7. The efficient markets hypothesis

The concept of market efficiency underpins almost all financial theory and decision models. When financial markets are efficient, the price of a securitysuch as a share of a particular corporations common stockshould be _____ the present value estimate of the firms expected cash flows discounted by its appropriate rate of return (also called the intrinsic value of the stock).

Almost all financial theory and decision models assume that the financial markets are efficient. The informational efficiency of financial markets determines the ability of investors to beat the market and earn excess (or abnormal) returns on their investments. If the markets are efficient, they will react rapidly as new relevant information becomes available. Financial theorists have identified three levels of informational efficiency that reflect what information is incorporated in stock prices.

Identify the form of capital market efficiency under the efficient market hypothesis described in the following statement:

Current market prices reflect all information contained in past price movements.

This statement is consistent with: (choose 1)

1.Weak form efficiency

2.Strong form efficiency

3.Semistrong form efficiency

Consider that there is a strong form of efficiency in the markets.

A pharmaceutical company announces that it has received Federal Drug Administration approval for a new allergy drug that completely prevents hay fever. The consensus analyst forecast for the companys earnings per share (EPS) is $5.00, and insiders agree with analyst expectations. They too expect that, with this new drug, earnings will drive the EPS to $5.00. What will happen when the company releases its next earnings report?

1.There will be some volatility in the stock price when the earnings report is released; it is difficult to determine the impact on the stock price.

2.The stock price will increase and settle at a new equilibrium level.

3.The stock price will not change, because the market already incorporated that information in the stock price when the announcement about FDA approval was made.