25556 Chap.5 Market Prices, Volatility and Market Risk
Market Prices, Volatility and Market Risk
Once securities trade, their prices move every day, and the second half of Topic 2 asks why. The starting point is the efficient markets hypothesis, which says prices absorb relevant information so quickly that they sit at fair value and wander randomly as news arrives.
Its weak, semi-strong and strong forms differ only in how much information prices are assumed to contain.
The chapter then tests that idea against what markets actually do: size and value anomalies, January effects, bull and bear runs that outpace profits, and bubbles that end in sharp corrections. Behavioural finance offers explanations through biases such as anchoring, confirmation, overconfidence and self-attribution.
It ends with volatility, measured by variance or standard deviation, and with why a variable that moves at random exposes investors to market risk while also offering higher potential returns.
What this chapter covers
- 01
The efficient markets hypothesis and its three forms
- 02
Fair value and the random walk of prices
- 03
Anomalies, bull markets and bear markets
- 04
Price bubbles measured against fair value
- 05
Behavioural biases in investor decisions
- 06
Volatility, standard deviation and market risk
Worked example · free
Measure a price bubble against fair value for an avocado grower's shares
- 1Fair value: month 6 is 10.00 × 1.01 to the power 6 = $10.62; month 9 is 10.00 × 1.01 to the power 9 = $10.94.
- 1Peak premium: 16.00 ÷ 10.615 − 1 = 0.507, so the market price was about 50.7% above fair value.
- 1Correction: 10.60 ÷ 16.00 − 1 = −0.3375, a fall of 33.75% from the peak in three months.
- 1Month 9: 10.60 ÷ 10.937 − 1 = −0.031, so the price has overshot to about 3.1% below fair value.
Key terms
- Efficient markets hypothesis
- The proposition that security prices already reflect the information relevant to their value.
- Fair value
- A price at which neither the buyer nor the seller of an asset is consistently favoured.
- Random walk
- A price path whose next step is equally likely to go up or down, whatever the last step was.
- Price bubble
- A period when prices climb above fair value on excessive optimism and are then corrected sharply.
- Volatility
- How widely a variable moves around its average, usually measured by variance or standard deviation.
- Anchoring
- A bias in which a decision leans too heavily on an irrelevant reference figure.
Market Prices, Volatility and Market Risk FAQ
What are the three forms of market efficiency?
Weak-form efficiency means prices already contain the information in past prices. Semi-strong efficiency adds all public information, so only private inside information could still give an edge. Strong-form efficiency means prices contain every price-sensitive fact, so no kind of information can be used to earn returns above those that the risk taken justifies.
Why do share prices follow a random walk?
Prices move when new information changes fair value, and that information arrives unpredictably. Because traders act quickly, the price adjusts almost at once, so the next move is as likely to be down as up. Predictable patterns would be traded away by informed traders before they could be exploited.
Can bubbles exist if markets are efficient?
The EMH implies prices should stay close to fair value, yet history shows prices sometimes run far above it and then collapse, as in the dot-com boom. Bubbles, anomalies and long bull and bear runs are evidence that markets are not always efficient, often because sentiment and biases distort expectations.
How is volatility related to risk?
Volatility measures how much a variable swings around its average. Because those swings are random and cannot be forecast consistently, they expose investors to losses, which is market risk. More volatile assets are riskier, but they also offer the possibility of higher returns, so volatility on its own is not a reason to avoid an asset.
What is an abnormal return?
It is the part of a return that is not explained by the risk taken: the actual return minus the return expected for that level of risk. Under the efficient markets hypothesis, traders using information already reflected in prices should earn abnormal returns that average zero over time.
Exam move
Make a three-row table for the forms of efficiency, listing the information each one assumes prices contain and the kind of information that could still earn an edge, then test yourself with short scenarios about chart reading, public news and inside tips. Practise the bubble arithmetic by growing a fair value month by month and comparing it with a price path you invent.
Compute a standard deviation by hand from five or six returns at least twice, writing each squared deviation, so the steps become automatic. For behavioural finance, invent one fresh example of each of the four biases rather than memorising the workshop's cases.
Working through Market Prices, Volatility and Market Risk in 25556? Sia is AskSia’s AI Finance tutor — ask any 25556 Market Prices, Volatility and Market Risk question and get a clear, step-by-step explanation grounded in how 25556 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
