Read the relevant contents regarding Stock Market Efficiency on page 46-50 of the textbook. Then read the Wall Street Journal (WSJ) Oct. 2011 Article Trader Draws Record Sentence (Link posted below). Do your own research if necessary. 20110511_Rajaratnam Guilty on All Counts in U.S. Insider-Trading Case - Bloomberg.pdf

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Discuss the following:

(1) Who is the main character in the WSJ story? Why was he convicted?

(2) Name a few the companies that are involved in Mr. Rajaratnams case.

(3) What is your opinion towards stock market efficiency? Why insider trading is illegal?

Page 46-50

Stock Market Efficiency

To begin this section, consider the following definitions:

• Market price: The current price of a stock. For example, the Internet showed that on one day, Twitters stock traded at $15.63. The market price had varied from $15.50 to $16.00 during that same day as buy and sell orders came in.

• Intrinsic value: The price at which the stock would sell if all investors had all knowable information about a stock. This concept was discussed in Chapter 1, where we saw that a stocks intrinsic value is based on its expected future cash flows and its risk. Moreover, the market price tends to fluctuate around the intrinsic value, and the intrinsic value changes over time as the company succeeds or fails with new projects, competitors enter or exit the market, and so forth. We can guess (or estimate) Twitters intrinsic value, but different analysts will reach somewhat different conclusions.

• Equilibrium price: The price that balances buy and sell orders at any given time. When a stock is in equilibrium, the price remains relatively stable until new information becomes available and causes the price to change.

• Efficient market: A market in which prices are close to intrinsic values and stocks seem to be in equilibrium.

When markets are efficient, investors can buy and sell stocks and be confident that they are getting good prices. When markets are inefficient, investors may be afraid to invest and may put their money under the pillow, which will lead to a poor allocation of capital and economic stagnation. From an economic standpoint, market efficiency is good.

Academics and financial professionals have studied the issue of market efficiency extensively. As generally happens, some people think that markets are highly efficient, some think that markets are highly inefficient, and others think that the issue is too complex for a simple answer. With this point in mind, it is interesting to note that the 2013 Nobel Prize in Economics was awarded to three distinguished scholars (Eugene Fama, Lars Hansen, and Robert Shiller) for their empirical analysis of asset prices. Professor Hansen was cited for his work in developing statistical models for testing the rationality of markets. Also, acknowledging the validity of different views in this area, the Nobel Committee saw fit to simultaneously recognize Professor Fama (a pioneer in developing efficient market theory) and Professor Shiller (a noted skeptic of market efficiency).

Those who believe that markets are efficient note that there are 100,000 or so fulltime, highly trained professional analysts and traders operating in the market. Many have PhDs in physics, chemistry, and other technical fields in addition to advanced degrees in finance. Moreover, there are fewer than 3,000 major stocks; so if each analyst followed 30 stocks (which is about right, as analysts tend to focus on a specific industry), on average, 1,000 analysts would be following each stock. Further, these analysts work for organizations such as Goldman Sachs, JPMorgan Chase, and Deutsche Bank or for Warren Buffett and other billionaire investors who have billions of dollars available to take advantage of bargains. Also, the SEC has disclosure rules that, combined with electronic information networks, means that new information about a stock is received by all analysts at about the same time, causing almost instantaneous revaluations. All of these factors help markets to be efficient and cause stock prices to move toward their intrinsic values.

However, other people point to data that suggest that markets are not very efficient. For example, on May 6, 2010, the Dow Jones Index fell nearly 1,000 points only to rebound rapidly by the end of the day. In 2000, Internet stocks rose to phenomenally high prices, and then fell to zero or close to it the following year. No truly important news was announced that could have caused either of these changes; if the market was efficient, its hard to see how such drastic changes could have occurred. Another situation that causes people to question market efficiency is the apparent ability of some analysts to consistently outperform the market over long periods. Warren Buffett comes to mind, but there are others. If markets are truly efficient, then each stocks price should be close to its intrinsic value. That would make it hard for any analyst to consistently pick stocks that outperform the market.

The diagram on the next page sums up where most observers seem to be today. There is an efficiency continuum, with the market for some companies stocks being highly efficient and the market for other stocks being highly inefficient. The key factor is the size of the companythe larger the firm, the more analysts tend to follow it and thus the faster new information is likely to be reflected in the stocks price. Also, different companies communicate better with analysts and investors, and the better the communications, the more efficient the market for the stock. In an inefficient market, it might be possible to purchase the companys stock at a low price and then be able to turn around and sell it at a higher price making a profit. This is called arbitrage.

As an investor, would you prefer to purchase a stock whose price was determined in an efficient or an inefficient market? If you thought you knew something that others didnt know, you might prefer inefficient markets. But if you thought that those physics PhDs with unlimited buying power and access to company CEOs might know more than you, you would probably prefer efficient markets, where the price you paid was likely to be the right price. From an economic standpoint, it is good to have efficient markets in which everyone is willing to participate. So the SEC and other regulatory agencies should do everything they can to encourage market efficiency.

Thus far we have been discussing the market for individual stocks. But the notion of efficiency applies to the pricing of all assets. For example, the dramatic rise and subsequent collapse of housing prices in many U.S. markets suggests that there was a lot of inefficiency in these markets. It is also important to realize that the level of market efficiency also varies over time. In one respect, we might expect that lower transactions costs and the increasing number of analysts would cause markets to become increasingly efficient over time. However, the recent housing bubble and the previous bubble for Internet stocks provides some contrary evidence. Indeed, these recent events have caused many experts to look for alternative reasons for this apparent irrational behavior. A lot of their research looks for psychologically based explanations, which we discuss in the next section.