This is one of the topics that is, as I very quickly suggested before at the very basic level of modern financial theories, one of the bedrocks of modern financial theory. A lot of the results that we actually take for granted and that we discuss on a daily basis are based on the idea of market efficiency. We think about market efficiency, it's something that most people tend to think about that applies to portfolio management, which it does in a very deep way, but it also has implications for corporate finance. We tend to think about Corporate/corporation companies and of course that is true, but remember that companies need to make investments. Investments require capital and capital is provided by investors, so investors cannot be out of the picture in corporate finance. We need to deal with them, we need to know how they think, we need to know how they would react to the different policies that companies are implementing over time. Although it is in a way, race, return, and diversification, it seems to be more of an investments related topic. It is also very much related to a corporate finance. I always tend to think that when we talk about market efficiency, we have three very important challenges. Challenge number 1 is to understand the importance of the topic, and this is not always done or at least not always done properly. Number 2 is to understand the implications, and these are critical. There's many implications, particularly for investors, but also for companies too. Number 3, we need to understand that although this may sound theoretical or even philosophical, this is a very practical issue. I will strive to show you the applications and some of the very applied parts of market efficiency. Having said that, let me start with a definition. I don't like to call this a definition, but yes I like to start with what market efficiency is related to. It's basically related to two ideas. One is the idea of the relationship between price and value. Notice here that I'm putting market price equals intrinsic value. I put that in quotations because I don't want you to think of that as a formula. It is not a mathematical formula in any way. It basically says that there is something that is objective and observable, that is the market price, and there's something that is subjective and not necessarily observable, which is the intrinsic value. There's a fundamental difference between these two. A price is a number that you see on a trading screen, and that number is observable because we can see that number, but it's objective because again, you can like it or not, you can think is too high or too low, but that number will remain that particular number there. It's objective, it's observable, that's the market price. That's pretty much the opposite from what intrinsic value is. Intrinsic value is an opinion of what someone thinks that may be the value of that company. Your thoughts and my thoughts and the thoughts of different people may be different in terms of what is the intrinsic value of that. You may think that a company is trading at a very high price or at a very low price because your idea of intrinsic value doesn't match, doesn't coincide with the market price. Whenever there's a difference between what a company is trading for and the real, the actual value of that company as if that number existed, as if we all agreed. What is that intrinsic value when these two things are equally to one of the ways to think about market efficiency? That markets properly reflect the underlying, the intrinsic value of a company. Again, different people may have different ideas, different views of what that intrinsic value is, but let's suppose that there's a right one out there. Well, that one is the one that needs to match the market price. Now, there's a lot of ways in which we could see this. One of those is, let me show you a very quick example. This is an article that as you see there, it says that Bayer, the company, actually lost a judgment in court, and that implies that they may have to pay a lot of money to a lot of people. Well, as you see there, the market reaction to this, is on the very same day that we learned about this information, the market price of Bayer goes down almost 10 percent. Now, the idea here is something, quote and quote, bad happens to Bayer that is going to cause the money, and basically that needs to be reflected into the market price, which is done very quickly. We can argue endlessly whether 9.6 or minus 9.6 is actually the right reaction. Should it have been higher, should it have been lower? But of course it's a quick reaction and in the right direction, and that is what an efficient market is all about. If that is the right amount, minus 9.6 percent even better, but that is a non-testable part, meaning that you can I have these agreements about how much the price should have gone down, but we probably shouldn't discuss too much whether the price should have gone down. We agree that if this bad thing happened by Bayer, then it's going to cost them money and the price should actually go down. Market efficiency, that's not a textbook example, but it's an example of what it is about. The more quickly and the more accurately market prices tend to reflect fundamental information, then the more efficient markets tend to be. Now the second part of the definition, it is very much related to price predictability. We tend to think that when markets are efficient, you have no ability to forecast market prices, and I'm going to add something very important, consistently over time. Because you can always get lucky and think that stock is going to shut up 5 percent tomorrow or 10 percent tomorrow, and you may get it right. The question is, can you do it over, and over, and over, and over again? That part, consistently over time is very important. We tend to think that when markets are efficient, you don't have that consistent ability to forecast market prices for a very simple reason. Everything we know about a company, if all the fundamental information is already impounded on the price, then anything that happens from this point on is the reaction to new information. But if that new information is unpredictable and we don't know when it's going to arrive, well, that make prices unpredictable too. If everything that we know, if everything that is relevant is reflected in the price, whatever is going to happen between today and tomorrow, between today and next week, is something that we didn't expect today, that we didn't know today, and therefore, it was not impounded in the price. There's always these two aspects of market efficiency. One is the idea between price and fundamental value, and the other is the idea that if that equality, if you will, is correct, then that make prices unforecastable, at least in a way that is consistent over time. That you can be successful once or twice or maybe a few times, but you cannot do it over, and over, and over, and yet over again. Now, it's important that if you really think about these two characteristics of market efficiency, the first implies the second. It is because markets tend to reflect all that information that then prices become unpredictable, but two does not imply one, meaning prices could be unforecastable. It could be very difficult to forecast them consistently over time, but it doesn't have to be necessarily because prices reflect all that information, meaning that if you had completely rational people in the market, you wouldn't be able to forecast prices. But not because markets are efficient, simply because markets would be completely irrational. It is important that when you think about these two aspects of market efficiency, the first implies the second, but the second does not necessarily imply the first. These are the two ideas that we're going to keep in mind throughout the rest of the session. The equality, if you will, not in a mathematical sense, but in ideological sense between price and intrinsic value, or fundamental value and the impossibility of forecasting prices consistently and successfully overtime.
