Capital Market Efficiency and Its Implication for Financial Reporting
Capital market efficiency has been a widely debated topic since the term was introduced. The efficient market hypothesis was introduced by Eugene Fama in 1970 and is one of the most important topics that is covered in financial accounting theory. There have been many papers and studies that have backed the efficiency market hypothesis. There have also been many others that have tried to show that the markets are inefficient. Are securities markets efficient or not? I believe that they are, and because they are efficient, there are multiple implications of efficient securities markets for financial reporting. In 1970, Eugene Fama introduced the efficient market hypothesis. Since there are many definitions and forms of an efficient securities market, I will focus my attention on the semi-strong form. In the semi-strong form, a market is considered efficient when security prices traded on that market at all times fully reflect all information that is publicly known about those securities. This hypothesis or theory has had many proponents for and many against it in recent years. These people have done their own studies and research on the market trying to either prove or disprove that the markets are efficient. An important statement in the definition of an efficient securities market is publically known. It focuses on the theory that the market prices are efficient and include all publicly known information. It does not rule out that some people will have inside information, and they will know more about the company than the market. Since these people know more than the market, they may be able to earn excess profits on their investments if they choose to take advantage of their inside information. While most insider trading is legal, it is illegal for insiders to trade when they trade with information that is not publicly known to further their own profits. By enacting trading laws, like insider trading, it just further solidifies that the markets are efficient. Market efficiency is a relative concept. This means that the market is efficient relative to the quality and quantity of the publicly known information. Nothing in the definition suggests that the current market prices reflect the real firm value. Due to the possible presence of inside information, for example, the market prices may be incorrect. What the definition does imply is that once new or corrected information comes along the market will adjust the prices quickly. This adjustment happens because rational investors will revise their beliefs. They will start buying and selling securities due to their new beliefs which in turn will change prices. Another important point of the theory is that investing is fair game if the market is efficient. In an efficient market there is an expected return on that security, and one way to establish the expected or normal return is by using the capital asset pricing model. In an efficient market, the investors cannot expect to earn excess returns on a security over and above the expected return of the capital asset pricing model. Under the efficient market hypothesis, a security’s market price should fluctuate randomly over time. The reason that prices will fluctuate is that anything about the firm that can be expected will be properly reflected in the price by the efficient market as soon as the expectation is formed. The only reason that prices in an efficient market will change is if some unexpected and relevant information comes along. By examining a time series form by the sequence of price changes, the time series should fluctuate randomly. A random walk is a time series of price movements that will not follow any patterns or trends and that these past movements cannot be used to predict future price movements. There seems to be an increasing number of people against the theory of market efficiency...
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