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Current prices are set so that the optimal forecast of RET equals
the equilibrium RET.
Efficient Markets Theory:
Example
• Assume you own a stock that has an
equilibrium return of 10%.
• Also assume that the price of this stock has
fallen such that the return currently is 50%.
– Demand for this stock would rise, pushing its
price up, and yield down.
Efficient Markets: Theory
• If RETof > RETeq, demand for the asset rises
and the current price of the asset rises,
causing RETof to fall until it equals RETeq.
• RETeq < RETof = (Poft+1 – Pt) Pt up RETof
down Pt
Efficient Markets: Theory
• If RETof < RETeq, demand for the asset falls
and the current price of the asset falls,
causing RETof to rise until it equals RETeq.
• RETeq > RETof = (Poft+1 – Pt) Pt down
RETof up Pt
Efficient Markets: Summary
• RETof > RETeq Price rises RETof falls