Essay Example on Financial Economics Theories

2021-05-25 17:29:44
5 pages
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Wesleyan University
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Critical thinking
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Efficient Market Theory

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The efficient market theory is a hypothesis illustrating how the prices of bonds, stocks, and other different securities reflect on the financial information, for instance, of a particular company. In my opinion, the efficient market hypothesis has been essential for investors in the stock exchange which helps them in predicting future financial trends. Changes in prices of securities may occur as a result of active trading which moves the prices to a level where the returns generated from the adjustment of an expected risk will equal that of all the securities. Any other changes may be the outcome of the events that were unknown before but are quickly building up into prices (Shiller, 2003). This paper examines the efficient market theory and other finance market principles and how they influence the decisions of investors.

In any active market, I would argue that the investment capital should be allocated to the use that will generate more returns. Market efficiency explains why investors cannot outperform the market or in a way find securities whose prices are below what they should be selling at and use them to influence the market by performing better than those already selling at higher prices. We can also not fail to note that, according to the market efficient hypothesis, the stock prices provide all the information regarding a company. I would argue that a firm which is doing well in the stock market is making huge returns from its operations. The reason for the above is because investors will be attracted to buy securities for a company realizing maximum profits since it is predictable that the securities will sell at higher prices in the future (Thomsett, 2016). As an investor, this becomes the perfect moment to invest by buying the company's shares for future sale. An overreaction due to the positive earnings would have negative returns and unless the market corrects itself the market retreat would continue (Shiller, 2003).

For example, in the 15th October 2009, the IBM announced quarterly profits of $ 2.40 per share which were 2 cents better than what analysts had predicted of $ 2.38 per share. Just as I have illustrated above, such a rise would result in an increase in the stock prices. In the case of IBM, that same day the price of the stock rose to $ 3.48 within hours. The next day the company experienced a rather unusual market retreat by falling $ 6.34 as the market overreacted to the positive returns. Mostly, such scenarios do not take long, and the market corrects the overreaction by the sale of the stock (Thomsett, 2016).

Capital Asset Pricing Model

The capital asset pricing model has been utilized in the calculation of the needed return rates for the risky assets. The required speed of return illustrates the rise in value that an individual expects to see but only based on the intrinsic level of risk of the property. As an analyst, I could use the capital asset pricing model to decide on what fee I should pay for an individual stock. In the above I mean, for example, if paying for stock A is riskier than paying for capital B, then I would expect the price of stock A to be lower than that of stock B so as it can compensate me for taking on the higher risk of buying stock A. The model has often been used for determining the fair price of any investment. The above is applied by calculating the risky asset's rate of return by the utilization of the capital asset pricing hypothesis and the rate determined can be used for discounting future investment cash flows to a level same with their present price value which at the end aids in reaching the fair value of the investment (Barberis et al. 2015). Once one has calculated the investment's fair value, you can use it for comparing with the market price such that if it is higher than the market price, the stock is a bargain (Barberis et al. 2015). If the fair price is lower, I would recommend one to consider investing somewhere else since the stock is overvalued.

Dividend Irrelevance Theory

The dividend irrelevance theory illustrates the influence of dividend policy within a company. According to the hypothesis, in a perfect world where there are no bankruptcy costs or taxes, the dividend policy in any firm is irrelevant. The theory further suggests that the dividend policy will have no effect on the stock price of the company's capital structure. As an investor, I would suggest that if you are an investor and gets a dividend that is more than you expected then I would advise you to re-invest in the same company's stock using the extra cash flow. In case the expected dividend is small than what you anticipated I would recommend you sell part of your shares and replicate the similar amount of cash flow you would have received if the dividend had reached your expectations (Ani, 2016). It is important to note that in both cases as an investor you are irrelevant to the dividend policy of the company because you are creating your cash flow.

Capital Structure Theory

The capital structure model proposes that the valuation of a company is immaterial to the capital structure of a firm which means that the market value of a company depends on its operating returns and profit margins. Therefore, the capital structure of a firm illustrates the way a company finances its assets which can either be through equity or debt. The theory further indicates that the market value of a company will be affected by the prospects of future growth apart from the associated risk in the investment. The above means that the firm's value is not dependent on the capital structure or the financing decisions the business may implement (Brusov et al., 2015). By saying the above, I mean that you should not fail to invest in a company's stock due to its capital structure. As long as the firm has a high prospect to grow, then its market value is higher meaning the company's share prices will be high thus generating higher returns. Whether the company is financing its assets through debts or equity, as long as it has the potential to grow regarding market value, then as an investor you should know the company's shares for as long as its market value is increasing (Brusov et al., 2015). Additionally, the prospect for growth of the company is an indication of higher profit margins and other returns within the company an assurance that if you invest in the company's stock, you will enjoy increased profits in the future from the sale of shares or dividend returns.


Ani, G. (2016). Dividend Irrelevance Theory. Dividend.Com. Retrieved

from, N., Greenwood, R., Jin, L., & Shleifer, A. (2015). X-CAPM: An extrapolative

capital asset pricing model. Journal of Financial Economics, 115(1), 1-24.

Brusov, P., Filatova, T., Orekhova, N., & Eskindarov, M. (2015). Capital Structure:

ModiglianiMiller Theory. In Modern Corporate Finance, Investments and Taxation (pp. 9-25). Springer International Publishing.

Shiller, R. J. (2003). From efficient markets theory to behavioral finance. The Journal

of Economic Perspectives, 17(1), 83-104.

Thomsett, M. (2016). The Inefficiency of the Efficient Market Theory Defending

the Fundamental Approach. BETTER INVESTING Empowering Investors Since 1951. Retrieved from

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