Capital Market Efficiency - Essay Sample

An efficient capital market is a situation whereby the current prices for a certain asset are fair when considering the prevailing market conditions. A market is said to be efficient if it mirrors all the information presented to market participants and investors at any given time. According to the efficient market hypothesis, all stocks are ideally priced in accordance to their intrinsic investment properties. All participants in the market should possess this knowledge in equal measures. This essay looks at the three forms of market efficiency, the behavioral challenges encountered in achieving efficiency, and its effects on corporate finance. It will also look at whether or not real estate should be considered an efficient capital market.

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The three forms of market efficiency are weak, semi-strong, and strong. The weak form suggests that all new public and private information may or may not be available to market participants, and that historical price information is the only one accessible. It suggests that not all information is included in the current stock price. This form is used to argue against technical analysis, implying that previous price performance does not necessarily offer a predictive power on a certain assets future price.

The semi-strong form of market efficiency suggests that public information concerning a certain business organization is available to market participants together with the historical price data accessible in the weak form. This information is included in the current stock price. As soon as information is available to the public, investors immediately price the asset in a way that reflects the new information. This form is used to argue against fundamental analysis, implying that any information made public does not present predictive power on the future price of an asset.

The strong market efficiency form suggests that non-public insider information can also be factored into the current stock price together with the knowledge in the semi-strong and weak forms. The information may only be available to corporate directors and not known to investors. Nonetheless, the current price of stock still mirrors it. Consequently, price prediction cannot be boosted by even the knowledge of insider information.

There are certain behavioral challenges when it comes to achieving market efficiency. For one, the efficient market hypothesis (EMH) operates under the assumption that all investors recognize all available information in exactly the same way. The various methods used to analyze and value stock present some problems for EMHs validity. Since market participants value stocks differently, it becomes difficult to ascertain what a commodity should be priced in an efficient market. Also, the EMH assumes that, since investors have equal access to information, they can only attain identical results. According to the hypothesis, if one investor makes a profit, then all the other investors will be profitable. This cannot be the case in reality.

Capital market efficiency does affect corporate finance in several ways. The decisions resulting from technical analysis are based on past results. However, EMH states that previous results cannot be used to predict future trends in the market. Hence, the hypothesis does not recognize the application of technical analysis as a way of generating investment returns. In my own opinion, real estate is not an efficient market. This is because the efficient market hypothesis operates under the assumption that all buyers and sellers have equal access to information. The hypothesis simply does not apply to the real estate sector. Thus, it is possible to quickly buy and sell properties and make a lucrative profit.

References

Kristoufek, L., & Vosvrda, M. (2013). Measuring capital market efficiency: Global and local correlations structure. Physica A: Statistical Mechanics and its Applications, 392(1), 184-193.