Effective Market Hypothesis - Essay Example

Effective Market Hypothesis 1. Introduction Ohlson’s paper developed an analysis of a model that concentrates on the firm’s market. The contemporary and future earnings, book values and dividends are considered in the analysis. The accounting has to provide the underpinnings of the owners’ equity accounting. This is capable of constructing surplus relation applies; dividends reduce current book value and current earnings. The theory establishes the importance of integrative function to the statement of changes in owner’s equity. The theory emphasizes on the bottom line items of the balance sheet and income statement, book value and earnings. This format requires the changes in book value. This makes equal earnings after reducing dividends and provides net of capital contribution. This relation according to Ohlson is a clean surplus relation as the changes in assets and liabilities are passed through the income statement. It is better to use this theory without connecting it to a user’s perspective on accounting data. The numerous methods followed in valuing derivative securities include valuing an option on a stock or index that can pay continuous dividends. The unfamiliar or foreign contracts will have no closed form of solution. This needs Monte-Carlo simulation, numerical integration, analytical and series approximation. The probabilities of a jump process by Schwartz in 1998 are to underlie the diffusion process corresponding to the coefficients of the difference equation. The trinomial tree is termed as equivalent to the explicit finite difference. This generalized multinomial jump process equivalent to a complex implicit finite difference in approximation. The two state lattice approaches has proved to be powerful tool and can be used to value a wide variety of contingent claims. The standard binomial approach is generalised and was included in the main existing models as particular cases of alternative approach. There are alternative analytical approximations for continuous time valuation like CRR model in case of single state variable. The lattice approach in valuating the option was based on a moment matching methodology. The introduction of numerically optimised parameter the non negativity of the risk neutral probabilities was ensured. 1 2. Deprival Value Approach 2.1 Equity valuation : In the following equation the P is obtained by discounting the expected value. Let the d­t = $5 Let the cost of equity = 6 R = 7 T = 1 Then = 5. 7­-1 = 5/7 = 0.714 In order to have clean surplus identity Bt = bt-1 + xt- dt = 1000000 + 100000 – 5 = 1099995. In this manner the book value of a particular year depends on the book value of the previous year and the expected discount of the present year. The book value may decrease if the expected dividend is more. 2.2 Deprival value: The deprival value approach to the computation of depreciation is important. The depreciation is considered as a single technique that is devoid of theoretical economic content. This helps in assigning the cost to the products or periods. The time can be considered as opportune to resurrect any idea. The connection of deprival values with implicit pricing in a used asset market. The attention of the investors should be drawn towards the deprival value depreciation model. The clarification of certain issues that are cause for the difficulty and highlighting the deprival values are necessary and are important properties. 2 2.3 Valuation model and information dynamics: The valuation model and information dynamics has attracted considerable attention among accounting researchers. The valuation can be done by residual income valuation model and information dynamics is linear. The firm value is expressed as the sum of the book value of equity. The present value of future abnormal earnings is also included. The dividend discount model finds an application in residual income valuation model. The mechanism of abnormal earnings will be linked to the information of future abnormal earnings in linear information dynamics. As the linear information modelling contain, the variable vt the empirical testing of linear information dynamics will be difficult. This is due to the fact that the variable reveals the information about the extra abnormal earnings not yet captured. These abnormal earnings are not captured in current financial statements. Even then they are capable of affecting the future abnormal earnings. The internal properties of the abnormal earnings will make difficult to observe them. The integral role of vt is considered as a key in LIM and helps in improvement of linear information dynamics. 3. Models of valuation The residual income valuation of dividend discount model defines the value of a firm as the present value of the expected future dividends. In this vt is considered as the value of the firm after a time t. The entries to retained earnings are decided by clean surplus concept and enable the provision of book value of equity. The normal earnings of the firm is calculated by the book value of equity at date t-1 multiplied by capital cost to make the earnings in the period t minus normal earnings as abnormal earnings. The main problem in this method is the confusion of terminology. The abnormal earnings is termed as residual income in valuation model. This implies that the value of a firm will be equal to its book value of equity and the present value of anticipated abnormal earnings. The advantage of residual income valuation is that the firm value is not affected by accounting choices. 