Capital Market Theories: Market Efficiency Versus Investor Prospects

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Kathleen Hodnett
Heng-Hsing Hsieh

Keywords

Capital Market Theories, Markowitz Portfolio Theory, Capital Asset Pricing Model, Arbitrage Pricing Theory, Behavioral Finance, Prospect Theory, Efficient Market Hypothesis, Separation Theorem, Rollís Critique, the Benchmark Error

Abstract

This paper reviews the development of capital market theories based on the assumption of capital market efficiency, which includes the efficient market hypothesis (EMH), modern portfolio theory (MPT), the capital asset pricing model (CAPM), the implications of MPT in asset allocation decisions, criticisms regarding the market portfolio and the development of the arbitrage pricing theory (APT). An alternative school of thought proposes that investors are irrational and that their trading behaviors are driven by psychological biases such as greed and fear. Prospect theory and the role of behavioral finance that describe investment decisions in imperfect capital markets are presented to contrast the Utopian assumption of perfect market efficiency. The paper concludes with the argument of Hirshleifer (2001) that heuristics are shared by investors and asset prices may not reflect their long-term intrinsic values as indicated by efficient capital market theories.

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