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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.

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Capital Markets Theory

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  1. Capital Markets Theory Lecture 5 International Finance

  2. 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 International Finance

  3. Measures of risk Estimation of market and specific risk using the regression approach 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 International Finance

  4. Capital Asset Pricing Model (CAPM) This shows the relationship between expected returns and market risk, Beta. It useful for both financial and physical investments, particularly for asset valuation. rk = expected return on equity k rf=risk free rate of return/interest rate rm=expected return on the market portfolio/security =beta coefficient of equity, k International Finance

  5. 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)=1.2 Y=0.5+0.7(-1)=0.2 International Finance

  6. Efficient Market Hypothesis(EMH) • Theory • Evidence • Implications • Concluding remarks International Finance

  7. Adaptive Expectations • Adaptive Expectations • Expectations depend on past experience only. • Expectations are a weighted average of past experiences. • Expectations change slowly over time. International Finance

  8. 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. International Finance

  9. 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. International Finance

  10. “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. International Finance

  11. 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. International Finance

  12. 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. International Finance

  13. Efficient Markets R = Pt+1 – Pt + D Pt Re = Pe t+1 – Pt + D Pt Pet+1 = Poft+1 which means Ret+1 = Roft+1 Re = Rof = R eq Current prices are set so that the optimal forecast of R equals the equilibrium R. International Finance

  14. 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. International Finance

  15. 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 = (Poft+1 – Pt)/ Pt Pt up Rof down International Finance

  16. 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= (Poft+1 – Pt)/Pt Pt down Rof up International Finance

  17. 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. International Finance

  18. 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. International Finance

  19. 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. International Finance

  20. 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. International Finance

  21. 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. International Finance

  22. 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. International Finance

  23. 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. International Finance

  24. 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. International Finance

  25. Evidence in Support of EMH • 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. International Finance

  26. Evidence in Support of EMH • 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. International Finance

  27. 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. International Finance

  28. Evidence against EMH • 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. International Finance

  29. Evidence against EMH • 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. International Finance

  30. 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. International Finance

  31. 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. International Finance

  32. 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. International Finance

  33. CAPITAL MARKETS IN DEVELOPING COUNTRIES EQUITY AND BOND MARKETS International Finance

  34. 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 International Finance

  35. Selected Stock Exchanges 2009 International Finance

  36. 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) International Finance

  37. The bond market Selected Exchanges With Bond Trading Activities, 2009 International Finance

  38. New Bond Issues in Developing Countries, 2005-2007 Bond market International Finance

  39. 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. International Finance

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