1. Sinking fund
A fund to which money is added on a regular basis that is used to ensure investor
confidence that promised payments will be made and that is used to redeem debt
securities or preferred stock issues.
Copyright © 2012, Campbell R. Harvey. All Rights Reserved.
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Sinking Fund
A fund or account into which a person or company deposits money on a regular basis in
order to repay some debt or other liability that will come due in the future. For example,
if one has a loan with a balloon maturity of seven years, one may put money into a
sinking fund for seven years in order to be ready to pay off the principal when it comes
due. Some bonds have sinking fund provisions, requiring the issuer to put money aside to
repay bondholders at maturity.
Farlex Financial Dictionary. © 2012 Farlex, Inc. All Rights Reserved
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sinking fund
The assets that are set aside for the redemption of stock, the retirement of debt, or the
replacement of fixed assets.
Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David
L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton
Mifflin Company. All rights reserved.
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Sinking fund. To ensure there's money on hand to redeem a bond or preferred stock issue,
a corporation may establish a separate custodial account, called a sinking fund, to which
it adds money on a regular basis.
Or the corporation may be required to establish such a fund to fulfill the terms of its
issue. The existence of the fund allows the corporation to present its investments as safer
than those issued by a corporation without comparable assets.

2. However, sinking fund assets may be used to call bonds before they mature, reducing the
interest the bondholders expected to receive.
Dictionary of Financial Terms. Copyright © 2008 Lightbulb Press, Inc. All Rights
Reserved.
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sinking fund
Money set aside in a special account to which regular contributions are made by way of
additional money and/or interest on the money,with the plans that by a specified date the
fund will be sufficient for a particular purpose.Prospective homeowners may set up a
sinking fund for a house down payment,and companies usually establish sinking funds to
pay off bonds.
The Complete Real Estate Encyclopedia by Denise L. Evans, JD & O. William Evans,
JD. Copyright © 2007 by The McGraw-Hill Companies, Inc.
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Bond valuation
From Wikipedia, the free encyclopedia
Jump to: navigation, search
Financial markets

3. • Public market
• Exchange
• Securities
Bond market
• Bond valuation
• Corporate bond
• Fixed income
• Government bond
• High-yield debt
• Municipal bond
Stock market
• Common stock
• Preferred stock
• Registered share
• Stock
• Stock certificate
• Stock exchange
• Voting share
Derivatives market
• Credit derivative
• Futures exchange
• Hybrid security
• Securitization
Over-the-counter
• Forwards
• Options
• Spot market
• Swaps
Foreign exchange

4. • Currency
• Exchange rate
Other markets
• Commodity market
• Money market
• Reinsurance market
• Real estate market
Practical trading
• Clearing house
• Financial market participants
• Financial regulation
Finance series
• Banks and banking
• Corporate finance
• Personal finance
• Public finance
• v
• t
• e
Bond valuation is the determination of the fair price of a bond. As with any security or
capital investment, the theoretical fair value of a bond is the present value of the stream
of cash flows it is expected to generate. Hence, the value of a bond is obtained by
discounting the bond's expected cash flows to the present using an appropriate discount
rate. In practice, this discount rate is often determined by reference to similar instruments,
provided that such instruments exist. Various related yield-measures are calculated for
the given price.
If the bond includes embedded options, the valuation is more difficult and combines
option pricing with discounting. Depending on the type of option, the option price as
calculated is either added to or subtracted from the price of the "straight" portion. See
further under Bond option. This total is then the value of the bond.
Contents

