Understanding the Efficient Market Hypothesis

The Efficient Market Hypothesis (EMH) reasons that market values are a comprehensive replication of all the evidence accessible in a certain market. Arnade and Hoffman (2015, p. 538) defines an efficient market as a market that has a huge number of cogent, profit maximisers, who are vigorously challenging with each other, and trying to project the forthcoming market values of separate securities, and where essential existing evidence is simply available to every contestant in that market. In short, at any time in an efficient market, the definite value of the security could be a decent approximation of its inherent value. Malkiel and Fama (1970) acknowledged the three distinct levels or sometimes referred to as ‘strengths,’ at which a market could effectual.

Strong-From

The strongest type of EMH stipulates that a market is only considered to be effective if all evidence that is applicable to the value of a share, whether largely accessible to the current stakeholders is swiftly and precisely echoed in the market price. For instance, if the existing market value is lesser than the price vindicated by some part of privately held material, the relevant holders of this evidence will utilise the valuing anomaly by acquiring stocks. They remain to exploit this gap, until the additional demand for the market stocks will drive the prices of shares up to the level that is reinforced by their cloistered information (James 2015). At the point where the price of the market shares has increased, they will no longer have any incentive to continue buying, and will, therefore, resort to withdrawing from the market, which will lead to price stabilisation at the new equilibrium level.

Semi-Strong-Form

In a relatively less rigorous market, Kaniel, Saar, and Titman (2008, p. 295) write that the market will be effectual if all the appropriate publicly accessible evidence is promptly echoed in the market price; such a market is referred to as the semi-strong category of the EMH. Theoretically, a strong system of market is the most fascinating, while the semi-strong one pleas to the sense of most people. According to the principles of a semi-strong EMH, the market can easily digest the news on the relevant evidence by variating the price to a new symmetry level, which mirrors the modifications in supply and demand that is instigated by the development of the same evidence. What the semi-strong form of EMH can lack in respect to intellectual rigour, it can defiantly gain it in terms of its observed strength, since it is less problematic to test than the robust form (Arnade and Hoffman 2015, p. 540). One challenge with the semi-strong form mendacities in the recognition of the right public policy, with the relevant evidence.

Weak-form EMH

This is the slightest demanding form of EMH that restrictions itself to one subset of public evidence; these are past information about the value of shares. The principles of Weak form EMH stipulates that new material must be by description unconnected to the initial evidence, otherwise, it will not be considered as new. Malkiel and Fama (1970, p. 411) added that every movement in the share value as a reaction to the new evidence cannot be projected from the last program or value, and the progress of price adopts the traits of the random walk. In short, the history of the market cannot be used to forecast the future of the market prices. All these different types of EMH have diverse consequences with respect to searching for more returns from the stock market. That is for returns more than what legitimate by the jeopardies that are sustained in holding certain investments.

In order to examine market efficiency in the London Stock Market, this paper will use the FTSE 100 stock part to justify the level of efficacy in the UK capital market. The FTSE 100 stock indices comprise of the largest companies in the United Kingdom; this means that this is among the most coveted market to invest in and attracts the serious or rather elite stakeholders. Besides, these companies are viewed as a role model for small entities in the United Kingdom. Some scholars have referred to the FTSE 100 stock market as the “blue chip,” a phrase that was coined after the name of a company that computes the index and the facts of the companies on FTSE 100. Therefore, an analysis of this stock market can help in forging a strong analysis in LSE. The paper will use study FTSE 100 index to validate market efficiently. The study will use 5 years that is from 2006 to 2011. The period between 2006-2011 was characterised by economic stabilisation before the 2012 economic recession, and therefore, this is the right moment to analyse the London stock exchange. Figure 1 shows the dynamics of the FTSE 100 from 2006 to 2011 (5 years period).

Besides, the treasury bills or bearer Government securities that stood in for a charge on the UK combined fund. This was used in the least denominations of 5,000 at a discount market worth for some time, which did not last more than one year. The first step to finding market efficiency would be to find the average market profitability of the chose market index. The average profitability of the market index is equal to the extent of the mid value in any illustration; this can be obtained by coalescing the number from the list and calculating them with a single figure, which is the average. While calculating the average there is a possibility of having a standard deviation, which is quantified as the dispersal of a mean from a certain data set. The further the data extends apart, the further the deviation. In the stock market, the standard deviation is applied to quantify the volatility of an asset. Figure 2 represents the standard deviation of the sample.

