8. The efficient markets hypothesis The concept of market efficiency undervins almost all finandial theory and dedision models. When financial markets are efficient, the price of a security - such as a stare of a particular corporation's cormon stock-should be the present value extimate of the firm's expected cash flows discounted by its appropriate rate of return (also called the intrinsic value of the stock). Almost all finandal theory and dedsion models assume that the financial markets are effident. The informational efficiency of financial markets determines the ability of investars to "beat" the market and eam excess (or abnormal) returns on their investments. If the markets are nfficient, they will react raphily as new relevant information becomes avallable. Financlal theorists have identified three levels of informational efficlency that reflect what information is incorporated in stock prices. toentify thie form of capital market efficiency under the efficient macket tivpothesis desaibed in the following statement: Curtent matket orces refect all information contained in past price movements. This statement is consistent with: Weak form effidency Strong form efficiency Semistrong form efficiency Consider that there is a weak form of efficiency in the markets. A pharmaceutical company announces that it has received Federal Drug Administration approval for a new alleroy dnio that completely prevents hay fever. The consensus analyst forecast for the company's earnings per share (EPS) is $4.50, but insiders know that, with this new drug, earnings will increase and drive the EPS to $5.00. What will happen when the company releases its next earnings report? There will be some volatility in the stock price when the earrings report is released, but it is difficult to determine the impact on the stock. price. However, the orices will eventually adfust to the news announcernent. The stock orke will increase and settle at a new equiliterium level. The stock price will not change, because the market already incorporated that information in the stock price when the announcement was. made