In concluding that only systematic risk matters, finance theory assumes that frictions in capital markets are negligible. The absence of frictions implies that all market participants become as costlessly and equally informed as everyone else — that is, no individual is more informed than others or, to use a technical term, there is no information asymmetry. This assumption, combined with several other assumptions, implies that news events have an instantaneous impact on prices. That is, prices reach a new level immediately upon the news event, thus fully reflecting the news content in price at all times.
Such abstraction from reality helps our understanding of how share prices behave and the role of, and demand for, capital market institutions. This, in turn, contributes to our understanding of the regulatory and standard-setting implications. However, the abstraction comes at a cost. It ignores the extensive role of information intermediaries, the nature of trading, and the transaction costs of trading shares. Recent research has discovered much about the importance of frictions.
Authors: David Phillips, Philip Wright
Source: European Business Forum (EBF)
Subjects: Economics, Finance
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