Capital Market Efficiency Research example

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Capital Market Efficiency Research

An effective capital market is a market where the new information in the share prices is accurately and quickly reflected. The value of shares and bonds fluctuates depending on the present value of future cash flows. Capital market efficiency is evaluated by its success in incorporating and inducting these fluctuations and all information in general, about the essential value of securities, into the current price of the securities. Prices should, therefore change only due to unexpected new information (James & John, 2008).

Behavioral finance is the study of an investor’s psychology-based assumptions based on the individual’s principles of decision making, to explain stock market abnormalities. Behavioral finance looks at how an investor’s characteristics and information structure influence the decision making of an investment and also the market outcomes. According to James and John (2008), behavioral finance, investors are prone to irrational, unpredictable and biased manner. One of the psychological biases is the herd instinct, where an individual feels the need to follow groups and popular trends without the deep consideration of their views. Another type of bias is overconfidence in one’s skills and abilities and makes inaccurate investing options, such as overtrading. Next, is the familiarity bias which involves individuals investing only in their familiar residence, for example, their country or in the company they work for. The naïve diversification bias is that which an investor invests in every available option to him or her. Other forms of bias include regret aversion, mental accounting, anchoring, belief perseverance, and hindsight bias.

Efficient market exists in three forms. One is the Weak-form efficient market hypothesis. It states that the historical information of the previous returns and prices on traded assets is entirely reflected in the security prices and therefore, historic prices cannot be used to determine future prices. Secondly, there is the semi-strong efficient market. This hypothesis alludes that all publicly available information such as financial reports, tax rates, industry conditions, news reports, etc., is already reflected in the current price of the stock. Investors thus, cannot use this information to predict a future price. The strong form is the third form of an efficient market. It claims that security prices reflect all information which includes historical and current information, publicly available as well as insider information. This implies that there is no kind of information retrieved that can give investors returns that surpass standard market returns.

There are certain implications of market efficiency to corporate finance. For instance, a firm’s performance can be measured by its security returns. Also, the change in accounting of a firm cannot affect the price of stock. Financial managers cannot manipulate the earnings per share and can also not “time” issuing of stocks and bonds by using available information. A firm may sell many shares of stocks or bonds without depressing prices and there is also no benefit in influencing the earnings per share.

Real estate is an inefficient capital market. Real estate transactions are confidential in that, the buyer …

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