5. • 1 Bond valuation
o 1.1 Present value approach
o 1.2 Relative price approach
o 1.3 Arbitrage-free pricing approach
o 1.4 Stochastic calculus approach
• 2 Clean and dirty price
• 3 Yield and price relationships
o 3.1 Yield to Maturity
o 3.2 Coupon yield
o 3.3 Current yield
o 3.4 Relationship
• 4 Price sensitivity
• 5 Accounting treatment
• 6 See also
• 7 References and external links
Bond valuation
[1]
As above, the fair price of a "straight bond" (a bond with no embedded options; see
Bond (finance)# Features) is usually determined by discounting its expected cash flows at
the appropriate discount rate. The formula commonly applied is discussed initially.
Although this present value relationship reflects the theoretical approach to determining
the value of a bond, in practice its price is (usually) determined with reference to other,
more liquid instruments. The two main approaches, Relative pricing and Arbitrage-free
pricing, are discussed next. Finally, where it is important to recognise that future interest
rates are uncertain and that the discount rate is not adequately represented by a single
fixed number - for example when an option is written on the bond in question - stochastic
calculus may be employed.
Where the market price of bond is less than its face value (par value), the bond is selling
at a discount. Conversely, if the market price of bond is greater than its face value, the
bond is selling at a premium.[2] For this and other relationships relating price and yield,
see below.
Present value approach
Below is the formula for calculating a bond's price, which uses the basic present value
(PV) formula for a given discount rate:[3] (This formula assumes that a coupon payment
has just been made; see below for adjustments on other dates.)

6. where:
F = face value
iF = contractual interest rate
C = F * iF = coupon payment (periodic interest payment)
N = number of payments
i = market interest rate, or required yield, or observed / appropriate yield to
maturity (see below)
M = value at maturity, usually equals face value
P = market price of bond.
Relative price approach
Under this approach - an extension of the above - the bond will be priced relative to a
benchmark, usually a government security; see Relative valuation. Here, the yield to
maturity on the bond is determined based on the bond's Credit rating relative to a
government security with similar maturity or duration; see Credit spread (bond). The
better the quality of the bond, the smaller the spread between its required return and the
YTM of the benchmark. This required return is then used to discount the bond cash
flows, replacing in the formula above, to obtain the price.
Arbitrage-free pricing approach
See: Rational pricing: Fixed income securities.
As distinct from the two related approaches above, a bond may be thought of as a
"package of cash flows" - coupon or face - with each cash flow viewed as a zero-coupon
instrument maturing on the date it will be received. Thus, rather than using a single
discount rate, one should use multiple discount rates, discounting each cash flow at its
own rate.[1] Here, each cash flow is separately discounted at the same rate as a zero-
coupon bond corresponding to the coupon date, and of equivalent credit worthiness (if
possible, from the same issuer as the bond being valued, or if not, with the appropriate
credit spread).
Under this approach, the bond price should reflect its "arbitrage-free" price, as any
deviation from this price will be exploited and the bond will then quickly reprice to its
correct level. Here, we apply the rational pricing logic relating to "Assets with identical
cash flows". In detail: (1) the bond's coupon dates and coupon amounts are known with

7. certainty. Therefore (2) some multiple (or fraction) of zero-coupon bonds, each
corresponding to the bond's coupon dates, can be specified so as to produce identical cash
flows to the bond. Thus (3) the bond price today must be equal to the sum of each of its
cash flows discounted at the discount rate implied by the value of the corresponding
ZCB. Were this not the case, (4) the abitrageur could finance his purchase of whichever
of the bond or the sum of the various ZCBs was cheaper, by short selling the other, and
meeting his cash flow commitments using the coupons or maturing zeroes as appropriate.
Then (5) his "risk free", arbitrage profit would be the difference between the two values.
Stochastic calculus approach
When modelling a bond option, or other interest rate derivative (IRD), it is important to
recognize that future interest rates are uncertain, and therefore, the discount rate(s)
referred to above, under all three cases - i.e. whether for all coupons or for each
individual coupon - is not adequately represented by a fixed (deterministic) number. In
such cases, stochastic calculus is employed.
The following is a partial differential equation (PDE) in stochastic calculus which is
satisfied by any zero-coupon bond.
The solution to the PDE - given in [4] - is:
where is the expectation with respect to risk-neutral probabilities, and
is a random variable representing the discount rate; see also Martingale
pricing.
To actually determine the bond price, the analyst must choose the specific short rate
model to be employed. The approaches commonly used are:
• the CIR model
• the Black-Derman-Toy model
• the Hull-White model
• the HJM framework
• the Chen model.
Note that depending on the model selected, a closed-form solution may not be available,
and a lattice- or simulation-based implementation of the model in question is then
employed. See also Jamshidian's trick.

