Sources of Corporate Finance: Market Efficiency

Question 1

Price Formation/ Discovery

Answer 1

• Markets are where buyers and sellers interact.

- This interaction generates prices where demand and supply are matched.

Question 2

Perfect Markets

Answer 2

• Large number of buyers and seller.
• Participants have same expectations of economic factors such as interest rates and inflation.
• Entry and exit to market is free.
• Information is available to everyone.
• No factors to inhibit trade such as tax or transaction costs.

Question 3

Market Efficiency

Answer 3

Markets are efficient if the market value of securities rapidly and correctly reflect all relevant information as it becomes available, known as the Efficient Market Hypothesis.
Efficient:
-all info is known, the market value of the share reliably reflects the true economic value of the share
-all info is never known- significant uncertainties in relation to future
-settle for price correctly reflecting all information

Capital markets are highly competitive:

• fierce competition eliminates profit opportunities
• shares and bonds are usually fairly priced

Question 4

Forms of EMH: Weak

Answer 4

• Reflects information derived from past share price movements
• Prices follow a random walk
• If past price changes could be used to predict future price changes, investors could make easy profits

Question 5

Forms of EMH: Semi-strong

Answer 5

• Securities will be fairly prices
• Price adjusts immediately to any new information
• Disclosure of new information will change price
• Cannot identify mis-pricing by looking at public information

Question 6

Forms of EMH: Strong

Answer 6

• MV reflects all relevant information even if not publicly disclosed
• Cannot identify mis-priced shares

Question 7

Can you beat the market?

Answer 7

Investors identify under-valued share

• fundamental analysis
• buy this share before share price goes up
• make a gain
• market value is not reflecting all info (violates semi-strong EMH)

Technical Analysis (chartist)

• study past price movements to identify patterns
• look for similar patterns (violates weak from EMH)

Question 8

Efficiency “Anomalies”

Answer 8

• Small-cap stocks perform better than large-cap stocks
• Time anomalies: returns higher in January, and returns lower on a Monday
• Royal dutch/shell
• each had a fixed share of the same cash flow
• market value should be equal but regularly diverged
• Bubbles
• prices rise rapidly and more investors join in driving higher again

Question 9

Behavioural Finance

Answer 9

• seeks to explain anomalies
• people are not 100% rational 100% of the time
• attitude to risk
• beliefs about probabilities
• investors are slow to process and respond
• overconfidence