Sources of finance

Question 1

3 main types of capital finance

Answer 1

1. Ordinary shares (equity) (Ke)
2. Preference shares (Kp)
3. Debt (Kd)

Question 2

Efficient market hypothesis: 3 types of market efficiency

Answer 2

1. Weak
2. Semi strong
3. Strong

Question 3

Efficient market hypothesis: Weak efficiency

Answer 3

Includes only past share price movements

In a weak form efficient market, when a new event happens (or is made public) the share price doesn’t react instantly. It takes some time for the new information to be
fairly reflected in the price.

If the market was only weak form efficient: It would be possible to consistently beat the market by insider trading or by analysing new public information (as long as you acted quickly). However, it would be impossible to beat the market consistently simply by charting past share price movements (known as chartism)
Share prices would follow a random walk with no patterns or trends.

So is it?
Most people would say yes, the market is at least weakly efficient.
In practise research has shown that only 0.1% of a share price change on one
day can be predicted from knowledge of the change on the previous day

Question 4

Efficient market hypothesis: Semi strong efficiency

Answer 4

All public information included in the share price. (Including past movements)

The moment a new event is made public; the share price instantly moves to
incorporate the impact of the event.

If the market was semi strong form efficient, it would be possible to beat the market consistently by insider trading – i.e. acting on information before it was made public. It would also be impossible to consistently beat the market simply by analysing new public information about the company.

Question 5

Efficient market hypothesis: Strong efficiency

Answer 5

All information (including private) included in the share price

The moment a new event takes place; the share price instantly moves to incorporate the impact of the event.

If the market were strong form efficient, it would be impossible to beat the market consistently, even by insider trading

Question 6

How does the Stock Exchange try to prevent insider trading?

Answer 6

Quick release of information

Question 7

Is the market strong efficient?

Answer 7

More or less – or at least most commonly traded stocks tend be fairly semi
strong efficient for most important new pieces of information.

In practice, share prices tend to react within 5 – 10 minutes of any new
information being released (as long as the markets are open)

Question 8

If the market is semi strong then a number of key conclusions that can be drawn:

Answer 8

1. Shares are fairly priced
The purchase is a zero NPV transaction

2. Managers can improve shareholders’ wealth
By investing in positive NPV projects and communicating this to the market

3. most investors (including professional fund managers) cannot consistently beat
the market
Without inside information.

Question 9

4 Behavioural factors that can cause inefficiency in a market

Answer 9

1. Overconfidence and miscalculation of probability
2. Conservatism and cognitive dissonance
3. Availability bias and narrow framing
4. Representativeness and extrapolative expectation

Question 10

Behavioural factors that can cause inefficiency in a market: Overconfidence and miscalculation of probability

Answer 10

Investors overestimate their abilities and the accuracy of their forecasts. It has also been shown that they tend to overestimate the likelihood of unusual events and
underestimate the likelihood of common ones.

Question 11

Behavioural factors that can cause inefficiency in a market: Conservatism and cognitive dissonance

Answer 11

Investors tend to be naturally conservative and resistant to changing their minds.

They will often continue with a long held belief even in the face of significant
evidence to the contrary.

Question 12

Behavioural factors that can cause inefficiency in a market: Availability bias and narrow framing

Answer 12

Investors pay attention to one particular fact more than they should simply because it is prominent in their minds. This leads to overreliance on one factor or observation rather than a broad view.

Question 13

Behavioural factors that can cause inefficiency in a market: Representativeness and extrapolative expectation

Answer 13

Investors have a tendency to assume that history will repeat itself. They also have a tendency to buy shares if their price has risen and sell them after their prices have
fallen