Financial Markets

Corporate Finance
Introduction
 Money Markets

 Capital Markets

 Efficient Market Hypothesis

 Risk/Return Trade-Off
Financial Markets
 ‘Collection of economic units with surplus funds (individuals,
corporations, government etc) who lend funds to other economic units
wanting to borrow’

 Role of financial markets:

 Channel funds from savers to spenders (crucial to entrepreneurs)
 Allow consumers to time purchases better
 E.g. mortgages
Financial Market Classification
 Primary Markets: market where a security is first issued

 Secondary Markets: market where security is subsequently

traded
 Exchanges
 OTC
Capital Market Efficiency
 Ask the question:
‘If N Plc shares are valued at $1.30, is this value reliable (i.e. fair, true, accurate)?

 What you would really be asking is:

 How efficient is the stock market at valuing the shares of the company?

 So … an efficient market is one in which security prices fully reflect all available
information

 Equal chance of being too pessimistic or too optimistic

 New information is rapidly and rationally incorporated into share prices in an unbiased
way
Perfect Markets
 According to Megginson (1997) a perfect market has certain
characteristics:
 Absence of taxes or transaction costs that may inhibit buying/selling
 Equal expectations of all participants regarding asset prices, interest rates etc
 Entry/exit from market is free
 Info has no cost and is freely available to all market participants
 Large number of buyers/sellers, none dominating the market
Features of Efficient Market
 Operational Efficiency: transaction costs should be
as low as possible and required trading quickly
actioned
 Benefit of competition

 Allocation Efficiency: capital market, through pricing

efficiency, allocates scarce funds to where they can
best be used

 Pricing Efficiency: prices of capital market securities

should fully reflect all information concerning past
events and expected future events (EMH)
Efficient Market Hypothesis

‘There is no other proposition in economics which has more

solid empirical evidence supporting it than the efficient market
hypothesis (Jensen, 1978)
Efficient Market Hypothesis
 EMH is concerned with establishing the prices of capital market
securities and states that the prices of securities fully and fairly reflect
all relevant available information

 Not possible to consistently outperform the market by using information the

market already knows (unless you get lucky!!)
 New information is quickly incorporated into share prices
 Distinguishes between three different levels of efficiency
Weak Form Efficiency
 Share price reflects all info about past price movements
 Chartism/technical analysis

 Share prices often follow random walk (Kendall, 1953)

 No patterns or trends
 Prices rise/fall depending on whether next piece of news is
good/bad
 Only 0.1% of a share price change in one day can be
predicted from knowledge of change on the previous day
 Tossing a coin 100 times

 Current evidence:
 Future prices cannot be predicted from past movements
 Chartism/technical analysis cannot help make a consistent gain
on the market
Semi-Strong Efficiency
 Share price incorporates all past information and all publicly available information
 Analysts look to future growth prospects and compare to current price (under/over valued)

 Evidence:
 Share prices react within 5-10 minutes of any new information
 Rise when good news
 Fall when bad news

 Result:
 Stock market is semi-strong efficient so:
 Examining publicly available information will not provide opportunities to consistently beat the
market
 Only those trading in first few minutes after news breaks can beat the market
Strong Form Efficiency
 Share price incorporates all information, whether public or private,
including as yet unpublished

 Evidence:
 Insiders have access to unpublished information. If market was strong:
 Share price wouldn’t move when news broke about take over (would move
when initial decision is made)
 No need to ban ‘insider trading’ as insiders couldn’t make money by trading
before news became public

 Result:
 Stock market is not strong so:
 Insider dealing faces severe punishment
 Stock exchange encourages quick release of info to prevent insider trading
 Insiders forbidden from trading shares at crucial times

 Insider trading
 R Foster Winans
 Martha Stewart
 James Sanders
Implications of EMH
 Implications for investors if stock market is efficient:
 Paying for investment research will not produce above average returns
 Studying published accounts and investment tips will not produce above average returns
 There are no bargains to be found on stock market

 Implications for managers:

 Share price fairly reflects value and market expectations about future performance and
returns – so focus should be on decisions that will increase shareholder value
 Window dressing financial statements will not mislead market
 Timing of new issues of shares not important as shares are underpriced
‘Anomalies’ in Share Price Behaviour
 Calendar effects:
 The weekend effect
 Last 15 minutes of trading
 January/April effect in US/UK

 Size anomalies
 Smaller companies outperform market

 Under-reaction
 Post unexpected earnings announcements
 Repurchase of shares
Perspectives on EMH
 Strong statements portend reversals’ (Shliefer, 2000)

 I’m convinced that there is much inefficiency in the market … when the price of a
stock can be influenced by a ‘herd’ on wall street with prices set at t eh margin by
the most emotional person, or the greediest person, or the most depressed person,
it is hard to argue that the market always prices rationally. In fact, market prices are
nonsensical … there seems to be some perverse human characteristic that likes to
make easy things difficult.
(Warren Buffet, 1984)
Criticisms of EMH
 Behavioural finance proponents

 Assumes rational human behaviour

 Frequent and systematic errors by investors

 Academic proponents ‘it might work in practice, but it’ll never

work in theory’
Conclusion
 EMH as incomplete explanation of share price behaviour

 Behavioural economists

 Well developed capital markets may be semi-strong efficient

 Emerging capital markets may be weak form efficient

 Alternative theories for explaining market movements