Explain the three forms of market efficiency

Capital Market Efficiency Paper

The purpose of the following paper is to explain what it means to have an efficient capital market. The author demonstrates an understanding of the various levels of market efficiency; this includes how behavioral finance can hinder reaching market transparency. There are several areas of the market discussed in this paper including behavioral challenges, market efficiency, corporate finance, and an opinion on real estate market being an efficient capital market (University of Phoenix, 2017).

Behavioral Challenges in Achieving Efficiency

There are three conditions concerning behavioral financial; the three conditions are known as rationality, independent deviation from rationality, and arbitrage (Ross, Westerfield, Jaffe, & Jordan 2016). All three conditions play their role in the behavioral changes in achieving efficiency. Each of these three conditions is based on human error, reasoning, and confidence levels. A person can be irrational when investing in the stock market, which can lead to overconfidence and regret regarding investments. One may also make irrational decisions based on familiarity relating certain stocks on the market. One could become repetitive with his or her stock options due to having inadequate information because he or she might invest using information gained from past events. Also, one could be too conservative when investing in the market and miss opportunities to invest in a new stock with the potential to earn millions or billions of dollars.

Forms of Market Efficiency

There are three form of market efficiency known as the weak-form, the semi-strong form, and the strong-form (Ross, Westerfield, Jaffe, & Jordan 2016).Concerning weak-form efficiency, if one analyzes the prices of past stocks, he or she will not be able to predict the future prices; they are completely random. According to Ross, Westerfield, Jaffe, & Jordan (2016), “The semi-strong form of the efficient market hypothesis implies that prices should reflect all publicly available information”. Concerning the strong-form efficiency, all figures in a market, both public and private, are allocated for in a stock’s price. Believers of the strong-form efficiency trust that not even insider trading can give an investor a lead; this level of effectiveness suggests that profits above normal returns cannot be gained (“Investopedia, LLC.,” 2017).

Implications to Corporate Finance

The market value of an organization should disclose the present value of the company’santicipatedfuture net cash flow if the capital markets were completely efficient; this has some crucial significanceconcerning corporate finance. Myers (1974) presented excellent advice regarding corporate finance:

1. Executives must make the most of the current market value of an organization.

1. Security returns are vital measures of a company’sfinancial performance.

1. No advantagesareaccumulated by manipulating EPS (earnings per share).

1. Accurate calculation of future payoffs indicates new shares of stocks being issuedat market price (Myers, 1974).

Real Estate Market

The real estate market would not be considered an efficient capital market; the capital market is a part of the financial structure concerned with raising capital by dealing with bonds,shares, and other long-term investments. The market for housing is not associated with the stock market (Ross, Westerfield, Jaffe, & Jordan 2016); one cannot buy stock in real estate, they can only buy properties.

Conclusion

The capital market is full of theories and a structure that contains many levels one must gain an understanding to so he or she can be successful in the market. The capital market structure must not be taken lightly, and one must educate his or herself before making any investment in the market. The preceding paper covered some points regarding the structure of the capital market, but there is always more to be learned to gain a true understanding of the market.

References

Investopedia, LLC. (2017). Retrieved from

http://www.investopedia.com/terms/s/strongform.asp

Myers, S. (1974). Interactions of Corporate Financing and Investment Decisions-Implications for

Capital Budgeting. The Journal of Finance, 29(1), 1-25. doi:10.2307/2978211

Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2016). Corporate Finance (11th). New York,

NY: McGraw-Hill.

University of Phoenix. (2017). Capital Market Efficiency Paper. Retrieved from University of

Phoenix, FIN/571 – Corporate Finance website.