Advanced Investment Theory and Practice - Assignment Example

 Advanced Investment Theory and Practice Introduction Financial Market Efficiency Financial market is considered a market for the exchange of credit and capital, which consists the capital markets and the money markets (McLindon 1996). Whereas capital market is considered a market where long-term securities or debt are traded, the money market is considered a market for debt securities are short-term (McLindon 1996). While looking at the financial market, it is important to understand the market efficiency and efficient market. On the one hand, market efficiency is a condition where current prices reflect available public information concerning security (McLindon 1996). The underlying idea concerning market efficiency is that competition drives information into the price rapidly. In looking at the financial market, the highest price an investor is ready to pay for financial asset is really the current value of cash payments in the future that are discounted at a high rate to reimburse for uncertainty in the projection of cash flow. For this reason, investors are actually trading information as a commodity in the financial market for information concerning the degree of certainty and future cash flows. Efficient market, on the other hand, materializes when new information is rapidly integrated into the price to make the price become information (McLindon 1996). To put it plainly, current market price mirrors available information. The current market price under these conditions in a financial market could be a good estimate that is unbiased for the value of investment. Let us look at efficient market hypothesis and its implication on portfolio management and security analysis. Efficient Market Hypothesis Efficient market hypothesis has been agreed as one of the foundation of modern financial economics. It was first defined in financial literature by Fama in 1965 where security prices completely reflected available information (Fama 1965). She defined it as an idea that information is efficiently and rapidly integrated into asset prices at any time to allow for old information not to be used to predict future movements of price. As a result, efficient market hypothesis is being distinguished in three versions depending on the level of information that is available. These versions of efficient market hypothesis are weak form, semi strong form, and strong form. Let us look at them and then look at the portfolio in efficient markets. Weak Form This insists on current prices reflecting past volume and price information. The information in the past sequence of security prices is totally reflected in the market prices that are current of that security. The name “weak form” is because the prices of security are public and information easily accessible. This means that no individual should be capable to outperform the market utilizing what everyone else knows. However, there are financial researchers who study the stock price series of the past and volume data of trading in an attempt to make profit. This is a technique of analysis that is stressed by efficient market hypothesis as ineffective for forecasting changes in future prices. Semi Strong Form This insists that available information that is public is integrated into prices of assets. To explain this in a simple way, available public information is completely reflected in a market price of current security. Public information in addition to past prices also states data reported in financial statements of a company, economic factors, and announcement of a company. This means that no individual should be capable to outperform the market utilizing something that everyone else knows. This shows that financial statements of a company are of no assistance in predicting movements of future price and securing returns of high investments. Strong Form This insists that inside information (or private information) is rapidly integrated by prices in the market and hence cannot be utilized to collect profits from abnormal trading. Accordingly, information both private and public is completely at a market price of current security. This implies that the management of a company is not capable of making gains from the company’s inside information it has. They are not capable of taking the benefits to profit from inside information, such as taking over decisions that have been made five minutes ago in a meeting. The reasoning behind this is that there is an anticipation of the market in an unbiased way and hence information has been evaluated and incorporated into the price of the market in a much more informative and objective way than the insiders. It is usually accepted by economists that studies of empirical nature have provided evidence that is sufficient to accept the semi strong and weak forms of the efficient market hypothesis (Ball & Brown 1968). It is in this way that in this paper reference to efficient markets will be made. Implications of Efficient Market Hypothesis for Portfolio Management and Security Analysis The question to ask is, “what are the several implications of a market that is efficient for portfolio management?” As far as security analysis is in question, the efficient market hypothesis plainly put forward that neither fundamental analysis nor technical analysis is meaningful, unless, as Lorie and Hamilton explain, the scale of investable funds is sufficient in the process of analysis (Lorie & Hamilton 1973). The process of portfolio management is simple to explain. The whole process is adequately basic to allow the writing of a computer programme to replicate nearly precisely the portfolio, which a manager chose (Clarkson & Meltzer 1960). For example, Black presents an intense but convincing case for a passive portfolio management strategy (Black 1971). He explains that in case an investor does this, that investor will not try to outguess changes in the market. He continues saying the investor will not try to pick stocks that are thought not to do better than other stocks. The investor will usually sell only to establish losses in tax, or when the investor requires money. The investor may borrow against portfolio when money is required, rather than selling, in order to avoid realizing gains in capital. Furthermore, the investor will try to minimize investment expenses, taxes, and costs. As correctly pointed out above by Black, a portfolio strategy that is passive does not mean randomly purchasing securities, but choosing a portfolio that is well diversified in harmony with the utility of investor towards risk. Simply put, there still remains the requirement for estimates of contributions that individual securities make to the diversified portfolio riskiness. The task would be simplified if riskiness could be judged by historical data reference. Blume in a study shows that riskiness changes only gradually through time so that measures of risk that are historic provide the foundation for a good objective future risk estimates (Blume 1971). It is, therefore, obvious that although the theory of portfolio taken together with the efficient markets concept has significant implications for management of portfolio, understanding and knowledge of