Information Asymmetry and Market Efficiency

Vocabulary flashcards created from lecture notes covering information asymmetry, market efficiency forms, event studies, pricing measures, and behavioral finance.

Frictionless Capital Market

An ideal market assumption where there are no taxes, transaction costs, fees, or restrictions, allowing participants to buy, sell, and borrow freely at will.

Homogeneous Expectations

The assumption in ideal capital markets that all market participants share the exact same set of information and form identical future expectations.

Information Asymmetry

A situation in financial economics where one party, such as a firm's management or insiders, possesses more or better information about a firm's true value than outside investors.

Lemons Problem

An economic model illustrating information asymmetry in which unobservable quality causes sellers of poor-quality goods (lemons) to misrepresent quality, potentially leading to market degradation or collapse.

Pooling Equilibrium

A market state under asymmetric information where low-quality sellers successfully mimic high-quality sellers, resulting in a single uniform temporary equilibrium price for all units.

Adverse Selection

A market inefficiency arising from asymmetric information before a transaction occurs, where higher-risk individuals or financially distressed firms are more likely to participate, disadvantaging the uninformed party.

Costly Signaling

An action taken by an insider, such as an entrepreneur retaining a large fraction of equity, to signal project quality to the market by incurring personal costs and losing diversification benefits.

Float

A measure of stock ownership concentration and public investor interest, defined as total shares outstanding minus shares held by insiders and other $5\text{\%}$ owners.

Turnover

A measure of public trading interest, defined as the ratio of shares traded over a specified time period (such as a year) to total shares outstanding.

Bid-Ask Spread

The percentage difference between the selling price (Ask) and buying price (Bid) set by a dealer, calculated as $\text{Spread} = \frac{\text{Ask} - \text{Bid}}{\frac{\text{Ask} + \text{Bid}}{2}}$.

Strong-Form Efficiency

A level of market efficiency where stock prices reflect all information, both public and private, making it impossible to earn abnormal returns using private information.

Semi-Strong Form Efficiency

A level of market efficiency where stock prices reflect all publicly available information, implying that fundamental analysis of financial statements cannot yield abnormal profits.

Weak-Form Efficiency

A level of market efficiency where stock prices reflect all information contained in past prices, meaning historical returns cannot be used to predict future returns.

Technical Analysis

A trading approach that attempts to predict future stock prices based on historical price data and volume patterns, which contradicts the Efficient Market Hypothesis and Random Walk theory.

Event Study

An empirical methodology based on semi-strong form market efficiency that evaluates management decisions and market pricing by measuring stock price reactions to corporate announcements.

Unexpected Surprise

The unexpected component of an announcement evaluated in event studies, defined as $\text{Surprise} = \text{Actual} - \text{Expected}$.

Behavioral Finance

An alternative view to the Efficient Market Hypothesis proposing that investor irrationality, cognitive biases, and short-term overreactions directly influence stock prices and create mispricings.

Noise Trader Risk

The risk that irrational traders push asset prices away from fundamental values for extended periods, creating mispricing and losses for arbitrageurs even when true asset values are known.

Market Model Equation

A linear regression equation used in event study methodology to calculate expected return, expressed as $R_{i,t} = \beta_i R_{m,t} + \frac{\text{d}}{\text{d}t}\beta_i + \tau_{i,t}$.

Forms of Market Efficiency Diagram

A structural representation showing the nested relationship of information subsets in the Efficient Market Hypothesis: Past Prices contained within All Publicly Available Information.

Theoretical Consequences of Information Asymmetry Table

A comparative analysis showing true firm values versus market values across pooling, partially-separating, and fully-separating equilibria for firms A through E.

Noise Trader Risk Mispricing Example

An illustration demonstrating how noise trader risk can cause an asset's price to decline from $90$ to $80$ despite a true value of $100$, producing a profit of $-10$ and an increased mispricing of $20$.