Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionV. Risk and Return 12. Some Lessons from
Capital Market History(^432) © The McGraw−Hill
Companies, 2002
CAPITAL MARKET EFFICIENCY
Capital market history suggests that the market values of stocks and bonds can fluctuate
widely from year to year. Why does this occur? At least part of the answer is that prices
change because new information arrives, and investors reassess asset values based on
that information.
The behavior of market prices has been extensively studied. A question that has re-
ceived particular attention is whether prices adjust quickly and correctly when new in-
formation arrives. A market is said to be “efficient” if this is the case. To be more
precise, in an efficient capital market, current market prices fully reflect available in-
formation. By this we simply mean that, based on available information, there is no rea-
son to believe that the current price is too low or too high.
The concept of market efficiency is a rich one, and much has been written about it. A
full discussion of the subject goes beyond the scope of our study of corporate finance.
However, because the concept figures so prominently in studies of market history, we
briefly describe the key points here.
Price Behavior in an Efficient Market
To illustrate how prices behave in an efficient market, suppose the F-Stop Camera Cor-
poration (FCC) has, through years of secret research and development, developed a
camera with an autofocusing system whose speed will double that of the autofocusing
systems now available. FCC’s capital budgeting analysis suggests that launching the
new camera will be a highly profitable move; in other words, the NPV appears to be
positive and substantial. The key assumption thus far is that FCC has not released any
information about the new system; so, the fact of its existence is “inside” information
only.
Now consider a share of stock in FCC. In an efficient market, its price reflects what
is known about FCC’s current operations and profitability, and it reflects market opin-
ion about FCC’s potential for future growth and profits. The value of the new autofo-
cusing system is not reflected, however, because the market is unaware of the system’s
existence.
If the market agrees with FCC’s assessment of the value of the new project, FCC’s
stock price will rise when the decision to launch is made public. For example, assume
the announcement is made in a press release on Wednesday morning. In an efficient
market, the price of shares in FCC will adjust quickly to this new information. Investors
should not be able to buy the stock on Wednesday afternoon and make a profit on Thurs-
day. This would imply that it took the stock market a full day to realize the implication
of the FCC press release. If the market is efficient, the price of shares of FCC stock on
CONCEPT QUESTIONS
12.4a In words, how do we calculate a variance? A standard deviation?
12.4bWith a normal distribution, what is the probability of ending up more than one
standard deviation below the average?
12.4c Assuming that long-term corporate bonds have an approximately normal distri-
bution, what is the approximate probability of earning 14.7 percent or more in
a given year? With T-bills, roughly what is this probability?
12.4dWhat is the second lesson from capital market history?
CHAPTER 12 Some Lessons from Capital Market History 403
12.5
efficient capital market
A market in which
security prices reflect
available information.