8. Clean and dirty price
Main articles: Clean price and Dirty price
When the bond is not valued precisely on a coupon date, the calculated price, using the
methods above, will incorporate accrued interest: i.e. any interest due to the owner of the
bond since the previous coupon date; see day count convention. The price of a bond
which includes this accrued interest is known as the "dirty price" (or "full price" or "all in
price" or "Cash price"). The "clean price" is the price excluding any interest that has
accrued. Clean prices are generally more stable over time than dirty prices. This is
because the dirty price will drop suddenly when the bond goes "ex interest" and the
purchaser is no longer entitled to receive the next coupon payment. In many markets, it is
market practice to quote bonds on a clean-price basis. When a purchase is settled, the
accrued interest is added to the quoted clean price to arrive at the actual amount to be
paid.
Yield and price relationships
Once the price or value has been calculated, various yields relating the price of the bond
to its coupons can then be determined.
Yield to Maturity
The yield to maturity is the discount rate which returns the market price of the bond; it is
identical to (required return) in the above equation. YTM is thus the internal rate of
return of an investment in the bond made at the observed price. Since YTM can be used
to price a bond, bond prices are often quoted in terms of YTM.
To achieve a return equal to YTM, i.e. where it is the required return on the bond, the
bond owner must:
• buy the bond at price P0,
• hold the bond until maturity, and
• redeem the bond at par.
Coupon yield
The coupon yield is simply the coupon payment (C) as a percentage of the face value (F).
Coupon yield = C / F
Coupon yield is also called nominal yield.
Current yield

9. The current yield is simply the coupon payment (C) as a percentage of the (current) bond
price (P).
Current yield =
Relationship
The concept of current yield is closely related to other bond concepts, including yield to
maturity, and coupon yield. The relationship between yield to maturity and the coupon
rate is as follows:
• When a bond sells at a discount, YTM > current yield > coupon yield.
• When a bond sells at a premium, coupon yield > current yield > YTM.
• When a bond sells at par, YTM = current yield = coupon yield
Price sensitivity
Main articles: Bond duration and Bond convexity
The sensitivity of a bond's market price to interest rate (i.e. yield) movements is
measured by its duration, and, additionally, by its convexity.
Duration is a linear measure of how the price of a bond changes in response to interest
rate changes. It is approximately equal to the percentage change in price for a given
change in yield, and may be thought of as the elasticity of the bond's price with respect to
discount rates. For example, for small interest rate changes, the duration is the
approximate percentage by which the value of the bond will fall for a 1% per annum
increase in market interest rate. So the market price of a 17-year bond with a duration of
7 would fall about 7% if the market interest rate (or more precisely the corresponding
force of interest) increased by 1% per annum.
Convexity is a measure of the "curvature" of price changes. It is needed because the price
is not a linear function of the discount rate, but rather a convex function of the discount
rate. Specifically, duration can be formulated as the first derivative of the price with
respect to the interest rate, and convexity as the second derivative (see: Bond duration
closed-form formula; Bond convexity closed-form formula). Continuing the above
example, for a more accurate estimate of sensitivity, the convexity score would be
multiplied by the square of the change in interest rate, and the result added to the value
derived by the above linear formula.
Accounting treatment
In accounting for liabilities, any bond discount or premium must be amortized over the
life of bond. A number of methods may be used for this depending on applicable

10. accounting rules. One possibility is that amortization amount in each period is calculated
from the following formula:
= amortization amount in period number "n+1"
Bond Discount or Bond Premium = =
Bond Discount or Bond Premium =
The 4 Primary Types of Bonds
There are millions of different bond issues, but there are only a few types of bonds. In
fact, the large majority of bonds fall into one of the 4 categories outlined below. As you
can see from the links in each section, we have lots of information on all the different
types of bonds here at Learn Bonds, so enjoy!
1. US Government Bonds (Treasuries)
When people talk about the US debit being over $16 trillion, what they are really saying
is the US Government has over $16 trillion worth of outstanding debt. Much of this

