Financial Markets and Institutions (2-downloads)

119

Rationale Behind the Hypothesis

To see why the efficient market hypothesis makes sense, we make use of the concept

of arbitrage, in which market participants (arbitrageurs) eliminate unexploited

profit opportunities, meaning returns on a security that are larger than what is jus-

tified by the characteristics of that security. There are two types of arbitrage, pure

arbitrage, in which the elimination of unexploited profit opportunities involves no

risk, and the type of arbitrage we discuss here, in which the arbitrageur takes on some

risk when eliminating the unexploited profit opportunities. To see how arbitrage leads

to the efficient market hypothesis, suppose that, given its risk characteristics, the

normal return on a security, say, Exxon-Mobil common stock, is 10% at an annual

rate, and its current price P

t

is lower than the optimal forecast of tomorrow’s price

so that the optimal forecast of the return at an annual rate is 50%, which is

greater than the equilibrium return of 10%. We are now able to predict that, on

average, Exxon-Mobil’s return would be abnormally high, so there is an unexpected

profit opportunity. Knowing that, on average, you can earn such an abnormally high

rate of return on Exxon-Mobil because R

of

> R*, you would buy more, which would

in turn drive up its current price relative to the expected future price 

, thereby

lowering R

of

. When the current price had risen sufficiently so that R

of

equals R* and

the efficient market condition (Equation 4) is satisfied, the buying of Exxon-Mobil

will stop, and the unexploited profit opportunity will have disappeared.

Similarly, a security for which the optimal forecast of the return is –5% while

the equilibrium return is 10% (R

of

< R*) would be a poor investment because, on aver-

age, it earns less than the equilibrium return. In such a case, you would sell the

security and drive down its current price relative to the expected future price until

R

of

rose to the level of R* and the efficient market condition is again satisfied. What

we have shown can be summarized as follows:

Another way to state the efficient market condition is this: In an efficient market,