In comparison to other indices in the London Stock exchange (the other stock indices used for comparison purposes were selected randomly; they comprise of the UK government T. Bill, and the UK Coal Plc), the UK Coal Plc proved to have the highest volatility, followed by the FTSE 100, and the UK Government T.bill recorded the lowest volatility. This means that a risk-averse investor is likely to invest in UK T bills since it portrays a low-risk value.

The efficiency of the Market

A mean to variance principle is applicable when the return of two projects is equal, but the second one varies, meaning that the standard deviation is more than the first one. Therefore, a researcher is likely to choose the first project. In the case, as this one where the probability means is equal to 0, the z-test static is 0.841, while the z-value is at 95%. Given the below assumptions; first, the projected average return from trading approach does not significantly vary from zero. Secondly, the projected average return from the trading strategy has a huge difference from zero. However, in this case, the analysis will assume that the null hypothesis that states average returns from trading does not have significant variance from zero; besides the z-test statistic is not hugely different from zero. This implies that the market is weak-form efficient. However, if all the potential stakeholders and investors assume that a market is efficient, such market would actually not be efficient, since no one will analyse the securities and establish the best portfolio, while an efficient market ought to be determined by investors who have to perceive the that the market is already inefficient and instead trade their stocks to outpace the market. Therefore, a stakeholder has the potential of gaining higher returns in any market by purchasing riskier investments.

Money Market Vs Capital Market Difference

Both money market and Capital markets are considered to be integral parts of the financial market. However, money markets are applied in the short-term loaning and borrowing, while assets are apprehended annually, while capital markets are applied in long term securities, they have a straight or unintended effect on the investment (Wurgler 2000, p. 200). The capital market comprises of the stock market and liability market. The chart below gives a summary of the financial market.

Money Markets

Money markets are comprised of a disorderly market where financial organisations, money traders and dealers trade in monetary instruments within a short time. These actors trade within a short-term liability procedure such as trade credit, T bills, and business papers among others, which can be liquidated easily usually within a period of not more than 1 year. Conducting trade over the money market is conducted mostly via the counter (OTC), meaning that there is little use of exchanges (James 2015). These systems provide various business with short term loans and take a centre stage in giving liquidity in the state in the short-run. It also assists industries and businesses with working capital necessities. The money market gives a variety of tasks for all the parties involved, which are functions for separate companies or government organisations. In this case, liquidity is used as the key driver for retrieving money markets. In cases, where short-term debts are distributed, it is used in most cases to carter for the operating costs or working capital for a business or a governmental agency, and not in the case of large-scale schemes. Entities might want to capitalise in the funds as soon as they can, and analyse the financial market to achieve this, or could sometimes essential to conceal payroll and seek help from the market to assist (Lewis 2016.). The financial market played an essential part in declaring businesses and governmental agencies to preserve the estimated scope of liquidity daily, devoid of deteriorating and demanding for an additional costly loans, without keeping surplus funds and missing the prospect of acquisition the interests on the market (Gabor and Ban 2016, p. 617). Besides, investors can utilise the money market fund in a safer way. Unlike capital markets, the financial market is measured to have a relatively considerate cost. Risk-averse stakeholders are always keen to access them with the expectation that liquidity is available. The people earning lower wages on a fixed income, prefer using such types of investments, because of the safety that is connected due to the safety linked with such categories of reserves. The graph below shows the UK T bills over a period of time.

Capital Market

The capital market is defined as a category of the monetary market where fiscal products such as bonds, stocks and debentures are vended for an extended period. The capital market has the mandate of servicing long-term funding and long-term capital prerequisite. The financial market involves two major categories, which are, the Primary market; this involves the fresh subject of securities that are presented to the public and secondary market, where the allotted equities are traded between stakeholders (Borovička 2011). In totality, both money markets and capital markets include of a bigger section of the monetary market and are frequently used in tandem to achieve liquidity and risks for individuals’ corporations and governments. For example, the figure below, show the FTSE 100 progression over a span of various months and years.

