BFN3104

Capital Market Efficiency

Questions
1.

How can arbitrage be used to define a perfect market?

A perfect market can be defined as a market in which there are never arbitrage
opportunities.

2.

What conditions must hold for a perfect market to exist?

A perfect capital market must have no barriers to entry, perfect competition, infinitely
divisible financial assets, no transaction or bankruptcy costs, free and fully available
information, no tax asymmetries, and no government restrictions on trading.

3.

What does the term collective wisdom mean?

Collective wisdom is the combination of all opinions regarding the value of a
security. This net opinion resulting from competition is more accurate than any single
valuation.

4.

What is value additivity?

Value additivity means that the value of a group asset equals the value of them sum of
each individual asset.

5.

What is asymmetric information?

Asymmetric information is information that is known by few participants in a
transaction or market but not by the public.

6.

Explain how similarity of assets contributes to the efficiency of the capital

markets.
The similarity of assets contributes to the efficiency of capital markets because
investors are indifferent to which securities they hold and base their decisions only on
the risk and return of a security. This makes markets efficient because the prices of
securities adjust so that they all offered a better risk-return tradeoff. If one security
offered a better risk-return tradeoff than another, investors would buy that security
causing the price to rise and the expected return to fall.

7.

Two firms both announce 20% earnings increases. One firms stock increases
substantially and the other firms stock is basically unchanged. Why did the market
react differently to these announcements.
The market reacted differently to the announcements because one was expected and
one was unexpected, and prices are made on expectations. The investors of the firm
that remained unchanged were expecting the firm that remained unchanged were
expecting the firm to have a 20% increase in earning, causing the price of the
securities to be fairly valued at the time of the announcement. Investors of the firm

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with rising stock were not expecting the firms earnings to increase, and thus
reevaluated the value of the stock after the earnings announcement.

Problems
1.

Which of the following transactions would allow you to make arbitrage profits?
a. You can buy 15,000 shares of Denver Crude Drilling Company for $2.125 per
share in New York and sell them for $2.625 in Atlanta. Transaction costs will be
$0.25.
Arbitrage Profit = Sales Prices Purchases Price Transactions costs
Arbitrage Profit = $0.25 per share
Arbitrage Profit = $0.25 per share * 15000 shares = $3750
b. You can buy a used single-engine plane in Phoenix for $135,000 and fly to
Vancouver and sell it for $148,000. Transaction, licensing, and shipping costs
total $18,000.
Arbitrage Profit = $148000 - $135000 - $18000 = -$5000
c. You can buy a Tuscarora General Obligation bond for $1,050 from an
acquaintance and sell it for $1,065 to a municipal bond dealer. Commissions will
be $20.
Arbitrage profit = $1065 - $1050 - $20 = -$5
Overall: Opportunity A allows an arbitrage profit.

2.

You can purchase Nestle stock in London for $35 per share and sell it in New
York for $35.875 per share.
a. If transaction costs are $0.50 per share, can you earn an arbitrage profit on
trading Nestle shares?
Arbitrage profit = $35.875 - $35 - $0.50 = $0.375 per share
b. What is the largest transaction cost you could absorb with these Nestle
share prices and still make a profit?
Arbitrage Profit = Sales Prices Purchases Price Transactions costs
0 = $35.875 - $35 - Transactions costs
Transactions costs = $0.875 per share
Conclusion: Any transaction cost less than $0.875 per share will allow an
arbitrage profit.

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