11. outstanding debt is in the form of bonds they have issued, called treasuries. Treasuries
are different from all other types of bonds, because they are issued by the US
government, and are therefore considered free of credit risk. For this reason, the yields of
all other types of bonds are compared to the yield on a treasury with the same maturity.
Here are some of our more popular articles on Treasury bonds.
An introduction to treasury bonds – In this article and video we talk about the different
types of treasury bonds, and how treasuries differ from other types of bonds.
Treasury Auctions 101 – Here we discuss how treasury bonds are sold after they are
issued, and how individuals can buy treasuries through the auction commission free.
Treasury inflation protected securities – TIPS are a special type of treasury bond that is
designed to protect investors from inflation. Learn more here.
The Safety of US Treasuries – With the US debt level rising at a rapid pace, some are
starting to question just how safe US Treasuries really are. Here are the facts.
2. Agency Bonds (Agencies)
Agency bonds are bonds issued by institutions that were originally created by the US
Government to perform important functions such as fostering home ownership, and
providing student loans. The primary government agencies are Fannie Mae, Freddie
Mac, Ginnie Mae and Sallie Mae. While these agencies technically operate in a similar
manner to a corporation, they are thought to be implicitly backed by the US government.
You can learn more about Agency bonds here.
3. Municipal Bonds (Munis)
State and local governments often borrow money by issuing bonds, similar to the US
Government, but on a smaller scale. Municipal bonds fund a wide variety of projects and
government functions ranging from police and fire departments to bridges and toll roads.
Municipal bonds are popular among individual investors because they provide tax
advantages that other types of bonds do not. Most municipal bonds are free from federal
income taxes. If you buy a municipal bond in the state where you reside then it is often
free from state and local income taxes as well.
Here are some of our more popular articles on Municipal Bonds:
An Introduction to Municipal Bonds – The different types of municipal bonds, how to
buy municipal bonds, what you should consider before investing and more.

12. Municipal Bond Safety - There has been lots of talk about a coming wave of defaults in
the municipal bond market, however the facts show otherwise.
5 Tips for Municipal Bond Investors – Our interview with Peter Hayes, one of the top
municipal bond fund managers in the world.
How to buy municipal bonds – If you are considering buying individual municipal bonds,
you may want to consider doing so through what is known as the retail order period.
Learn more here.
4. Corporate Bonds (Corporates)
And last but certainly not least are corporations, who often choose the bond market to
raise capital as well. A corporation can issue bonds for many reasons, including paying
dividends to shareholders, purchasing another company, funding an operating loss, or
expansion. Corporate bonds differ from other types of bonds because they are almost
always taxable at both the federal and state level. As a group, corporate bonds also have
much more credit risk than the other types of bonds outlined above.
Here are some of our more popular articles on corporate bonds.
An introduction to corporate bonds – More on how corporate bonds differ from other
types of bonds, where to find corporate bond prices, callable bonds, bond covenants and
more.
Junk Bonds – Feeling adventurous and willing to take on much more risk than with other
types of bonds for a potentially higher payout? Then junk bonds may be for you.
Corporate bond defaults – Ever wonder what happens after a corporation defaults on its
bonds? This article gives you all the details.
This lesson is part of our free guide to The Basics of Investing in Bonds. To continue to
the next lesson go here.
Financial market efficiency
From Wikipedia, the free encyclopedia
Jump to: navigation, search
It has been suggested that Efficient-market hypothesis be merged into this article
or section. (Discuss) Proposed since April 2012.
Financial markets

13. • Public market
• Exchange
• Securities
Bond market
• Bond valuation
• Corporate bond
• Fixed income
• Government bond
• High-yield debt
• Municipal bond
Stock market
• Common stock
• Preferred stock
• Registered share
• Stock
• Stock certificate
• Stock exchange
• Voting share
Derivatives market
• Credit derivative
• Futures exchange
• Hybrid security
• Securitization
Over-the-counter
• Forwards

14. • Options
• Spot market
• Swaps
Foreign exchange
• Currency
• Exchange rate
Other markets
• Commodity market
• Money market
• Reinsurance market
• Real estate market
Practical trading
• Clearing house
• Financial market participants
• Financial regulation
Finance series
• Banks and banking
• Corporate finance
• Personal finance
• Public finance
• v
• t
• e
In the 1970s Eugene Fama defined an efficient financial market as "one in which prices
always fully reflect available information”.[1]
The most common type of efficiency referred to in financial markets is the allocative
efficiency, or the efficiency of allocating resources. This includes producing the right
goods for the right people at the right price.

