James Larson, CFA, manages a large capitalization growth mutual fund. Larson's benchmark is the Russell 1000 Growth index. Larson's colleague, Kevin Moore,
CFA, manages an index fund which mimics the Russell 1000 index. Moore believes that the capital markets are fully efficient, while Larson disagrees. Larson defends his position with the following supporting statements.
Statement 1:Market participants must be adequately compensated for processing new information to ensure the markets remain efficient. Yet a perfectly efficient market provides no incentive to sufficiently reward investors for processing new information. Hence, markets cannot be fully efficient.
Statement 2:Low trading costs have led to greater trading activity, which has had the unintended consequence of greater securities mispricing.
Are Larson's statements correct?
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A. B. C.B
Let's analyze each statement individually to determine their accuracy:
Statement 1: "Market participants must be adequately compensated for processing new information to ensure the markets remain efficient. Yet a perfectly efficient market provides no incentive to sufficiently reward investors for processing new information. Hence, markets cannot be fully efficient."
This statement argues that for markets to remain efficient, market participants must be adequately compensated for the effort and costs associated with processing new information. However, a perfectly efficient market, by definition, incorporates all available information into security prices instantaneously, leaving no opportunity for investors to profit from new information. Therefore, according to the statement, a perfectly efficient market would not provide sufficient incentives for investors to process new information.
This statement implies that markets cannot be fully efficient because they would require some level of mispricing or compensation to incentivize investors to process new information. However, this argument is not universally accepted. It is based on the assumption that market efficiency is solely defined by the absence of mispricing and that investors should always be rewarded for processing new information. Some economists and theorists argue that market efficiency can exist even if investors are not explicitly compensated for processing new information, as long as prices reflect the available information accurately. Therefore, Statement 1 is a subjective viewpoint and not universally correct.
Statement 2: "Low trading costs have led to greater trading activity, which has had the unintended consequence of greater securities mispricing."
This statement suggests that lower trading costs have resulted in increased trading activity. The argument is that greater trading activity can lead to higher instances of securities mispricing. The rationale behind this idea is that as trading activity increases, there is a higher likelihood of investor errors, speculation, or irrational behavior, which can cause mispricing.
While it is true that increased trading activity can contribute to greater instances of securities mispricing, it is not a universal outcome. Mispricing can occur for various reasons, including information asymmetry, behavioral biases, market inefficiencies, or temporary imbalances in supply and demand. It is important to note that increased trading activity does not necessarily imply mispricing in every instance.
Therefore, Statement 2 is partially correct in highlighting a potential unintended consequence of greater trading activity, but it should be considered in conjunction with other factors that can contribute to securities mispricing.
To summarize, Larson's Statement 1 is a subjective viewpoint that argues against the possibility of fully efficient markets based on the notion of investor compensation for processing new information. Statement 2 acknowledges a potential unintended consequence of increased trading activity but does not fully explain the complexities of securities mispricing. Thus, the correct answer is:
C. Only Statement 2 is correct.