Capital Markets Theory

Capital Markets Theory

Lecture 5

International Finance

Lecture Plan

• A review of selected concepts– Measures of risk– Estimation of risk– Capital Asset Pricing Model– The Efficient Market Hypothesis– Capital Markets in Developing Countries– Concluding remarks


Measures of risk


y is the return on the chosen security

Beta is the sensitivity of the returns of the security to the overall changes in the market.Alpha – specific/idiosyncratic risk

Estimation of market and specific risk using the regression approach

Capital Asset Pricing Model (CAPM)


rk = expected return on equity krf =risk free rate of return/interest raterm =expected return on the market portfolio/security =beta coefficient of equity, k

This shows the relationship between expected returns and market risk, Beta. It useful for both financial and physical investments, particularly for asset valuation.

Measures of risk cont’d

y =0.5 + 0.7x – Regression result

Sensitivity of infraco shares to market is 0.7.If market portfolio moves up or down by 1%

Y=0.5+0.7(1)=1.2Y=0.5+0.7(-1)=0.2


Efficient Market Hypothesis(EMH)

• Theory• Evidence• Implications• Concluding remarks


Adaptive Expectations

• Adaptive Expectations– Expectations depend on past experience

only.• Expectations are a weighted average of past

experiences.• Expectations change slowly over time.


Rational Expectations

• The theory of rational expectations states that expectations will not differ from optimal forecasts using all available information.– It is reasonable to assume that people

act rationally because it is is costly not to have the best forecast of the future.


Rational Expectations

• Rational expectations imply that expectations will be consistent with optimal forecasts (the best guess of the future) using all available information, but…..– It should be noted that even though a rational

expectation is identical to optimal forecast using all available information, a prediction based on it may not always correct.


“Non-rational” Expectations?

• There are two reasons why an expectation may fail to be rational:– People might be aware of all available

information but find it takes too much effort to make their expectation the best guess possible.

– People might be unaware of some available relevant information, so their best guess of the future will not be accurate.


Rational Expectations: Implications

• If there is a change in the movement of a variable, there will be a change in the way expectations of this variable are formed.

• The forecast errors of expectations will on average be zero and cannot be predicted ahead of time.– Thus forecast errors of expectations are

unpredictable.


Efficient Markets• Efficient markets theory is the application of

rational expectations to the pricing of securities in financial markets.– Current security prices will fully reflect all available

information because in an efficient market all unexploited profit opportunities are eliminated.


Efficient MarketsR = Pt+1 – Pt + D

Pt

Re = Pe t+1 – Pt + D

Pt

Pet+1 = Pof

t+1 which means Ret+1 = Rof

t+1

Re = Rof = R eq

Current prices are set so that the optimal forecast of R equalsthe equilibrium R.


Efficient Markets Theory: Example

• Assume you own a stock that has an equilibrium return of 10%.

• Also assume that the price of this stock has fallen such that the return currently is 50%.– Demand for this stock would rise, pushing

its price up, and yield down.


Efficient Markets: Theory

• If Rof > Req, demand for the asset rises and the current price of the asset rises, causing Rof to fall until it equals Req.• Req < Rof = (Pof

t+1 – Pt)/ Pt Pt up Rof down


Efficient Markets: Theory

• If Rof < Req, demand for the asset falls and the current price of the asset falls, causing Rof to rise until it equals Req.• Req > Rof = (Pof

t+1 – Pt)/Pt Pt down Rof up


Efficient Markets: Summary

• Rof > Req Price rises Rof falls

• Rof < Req Price falls Rof rises

• In an efficient market, all unexploited profit opportunities are eliminated.


Efficient Markets Theory• Weak Version

– Prices of traded financial assets reflect all past prices.

• In this case, information about recent trends in stock prices would be of no use in selecting stocks.

• “Market watchers” and “chartists” are wasting their time. Technical analysis is not helpful.


Efficient Markets Theory• Semi- Strong Version

– Prices of traded financial assets reflect all past prices as well as all currently available public information.

• In this case, it does no good to pore over annual reports or other published data because market prices will have adjusted to any good or bad news contained in those reports as soon as they came out.

• Insiders, however, can make abnormal returns on their own companies’ stocks.


Efficient Markets Theory• Strong Version

– Prices of traded financial assets reflect all past prices, currently available information as well as inside information or privately held information.