3.2 Linear information Model: The linear information model proposed by Ohlson in 1995 describes the time series behaviour of abnormal earnings. Researchers like Dechow et al in 1999 emphasised the real achievement of Ohlson that the LIM creates a link between the current information and firm’s intrinsic value. This is due to the assumption of the time series behaviour of the abnormal earnings. The LIM of ohlson assumes the source of abnormal earnings as the monopoly rents. This is due to the fact that thee monopoly rents return towards the cost of capital in the long run. Though operating assets and earnings are used, they result in the abnormal earnings or residual income. This is due to the assumption that the abnormal earnings are generated from two sources. The first one being monopoly rents as the market competition is expected to force returns toward the cost of capital in the long run. After that the accounting conservatism is considered. This depresses the value of assets below their market value. Thus Ohlson model will consider the unbiased accounting as aggressive accounting. This obtains the valuation functions of a firm without requiring explicit forecasts of future dividends or additional assumptions about the calculations of terminal value. The testing of the Ohlson model is difficult as vt is unobservable. As a result in the course of time the vt is taken as a constant and this made estimation simpler than before. 3 (b) 4. Analysis of Raw Data 4.1 Suggestions from analysis: The relationship between equity prices and the book or accounting figures are considered important after the Ohlson’s model. The paradigm is that the theoretical and empirical literature can be predicated on the assumption that there is a purely linear relationship between the price of f rim’s equity stock and the book figures appearing in the financial statements. The evidence suggests that there is potential and highly non linear relationship between equity prices and the summary measures appear on corporate financial statements. 4.2 flawed equation valuation: The data from the 3,500 firms in UK suggests that the market value divided by book value is more than the earnings divided by book value. This implies that the market value of the equities of different firms is placed above than the earnings they incur. The Market value added can be given by subtracting the invested capital from the market value of the company as follow. MVA = Company’s market value – invested capital In the Raw data The market value to the book value ratio is more than one and yet times more than 4. In this case let the invested capital is x. Then the market value is 4x The MVA = Company’s market value – invested capital value 4x – x = 3x. This is the market value added. This can be termed as flawed when we consider the earnings dividend from the raw data. For the company that is having added market value as 3x the earnings dividend is -1. This means the earnings from the dividend has been decreased. This represents that the earnings per share is decreasing. It can be calculated as follows. (Net income – dividends on preferred stock)/average outstanding shares This is obtained as -1. this implies the net income is less than the dividends on the preferred stock. For example if the dividends on preferred stock is 3, net income is 1 and average outstanding shares stands on a constant 2 then EPS = -1. the company is getting more market value by giving dividends more than the net income. This can be termed as an example of flawed equation valuation. 4.2 Market value and earnings: This does not mean that the market value and the earnings should be equal. The earnings are not at par with the market value of the equity that is needed to be offered for the equity. When the earnings that can be attributed are divided by equity, the value is negative denoting that there is much probability for the decrease of attributable earnings and that is being positive when market value divided book value. This denotes that the market value is increasing at a greater pace than the attributable earnings of the equity of the company. Such evidence as exists however is highly suggestive as the relationship between the market to book ratio and the earnings to book ratio of 45,000 firm years covering from 1976 to 1994 have shown the convex function of the earnings to book ratio. This is due to the fact that the market value is compatible with the real options available to the firms. This makes significant contribution to overall equity value. In case of 12,000 UK firms also, the highly convex relationship ship between the market value to book value was proved to be more convex than the earnings to the book value. This develops an aggregation theorem that shows the real options available to firms are reasonable for the expectation of the convex relationship between equity prices and earnings. The empirical estimation of the convex relationship mentioned above between equity prices and earnings rises complex econometric issues. This is confirmed by the wrong specification problems that arise when one attempt to fit the linear and hyperbolic regression models to their data. The real options make the overall value of equity to hinge on a crucial risk parameter that governs the evolution of the recursion value of equity. The difficulty in observation of recursion value of equity directly will pose problems for estimation of this risk parameter on which the recursion value depends on. This can be overcome by using the older statistics based on sample of market to book ratios for a given firm or industry in combination with the aggregation theorem developed. This will result in disaggregating the overall market value of equity into estimates of its recursion value and real value components. The analysis should review the empirical data that relates to the equity value and earnings. The fundamental assumption about the relationship between the book value of equity and its real value can be used in the analysis. This is capable of underscoring the most of the empirical work. This result can be combined with the assumed relationship between book value and real value of equity. This is do disaggregate equity value into its estimated recursion and real value components. In case of raw data observed in the 3500 companies earnings of equity and value of equity