Efficient Market Hypothesis

The efficient-market hypothesis emphasizes that arbitrage will rapidly eliminate any profit opportunities and drive market prices back to fair value. Behavioral-finance specialists may concede that there are no easy profits, but argue that arbitrage is costly and sometimes slow-working, so that deviations from fair value may persist. Sorting out the puzzles will take time, but we suggest that financial managers should assume, at least as a starting point, that there are no free lunches to be had on Wall Street.The ‘no free lunch’ principle gives us the following lessons of market hypothesis have on Finance. 1. By and large market prices are the best proxies for intrinsic values. Hence the objective of corporate finance should be to maximize the current market value of the firm. 2. The return earned by shareholders in the market place represents the most meaningful measure of firm performance. Hence, one can judge a corporate policy or event in terms of its impact on security returns. 3. Firms should not try to take advantage of short term forecasts of stock prices based on past price movements.Put differently, it is futile to ‘time’ security issues, at least in the short run. 4. There are no financial illusions in the market. Hence, manipulation of accounting earnings does not pay. Likewise, stock splits and bonus issues, per se, represent inconsequential decisions. 5. If a firm’s stock price has significantly underperformed the market in recent periods, despite its fundamentals remaining sound, it should wait to make equity issues, provided there is no immediate compulsion to raise equity finance to support a worthwhile investment strategy. . If interest rates are at their historic lows, debt may be issued if the firm requires debt currently or in the foreseeable future. If interest rates are at their historical highs, debt financing may be deferred if the firm can do so. 7. Security prices convey a lot of information about the future. If the stock of a firm has an unusually low price-earnings multiple, it means that there are serious concerns about its future.Likewise, if the yield on the bonds of a firm is much above the average, it means that the firm will have financial difficulties in servicing its debt. 8. As securities are bought for their prospective cash flows, they are akin to unbranded products or commodities. Hence the demand for them is very elastic. This means that a company should be able to sell large blocks of additional securities without depressing prices, provided it can convince investors that it does not have private information. 9.If new securities are issued at market prices, there should be no concern about the transfer of wealth from existing shareholders to new shareholders. 10. Investors will not pay for what they can accomplish on their own. For example, if investors can diversify on their own they will not regard favorably a merger proposal that promises them the benefit of diversification. Likewise, if investors can resort to personal leverage the way a company does, they will not perceive any gain from corporate leverage.

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