The central concepts of finance - Essay Example

The central concepts of finance Abstract One of the central concepts of finance is the market efficiency, a term used to describe a situation whereby relevant information in a market is translated into the price of financial assets. Normally, the term efficiency is used to describe operational balances of the factors employed in a market system. However, this paper looks into the balances that result from the relevancy of informational efficiency of financial markets. According to Luisa, et al, (1998), in the event that the capital markets are sufficiently competitive, simple macroeconomic principles argues that most of the investors back off major investments since they don’t expect to achieve major profits from their investment options. In this case therefore, as argued by Bodie, et al, (2011), if the market is not able to predict its fluctuations, but does asses them as being likely or less likely, then the likelihood can be accessed through mathematical process using the relevant information in the market. Thus, factors such as price reflect all the relevant information that is available in terms of the total value of an asset. With the introduction and analysis of the financial efficiency, this paper provides a comprehensive analysis of the market efficiency types and the approaches to test this efficiency. Introduction After the emergence of stock market, there was a widespread concern and controversy that made most of the investors to be keen when participating in the market. The situation was caused by the fact that their approach of making their profits seemed inappropriate. Considering that the stock market is an important component of the capital market, many economists in the world developed serious concerns and interests in exploring the trend of stock price. In this case, even though the intentions were different, there has been a central focus on the trend of the capital market in the global financial market. As the efficient market hypothesis became known to many, it became also an important part of the school of rational expectations theory, and one of the theoretical foundations of modern economic principles. As argued by the America financial economist, Fama (1965), if the market price fully reflect the all of available information, it could be said that the market achieving the efficiency. This concept hypothesis therefore proves that in the event that the current price of capital market has fully reflected the public information of the market, it will change the price only to receive new information. The stock price in the future can only be decided by the new information, and a previous gain has nothing to do with the current earning. Thus, they are independent from each other. The efficient market hypothesis (EMH) is a general operato-efficient term describing a situation where no one (investor) is able to make excessive profits in the market (Saad, & Zantout, 2014). The purpose of this paper is therefore to analyze the concept of the market efficiency by citing its types as well as defects and effects to the economic society. More than that, the paper examines the relationship among the efficiency market hypothesis, random walk theory, and empirical test of the efficient market. Efficient capital market The effective capital market theory is based on certain premises or hypothesis. One of the assumptions of this theory is that market investors are all rational, that is to say, the market investors are based on the goal of profit maximization, and the stock investors are mutually independent of value of the stock to make analysis and evaluation (Luisa, et al, 1998). Secondly, information could make the stock prices to change the internal and external market which are randomly entering the market. In this case, any pieces of new information are independent from each other. Thirdly, the stock investors could adjust their investment based on this new information rapidly (Barnes, 2009). Therefore, the stock price would change randomly and independently. Finally, the efficient market hypothesis required in the stock market has adequate participants, traders and trading volume. A plenty of trading patterns would promote the market efficiency as the stock price changing quickly. When the investors are fully rational, they build on the assets evaluation approach to the basic value and once the information raised, the investors reacted immediately, and the asset price includes all available information (Luisa, et al, 1998). However, the rationality of all investors is not a necessary condition for the establishment of EMH since the non rational investors’ trading could offset each other if their trading is independent. Therefore, in order for the asset prices to remain close to the basic value it would rather be that the randomness and independency are very important facts. Types of market efficiency The efficient market hypothesis assumes that the stock prices already reflect all available information, which is actually presenting a strong form efficient market. However, the reality of the capital market assumes that the capability of gaining the useful information could be totally different. Correspondingly, the validity of market also could be divided into strong type and weak type. According to the different categories of information gaining, Fama (1965) demonstrated the three types of market efficiency as the weak-form efficiency, semi-strong, efficiency and strong efficiency. At the same time, the information categories could be divided into three parts: the historical information, the public information and the private information. In the weak-form efficient market, the current stock price could be totally expected as a demonstration of the past trading information, the “yesterday price”. However, this old price is neither used to describe current price nor to predict future price (Kitson, 2012). Therefore, the technical staffs predict the future price through analyzing the historical price and the trading volume that would not be a great method to gain a significant profit for the investor. The book price shows all trading information. The