Stock Markets Essay Example | Topics and Well Written Essays - 1500 words

Stock Markets - Essay Example Hypothesis being the Greek word for "assumption", the Efficient Markets Hypothesis therefore assumes that capital markets, of which the stock or equity market is one, is efficient. And what we mean when we say that a market is efficient is that buyers and sellers of stocks have all the relevant information they need to make an intelligent decision to either buy or sell stocks in companies at a certain price that reflects all available information. The first to propose the hypothesis is Eugene Fama of the University of Chicago in a paper (1970) where he presented a method of testing the efficiency of the New York Stock Exchange. Since then, hundreds of studies have been conducted to either prove or disprove the hypothesis. Since we know that in science, a scientific hypothesis that survives experimental testing becomes a scientific theory, the fact that the efficiency of markets remains a hypothesis begs the question: why Do test results thus far show that capital markets are inefficient because scientific investigation has not proven otherwise Or, if capital markets are efficient, and stock prices reflect all available information, then why is the trade on mere pieces of paper (called stocks) growing Is it a case of altruistic holders of stocks, seeing the potential for future earnings, selling these stocks to others in order to share the wealth Or are all sellers of stocks just looking for another fool to unload a worthless piece of paper And why do people still make (and lose) money in the stock market And if capital markets are efficient, are all investing decisions intelligent and based on complete information As we will show, capital market efficiency does not necessarily mean an increase in the intelligence quotient of all investors. Power of Information in Capital Markets Today Capital markets have the advantage of getting buyers and sellers to agree on a deal without the use of financial intermediaries like banks and insurance companies who direct the flow of resources from savers to borrowers. Capital market transactions are therefore deemed more efficient in the absence of intermediaries except for brokers who put buyers and sellers together and get a small commission for the effort, making the deal almost frictionless. This is one factor that leads to our hypothesis: the low transaction costs of capital markets enhance its efficiency. With transaction costs negligible, the only real factor that determines the current price of a stock should be the net present value of its future cash flows in the form of dividends and, assuming the company lasts long enough, capital gains when the stock is sold at a future date. After all, a stock is nothing else but a claim to a company's future cash flows. A company's cash flow is affected by several factors, among which are its business prospects, management quality and strategic plans, the economy's over-all performance, and the company's standing within the economy. If all these pieces of information are known, making a study of free