• In an efficient capital market, a security’s price reflects all available information about the intrinsic value of the security.

• Security prices can be used by managers of both financial and non-financial firms to assess their cost of capital accurately.


Efficient Markets: Strong Version

• Security prices can be used to help make correct decisions about whether a specific investment is worth making.

• In this case, even insiders would find it impossible to earn abnormal returns in the market.

– Scandals involving insiders who profited handsomely from insider trading helped to disprove this version of the efficient markets hypothesis.


The financial market crash

• For instance, the stock market in 1987 convinced many financial economists that the stronger version of the efficient markets theory is unlikely.– It appears that factors other than market

fundamentals may have had an effect on stock prices.

• This means that asset prices did not reflect their true fundamental values.


The financial market crash

• But, the crash has not convinced financial economists that rational expectations was incorrect.– Rational Bubbles

• A bubble exists when the price of an asset differs from its fundamental market value.

– In a rational bubble, investors can have rational expectations that a bubble is occurring, but continue to hold the asset anyway.

– They think they can get a higher price in the future.


Evidence in Support of EMH

– Performance of Investment Analysts and Unit Trust Funds

• Generally, investment advisors and unit trust funds do not “beat the market” just as the efficient markets theory would predict.

– The theory of efficient markets argues that abnormally high returns are not possible.



– Random Walk• Future changes in stock prices should be

unpredictable.– Examination of stock market records to see if

changes in stock prices are systematically related to past changes and hence could have been predicted indicates that there is no relationship.

– Studies to determine if other publicly available information could have been used to predict stock prices also indicate that stock prices are not predictable.



– Technical Analysis• The theory of efficient markets suggests that

technical analysis cannot work if past stock prices cannot predict future stock prices.

– Technical analysts predict no better than other analysts.

– Technical rules applied to new data do not result in consistent profits.


Evidence against EMH

– Small Firm Effect• Many empirical studies show that small firms

have earned abnormally high returns over long periods.

– January Effect• Over a long period, stock prices have tended to

experience an abnormal price rise from December to January that is predictable.



– Market Overreaction• Recent research indicates that stock prices

may overreact to news announcements and that the pricing errors are corrected only slowly.

– Excessive Volatility• Stock prices appear to exhibit fluctuations that

are greater than what is warranted by fluctuations in their fundamental values.



– Mean Reversion• Stocks with low values today tend to have high

values in the future.• Stocks with high values today tend to have low

values in the future.– The implication is that stock prices are predictable

and, therefore, not a random walk.


Efficient Markets Theory: Implications

• Investment tips cannot help an investor outperform the market.– The information is already priced into the security.

• Investment tip is helpful only if you are the first to get the information.

• Stock prices respond to announcements only when the information being announced is new and unexpected.


Concluding remarks

• The theory of rational expectations states that expectations will not differ from optimal forecasts using all available information.

• Efficient markets theory is the application of rational expectations to the pricing of securities in financial markets.


Concluding remarks:• The evidence on efficient markets theory is mixed,

but the theory suggests that tips, investment advisers’ published recommendations, and technical analysis cannot help an investor outperform the market all the time.

• The 1987 financial crisis and more recently, the crisis that began in 2007 convinced many economists that the strong version of the efficient markets hypothesis was not correct.


EQUITY AND BOND MARKETS

CAPITAL MARKETS IN DEVELOPING COUNTRIES


Equity Market

• Stock markets are becoming more important.• 19 Exchanges in 2010 as compared to 7 in

1981 in Africa• Oldest Exchanges:

– Alexandria in Egypt, 1883– JSE, 1887– Zimbabwe, 1896



Selected Stock Exchanges 2009

Features of stock exchanges in developing countries

• Low liquidity levels, turnover ratios• Thin trading, low trade volumes• Limited listings

– Only three Exchanges have more than 100 listed companies

– Four Exchanges have less than 10 listed companies (Libya (10, Mozambique (9), Cameroon (4), Cape Verde (4)


The bond market


Selected ExchangesWith Bond Trading Activities, 2009

Bond market


New Bond Issues in Developing Countries, 2005-2007

Why developing country markets are more inefficient

• Inefficiency due to:– small market size, limited number of traders and

trade. Reduced scope of diversification. – differences in the expectations of investors about

the trade-offs between risk and returns.– weak governance and market infrastructure. – high transaction costs which in turn limits the

participation of financial market players.


Documents

Capital Markets Theory