15. A trait of allocatively efficient financial market is that it channels funds from the ultimate
lenders to the ultimate borrowers in a way that the funds are used in the most socially
useful manner.
Contents
• 1 Market efficiency levels
• 2 Efficient Market Hypothesis (EMH)
o 2.1 Random Walk theory
 2.1.1 Evidence
 2.1.1.1 Evidence of Financial Market Efficiency
 2.1.1.2 Evidence of Financial Market In-Efficiency
• 3 Market efficiency types
• 4 Conclusion
• 5 References
• 6 Bibliography
Market efficiency levels
Eugene Fama identified three levels of market efficiency:
1. Weak-form efficiency
Prices of the securities instantly and fully reflect all information of the past prices. This
means future price movements cannot be predicted by using past prices. It is simply to
say that, past data on stock prices are of no use in predicting future stock price changes.
Everything is random. In this kind of market, should simply use a "buy-and-hold"
strategy.
2. Semi-strong efficiency
Asset prices fully reflect all of the publicly available information. Therefore, only
investors with additional inside information could have advantage on the market. Any
price anomalies are quickly found out and the stock market adjusts.
3. Strong-form efficiency
Asset prices fully reflect all of the public and inside information available. Therefore, no
one can have advantage on the market in predicting prices since there is no data that
would provide any additional value to the investors.
Efficient Market Hypothesis (EMH)

16. Fama also created the Efficient Market Hypothesis (EMH) theory, which states that in
any given time, the prices on the market already reflect all known information, and also
change fast to reflect new information.
Therefore, no one could outperform the market by using the same information that is
already available to all investors, except through luck.[2]
Random Walk theory
Another theory related to the efficient market hypothesis created by Louis Bachelier is
the “random walk” theory, which states that the prices in the financial markets evolve
randomly and are not connected, they are independent of each other.
Therefore, identifying trends or patterns of price changes in a market couldn’t be used to
predict the future value of financial instruments.
Evidence
Evidence of Financial Market Efficiency
• Predicting future asset prices is not always accurate (represents weak efficiency
form)
• Asset prices always reflect all new available information quickly (represents
semi-strong efficiency form)
• Investors can't outperform on the market often (represents strong efficiency form)
Evidence of Financial Market In-Efficiency
• January effect (repeating and predictable price movements and patterns occur on
the market)
• Stock market crashes, Asset Bubbles, and Credit Bubbles[3][4]
• Investors that often outperform on the market such as Warren Buffett,[5]
institutional investors, and corporations trading in their own stock[6]
• Certain consumer credit market prices don't adjust to legal changes that affect
future losses [7]
Market efficiency types
James Tobin identified four efficiency types that could be present in a financial market:[8]
1. Information arbitrage efficiency

17. Asset prices fully reflect all of the privately available information (the least demanding
requirement for efficient market, since arbitrage includes realizable, risk free
transactions)
Arbitrage involves taking advantage of price similarities of financial instruments between
2 or more markets by trading to generate losses.
It involves only risk-free transactions and the information used for trading is obtained at
no cost. Therefore, the profit opportunities are not fully exploited, and it can be said that
arbitrage is a result of market inefficiency.
This reflects the weak-information efficiency model.
2. Fundamental valuation efficiency
Asset prices reflect the expected past flows of payments associated with holding the
assets (profit forecasts are correct, they attract investors)
Fundamental valuation involves lower risks and less profit opportunities. It refers to the
accuracy of the predicted return on the investment.
Financial markets are characterized by predictability and inconsistent misalignments that
force the prices to always deviate from their fundamental valuations.
This reflects the semi-strong information efficiency model.
3. Full insurance efficiency
It ensures the continuous delivery of goods and services in all contingencies.
4. Functional/Operational efficiency
The products and services available at the financial markets are provided for the least cost
and are directly useful to the participants.
Every financial market will contain a unique mixture of the identified efficiency
types.
Conclusion
Financial market efficiency is an important topic in the world of Finance. While most
financiers believe the markets are neither 100% efficient, nor 100% inefficient, many
disagree where on the efficiency line the world's markets fall.
It can be concluded that in reality a financial market can’t be considered to be extremely
efficient, or completely inefficient.

