FNCE90065 Chap.10 Market Efficiency, Arbitrage and Incentives
Market Efficiency, Arbitrage and Incentives
Market efficiency, arbitrage and incentives explain how information becomes action. This chapter treats price as a response to expected cash flows and required return, tests whether apparently different prices attach to truly equivalent payoffs, and analyses how rewards and control rights shape behaviour.
It avoids the false claim that an efficient market is always perfectly priced and the false claim that every price gap is risk-free arbitrage. The skill is naming the mechanism behind adjustment.
What this chapter covers
- 01
Prices respond to information about future cash flows and required return
- 02
Expected information may already be reflected before an announcement
- 03
Arbitrage requires equivalent payoffs across timing, states and currency
- 04
Trading costs, risk and constraints can explain persistent price differences
- 05
Incentive design links measured outcomes to decision-maker behaviour
- 06
Governance and monitoring address information gaps and agency conflicts
Worked example · free
Test an apparent arbitrage gap
- 1Compare payoff certainty rather than face value alone.
- 1Identify Claim B's different credit risk.
- 1Identify Claim B's different liquidity and execution constraints.
- 1Conclude that equivalent state-contingent payoffs have not been established.
Key terms
- Market efficiency
- Market efficiency describes how available information is incorporated into market prices.
- Information surprise
- Information surprise is the difference between an announcement and what market participants expected.
- Arbitrage
- Arbitrage is a set of executable positions that exploits inconsistent prices without net future risk after costs.
- Agency problem
- An agency problem arises when a decision maker's incentives differ from the interests of those providing resources.
- Governance
- Governance is the system of oversight, rights and incentives used to direct and monitor decisions.
Market Efficiency, Arbitrage and Incentives FAQ
Does market efficiency mean prices are always correct?
No. Efficiency concerns how information is incorporated and whether easy excess profits persist, not access to an observable perfect value. Prices can change when expectations about cash flows, risk or required return change. A new price is still an estimate formed under uncertainty.
When is a price gap an arbitrage?
The strategies must deliver equivalent payoffs in every relevant state, at the same dates and in the same currency, and the required positions must be executable after costs. Differences in credit risk, liquidity, tax, settlement or short-sale access can make a price gap compensation rather than arbitrage.
How do incentives affect financial decisions?
Decision makers respond to the outcomes on which rewards, careers and control depend. A narrow short-term target can encourage actions that improve the measured number while reducing long-run value. Deferred measures, broader performance indicators, monitoring and governance can align the decision horizon with owner interests.
Exam move
For efficiency questions, separate the announcement from the surprise relative to expectations and identify whether cash-flow forecasts or required return changed. For arbitrage questions, build a state-by-state payoff table and refuse the label until timing, currency, risk and execution match. For incentive questions, write actor, objective, private information, reward and likely response in a chain.
Practise replacing vague claims such as the market is wrong or managers are greedy with a specific mechanism. End each explanation with the direction of price or behaviour adjustment that the mechanism predicts. Create an event-study timeline with expected information, announcement time and price adjustment.
For each news item, ask what the market plausibly anticipated; good accounting results can coincide with a price fall when the surprise is negative. Separate evidence of rapid incorporation from a claim that every observed price equals a known intrinsic value. Build examples for weak, semi-strong and strong information sets, then state exactly which return pattern would challenge each proposition.
For arbitrage, write the acquisition and financing trades at time zero and the offsetting future payoffs by state. Check transaction costs, borrowing constraints, settlement dates, currency and counterparty exposure before declaring a riskless profit. If payoffs are only similar rather than identical, call the strategy relative-value speculation and identify the residual risk.
For incentives, draw a principal-agent chain that includes an action the principal cannot fully observe, a performance measure, a reward rule and an unintended response. Compare a sales target, accounting-profit target and long-term equity award, explaining what each measure encourages and what it neglects. Add governance or monitoring as a cost-benefit decision rather than a perfect cure.
In a final synthesis question, connect information, trading and incentives: explain how disclosure changes beliefs, how price adjustment changes financing terms and how compensation can change the manager's future action. Every conclusion should identify the actor, information change, mechanism and predicted direction. Add one counterexample where an apparent anomaly persists because implementation is costly or risky.
State why predictability alone is insufficient to establish an executable arbitrage after fees, funding constraints and timing uncertainty.
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