1. Copyright © 2002 Pearson Education, Inc. Slide 10-1

2. Copyright © 2002 Pearson Education, Inc. Slide 10-2 Chapter 10 Information and Financial Market Efficiency

3. Copyright © 2002 Pearson Education, Inc. Types of Expectations Adaptive expectations: market participants change expectations gradually over time. Rational expectations: market participants use all information available to them.

4. Copyright © 2002 Pearson Education, Inc. 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.

5. Copyright © 2002 Pearson Education, Inc. Efficient Markets Hypothesis When traders have rational expectations and when the cost of trading is low, equilibrium price = forecast of fundamental value. Prices will change in reaction to changes in expected future returns, or in risk, liquidity, or information costs.

6. Copyright © 2002 Pearson Education, Inc. Slide 10-6 Figure 10.1 Flow of Information in an Efficient Financial Market

7. Copyright © 2002 Pearson Education, Inc. Slide 10-7 Table 10.1 Signals in an Efficient Market

8. Copyright © 2002 Pearson Education, Inc. 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 © 2002 Pearson Education, Inc. 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 © 2002 Pearson Education, Inc. 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 © 2002 Pearson Education, Inc. 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.