Advanced Investment and Theory - Assignment Example

Advanced Investment and Theory Introduction An efficient capital market can be used to mean, a market where the share prices accurately reflect new information and in a real time. The efficiency of a capital market is determined by its success in incorporating and receiving information about the elementary value securities into the security prices. This basic value of securities may be the present value of the cash flows expected in the future by the individual who owns the securities. If the value of stocks fluctuates, traders get encouraged to trade in a competitive manner with an aim of obtaining maximum profits and avoiding loses in their securities. This brings about the price movements in the direction of the current value of the cash flows in the future. An efficient capital market is the one that incorporates information accurately and in a steady manner into the security prices (Kleinbrod, 2006, Pg. 78). The weak-form efficient capital market is reached after the information regarding the history of previous returns and prices are fully reflected in the security prices. In such markets, the stock returns are unpredictable. The semi strong-form efficient market is realised whereby, the public information ids completely reflected in security prices. In the particular market, traders who have non-public information access may earn excess profits. In the third type of efficient market, the strong form, investors can under no circumstances, earn excess profits since every bit of information is incorporated into the prices of securities. The funds that flow from the capital markets, originating from savers to the firms aiming to finance projects must also flow into the best and highly valued projects. In this cse, information efficiency is of great significance. Stocks must have efficient prices. If securities were accurately priced, the investors who lack time for market analysis would gain confidence about making investments in the capital market (Moyer et al.2009, Pg.8). Literature review The efficient markets theory of financial economics explains that the price of a product reflects all available relevant information about the fundamental value of the product. Although the theory applies to every type of financial security, it discussion is mostly focused on one type of security, shares of common stock. The encyclopedia of economics states that, financial security stands for a claim in future cash flow. Therefore the fundamental value of the product is the present value of the cash flow that is expected by the security owner. According to the theory, the profit opportunities represented by the existing overvalued or undervalued stocks motivate investors to trade while their trading pushes the prices of stocks in the direction of the present value of their future cash flows. Various articles search for the mispriced stocks while their subsequent trading makeup an efficient market and cause prices to reflect fundamental values. (Satchell, 2007;Pg. 89) points out that, market efficiency is a scale. According to his article, the market is more efficient when the transaction costs in a market are lowest, including the costs of obtaining trading and information. Reliable information about firms is relatively cheap to obtain in U.S while the trading securities are cheap. As a result of this, the U.S security markets are believed to be realistically efficient. According to the Louis Bachelier, the French mathematician, on his analysis of stock market returns, statistical independence is documented in stock returns. This means that, todays, returns has nothing to do with influencing the magnitude of tomorrow’s returns. Anticipating the Efficient Market Theory, Louis modeled stock returns as a random walk. Louis contradicts his argument latter in his work about the fundamental value. He argued that stock prices are based on the economic fundamentals (Markowitz, 2000, Pg. 90). According to other researches, the stock prices always reflect everything that is known concerning the prospects of economy. It is argued that stock prices can never be predicted. If the available information is entrenched in the prices, they will therefore be moved only by unforeseen and unpredictable events. The consistency of positive past returns significantly affects the relation between past returns relatively affects the relation between the past returns and the cross-section of anticipated returns (Bruetsch, 2009, Pg. 77). Empirical evidence does not generally support the strong forms of the efficient market hypothesis. This was pointed out by Czech Republic capital market review, (1999) paper. Many researchers have explained ‘losers’ as stocks that have incurred poor returns in a couple of past years. The same researchers identify ‘winners’ as the stocks that have had high returns in the same number of past years. The main result on one study was that losers have a greater average returns than winners over the same number of past years. Why the Capital Markets are expected to be ‘Efficient’ When an investor puts money into the stock market, His/her goal is usually aimed at generating on the invested capital. For many investors, making a profitable return is not only the key mission, but also to beat the market. However, prices totally reflect the available information on a specific stock or market. According to the efficient market hypothesis, no investor can precede a return on the stock price since no one can access information that is not already available. According to this theory, stock prices can only respond to the information available in the market. However, since every participant in the market is privy to the same information, no investor therefore will have the ability to outperform or beat the market (HO, T. S. Y and YI, S.