to book value, the disaggregation has not been done and the reasons for the convex relationship cannot be explained unless the real options available for each company had been known. Thus the desegregation will start the study independently and the results should be analysed or examined collectively. The final procedural section goes on to apply these estimation procedures to much larger sample sizes drawn from different industry groupings. The risk parameters of the these four broad industry groupings can be used to estimate recursion value and real adaptation components. The disaggregation of equity values into their estimated recursion value and real value components will make the study simpler and clear about the risk parameters that the effect the earnings in near future and the market value in the long term. References: 1. Ota, Koji, "A Test of the Ohlson (1995) Model: Empirical Evidence from Japan" (November 1, 2001). Available at SSRN: http://ssrn.com/abstract=287513 2. Lee, Cheng F.(Editor). Advances in Quantitative Analysis of Finance and Accounting : New Series. Singapore: World Scientific Publishing Company, Incorporated, 2004. p 2. http://site.ebrary.com/lib/nulibraries/Doc?id=10088374&ppg=17 3. Parker, R. H. Development of Accounting in an International Context : A Festschrift in Honour of R. H. Parker. Florence, KY, USA: Routledge, 1997. p 122. http://site.ebrary.com/lib/columbiasouthern/Doc?id=10017342&ppg=134 Question 2 (a) 1. Carry Trade and Covered Interest Arbitrage 1.1 Carry trade: Carry trade is a strategy, which an investor sells a certain currency with a relatively low interest rate. These funds are used to purchase a different currency yielding a higher interest rate. This strategy can capture the differences between the exchange rates between the rates and works out when the difference is substantial. This also depends on the amount of leverage the investor uses. One of the most publicized example is yen carry trade. In general traders borrow the yen from Japanese bank and convert them into US dollars to buy a bond. The bond pays higher interest for him as the Japanese interest rate is 0 percent. This gives the trader a profit of 4.5 percent as long as the exchange between the currencies does not change. The profit depends on the leverage the trader takes into consideration. The risk involved in the carry trade is uncertainty in exchange rates. The important risk is appreciation of yen or depreciation of dollar in the above example. The funds should be hedged properly to minimize the risk results in huge losses due to change in currency exchange rates. 4 1.2 Covered Interest arbitrage: This is an investment strategy involves the buying of financial instrument denominated in a foreign currency. This is useful in hedging the foreign exchange risk by selling a forward contract. This is suggestible in the case of risk free financial instruments. This will give enough opportunity to gin when the interest rate difference between the home interest rate and foreign interest rate is not off set by the forward premium or discount of the foreign currency. This will beneficial as long as there is a chance of depreciation of the foreign currency we are buying in the future when compared to the home currency. This is because the trader tries to convert the investment in foreign currency. This involves the high interest rates of the foreign currency also. 1.3 Difference between the Carry trade and covered Interest Arbitrage: In case of carry trade the trader will make use of low interest rate in foreign country and takes loan from that central bank and converts them into the home currency to benefit from the high interest rate in home country. This yields high interest rate. Whereas in case of covered interest arbitrage the trader will make use of high value of a foreign exchange when compared to the home currency and enter into a forward contract expecting the home currency to appreciate. (b) 2. Investing in Unit Trusts 2.1 Index tracking unit trusts: The index tracking unit trusts are also known as tracker unit trusts, which aim to produce returns in line with a market or sector. The market may be a country and sector may be a technology. The accuracy of the investments will reflect the selected index. As the investments are tracked this allows to offer low charges and more money remains invested. The investment in index tracking unit trusts that invest overseas will be enable to benefit from the exchange rates between currencies and vice versa. Unit trusts are the investments that are designed for long term investments and the least time period will be 5 years. The amount of returns may rise or fall and this depends on the risk involved in the market and sector the fund invests. The returns of index tracking unit trusts investing in overseas are subjected to the exchange rate variations. The long term investment will compensate and allow in gaining reasonable returns. 5 In some index tracking stocks like NASDAQ 100 investment in one investment portfolio will give ownership in 100 stocks of NASDAQ 100 index. The index tracking unit trusts can buy the NASDAQ 100 index trading stock as they can buy them on margin and sell short or hold the shares in the long term. The long term holding of the shares may result in risk of loss and this is the case with every index tracking unit trust. Though there is convenient trading and tracking through out the day the company investing pension fund cannot invest on index tracking unit trusts due to high risk factor. This makes the passive investors to chose the private equity funds that involve the general partner in the form of management. 