Explore BrainMass

Market Efficiency

Discuss the following two scenarios.

Scenario 1: Is the following statement true or false? Explain.

When the 56-year-old founder of Gulf & Western, Inc. died of a heart attack, the stock price immediately jumped from $18.00 a share to $20.25, a 12.5% increase. This is evidence of market inefficiency because an efficient stock market would have anticipated his death and adjusted the price beforehand. Assume that no other information is received and the stock market as a whole does not move. Is the above statement true or false? Explain.

Scenario 2: Is the following statement true or false? Explain.

On January 10, 1985, the following announcement was made: "Early today the Justice Department reached a decision in the Universal Product Care (UPC) case. UPC has been found guilty of discriminatory practices in hiring. For the next five years, UPC must pay $2 million each year to a fund representing victims of UPC's policies." Should investors avoid buying UPC stock after the announcement because the litigation will cause an abnormally low rate of return? Assume market efficiency. Explain.

Solution Preview

Scenario 1: The above statement is false. The market may be pricing in some probability of his death, but that probability would not be close to 100%. Also, this type of risk is diversifiable risk. So an intelligent investor might be invested in a lot of other ...

Solution Summary

The solution explains the concepts of market efficiency using examples below.