Capital Market Efficiency Paper
Capital Market Efficiency Paper
Having an efficient capital market relates to the price of an asset and reflects that all information is available about that value to everyone. This type of efficiency is typically used in conjunction of shares of common stock within a company. This information either motivates or dissuades potential investors to trade within a specific corporation. I will discuss the three forms of market efficiency, the behavioral challenges it takes to achieve efficiency. How market efficiency impacts corporate finance, and if the real estate market is an efficient capital market.
Behavioral Challenges and Market Efficiency
Market efficiency or how market prices react to given evidence is separated into three forms. These three forms of market efficiency include the weak form, the semi-strong, and strong forms. In a weakly efficient market decision to buy or sell are based upon past prices of the commodity (Ross, 2016, pg. 437). The semi-strong form of efficiency states that the market is driven by all publically available information in price setting (Ross, 2016, pg. 463). In an efficiently strong market, all information that anyone knows about the market is used to determine the value of the asset (Ross, 2016, pg. 463).
However, market efficiency is often undercut by behaviors of those investing in the markets. Market efficiency relies on investors to utilize rationality in investing. However, the opportunity to create a profit often drives rationality from individual investors’ minds. This irrationality can be seen in the stock market today where companies with no real book value have assets trading at $250 even though they have negative cash flow and negative net income. More importantly, individual investors are independently irrational in their ways, meaning that their deviations from rationality are unlikely to cancel each other out. Finally, arbitrage or trading the same security across different markets due to a pricing error results in zero-risk opportunities for investors (Ross, 2016, p. 449). If the market were truly efficient, this price difference would not exist.
Corporate Finance Implications
Market efficiency directly impacts corporate finance in multiple ways. The first way in which corporate finance is affected is that creative accounting practices cannot be used to trick the market (Ross, 2016, 463). In an efficient market, investors have all the required information that is used to determine a company’s stock price. Therefore, investors can make informed, rational decisions. Another impact is that corporations cannot successfully time issues of debt or equity (Ross, 2016, p. 463). In a thoroughly efficient market stock is neither over nor undervalued therefore the timing decision, or deciding when to issue new equity has no impact on current stock prices. However, beings as the market are not truly efficient managers can use these tools to create extra value in their shares.
The Real Estate Market
The real estate market refers to the cost of purchasing a home versus its actual value, and it is not an efficient market. The definition of an efficient capital market is that it cannot be beaten because all relevant information is reflected by the price of the asset, and as new information is released the price immediately changes to reflect that new information (Ross, 2016, p. 434). However, there are so many variables that are incorporated to a home’s market value that a buyer cannot have all of the currently relevant information needed to be an informed purchaser, and the price of a three bedroom two bath home does not change instantly when new information is released.
Unlike a company’s income statement and balance sheet used to derive a company’s stock price. Homes have no financial documentation to balance their worth, and prices are often dictated by supply and demand. Furthermore, unlike a stock which has the same price no matter where you own it the same home’s value could change depending on its location, even if the difference is as little as two miles.
Market efficiency is a term to describe how accurately prices in a capital market reflect the information surrounding their cost. There are three types of efficiency weak, semi-strong, and strong the classification dependent upon the amount of data related to its pricing. Market efficiency is undercut but individual investor behavior and understanding these small derivatives can allow managers to plan accordingly. The real estate market based upon these definitions is not only in-efficient but it is also highly irrational.
Ross, S., Westerfield, R., Jaffe, J., & Jordan, B. (2016). Corporate Finance (11th). New York, NY: McGraw-Hill.