Capital Markets and The Efficient Market Hypothesis

2BUS0197 – Financial Management

Lecture 4

Francesca Gagliardi

Learning outcomes

By the end of this session students should appreciate:

The range of business finance sources

The significance of capital markets for a company

The efficient market hypothesis and the forms of market efficiency

The implications of the efficient market hypothesis also in light of the available empirical evidence

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Sources of business finance Internal finance

Retained earnings – cash generated by a company Efficiency savings – created by more efficient

management of working capital

External finance Equity – issue of ordinary shares Debt – raised through loans

Note: External finance also classified according to time horizon (short-, medium-, long-term)

An efficient financing policy aims to raise the appropriate level of funds, at the time they are needed, at the lowest possible cost

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Balance between internal and external finance The decision on the relative usage of internal and

external finance will depend on:

1. Level of finance required – small investments may be financed through retained earning, larger projects likely to require external funds

2. Cash flow from existing operations – the higher this is, the more internal sources can be raised

3. Opportunity cost of retained earnings – the required return on equity (cost of equity) is greater than the required return on debt (cost of debt)

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Balance between internal and external finance

4. Cost of external finance – the issue costs and the commitment to pay interest debt associated with raising external finance can be avoided by using retained earnings

5. Availability of external financing sources – range of sources available depends on firms’ characteristics (e.g. non-listed firms constrained on the amount of equity finance that can be raised; high geared firms perceived as risky, hence credit constrained)

6. Dividend policy – the higher the amount of distributed dividends, the more reliant on external financing

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Capital markets and firm financing

Capital markets are organisational frameworks within which long-term financial securities are traded

Companies needing long-term finance can meet investors who have finance to offer

The finance traded may be: Equity finance, hence issue of new ordinary shares

Debt finance, companies choose from loans and debt securities

Investors can buy and sell both company and government securities

The financial assets traded on capital markets include: ordinary shares; debentures; loan stocks; bonds; preference shares; eurobonds; treasury bills etc.

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Primary and secondary capital markets Primary markets: for new issues of equity and debt.

Companies can raise long-term funds from financial institutions and investors

Secondary markets: for dealing in existing securities. Investors can sell assets or buy new ones

The secondary market is also a source of pricing information for the primary market

Hence, the secondary market helps to increase the efficiency with which the primary market allocates new funds to their best use

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UK capital markets

The London Stock Exchange (LSE) is the main market for the equity and bonds

Smaller companies unable to seek a listing on the LSE can apply for a listing on the Alternative Investment Market (AIM)

AIM operated by the LSE since 1995 Market capitalisations between £2m and £100m

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Making trading decisions in capital markets

Investors base their decision making on the information provided by:

Companies’ financial statements

Financial analysis

Companies’ dividend announcements

Market expectations of future macroeconomic conditions (i.e. inflation, interest rates)

Companies’ investment decisions

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Capital market efficiency

Both companies and investors want capital markets to assign fair prices to the securities being traded. In other words, efficiency of capital markets is required

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Efficient markets’ characteristics

Operational efficiency: transaction costs should be as low as possible and trading should occur quickly

Pricing efficiency: prices of capital market securities fully and fairly reflect all information concerning past events and all events that the market expects to occur in the future

Allocative efficiency: funds allocated to the most efficient/profitable companies

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Efficient market hypothesis (EMH)

Concerned with establishing the prices of capital market securities

States that the prices of securities fully and fairly reflect all relevant available information (Fama, 1970)

Market efficiency refers to both the speed and the quality of the price adjustment to new information

Testing of hypothesis led to recognition of three forms of market efficiency

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Weak form efficiency

Capital markets are weak form efficient if current share prices reflect past information only

It is not possible to make abnormal profits in such markets by using technical analysis to study past share price movements

Strong supporting empirical evidence: share prices follow a random walk (e.g. Kendall, 1953; Fama, 1965; Megginson, 1997)

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Semi-strong form efficiency

Capital markets are semi-strong form efficient if current share prices:

Reflect all historical information Reflect all publicly available information React quickly and accurately to incorporate any new

information as it becomes available

It is not possible to make abnormal returns through studying publicly available company accounts

The empirical evidence supports this proposition (Fama et al, 1977; Franks et al, 1977)

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Strong form efficiency

Capital markets are strong form efficient if share prices reflect full information, publicly available or not

No one can make abnormal returns from share dealing

However, capital markets do not meet all the conditions for strong form efficiency since some investors do make abnormal profits by insider dealing

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Implications of efficient market hypothesis

If the stock market is efficient…

Paying for investment research is not profitable

No point in studying financial statements

No bargains on the stock market

Managers just need to focus on making the best investment decisions, since the market will interpret them correctly and the share price will adjust accordingly

Manipulation of accounts will not mislead the market

Timing of new issues of shares is not critical since shares are never underpriced

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Does the EMH hold?

Research suggests that most stock markets respond quickly and accurately to new information, and that only through insider dealing can investors make abnormal gains

Capital markets seem to be semi-strong form efficient

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Anomalies in share price behaviour

Although share prices tend to respond quickly and accurately to new information, research has shown some anomalies in the behaviour of share prices

Calendar effects – trading at particular times of the day/year can lead to positive or negative results

Size anomalies – returns from investing in smaller companies greater in the long-run than the average return from all companies. Possible reasons: compensation for higher risk, better growth prospects due to starting lower base

Value effects – above average returns from investing in value stocks, i.e. shares with high earnings, cash flows or tangible assets relative to current share price

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Behavioural finance

Alternative view to the EMH

Seeks to understand the market implications of the psychological factors underlying investor decisions and offers

Starting point: investors do not appear in practice to be consistently able to make decisions maximising their own wealth

Suggests that irrational investor behaviour can have significant and long-lasting effects on share price movements (e.g. Shleifer, 2000)

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Summary

Today we looked at:

Sources of business finance

Why capital markets are important for companies

The efficient market hypothesis and its implications

Empirical evidence on the validity of the efficient market hypothesis

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ReadingsTextbook

Watson D. and Head A., (2009), Corporate Finance Principles and Practice, 5th edition, FT Prentice Hall, Chapter 2, sections 2.1, 2.2, 2.3

Research papers

Fama, E. (1998), Market Efficiency, Long-term Returns and Behavioural Finance, Journal of Financial Economics, 49, pp. 283-306

Akintoye, I. R. (2008), Efficient Market Hypothesis and Behavioural Finance: A Review of the Literature, European Journal of Social Sciences, 7 (2), pp. 7-17

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Your tutorial activities for next week

During the seminar you will be expected to work on:

Q2, 3 p.66 (5th ed)Q2, 3 p.64 (4th ed)

To prepare for the seminar you should answer the following practice questions:

Q3, 7 p.63; Q1 p.64 (5th ed) Q3, 7 p.61; Q1 p.62 (4th ed)

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