One of the big issues in the current crisis is how much the mortgage-backed securities and securitized assets more generally, are worth, since the market does did not seem to price them correctly for long period of time. If markets are efficient, market prices can be trusted as they reflect asset fundamentals correctly. The basic idea behind market efficiency is that if something becomes under-priced, there is a profit opportunity. Investors can buy the under-priced security and make a profit. That incentive provides the arbitrage mechanism to make sure that prices rise to the correct level. In the crisis this mechanism appears to have broken down. In particular, it seems that there were limits to arbitrage. A good example is what happened in the fall of 2007. The prices of the mortgage –backed securities went down. Some investment banks and hedge funds thought the securities were cheap and bought more. But the problem was that the prices kept on going down and this caused difficulties for many investors”. Source: Allen, F. and Carletti E. (2009, p.17), ‘An Overview of the Crisis: Causes, Consequences and Solutions’, paper presented at the Conference on Global Market Integration and Financial Crises at HKUST July, pp.1- 45. (Another variant of this paper is available at: Allen, F. and E. Carletti, (2010), ‘An Overview of the Crisis: Causes, Consequences and Solutions’, International Review of Finance, 10 (1): 1-26). Required: Read, consider, and explain the key issues in the above paragraph in light of market efficiency and arbitrage with suitable graphs. (Maximum word limit 1000 words). Students must cite at least three reviewed journal papers in their answers.
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