Business Finance 2
An efficient capital market is one in which prices adjust instantaneously, and in an unbiased fashion, to the receipt of new information. For example, if a company announces an unexpectedly large increase in profit, then this information should be impounded in the company’s share price within a very short time, and there should be no expectation of making abnormal returns by purchasing shares in the company at the new price.
The answer depends on the meaning given to the word ‘correct’. If the phrase ‘correct price’ is taken to mean the price that would prevail if perfect information were available, then the efficient market hypothesis (EMH) does not imply that financial assets are always correctly priced. The price which is ‘correct’ in this sense can never be determined, and therefore the market may very well set an ‘incorrect’ price. However, the EMH does maintain that abnormal profits cannot be earned using publicly available information and a specific trading strategy. In an efficient market, mispriced assets cannot consistently be identified.
The main argument in support of efficiency is the existence of a competitive market in which numerous investors are competing in an effort to make abnormal returns. It is suggested that, in such a market, investors will seek information and take immediate action to buy or sell securities based on any new information. As a result, information will be impounded very quickly in market prices. Market efficiency may be improved by an increase in the quantity and quality of information that is made publicly available, and a reduction in restrictions on insider trading.
14. This statement is correct, in that in an efficient market, current security prices cannot be used as a basis for predicting future changes in security prices. In this sense, a company should take current security prices as ‘correct’ when making financial decisions. However,...
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