Q1. Define an “efficient market” and the three forms of market efficiency. Explain how each of the forms differs from a perfect market. Define arbitrage and explain what kind of information is needed for you to obtain arbitrage in each of the forms of market efficiency. (5 points)
Q2. Please compare the advantages and disadvantages of the following investment rules: Net Present Value (NPV), Payback Period, Discounted Payback Period, Average Accounting Return, Internal Rate of Return (IRR) and Profitability Index (PI). (You can start by considering the following questions for each investment rule: Does it use cash flows or accounting earnings? Does it consider all cash flows or not? Does it apply a proper discount rate? Whether the acceptance criteria are clear and reasonable? In what situation it can be applied? What kind of weakness does it have?) (5 points)
An efficient market is advocated by a hypothesis that under free movement of information, the true value of securities are fairly priced, which immediately and accurately reflect all information available to investors. By the assumptions that rational investors evaluate the price by ascertained future cash flows, and are able to learn and react quickly to new information once delivered, investors do not expect to achieve returns in excess of average market returns.
The three forms of market efficiency are weak, semi-strong, and strong. Different degree of information is reflected by price in different forms. Under weak form, the prices reflect all past publicly available information, like historical prices movements. Under semi-strong form, the prices reflect all publicly available information, like financial statements and news reports. Under strong form, the prices reflect all public and private information.
Generally, because of quick reflection of information in price and quick response of investors to the market, it is impossible for investors to obtain or use new information to...
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