Financial Theory and Cooperate Policy

Financial Theory and Cooperate Policy

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Question 10.1

This is a martingale because it is a fair game.

Question 10.5

Efficient market hypothesis does not state that arbitrageurs cannot generate profits. It is, however, vital that we ignore their accounting profits but focus on the net economic profits.

Economic profits = gross profits – opportunity costs

The costs comprise of fair return rate on human capital and physical capital and the expenses incurred while gathering information. The hypothesis in question requires that net expected economic profits should equal zero at the margin. Should the arbitrages have the ability to generate net positive economic profits consistently and in a long-term then many investors would have ventured into the arbitrage business till such a situation is close to impossible to occur.

Question 10.6

The poker game is a martingale since the knowledge of the previous games does not assist in the prediction of future winning’s mean value. The player doubles his stakes every time he loses and since he or she has a 17% chance of winning, he or she will recover his or her stakes in one win. It is, therefore, a fair game since gamblers with infinite wealth will gain amidst suffering catastrophic losses.

Yes, this implies that the options market is not a fair game since the investor only has 20% chance of generating profits from their investments.

Question 10.8

Excess profits tax is a special tax which is charged when a business entity earns income which is beyond a certain amount. They are imposed on some of the entities during certain emergencies such as war or when the business’ income surpasses a particular return amount on the capital invested. Its effect on the investor is reduced amount of return on their investment. This consequently kills the incentive for the investor to expand their current businesses or continue to invest in the particular current that imposes the tax.

Reference

Financial Theory and Corporate Policy, Copeland, Weston, Shastri, 4th Edition, 2005,Chapter 10