Efficient Market Assumption

In an efficient capital market, security prices adjust rapidly to the infusion of new information, and, therefore, current security prices fully reflect all available information. To be absolutely correct, this is referred to as an informational efficient market.

Three Assumptions of Efficient capital market

Although the idea of an efficient capital market is relatively straightforward, we often fail to consider why capital markets should be efficient. What set of assumptions imply an efficient capital market?  An initial and important premise of an efficient market requires that a large number of profit-maximizing participants analyze and value securities, each independently of the others.

A second assumption is that new information regarding securities.comes to the market in a random fashion, and the timing of one announcement is generally independent of others.

The third assumption is especially crucial: profit-maximizing investors adjust security prices rapidly to reflect the effect of new information. Although the price adjustment may be imperfect, it is unbiased. This means that sometimes the market will over-adjust and other times it will underadjust, but it cannot predict which will occur at any given time. Security prices adjust rapidly because of the many profit-maximizing investors competing against one another.

Because security prices adjust to all new information, these security prices should reflect all information that is publicly available at any point in time. Therefore, the security prices that prevail at any time should be an unbiased reflection of all currently available information, including the risk involved in owning the security. Therefore, in an efficient market, the expected returns implicit in the current price should reflect its risk, which means that investors who buy at these informationally efficient prices should receive a rate of return that is consistent with the perceived of the stock.