public and private information would not affect the stock price. The semi-strong form efficient market claims that the current stock price could not be predicted by analyzing the previous information, because the information collection of the semi-strong form would include both historical and public information (Bodie, et al, 2011). If the investors can gain some enterprise future information such as the dividend, the company loss and profit, the mergers and the acquisitions, then they would get a huge profit by adjusting the stock holding in time. The basic analysis would not have the ability to obtain large profits at this moment. The information collection of the strong form efficient market includes all of historical, public and private (Kitson, 2012). No one could gain excess profit in this form, because the strong form reflects all information in the current price, so investor cannot expect future price by either technical or essential analysis. The stock book price shows all intrinsic value. Whatever the rationality of the investor, their stock price would trend to the basic value. The EMH advantages It is an undeniable fact that the emergence of the efficient market hypothesis (EMH) had an enormous impact on the financial sector of the economy. The emergence of the efficient market hypothesis gave, for the first time, the investors some hope of controlling the stock market and relieved of some unease in the market. Before the hypothesis emerged, the investors have been divided along two kinds of viewpoints; some of them believed the stock price could be predicted by analysis of the previous price fluctuation and transaction volume (Bodie, et al, 2011). Others on the other hand considered the stock market as irregular and unpredictable. In fact, through the combination of these two considerations, the investors would achieve the present efficient market hypothesis. The scientists explored the stock market through establishing numerous models in order to find out any possible relationships between some elements, whether proportional or inversely. It was then found out that the stock price could not be separated from market information. The experimental facts arranged the degree of reaction of stock price that faced different relevant information, and turned the disorderly stock market into the orderly information game (Luisa, et al, 1998). In order for the investors to get the principle of gaining the precious understanding of the huge profits in the stock market, a quick access to information and making the feedback accurately is mandatory. The efficient market hypothesis made sense of the confusing data in previous stock market and turned it to a benefit and profitable data that monitors and displays the future economic trend. Despite all these, the EMH, MM theory and CAPM model have a similar assumption. They are all interdependent. When testing the EMH, the pricing model should be balanced. When settling the pricing model, the environment should be under market efficiency (Bodie, et al, 2011). More than that, the hypothesis demonstrated the stock market that shows high reliance on information, so the government or regulatory authorities could notice the degree of the information exposure to position the development of the country’s stock market. The precious positioning could set a more reasonable trading system as well as the mode of supervision. The disadvantages of EMH The efficient market theory is not perfect though, because it has some flaws. EMH model is built on a perfectly competitive market, and the premise of perfect competition market is very strict. First, both parties have free access to the market, and then all traders have full knowledge and information. There is a gap between the completely competitive market and a practical market. It is not difficult to imagine the EMH model would face a deviation conclusion when using in the practical applications (Barnes, 2009). The essence of making profit on market economy is founded on the principles of different knowledge, different technologies, different ability to gather information, and different bias of feedback of numerous investors. One of the advantages of EMH is that the CAPM model was founded on the principles of the EMH model. However, if the market outcome is not balanced, it is hard to judge which model doesn’t in such a situation. The next point is that all investors cannot be completely independent and random since the reaction of a part of investors always affect the other investors like famous stock buyer, large investment companies, even your friends. They may affect the decision-making strategies of investors, and then the stock trading behavior may not be independent and random. Lastly, the information may be hard to define. The information may be vague and uncertain and thus very complicated. Information asymmetry is a phenomenon that often appears on the market (Barnes, 2009). Investors may find it very difficult to confirm the authenticity of information, but the enterprises could release their own good news (Kitson, 2012). Not only the information itself is difficult to define, the cost of access to information is difficult to define also. Therefore, these uncertainties might affect the EMH model from a strong assurance of operation. The empirical approaches After the proposal of the capital market efficiency theory, many scholars were enthusiastic to experiment the market effectiveness. LI (2001) summarized the test method into three categories. The first category was the statistical test, whose purpose was to detect whether the expectation of abnormal returns is zero or not. However, the reliability of this method was built on the perfection of the premise expectation model. The second category was to test whether the rule could be used to gain profits. The use of particular transaction information or rules to observe if it could get abnormal return rate. Generally, a long-term holding yield can be seen as normal yields. The third detection method based on the balance of price and value, such that by the uneven match between price and value, the fluctuation would reflect the status of current market. Empirical test