ABSTRACT

INTRODUCTION Imagine for a moment that investors could accurately predict the future movement of stock prices. How lucky they would be! They would immediately reap profi ts by simply purchasing those stocks whose prices they knew would go up and selling those whose prices they knew would fall. This situation assumes that all investors had access to the same costless information and interpreted it accurately. But, as we will see later, even if it were true, this situation could not persist for long. In an informationally effi cient market, investors cannot make abnormal profi ts. Recall that economists want to see an economy (or market) that is allocationally effi cient, which means that fi nancial capital should be channeled effi ciently to its best uses. For example, the securities of high-risk industries will command higher prices (returns) in anticipation of higher profi ts and securities of lower-risk industries will command lower expected rates of return. Thus investors in such an economy expect to pay and receive fair prices for their traded assets. So in order to understand that, we must fi rst explain what is meant by market effi ciency. This is the

main task of this chapter. Once we defi ne it, we shall then trace the implications of market effi ciency with respect to some of the investment strategies we have learned so far and then present some empirical evidence of market effi ciency.