What Is The Role Of Capital Market?
From a firm’s perspective, the role of a capital market is to be a liquid market where firms can interact with investors to obtain valuable external financing resources. From investors’ perspectives, the role of a capital market is to be an efficient market that allocates funds to their most productive uses.
This is especially true for securities that are actively traded in broker or dealer markets, where the competition among wealth-maximizing investors determines and publicizes prices that are believed to be close to their true value.
The price of an individual security is determined by the interaction between buyers and sellers in the market. If the market is efficient, the price of a stock is an unbiased estimate of its true value, and changes in the price reflect new information that investors learn about and act on.
For example, suppose a certain stock currently trades at $40 per share. If this company announces that sales of a new product have been higher than expected, investors will raise their estimate of what the stock is truly worth.
At $40, the stock is a relative bargain, so there will temporarily be more buyers than sellers wanting to trade the stock, and its price will have to rise to restore equilibrium in the market. The more efficient the market is, the more rapidly this whole process works. In theory, even information known only to insiders may become incorporated in stock prices.
Not everyone agrees that prices in financial markets are as efficient as described in the preceding paragraph. Advocates of behavioral finance, an emerging field that blends ideas from finance and psychology, argue that stock prices and prices of other securities can deviate from their true values for extended periods.
These people point to episodes such as the huge run-up and subsequent collapse of the prices of Internet stocks in the late 1990s and the failure of markets to accurately assess the risk of mortgage-backed securities in the more recent financial crisis as examples of the principle that stock prices sometimes can be wildly inaccurate measures of value.
Just how efficient are the prices in financial markets? That is a question that will be debated for a long time. It is clear that prices do move in response to new information, and for most investors and corporate managers the best advice is probably to be cautious when betting against the market.
Identifying securities that the market has over- or undervalued is extremely difficult, and very few people have demonstrated an ability to bet against the market correctly for an extended time.
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