Considering three different forms or levels of market efficiency. Refer to the o
ID: 1250599 • Letter: C
Question
Considering three different forms or levels of market efficiency. Refer to the oppropriate forms of market efficiency in answering the following questions:a) Why is insider trading illegal?
b) Why and how do small investors benefit from efficient markets?
c) If you were a stock trader and markets were not efficient, how would this influence your trading activity? What does this tell you about why markets may be efficient?
d) Consider the case of a day trader who looks only at the past history of stock prices in conducting his or her trades. How likely would it be for such a person to beat the market? What does this suggest about investing in the "entire market" (such as by purchasing shares in an index fund) rather than attempting to pick individual stocks?
Explanation / Answer
a) Insider trading is illegal because those types of trades involve parties where both sides do NOT have equal information about what they are buying and selling and if they both did, the price of the security in the market would likely be different. b) Small investors benefit from efficient markets because it provides them with the knowledge that when they go to the market to buy a security the price it trades for reflects all relevant information regarding its value. c) If the markets were not semi-strong or strong efficient, then I would likely refrain from buying securities UNLESS I myself had inside information. If I knew people were trading a security with material information regarding its value that I did not know myself, I would likely not trust the participants. d) In order to 'beat' the market as a day trader using charts, one would have to assume that markets were all less than weak form efficient, which is the lowest of the three. Weak form states that no one can derive future stock movements based on previous prices. It is VERY unlikely for someone using this technique to beat the market. If you believe that the market is either weak form, semi-strong or strong in its efficiency, it is pointless to pick certain stocks or securities and it would just be best to own an index fund that tracks the overall market. Hope this helps!