An informed trader learns that a company's earnings will far exceed market expectations. She buys the stock aggressively. Before any public announcement, the stock price rises significantly. What best explains this price movement?
AOther market participants observe the order flow and price movements, update their beliefs, and trade in the same direction
BThe informed trader's large order volume triggers algorithmic buying programs that push the price up mechanically
CMarket makers, observing the informed buying, widen their spreads to signal that positive news is imminent
DThe EMH ensures prices instantly jump to the correct level the moment any informed participant begins trading
This is the microstructure mechanism of price discovery: informed trading moves prices through belief aggregation, not magic. When the informed trader buys, she pushes prices up. Other traders observe this order flow and infer that someone with private information thinks the stock is cheap — so they buy too. This cascade of updating continues until the price reflects the earnings surprise. No single participant knows the 'right' price; it emerges from aggregation. Option D (EMH as instant mechanism) confuses the equilibrium endpoint with the actual process of getting there.
Question 2 Multiple Choice
An analyst is certain that a stock worth $50 is trading at $30. He borrows heavily to buy it, expecting a large gain. Instead, the stock falls to $20 over the next few months. Which of the following best explains why this mispricing might persist and even worsen?
AThe EMH guarantees prices are correct, so the analyst's valuation must be wrong
BThe analyst faces funding risk — he may be forced to liquidate at a loss before the price corrects, even if his thesis is right
CInformed traders are already buying the stock, so additional arbitrage capital provides no further corrective pressure
DShort-selling restrictions prevent other informed traders from taking offsetting positions
This is 'limits to arbitrage' — the central reason mispricings can persist. The analyst may be right about fundamental value but wrong about timing. As the price falls from $30 to $20, he faces margin calls, investor redemptions, or exhausted borrowing capacity. He may be forced to sell at $20, crystallizing a loss, just before the price eventually corrects to $50. The risk is not informational but financial: capital constraints and the possibility of being right-but-early prevent full arbitrage. Mispricings can widen in the short run precisely when arbitrage is most constrained.
Question 3 True / False
Narrow bid-ask spreads in a market accelerate price discovery because market makers can respond more readily to informed order flow and revise their quotes toward fundamental value.
TTrue
FFalse
Answer: True
Market makers earn the spread as compensation for adverse selection risk — the risk of trading against an informed counterparty. When an informed trader hits their ask, market makers revise quotes upward (for buys) to protect themselves, transmitting information into prices through quote revision. In liquid markets with narrow spreads, this adjustment is rapid and competition among market makers keeps quotes tight and responsive. In illiquid or opaque markets with wide spreads, the quote revision process is slower and more costly, slowing price discovery.
Question 4 True / False
According to the Efficient Market Hypothesis, prices are generally exactly at their fundamental value, so no process of price discovery is necessary in an efficient market.
TTrue
FFalse
Answer: False
The EMH describes an endpoint — the state toward which efficient markets tend — not a mechanism. Even in an efficient market, prices start at the wrong level after new information arrives and must be corrected through trading. Price discovery is the process by which informed traders, arbitrageurs, and market makers drive prices toward fundamental value. The EMH says this process is fast and that residual mispricings are small and unpredictable, not that prices are always correct without any adjustment process occurring.
Question 5 Short Answer
Why can a mispricing persist even when there are informed traders who know the correct fundamental value of the asset?
Think about your answer, then reveal below.
Model answer: Correcting a mispricing requires taking and holding a large position until the market agrees with the informed trader's view — which may take time. During that interval, the mispricing can worsen, generating mark-to-market losses. Margin calls, investor redemptions, or borrowing constraints may force the trader to close the position at a loss before the correction occurs. This 'funding risk' creates a band around fundamental value within which prices can wander even in the presence of fully informed arbitrageurs.
This is the core of 'limits to arbitrage' theory (Shleifer and Vishny). Arbitrage is not riskless in practice — it requires capital, and capital faces constraints. The most perverse implication is that arbitrage is most difficult exactly when markets are most dislocated: in stressed markets, funding is scarce, positions are crowded, and the risk of being forced out before correction is highest. This explains why some of the largest mispricings persist longest, contrary to the naive prediction that big mispricings attract more capital and correct faster.