efficient market hypothsis general (first paper ) Flashcards
(16 cards)
What is the Efficient Market Hypothesis (EMH)?
EMH is the idea that security prices fully reflect all available information, making it impossible to consistently earn above-normal returns.
Why does the EMH imply that price changes follow a random walk?
Because price changes reflect new information, and new information is, by definition, unpredictable.
What role did Samuelson (1965) and Mandelbrot (1966) play in EMH?
They provided a theoretical rationale showing that price changes must be independent over time if markets are competitive and profits are zero
Does empirical evidence fully support EMH?
Mostly yes, but some anomalies (e.g., Jensen 1978) suggest that inefficiencies can exist.
What does the Efficient Market Hypothesis (EMH) state in relation to firm value?
EMH states that the market price of a firm’s securities reflects all available information, including the present value of expected future net cash flows.
Why is the firm’s stock price considered a good indicator of value under EMH?
Because it incorporates both current performance and expectations about the future, reflecting the full value of future investment opportunities.
What is the main managerial implication of EMH for corporate objectives?
Managers should focus on maximizing the current market value of the firm, as it already reflects both present and future outcomes.
Why does EMH eliminate the need to choose between maximizing present or future value?
Because market prices already integrate all relevant time horizons via the present value of expected cash flows.
What assumption must hold for maximizing market value to align with shareholder interests?
Shareholders must care only about changes in wealth, not timing, form, or source of returns.
What does it mean when we say shareholders care only about wealth changes?
It means they are indifferent to whether returns come now or later, through dividends or capital gains — they only want total value maximization.
Why is this assumption useful in financial theory?
It simplifies the firm’s objective to a single goal — maximize firm value — making corporate decision-making more analytically tractable.
In efficient markets, why is increasing Earnings Per Share (EPS) without affecting cash flows considered irrelevant? (the third implication)
Because investors value firms based on the present value of expected future cash flows, not accounting figures like EPS. Cosmetic changes to earnings that don’t improve cash flows don’t increase firm value.
Under the Efficient Market Hypothesis (EMH), how are existing shareholders fairly compensated when new shares are issued?
Because markets are efficient, new shares are issued at a fair price reflecting the firm’s true value. Although the percentage ownership of existing shareholders decreases, the overall value of their stake remains unchanged. The company’s total capital increases proportionally, so no value is lost or unfairly transferred — the shareholders are still rightly compensated.
What is the fifth implication of the Efficient Market Hypothesis (EMH) for corporate finance?
If markets are efficient, security returns (i.e., stock price changes + dividends) are meaningful measures of firm performance.
Why are returns meaningful in efficient markets?
Because prices reflect all available information, any change in return reflects the market’s assessment of new corporate decisions or news.
What classic study pioneered this empirical approach? ( the fifth implication)
The 1969 study by Fama, Fisher, Jensen, and Roll, which analyzed the effect of stock splits on firm value — setting the stage for modern event studies.
