3-Milestones Page 85 Wednesday, February 4, 2004 12:47 PM
Milestones in Financial Modeling and Investment Management 85ferent markets. Absence of arbitrage is the fundamental principle for rel-
ative asset pricing; it is the pillar on which derivative pricing rests.EFFICIENT MARKETS: FAMA AND SAMUELSON
Absence of arbitrage entails market efficiency. Shortly after the Modigliani-
Miller theorems had been established, Paul Samuelson in 1965^14 and
Eugene Fama in 1970^15 developed the notion of efficient markets: A
market is efficient if prices reflect all available information. Bachelier
had argued that prices in a competitive market should be random condi-
tionally to the present state of affairs. Fama and Samuelson put this
concept into a theoretical framework, linking prices to information.
As explained in the previous chapter, in general, an efficient market
refers to a market where prices at all times fully reflect all available infor-
mation that is relevant to the valuation of securities. That is, relevant infor-
mation about the security is quickly impounded into the price of securities.
Fama and Samuelson define “fully reflects” in terms of the expected
return from holding a security. The expected return over some holding
period is equal to expected cash distributions plus the expected price
change, all divided by the initial price. The price formation process
defined by Fama and Samuelson is that the expected return one period
from now is a stochastic variable that already takes into account the “rel-
evant” information set. They argued that in a market where information
is shared by all market participants, prices should fluctuate randomly.
A price-efficient market has implications for the investment strategy
that investors may wish to pursue. In an active strategy, investors seek
to capitalize on what they perceive to be the mispricing of financial
instruments (cash instruments or derivative instruments). In a market
that is price efficient, active strategies will not consistently generate a
return after taking into consideration transaction costs and the risks
associated with a strategy that is greater than simply buying and hold-
ing securities. This has lead investors in certain sectors of the capital
market where empirical evidence suggests the sector is price efficient to
pursue a strategy of indexing, which simply seeks to match the perfor-
mance of some financial index. However Samuelson was careful to
remark that the notion of efficient markets does not make investment
analysis useless; rather, it is a condition for efficient markets.(^14) Paul A. Samuelson, “Proof the Properly Anticipated Prices Fluctuate Randomly,”
Industrial Management Review (Spring 1965), pp. 41–50.
(^15) Eugene F. Fama, “The Behavior of Stock Market Prices,” Journal of Business (Jan -
uary 1965), pp. 34–105.