2.3 MARKET EFFICIENCY
2.3.1 A
RBITRAGE
Asset prices generally obey the Law of One Price, which says that
prices of equivalent assets in competitive markets must be the same
[6]. This implies that if a security replicates a package of other
securities, the price of this security and the price of the package it
replicates must be equal. It is expected also that the asset price must
be the same worldwide, provided that it is expressed in the same
currency and that the transportation and transaction costs can be
neglected. Violation of the Law of One Price leads to arbitrage, which
means buying an asset and immediate selling it (usually in another
market) with profit and without risk. One widely publicized example
of arbitrage is the notable differences in prices of prescription drugs in
the USA, Europe, and Canada. Another typical example is the so-
called triangle foreign exchange arbitrage. Consider a situation in
which a trader can exchange one American dollar (USD) for one
Euro (EUR) or for 120 Yen (JPY). In addition, a trader can exchange
one EUR for 119 JPY. Hence, in terms of the exchange rates, 1 USD/
JPY > 1 EUR/JPY * 1 USD/EUR.
3
Obviously, the trader who
operates, say 100000 USD, can make a profit by buying 12000000
JPY, then selling them for 12000000/119 100840 EUR, and then
buying back 100840 USD. If the transaction costs are neglected, this
operation will bring profit of about 840 USD.
The arbitrage with prescription drugs persists due to unresolved
legal problems. However, generally the arbitrage opportunities do not
exist for long. The triangle arbitrage may appear from time to time.
Foreign exchange traders make a living, in part, by finding such
opportunities. They rush to exchange USD for JPY. It is important
to remember that, as it was noted in Section 2.1, there is only a finite
number of assets at the ‘‘best’’ price. In our example, it is a finite
number of Yens available at the exchange rate USD/JPY ¼ 120. As
soon as they all are taken, the exchange rate USD/JPY falls to the
equilibrium value 1 USD/JPY ¼ 1 EUR/JPY * 1 USD/EUR, and the
arbitrage vanishes. In general, when arbitrageurs take profits, they act
in a way that eliminates arbitrage opportunities.
Financial Markets 11
2.3.2 EFFICIENT MARKET HYPOTHESIS (EMH)
Efficient market is closely related to (the absence of) arbitrage. It
might be defined as simply an ideal market without arbitrage, but there
is much more to it than that. Let us first ask what actually causes price
to change. The share price of a company may change due to its new
earnings report, due to new prognosis of the company performance, or
due to a new outlook for the industry trend. Macroeconomic and
political events, or simply gossip about a company’s management,
can also affect the stock price. All these events imply that new infor-
mation becomes available to markets. The Efficient Market Theory
states that financial markets are efficient because they instantly reflect
all new relevant information in asset prices. Efficient Market Hypoth-
esis (EMH) proposes the way to evaluate market efficiency. For
example, an investor in an efficient market should not expect earnings
above the market return while using technical analysis or fundamental
analysis.
4
Three forms of EMH are discerned in modern economic literature.
In the ‘‘weak’’ form of EMH, current prices reflect all information on
past prices. Then the technical analysis seems to be helpless. In the
‘‘strong’’ form, prices instantly reflect not only public but also private
(insider) information. This implies that the fundamental analysis
(which is what the investment analysts do) is not useful either. The
compromise between the strong and weak forms yields the ‘‘semi-
strong’’ form of EMH according to which prices reflect all publicly
available information and the investment analysts play important role
in defining fair prices.
Two notions are important for EMH. The first notion is the
random walk, which will be formally defined in Section 5.1. In short,
market prices follow the random walk if their variations are random
and independent. Another notion is rational investors who immedi-
ately incorporate new information into fair prices. The evolution of
the EMH paradigm, starting with Bachelier’s pioneering work on
random price behavior back in 1900 to the formal definition of
EMH by Fama in 1965 to the rigorous statistical analysis by Lo
and MacKinlay in the late 1980s, is well publicized [9–13]. If prices
follow the random walk, this is the sufficient condition for EMH.
However, as we shall discuss further, the pragmatic notion of market
12 Financial Markets

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