Market Expectation Theory

The market expectation theory is a theory that explains the behavior of security prices upon a
company making a public announcement of an event such as earnings, dividend, and merger
announcements. The theory suggests that investors and market participants project the company's
overall anticipated performance/outcome at a particular moment in time, based on the market,
economic, political, and environmental factors. The theory also suggests that investors and market
participants have forecast information about the performances of the company. Any information
outside the forecasted results will trigger a reaction that affects the current security holders' value, as
reflected in the expected future economic earnings of the company. Thus, the price of a security is
determined by the market expectations (buyers and sellers) of the firm's future performance. The
market expectation theory is founded on the principle of market efficiency. It is useful to the event
studies and the market efficiency studies in analyzing the abnormal returns of security prices upon a
company making public announcements. The theory is also useful in analyzing the effect of events on
the value of the firm.