Lecture 8: Capital markets and efficient market hypothesis (EMH)

1. Lecture 8: Capital markets and efficient market hypothesis (EMH) Objectives: • Describe the nature and role of capital markets • Discuss the levels of Capital Market Efficiency • Discuss the Importance and Implications of Market Efficiency

2. Capital market Capital market is a market where finance is raised through the trading of securities (shares and bonds) and other forms of borrowing. Securities can be traded either in: • Primary market (for new issue) or • Secondary market (trade in existing securities)

3. Capital market Investment in: • Capital assets (factory, IT, Vehicles, buildings etc) • Financial assets (Shares, stocks, options)

4. Stock Markets • Stock exchange: • is a market where securities can be bought and sold, • market where government and industry can raise long-term capital • Principal functions: • enables companies to raise new capital (the primary market)

5. Stock Markets Dominant financial centres form the golden triangle in three different time zones: • USA • London, and • Tokyo

6. Importance of a well run stock exchange Please read on page 59 of the hand book

7. Principle of stock market efficiency The EMH states that the prices of financial securities fully reflect all available information. Do you agree with this theory?

8. Technical Analysis Share price prediction Current share price Time

9. Market efficiency and share dealing • Fundamental Analyst • Look at fundamental factors behind a share values: • Revenues company expect to generate • Costs expected to incur to generate revenue • Uncertainty about future costs and revenues • The price or return of comparative investment • Based on news and logic, a decision is made about the share price of a company.

10. The Efficiency Market Hypothesis (EMH) Fama (1970) Defined an efficient financial market as one in which security prices always fully reflect all available information. Fama identified 3 forms of market efficiency: • Weak-form efficiency Current security prices incorporate all information from the historical price record.

11. The Efficiency Market Hypothesis (EMH) • Implications of Weak-form efficiency • Studying past movement of company’s share prices provide no sure guide for predicting tomorrow’s share price • Prices follow a random walk – no systematic correlation between one movement and subsequent one • For this form of efficiency technical analysts cannot beat the market perhaps fundamental analysts can.

12. The Efficiency Market Hypothesis (EMH) Empirical Findings: • Kendall, 1953; Roberts, 1959; Fama, 1965; Jensen and Benington, 1970 studies overwhelmingly suggest that stock markets are efficient in the weak sense

13. Levels of The Efficiency Market Hypothesis (EMH) • Semi-strong form efficiency • Asserts that asset prices incorporate all publicly available information • Share prices should reflect all pertinent historical, current, and predictable future information obtainable from public sources; • Asset prices should fully and instantaneously in response to the arrival of relevant new information

14. Levels of Efficiency Market Hypothesis(EMH) • Implications of Semi-strong form efficiency • Impossible to identify mis-priced securities by analysing publicly available information • This means fundamental and technical analysts cannot beat the market unless those with insider information.

15. EMH • Finding:(Fama, Fisher, Jensen & Roll,1969) • Substantial support for this hypotheses • However, less overwhelming than that of weak form. For instance Briloff reported creative accounting of McDonald’s and share prices declined dramatically .

16. Levels of The Efficient Market Hypothesis (EMH) • Strong-form efficiency • Asset prices reflect all information, public and private • E.g. firm’s stock price should increase immediately after the board of directors vote for dividend increase and before the firm publicly announces the increase. • Share prices reflect all relevant information, even though some of that information may not have been publicly disclosed (i.e. insider information)

17. Levels of Efficiency Market Hypothesis (EMH ) Empirical findings • Strong - form efficiency • No one really expects stock markets to be strongly efficient in the strict sense • Formal research is hampered as researchers require insider information . Further Reading Briloff andthe CapitalMarkets, Journal of Accounting Research ,June 1979

18. Implications of stock market efficiency for managers • Market prices : • Prices quoted for shares and other securities will represent the best estimates available of their “true worth”.No point looking for undervalued shares

19. Implications of stock market efficient for managers • Timing new issues: • if stock market is inefficient, there is a risk that the price of a security will fall bellow its true worth .as a result, the timing of new issues would become a critical management decision . • Rate of return: • determined by the market. Managers cannot influence the rate of return by adopting particular financing strategies .

20. Reading Please read pages 64-66 of the hand book for more information on the stock exchange. You may search on the web for the stock exchange of your interest.

21. Stock market anomalies/seasonality • Month of the year effect (January, April) • Day of the week effect (Monday effect)