CFA CFA Level 1 Equity – Market Efficiency

Equity – Market Efficiency

  • This topic has 5 replies, 5 voices, and was last updated Apr-17 by Swift.
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      Found this question during my practice exam. Didn’t understand Schweser’s answer.

      Q. Under which of the following conditions are market values of securities most likely to be persistently greater than their intrinsic values?

      A. Short selling is restricted
      B. Transaction costs are high
      C. Arbitrage trading is restricted.

      Correct Answer is A because: Restrictions on short sales remove some of the selling pressure on overvalued securities that would otherwise drive their market values down toward their intrinsic values in an efficient market. Market inefficiency caused by high transaction costs or restrictions on arbitrage trading may allow market values that are different from intrinsic values to persist both for overvalued and undervalued securities.

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      First realize that the question is asking what causes market values to be persistently greater than their intrinsic value. This is the key to the question.

      High transaction costs do cause market prices to differ from the intrinsic value but high transaction costs do not cause prices to be persistently greater than their intrinsic value. High transaction costs can cause the security to be overvalued or undervalued so b isn’t the correct answer.

      Option c is wrong for the same reason as stated above. While restrictions on arbitrage prices do cause markets to be inefficient. A restriction on arbitrage means that overvalued securities will not be able to reach equilibrium and undervalued securities will be unable to reach equilibrium.

      Short-selling is a downward pressure and generally cause securities prices to fall. Therefore without short-selling prices will be higher than their intrinsic value.

      Think of when there are crisis and regulators want to prevent a massive decline in the security market they put restriction on short-selling to prop up prices because they are restricting a downward pressure on prices.

      If this is still confusing think of the the problems you have done regarding futures/forwards arbitrage. You can make a profit regardless if the security is overvalued/undervalued. Arbitrage in general brings prices into equilibrium and apply upward and downward pressure. The question is only interested in what causes downward pressure.

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      Got it @lulu123 and @Diya! Thanks a bunch! 🙂

    • Up

      Excellent answers @lulu123 and @diya!

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      what they’re basically saying is that if you are allowed to short sell, then you would do it when a price is too high (overvalued) in order to benefit from a decline in price later on

      however, if short selling is prohibited, then when price is too high, you cannot short sell and thus the price of the underlying security does not rebalance at a lower “correct” price (true value of the security)

      (the price would drop and become closer to the true intrinsic value of the security because when people are short selling, its like people getting rid of the security which drives the price down;

      conversely, if people are buying something: demand up –> price pushed up)

      therefore, the security can stay overvalued = price higher than intrinsic value of the security

      does this make sense?

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      I didn’t like this question either. I think the “persistently” bit is misleading but I guess they get around that by asking which answer is “most likely” to be correct.

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