An overview of financial Markets

1. Financial system. What are its components

2. Financial institutions and direct financing ( financial
intermediation)
3. Financial markets and indirect financing (issuance of
financial instruments)
4. Financial instruments ( financial securities / assets)
5. Regulation of the financial system
6. Nexus between financial system development and
economic growth
7. Financial markets and asset pricing: The concept of
efficient capital structure
8. Alternative explanation to efficient markets and asset
pricing
 Financial markets: Basic principles
1. Financial markets exist because people want to adjust their
consumption over time through borrowing and lending.
2. Provides a standard comparison for economic decisions
which interest rate ( Npv Rule)
3. Regardless of the individual’s preference for consumption
this year versus the next, regardless of how patient or
impatient the individual is, making the proper investment
decision depends only on comparing it with the alternatives
in the financial markets.
4. Besides providing a mechanism for making investment
choices, financial markets also provide us with the tools for
actually acquiring the funds to make the investments
EFFICIENT CAPITAL MARKETS
Efficient Capital Markets
In an efficient capital market, security prices adjust
rapidly to the arrival of new information, therefore the
current prices reflect all information about the security

Whether markets are efficient has been extensively

researched and remains controversial
 Why does it matter?
If prices do fully reflect all current information, it would
not be worth an investor’s time to use information to find
undervalued securities.
If prices do NOT fully reflect information, FIND AND
USE THAT INFORMATION, and perhaps you will be
able to make a killing in the market.
 Why Should Capital Markets Be
Efficient?
What would be the ingredients of an
“informationally” efficient market?
A large number of profit-maximizing participants analyze
and value securities
New information regarding securities comes to the market
in a random fashion
Profit-maximizing investors adjust security prices rapidly to
reflect the effect of new information
 Price adjustments are unbiased – correct on average.
Under these conditions, a security’s price would be
appropriate for its level of risk.
Alternative Efficient Market Hypotheses
The various forms of the efficient market hypothesis differ
in terms of the information that security prices should
reflect.
Weak-form EMH
Semistrong-form EMH
Strong-form EMH
Weak-Form EMH
Current prices fully reflect all security-market
information, including the historical sequence of prices,
rates of return, trading volume data, and other market-
generated information
This implies that past rates of return and other market data
should have no relationship with future rates of return
Implications of the Weak-From
EMH
Examining recent trends in price and other market data in
order to predict future price changes would be a waste of
time if the market is weak-form efficient.

A lot of people do price charting and other forms of

“technical analysis.”
Semistrong-Form EMH
Current security prices reflect all public information,
including market and non-market information
This implies that decisions made on new information after
it is public should not lead to above-average risk-adjusted
profits from those transactions
Implications of the Semi strong-
Form EMH

If the market is efficient in this sense, information in

periodicals, and even company annual reports is already
fully reflected in prices, and therefore not useful for
predicting future price changes.
Strong-Form EMH
Stock prices fully reflect all information from public
and private sources
This would require perfect markets in which all
information is cost-free and available to everyone at
the same time (which is clearly not the case)
Implication: Not even “insiders” would be able to
“beat the market” on a consistent basis
Behavioral Finance
A growing field of study in finance.
Rather than assuming ultra-rational behavior, the area
of behavioral finance seeks to incorporate how
humans actually behave.
Incorporates the ways in which psychology may impact
investment decisions
It has been useful for explaining various “anomalies” that
we observe in decision-making that are difficult to reconcile
with rationality
 Behavioral Finance
Using psychological biases to explain behavior
Why do investors persistently “ride” losers and sell
winners? This can be explained by prospect theory
Why do investors display overconfidence in forecasts?
This can be explained by the confirmation bias
Why do investors tend to put more money into failing
investments? This can be explained by the escalation bias
Implications of Market Efficiency
Overall, results indicate the capital markets are efficient as
related to numerous sets of information
There are substantial instances where the market fails to
rapidly adjust to public information
So, what techniques will or won’t work?
What do you do if you can’t beat the market?