Equilibrium Theory: Price and Fair Value

The equilibrium theory in finance is closely related to the concept of "fair value," which refers to a balance point in the market where the price of an asset accurately reflects all available information. At this point, the forces of supply and demand meet, and the asset is in equilibrium. Here's how it works:

1. Efficient Market Hypothesis (EMH): This theory states that prices fully reflect all available information at any given time. In other words, the market is always priced fairly because all known information is already incorporated into prices. The EMH assumes that investors are rational and will make trading decisions based on the best available information.

2. Price Adjustments: If new information emerges that alters the perceived value of an asset—such as a company's earnings report, a change in macroeconomic conditions, or a geopolitical event—investors will adjust their trading decisions based on this new information. If the information is positive, demand for the asset may increase, increasing the price. If the information is negative, supply may exceed demand as investors sell off the asset, driving the price down.

3. Return to Equilibrium: The price will continue fluctuating until it reaches a new equilibrium point, where the asset's price reflects the new information. Once the market absorbs the new information, the asset's price should stabilize around its new fair value.

In an efficient market, it's assumed that it's impossible to consistently achieve higher-than-average returns, as prices always reflect fair value. However, in real-world markets, various factors—such as investor irrationality, market manipulation, or information asymmetry—can cause prices to deviate from their fair value. Despite these deviations, prices tend to revert toward their fair value over the long term, as dictated by the equilibrium theory.