Financial Markets and Institutions (2-downloads)

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a. Select the bond fund you would recommend to an

investor who has a very low tolerance for risk and

a short investment horizon. Justify your answer.

b. Select the bond fund you would recommend to an

investor who has a very high tolerance for risk and

a long investment horizon. Justify your answer.

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116

Are Financial Markets 

Efficient?

Preview

Throughout our discussion of how financial markets work, you may have noticed

that the subject of expectations keeps cropping up. Expectations of returns,

risk, and liquidity are central elements in the demand for assets; expectations

of inflation have a major impact on bond prices and interest rates; expectations

about the likelihood of default are the most important factor that determines

the risk structure of interest rates; and expectations of future short-term inter-

est rates play a central role in determining the term structure of interest rates.

Not only are expectations critical in understanding behavior in financial mar-

kets, but as we will see later in this book, they are also central to our under-

standing of how financial institutions operate.

To understand how expectations are formed so that we can understand

how securities prices move over time, we look at the efficient market hypothe-

sis. In this chapter we examine the basic reasoning behind the efficient market

hypothesis in order to explain some puzzling features of the operation and

behavior of financial markets. You will see, for example, why changes in stock

prices are unpredictable and why listening to a stock broker’s hot tips may not

be a good idea.

Theoretically, the efficient market hypothesis should be a powerful tool

for analyzing behavior in financial markets. But to establish that it is in reality

a useful tool, we must compare the theory with the data. Does the empirical

evidence support the theory? Though mixed, the available evidence indi-

cates that for many purposes, this theory is a good starting point for analyz-

ing expectations.

6

C H A P T E R

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The Efficient Market Hypothesis

To more fully understand how expectations affect securities prices, we need to look

at how information in the market affects these prices. To do this we examine the