prices are always correct.Could possibly be over/undervalued assets at anypoint in time.–HOWEVER, in an efficient market there is no way tosystematicallyidentify which stocks are overvaluedor undervalued.
Market Efficiency–Some Intuition•SupposethepriceofFederatedAmericanMaterials Associated (FAMA) is currently $100.What if an announcement was made today (dayzero)thatthepriceofFAMAwouldDEFINITELY be $200 in eight days. What wouldhappen to the price of FAMA?
3–WHY?Let’stake a look at how prices are determinedin a market.
How Are Market Prices Determined•In order for a transaction to take place, youneed BOTH a buyer and a seller–At a particular price, why would someone buy astock?
–Why would someone sell at thatSAMEprice?
5Market Efficiency–FAMA Example•FAMA is worth $100 and it is announced that itwill DEFINITELY be worth $200 in about oneweek. What happens to the price.–Consider the incentives of someone who wants to buyFAMA to profit from this.Would they be willing topay $100 today for an investment that would be worth$200 in about one week? It seems that most investorswould jump at this chance and thus want to buy for$100.–In order to buy the stock though, it MUST be the casethat someone is willing to sell it to them.Since thesellers also know the information, would they bewilling to sell FAMA for its“current price”of $100?
6Market Efficiency–FAMA Example–No one who owns FAMA would be willing to sell for$100 when they could wait for eight days and get $200per share.–Thus, in order for the stock of FAMA to trade at all,buyers and sellers must agree on a price at which theyare both willing to trade.The most likely price giventhe information is $200.