-B, 2004, Pg. 5). In efficient markets, prices are random and not predictable; therefore, no investment plan can be discerned. The random walk of prices results in the failure of an investment plan that aims at beating the marketconsistently. According to the theory, given the transaction cost involved in the management, it would be of great profits for investors to put their money on index fund. In the real in sector of investment, there are some obvious arguments which pronounce some investors to have beaten the market while their investment strategies focused on undervalued stocks. These investors made millions. Market efficiency does not require that prices be equal to a fair value at all times. Prices may be at times undervalued in some random occurrences and eventually revert to their mean values (Krichene, 2013, Pg. 9). Past Performance and Stock Returns There is a positive relation between past performance and stock returns. The hypothesis assumes thatMany investors are unable to see through the hidden effect of option contracts or that their past performance at their high paying firms as well as their managerial confidence result to some value destroying activities. Option awards to risk-averse managers and make them willing to take less or more risk and thus a positive or negative association between future returns and the incentive pay. There must be a change from one particular investment to a new one (Salge, 1997, Pg. 8). The relationship between the past performance and the stock returns is analyzed with comparison about the past return in the old investment and the current returns in a new asset. This can be facilitated by the type of strategies applied during the past performance. If the investor does not transform his/her strategies in operating within the market, good returns resulting from the past strategies will dictate good returns in the current investment (Knight and Satchell, 2002, Pg. 34). A consistent loser in the market will require to change his strategies which are assumed to be the main reason behind his poor past performances. Establishing new strategies in investments may result to improved asset returns in the current investments. In this connection, past performances have got a strong relationship with the current stock returns in the sense that, if an investor performed poorly in the past investments, he/she can alter changes in the strategies applied and maybe experience great changes in his/her returns(Zhang, 2003, Pg. 67). To test the relationship between the past performance and the stock returns, there must be an existing market, where investors seek to carry out some transformations in their investments. Stock prices can place an investor in the top position in the market arena. The pricing criteria can enable an investor to win a large number of customers. Winning the customer trust would enable one to dominate the market. In this case, his past performance, which placed him on the top most position in the market, can as well act as a nostalgic effect to the customers. His second engagement to the market has also a high probability of dominating the top positions (Hebner, 2007, Pg. 12). Investors are their own builders or fluctuates their own businesses. Depending on their past performances, investors get to realize their position in the current market. They get to understand their peak and the reliable strategies that they can implement in order to place themselves into the competitive margin. In the place of poor past performance, investors would realize some areas that require improvements. This helps in the preparation of strong strategies which would place the investor into a better position the market. Fundamental Analysis The fundamental analysis examines the share price with respect to the underlying business. It monitors elements like earnings, cash flow, revenue, debts, product development as well as the regulatory environment for the reason of determining a fair value for a share price and to seek an abnormal returns and beating the market. It tries to determine and to predict future prices through an analysis of statistics, trends and charts (Brändle, 2010, Pg. 66).The analysis affirms that the pat performances of stocks and markets are the key indicators of the future performances. It focuses more on long term perspectives. This hypothesis is examined through the application of some tests, the random walk hypothesis and the filter rule, which confirms and gets consistent with the efficient market theory. According to the tests, various abnormalities suggest that markets are not very much efficient and thus there may be the possibility of seeking abnormal returns. If the market is semi strong form efficient, it means that neither technical nor the fundamental analysis will lead to abnormal profits (Külpmann, 2004, Pg. 87). Strong Form Efficient Market Hypothesis This is the strongest version among the three market hypotheses. It is a hypothesis that assumes that all information in a market, either private or public, is accounted for in a stock price. Under the strong efficient market hypothesis, an investor can under no circumstances earn excess profits since the entire information is incorporated into the security prices. The test ,for this efficiency, a market need to be existing whereby, investors con not earn consistent excess returns for a long time. No refutation should be expected even if some money managers have continuously observed to beat the market. A normal distribution of returns is expected to harvest a few dozen star performers(Thakor and Boot, 2008, Pg. 3). Conclusion The efficiency of a capital market is determined by its success in incorporating and receiving information about the elementary value securities into the security prices. This basic value of securities may be the present value of the cash flows expected in the future by the individual who owns the securities. If the value of stocks fluctuates, traders get encouraged to trade in a competitive manner with an aim of obtaining maximum profits and avoiding loses in their securities. This brings about the price movements in the direction of the current value of the cash flows in the future. An efficient capital market is the one that incorporates information accurately and in a steady manner into the security prices. Bibliography (1999). Czech Republic capital market review. Washington, D.C., The World Bank. BRÄNDLE, A. (2010). Volume based portfolio strategies analysis of the relationship between trading activity and expected returns in the cross-section of Swiss stocks. 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