Efficient Markets And Noise Trading. Essay

1758 words - 7 pages

INTRODUCTIONFinancial markets characterise by many entities that interact and affect each other in the trading process. In this context, there are two different approaches to stocks pricing: efficient markets (EM) and noise trading (NT). Each approach implements different scenarios that lead to different results. The aim of this paper is to look at these two different approaches and to compare and contrast between criteria that shape each approach. The first and second sections discuss the EM and NT approaches, respectively, whilst the third section compare and contrast between these two different approaches based on criteria such as investors behavior and risks involve.EFFICIENT MARKETS APPROACH.Shleifer (2000) defines an efficient market (EM) as "one in which security prices always fully reflects the available information" (p. 1). A prerequisite for this strong version of the approach is that information and trading costs are always zero (Fama, 1991). A weaker and more rational edition of the EM approach sates that "prices reflect information to the point where the marginal benefits of acting on information do not exceed the marginal costs" (Fama, 1991). Therefore, the approach implies that the price changes are independent of one another (Brealey & Myers, 1996).Investors follow this approach named arbitrageurs, fully rational investors whose trading decisions are not subject to sentiment (Shleifer & Summers, 1990). According to Malkiel (1996), the EM approach relies on three main assumptions. First, the market is so efficient in a way that nobody can buy or sell quickly enough to benefit. Second, perfect pricing exists. The approach holds that stocks sell at the best estimates of their basic values. Thus uninformed investors buying at the existing prices are getting full value for their investment, whatever stocks they purchase. Third, the approach involves that nobody has power over the market and that stock recommendations based on unfounded beliefs do not lead to large buying.The EM approach comes in either weak, semistrong, or strong form. The weak form in which prices reflect all information contained in the record of past prices whilst the semistrong form in which prices reflect, in addition to past prices, other published information. In the strong form, however, prices reflect not just public information but all the information that can be acquired by painstaking analysis of the company and the economy (Brealey & Myers, 1996). In general, Malkiel (1996) points out that all these three forms could not help investors.According to Shleifer and Summers (1990), substantial evidences shows that arbitrage does not completely counter responses of prices to fluctuations in uninformed demand. Because price changes may reflect new market information which changes the equilibrium price at which arbitrageurs trade, identifying such fluctuations in demand is tricky. Some recent studies do, however, avoid this objection by looking at...

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