18. The financial markets are a mixture of both, sometimes the market will provide fair
returns on the investment for everyone, while at other times certain investors will
generate above average returns on their investment.
MARKET EFFICIENCY - DEFINITION AND TESTS
What is an efficient market?
• Efficient market is one where the market price is an unbiased estimate of the true
value of the investment.
• Implicit in this derivation are several key concepts -
(a) Market efficiency does not require that the market price be equal to true value at
every point in time. All it requires is that errors in the market price be unbiased, i.e., that
prices can be greater than or less than true value, as long as these deviations are random.
(b) The fact that the deviations from true value are random implies, in a rough sense, that
there is an equal chance that stocks are under or over valued at any point in time, and
that these deviations are uncorrelated with any observable variable. For instance, in an
efficient market, stocks with lower PE ratios should be no more or less likely to under
valued than stocks with high PE ratios.
(c) If the deviations of market price from true value are random, it follows that no group
of investors should be able to consistently find under or over valued stocks using any
investment strategy.
Market Efficiency for Investor Groups
• Definitions of market efficiency have to be specific not only about the market that
is being considered but also the investor group that is covered.
o It is extremely unlikely that all markets are efficient to all investors, but it
is entirely possible that a particular market (for instance, the New York
Stock Exchange) is efficient with respect to the average investor.
o It is also possible that some markets are efficient while others are not,
and that a market is efficient with respect to some investors and not to
others. This is a direct consequence of differential tax rates and
transactions costs, which confer advantages on some investors relative to
others.
• Definitions of market efficiency are also linked up with assumptions about what
information is available to investors and reflected in the price. For instance, a
strict definition of market efficiency that assumes that all information, public as
well as private, is reflected in market prices would imply that even investors with
precise inside information will be unable to beat the market.
Classifications

19. • Strong versus Weak Form Efficiency:
- Under weak form efficiency, the current price reflects the information contained in all
past prices, suggesting that charts and technical analyses that use past prices alone would
not be useful in finding under valued stocks.
- Under semi-strong form efficiency, the current price reflects the information contained
not only in past prices but all public information (including financial statements and
news reports) and no approach that was predicated on using and massaging this
information would be useful in finding under valued stocks.
- Under strong form efficiency, the current price reflects all information, public as well
as private, and no investors will be able to consistently find under valued stocks.
Implications of market efficiency
• An immediate and direct implication of an efficient market is that no group of
investors should be able to consistently beat the market using a common
investment strategy.
• An efficient market would also carry very negative implications for many
investment strategies and actions that are taken for granted -
(a) In an efficient market, equity research and valuation would be a costly task that
provided no benefits. The odds of finding an undervalued stock should be random
(50/50). At best, the benefits from information collection and equity research would
cover the costs of doing the research.
(b) In an efficient market, a strategy of randomly diversifying across stocks or
indexing to the market, carrying little or no information cost and minimal execution
costs, would be superior to any other strategy, that created larger information and
execution costs. There would be no value added by portfolio managers and investment
strategists.
(c) In an efficient market, a strategy of minimizing trading, i.e., creating a portfolio and
not trading unless cash was needed, would be superior to a strategy that required frequent
trading.
What market efficiency does not imply:
An efficient market does not imply that -
(a) stock prices cannot deviate from true value; in fact, there can be large deviations
from true value. The only requirement is that the deviations be random.