the significant relationships between return and risk, and dividing of risk into unsystematic and systematic risk, are exceedingly significant in portfolio management that is successful. In addition, it is recommended that in the light of portfolio theories and efficient markets, individual securities cannot be priced based on their risk taken in separation from other securities. The purpose of a security analyst is to estimate return of security, covariance and risk with other securities or index of a market, in order for the manager of a portfolio to not be provided with a sell, hold or buy recommendations, but instead with an approximation of the parameters of security returns distribution. There are two fundamental capital market theories that are divisibility and liquidity. This means that every investor can change the portfolio composition of assets at a particular time when either his perceptions or requirements of factors of assets change substantially. The delicate nature of capital market to information that affects the risk of return characteristics of individual investment is essential to the efficient markets concept. Hence, it is in each investor’s interest to get information concerning the capital markets of security traded. This kind of information permits the investor to assess the prospects of every investment opportunity, and hence invest in the portfolio with a performance that is promising. This information demand generates the existence of channels of various information expected to provide investors with knowledge that is pertinent, such as stock prices, volumes, balance sheets of companies, and periodic income statements (Vasicek & McQuown 1972). However, the trustworthiness of such information disseminated is currently under challenge and this issue is considered separate. Empirical Tests of the Efficient Market Hypothesis Kuala Lumpur Stock Exchange (KLSE) study has been chosen to test different forms of efficiency. In the first study, Weak form efficiency in the Malaysian Stock Market was conducted by Kok and Goh to address issues of weak form of market efficiency by looking at random walk behaviour of prices of stock over a short period in the KLSE utilizing the closing levels of KLSE stock indices (Kok & Goh 1995). The test used are von Neumann’s ratio test, serial correlation test, run test and Ljung-Box-pierce Q test that are based on short horizons return. Kok and Goh utilized monthly, weekly, and daily closing levels of the seven KLSE stock indices for 9 years, that is, 1984 to 1992 (Kok & Goh 1995). In the run test to validate efficiency that compared the expected number of runs with the actual, to determine changes in price, there was no conclusion made by Kok and Goh because the results were in contrast among monthly, weekly, and daily data. The other test done was statistical test for independence where serial correlation test, von Neumann’s ratio test and Ljung-Box-pierce Q test was used. Serial correlation test on monthly, weekly and daily data was confirmed by Ljung-Box-pierce Q test that can test 12 lags. In addition, the results were reinforced with von Neumann’s ratio test. The statistical tests results on the KLSE daily stock indices show serial dependence in successive changes in price. The tests show the stock market in Malaysia has improved the efficiency from a weak form market that is inefficient in the middle of 1980s to an efficient market weak form ending 1980s and beginning 1990s. In another study, a test of semi strong form efficiency was chosen on KLSE, where the dividend announcements and annual earnings effects on prices of stock by Annuar and Shamsher was conducted (Annuar & Shamsher 1993). This study was concerned with analysis of semi strong efficiency of KLSE and the effect of content information changes in dividend announcement and annual earnings on prices of shares. Monthly closing prices were used by Annuar and Shamsher of stocks trading in the course of 1975 to 1989 with modifications on capitalization changes. Dividend and earnings information was collected from a size of sample. Annuar and Shamsher used study of events in an effort to portray that markets react rapidly to new information. While analyzing the effects of annual earnings on the price of stock, model of the market was utilized to generate projected returns with consideration of individual stock of systematic risk as well factors of the market. The average cumulative abnormal returns and abnormal returns for twelve months were taken as a measure of cumulative and average effects of dividend announcements and earnings, with anticipation that cumulative abnormal returns would randomly fluctuate at zero after announcement has been made. Assessment of Financial Markets Efficiency in Relevant Empirical Study Tests The two studies above came to the same conclusion concerning efficiency. In the weak form efficiency study, there is strong evidence that proves researcher’s conclusion as four statistical tests are being utilized to reinforce results. Nevertheless, with statistical tests only being utilized, this can be a big shortcoming as trading rule tests are ignored, such as the filter rules that may beat the market. In weak strong form efficiency study, two events have been tested, the dividend announcement and annual earnings on prices of stock. This is a good approach utilized by researches because modifications have been made on changes of capitalization on prices of stock because this may differ with the findings. Looking at both studies, there has been no attempt taken to project the expectation errors. There is no test that has no errors and people using research need to know the error margin for the purpose of relying on the research findings. Nevertheless, the conclusion has been reached that the second study of the semi strong form indicates that the financial market that is under research is regarded to be more efficient. Conclusion There is a relationship between efficient market hypothesis and portfolio management. Additionally, it is suggested that these theories will have significant conceptual effects on the analysis of security in practice. The role of a security analyst may be revised as the theories examined above gain better acceptance by the finance community. Bibliography Annuar, MN & Shamsher, M 1993, The efficiency of Kuala Lumpur stock exchange, Pernerbit University Pertanian, Malaysia. Ball, R &Brown, P 1968, ‘An empirical evaluation of accounting income numbers’. Journal of Accounting Research, vol.6, no.1, pp. 159-178. Black, F 1971, ‘Implications of the Random Walk Hypothesis for portfolio management’. Financial Analysts Journal, vol.27, no.2, pp. 16-22. Blume, M E 1971, ‘On the assessment of risk’. The Journal of Finance, vol.26, no.1, pp. 1-10. Clarkson, G P & Meltzer, B H 1960, ‘Portfolio selection: heuristic approach’. Journal of Finance, vol.15, no.4, pp. 312-326. Fama, E 1965, ‘Random walks in stock market prices’. Financial Analysts Journal, vol. 21, no.5, pp.55-59. Kok, KL & Goh, KL 1995, Malaysian securities market, Pelanduk Publications, Selangor. Lorie, JH & Hamilton, MT 1973, The stock market: Theories and evidence, Irwin, Homewood, Illinois. 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