On risk, rational expectations, and efficient asset markets
The notion of asset market efficiency -- that market prices "fully reflect" all available information -- requires the operation of mechanisms that rapidly incorporate new information into asset prices. Particularly problematic -- both theoretically and empirically -- has been the case where new information is not widely shared, so-called "strong-form" efficiency. This paper examines the relevance of a mechanism for attaining strong-form efficiency based on knowledgeable investors being willing to take large positions in order to eliminate unexploited profit opportunities. We examine theoretically and empirically, the latter using daily stock market data, the impact of a number of factors on the efficacy of this mechanism: the portfolio size and degree of risk aversion of potential investors, the ability to borrow, and the hedging opportunities provided by the stock market.
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