of the weak form efficient market rationality is the use of random walk method. This approach focuses on the study of the correlations of price that changes over. It also considered whether the pre-yield affect the post-yield or not is very important. If there is a linear relationship between the current stock price and the previous stock changing, then the historical price movements could be used to predict the future price. If the price changing could be settled in a pattern which means the correlation index is not zero or trend to zero, then the weak-form efficiency hypothesis cannot be established in the market. For that reason the investor are not able to obtain future stock trend by analyzing past stock information in a weak-form market efficiency. When the correlation index equal to zero, then it could be called non-autocorrelations and this is a weak-form efficient market. The current book price is only able to show a real-time stock value. However, as argued by Mollah (2007), the random walk testing method may show some possible drawbacks. Mollah (2007) used the random walk model to test the null hypothesis about the daily return rate are autocorrelation in Botswana Stock Exchange. The null hypothesis have been rejected in period of 1989-2005, so it is displayed the fluctuation of Botswana market and a weak-form efficient market. However, both the non-parametric test and parametric test reject the hypothesis of random walk model, which empirical evidence totally go against with the weak-form market regulation. Mollah (2007) also found out some other financial market having the randomness model like Kuwaiti market and India market. Fama (1965) also found some evidence of autocorrelations on US stock returns, whereby their correlation index were different form zero, but the empirical evidence showing the stock market was weak form efficient market. It looks interesting, because these market all showing two different types of efficiency on their own. Therefore, it is not conclusive that the random walk model have drawbacks without considering the risk-adjust returns, which may mislead investigators from determine the correct level of efficiency. The semi-strong efficient market is the market that reflects the public business information quickly and accurately. In this case, the pace of the new information reactions becomes the decisive issue whether the market could be entering the semi-strong market or not (Saad, & Zantout, 2014). Thus the semi-strong efficiency test commonly use the event study approach, that is, through studying the impact on stock returns of a specific event to obtain the information agility on current market. In the semi-strong market, investors can obtain excess profits through insider information, so through analysis the changing of excess return which could be used to test the information agility of the market (Barnes, 2009). First, there is need to set a special event, and then the researchers observed the fluctuations around the time when special even occurred. If the significant changes of excess return emerged just a short time before the incident, then the market may have reached the semi-strong form efficient because of the information responsive ability of market that is fast and short. If the excess profit occurred around the event continuously, then the market may need a further analysis with a high possibility that the market did not achieve the semi-strong efficient at that time. However, investors may still have some psychological factors can affect the accuracy of this testing method, and even fail in certain specific periods (Saad, & Zantout, 2014). For example, overreaction may cause a drastic change of the stock price which will go over the expected level. This reaction makes the actual stock price to be over the expressive public information, which could not pass the semi-strong efficiency test obviously. Meanwhile, there is no more private information. Therefore, the market efficiency is difficult to define, because the limitations of the test method. Another psychological concept called the functional fixation, which originally used to describe a cognitive disorder. Ijiri & Jensen (1996) introduced the concept to the stock market and financial analysis. The functional fixation considered the investors unable to comprehensively analyze the whole information, but only focused on the surface of the information in the decision-making process (Zhao & Wang, 1999). From the information perspective, if the investors cannot see through the public information, then this market should not be evaluated as the semi-strong efficiency. However, the reality is just a misconception brought from different state of knowledge and technical capabilities of each individual investor. The strong form efficient market hypothesis of the stock price exhibit historic, public and private information. This form needs a complicated test to determine the presence of a strong form market. The market could be detected in two ways. One of the ways is to analysis the insider trading by monitoring whether the insider could obtain the huge profits through internal sources or not (Saad, & Zantout, 2014). If so, then the market cannot achieve strong form efficiency. The other way involves monitoring the investment direction of large investment institutions or professional investment manager. If institutions obtain the excess profit by having the substantial contribution or internal meetings, which means the market is strongly ineffective (Kitson, 2012). Both options are necessary for the operation to be successful because the insider trading information is hard to provide to the public as it is also difficult to define what the internal message is. Even though the insider is a small portion of the society, the excess return that they find cannot be reflected in the larger stock market. Conclusion After the stock market emerged, economists concentrated on ordering the stock market and introduced the concept of market efficiency. This concept connects the information exposure level and the stock price together to demonstrate the market efficiency. 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