20. (b) no investor will 'beat' the market in any time period. To the contrary,
approximately half of all investors, prior to transactions costs, should beat the market in
any period.
(c) no group of investors will beat the market in the long term. Given the number of
investors in financial markets, the laws of probability would suggest that a fairly large
number are going to beat the market consistently over long periods, not because of their
investment strategies but because they are lucky. It would not, however, be consistent if a
disproportionately large number of these investors used the same investment strategy.
• In an efficient market, the expected returns from any investment will be
consistent with the risk of that investment over the long term, though there may
be deviations from these expected returns in the short term.
Necessary conditions for market efficiency
• Markets do not become efficient automatically. It is the actions of investors,
sensing bargains and putting into effect schemes to beat the market, that make
markets efficient.
• The necessary conditions for a market inefficiency to be eliminated are as
follows -
(1) The market inefficiency should provide the basis for a scheme to beat the market and
earn excess returns. For this to hold true -
(a) The asset (or assets) which is the source of the inefficiency has to be traded.
(b) The transactions costs of executing the scheme have to be smaller than the expected
profits from the scheme.
(2) There should be profit maximizing investors who
(a) recognize the 'potential for excess return'
(b) can replicate the beat the market scheme that earns the excess return
(c) have the resources to trade on the stock until the inefficiency disappears
Efficient Markets and Profit-seeking investors: The Internal Contradiction
• There is an internal contradiction in claiming that there is no possibility of
beating the market in an efficient market and then requiring profit-maximizing
investors to constantly seek out ways of beating the market and thus making it
efficient.
• If markets were, in fact, efficient, investors would stop looking for
inefficiencies, which would lead to markets becoming inefficient again.

21. • It makes sense to think about an efficient market as a self-correcting mechanism,
where inefficiencies appear at regular intervals but disappear almost
instantaneously as investors find them and trade on them.
Propositions about market efficiency
Proposition 1: The probability of finding inefficiencies in an asset market decreases as
the ease of trading on the asset increases. To the extent that investors have difficulty
trading on a stock, either because open markets do not exist or there are significant
barriers to trading, inefficiencies in pricing can continue for long periods.
• Example:
• Stocks versus real estate
• NYSE vs NASDAQ
Proposition 2: The probability of finding an inefficiency in an asset market
increases as the transactions and information cost of exploiting the inefficiency
increases. The cost of collecting information and trading varies widely across markets
and even across investments in the same markets. As these costs increase, it pays less and
less to try to exploit these inefficiencies.
Example:
Initial Public Offerings: IPOs supposedly make excess returns, on average.
Emerging Market Stocks: Do they make excess returns?
Investing in 'loser' stocks, i.e., stocks that have done very badly in some prior time
period should yields excess returns. Transactions costs are likely to be much higher for
these stocks since-
(a) they then to be low priced stocks, leading to higher brokerage commissions and
expenses
(b) the bid-ask becomes a much higher fraction of the total price paid.
(c) trading is often thin on these stocks, and small trades can cause prices to move.
Corollary 1: Investors who can estabish a cost advantage (either in information
collection or transactions costs) will be more able to exploit small inefficiencies than
other investors who do not possess this advantage.

22. • Example: Block trades effect on stock prices & specialists on the Floor of the
Exchange
• Establishing a cost advantage, especially in relation to information, may be
able to generate excess returns on the basis of these advantages. Thus a John
Templeton, who started investing in Japanese and othe Asian markets well before
other portfolio managers, might have been able to exploit the informational
advantages he had over his peers to make excess returns on his portfolio.
Proposition 3: The speed with which an inefficiency is resolved will be directly
related to how easily the scheme to exploit the ineffficiency can be replicated by
other investors. The ease with which a scheme can be replicated itselft is inversely
related to the time, resouces and information needed to execute it. Since very few
investors single-handedly possess the resources to eliminate an inefficiency through
trading, it is much more likely that an inefficiency will disappear quickly if the scheme
used to exploit the inefficiency is transparent and can be copied by other investors.
• Example: Investing on stock splits versus Index Arbitrage