2.2 Private Equity Funds: Private equity funds are the pools of capital invested by private equity firms. These firms exist in form of limited partnership or Limited Liability Company. This will be controlled by a private equity firm that acts as a general partner. The limited partnership of the general partner is called as fund. These funds are suitable to collect the funds from the investors like pension funds, financial institutions and wealthy individuals. These investors invest a specified amount and act as passive limited partners. The general partner identifies the relevant opportunity and will invest the capital amount available to the firm. The limited partners fund in a method of pro rate portion of the commitment. The investment decisions are made by general partner who manages the fund’s investments in the form of portfolio. The general partners will charge a management fee as a percentage of the fund’s total equity capital. In case of gross private equity returns they may be in excess of 20 percent per year if there is leveraged buy out of firms. This is due to increased leverage in the portfolio companies. These funds receive equity in the form of recapitalization also. 2.3 Efficient market hypothesis: The efficient market hypothesis assertion for the financial markets is important as it is informationally important. The prices of stocks, bonds, or any other asset will reflect known information and are unbiased in the sense that they reflect the collective beliefs of a large set of investors. This is an academic concept used to identify the assets that outperform the market. This is possible by information. Information can be a empirical study or the factors that affect the market. The efficient market utility needs rational expectations. This makes the agent to update the information according to the expectations. This makes efficient market hypothesis will deal with over and under reactions of the investors according to the information. EMH makes the investors’ reactions random and follows a normal distribution process. This can avoid the net effect on the market making abnormal profits. This follows an assumption that the market as a whole is right. 6 Though it is a corner stone, the efficient market hypothesis is highly controversial. This often arises disputes. As this will search the undervalued stocks the believers say that this is not a valid one. This even tries to predict trends in the market through fundamental and technical analysis. The above two aspects of finding low priced stocks and analyzing them with fundamental and technically will give the necessary assurance for the returns on the earnings. The large body of evidence and a same amount of disagreement is also existing. According to efficient market hypothesis the long beating of the market by any investor is important and Warren Buffett like investors have done it. It does not mean that the assumptions of the efficient market hypothesis are not valid. Primarily the efficient market hypothesis works on two points. The opportunity of increasing the value of the share in future and the earnings given by the stock due to the strong fundamentals and technical aspects. The fall of 1987 stock market is not according to efficient market hypothesis as lot of stocks fell by 20 percent on the same day. This gave a chance to assume that the efficient market analysis will deviate the values.7 In case of index tracking unit trusts, there is no opportunity for a passive investor. There will be no other general partner to invest from the side of the investor. The risk factor is more as the investor may or may not be aware of the information that can avoid loss. As the firm considered here is the one which wants to invest its pension fund there is less probability to take track of the funds by the investor. The investor wants low risk and minimum returns to pay for the pension of the retired employees. This can be done by private equity unit trusts as there will be a general partner to invest the other partners’ funds in the market according to the opportunity and even can change the form and place of the investment. In the case of index tracked unit trust, the opportunity for investment and the changes needed for it must be done by the investor only. As this is not possible in the present case, the it is suggestible to invest in private equity funds that will invest according to the efficient market hypothesis. In the date given the CRB continuous commodity index is found to be low price stock of 201.77 GBP with weak fundamentals. This is because though the price is lesser than the other stocks and assets that is the maximum price of that stock when compared to other stocks’ returns. The returns of the other stocks are in thousands of GBP and this stock’s maximum price is 201.77. So, here the efficient market hypothesis will not work in this model but in a different way. The consistency of the unit trusts can be tested using efficient market hypothesis and can be invested accordingly. The FTSE 100 stocks are showing lesser growth when compared to FTSE 350 value and FTSE small cap. According to efficient market hypothesis, the growth of the FTSE 100 is having more probability and the company can invest the pension fund in the private equity fund which is investing or have invested in FTSE 100 stocks to gain as much maximum profit as possible. As the risk factors for private equity funds are lesser than the index tracking unit trusts, it is suggestible to invest in private equity funds for minimum guaranteed returns as the risk is low due to actions of general partner. References 1. investopedia.com, 2007, carry trade, investopedia.com, ,electronic, 12-8-07, http://www.investopedia.com/terms/c/currencycarrytrade.asp 2. Legal and general, 2007, Index tracking unit trust, Legal and General, ,electronic, 12-8-07, http://www.legalandgeneral.com/investments/unit-trusts/index-tracking-unit-trust/risk-factors.html 3. Media wiki, 2007, effective market hypothesis, Wikipedia, ,electronic, 12-8-07, http://en.wikipedia.org/wiki/Efficient_market_hypothesis 4. investopedia.com, 2007, efficient market hypothesis, investopedia.com, ,electronic, 12-8-07, http://www.investopedia.com/search/results.aspx?q=efficient+market+hypothesis Read More