Corporate Finance

Markets are expected to behave efficiently and rationally. However studies suggest that when comparing small and large companies with similar betas, investors have received higher returns when choosing the smaller companies. This may mean that the markets are inefficient and consistently under-price small companies or that there is an additional risk and as yet un-quantifiable second risk variable that is correlated to company size. Discuss.

Efficiency is a term that has always been central to finance. Primarily, it is used to describe how the market reflects all relevant information about financial assets, through their own market price. This is formally known as the Efficient Market Hypothesis (EMH) concept. The concept has three forms: strong form where prices reflect all relevant information about their nature; semi-strong form where prices involve all public information; and weak form where prices do not contain any information about future changes and price changes are random. EMH concept requires that investors should have rational expectations; and suggests that even though investors can be wrong or right about the market by overreacting or under reacting to a change of information; the market as a whole is always right and reflects the truth. In other words, a current market price in any financial market should be the best unbiased estimate of the future value of an investment. However, the idea of market efficiency has recently fallen into dispute as a result of market events and growing empirical evidence of inefficiencies.

Capital Asset Pricing Model

Within the framework of Efficient Market Hypothesis, there is a standard financial tool called Capital Asset Pricing Model (CAPM). The Capital Asset Pricing Model, builded on the assumptions of EMH, is a model that describes the relationship between stocks’ expected return and their risk. In particular, CAPM asserts that “the expected return on any asset equals the risk-free rate plus a risk...