Discuss the efficient markets hypothesis and its significance for the

QUESTION

Discuss the efficient markets hypothesis and its significance for the theory of finance. Explain why market efficiency leads a manager to focus on NPV and free cash flow.
The Efficient Market Hypothesis states that at any given time, security prices fully reflect all available information. The implications of the efficient market hypothesis are truly profound. Most individuals that buy and sell securities (stocks in particular), do so under the assumption that the securities they are buying are worth more than the price that they are paying, while securities that they are selling are worth less than the selling price. But if markets are efficient and current prices fully reflect all information, then buying and selling securities in an attempt to outperform the market will effectively be a game of chance rather than skill. In finance, the efficient-market hypothesis ( EMH ) asserts that financial markets are œinformationally efficient. That is, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made. There are three major versions of the hypothesis: œweak, œsemi-strong, and œstrong. The weak-form EMH claims that prices on traded assets ( e.g., stocks, bonds, or property) already reflect all past publicly availableinformation. The semi-strong-form EMH claims both that prices reflect all publicly¦

vailable information and that prices instantly change to reflect new public information. The strong-form EMH additionally claims that prices instantly reflect even hidden or œinsider information. There is evidence for and against the weak-form and semi-strong-form EMHs, while there is evidence against strong-form EMH. [ citation needed ] Various studies have pointed out signs of inefficiency in financial markets. [1] Critics have blamed the belief inrational markets for much of the late-2000s financial crisis. [2] [3] [4] In response, proponents of the hypothesis have stated that market efficiency does not mean having no uncertainty about the future, that market efficiency is a simplification of the world which may not always hold true, and that the market is practically efficient for investment purposes for most individuals. [1]

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