Effects of Financial Markets on asset prices

Financial markets help in effectively guiding the movement of savings and venture in the economy in a manner that enhances the accrual of capital and the creation of goods. An integrated and developed financial market and institution, and a diverse collection of financial goods and apparatus suits the requirements of lenders and to a larger extent the whole economy. Instruments of financial markets such as bonds, and institutions like banks, pension schemes, and insurance companies give opportunities for stakeholders to specialize in certain markets, and spread risks, or participate in both practises. Fagereng, Guiso, Malacrino, and Pistaferri (2016) argues that a combination of actions from financial markets and institutions hugely determine the asset prices; the comparative mix of the two fails to appear to be a significant aspect determining in economic development. Lager monetary markets that comprise of various transactional activities give room for asset liquidity, especially for the participants of the markets, as compared to smaller markets with a small coverage of securities and participants and therefore limiting asset liquidity and trading activities, which eventually affects the price of assets. The United Kingdom’s financial system is among the most advanced markets in the world. In the UK financial markets, most assets are easily liquified; some have secondary markets to simplify the transmission of the current financial assets at a lower price. Another example is the creation of the European Union’s single banking market (which the UKthe m took part in); this system created a European financial market, which used the Euro to enable saving, lending, and investments. The Euro-based equity market serves all countries in the European Union that use the Euro as their currency, which helped to replace smaller, and less liquid assets that formerly were accessible in a state by state basis. Besides, the Euro is expected to improve the appeal of the Euro-based market and institutions to other parts of the globe. Within the EU market, the Euro has helped in eliminating the risks of the cross-border exchange rate, which are a fundamental portion of dealings between states with diverse currencies. The Euro constructed equity markets and organisations ought to make the credit distribution development in the European Union more efficient and competitive eventually. Main causes of exchange rate volatility in the foreign exchange markets There are various elements that could determine exchange rates. Most of these elements are directly linked to the trading relationship among countries; this is due to the fact that exchange rates are relative and are often expressed in reference to the currency of another country. The following are some of the major determinants of the exchange rates in reference to the Pound/Dollar spot exchange rate.

Differentials in inflation

Typically, any state that experiences lower inflation percentage inclines to exhibit an increasing worth on its currency, this because the country’s purchasing power grows comparative to other states. For example, in the 20th century, states with truncated inflation comprised of Japan, Switzerland, and Germany, while the USA achieved the status later. Recently, the United Kingdom has experienced inflation because of the current political climate (BREXIT). In comparison to the dollar, the American economy has remained relatively stable (Véron and Wolff 2016, p. 140). The dynamics of the BREXIT has led to the devaluation of the Pound in the international economy, due to the economic uncertainties related to this development.

Current Account Deficits

Kacperczyk, Nosal, and Stevens (2018) defined the existing account as the equilibrium of trade between a state and its trading associates, which reflects all outflows between states for goods, services and shares. A discrepancy in the existing explanation reveals that the state is spending more on foreign trade than its actual earnings. Averagely, both the UK and the USA do not have a deficit in their respective balance of trade. However, when comparing these two states the UK spends more on imports as compared to the USA. The fact that the UK spends more on imports, renders the Pound more volatile in the international markets and the dollar more stable.

Political Stability

Stakeholders certainly seek out stable states with vibrant monetary performances in which to devote their capital. A state with such constructive elements is likely to draw investment funds away from states that are assumed to have more political and financial uncertainties. Political uncertainties, for instance, are likely to lead to loss of self-confidence in a currency and negatively impact on the movement of capital to the currencies of more steady states. Such was evident in the initial weeks when the UK voted to support the BREXIT movement. During this period, the London Stock Exchange dwindled, and the Pound lost its international value, in reference to the dollar.

How might the exchange rate volatility impact international trade?

The main argument on the effect of exchange-rate instability on international trade depends on the prediction of the behaviour of traders. Adler, Castro, and Tovar (2016, p. 190) argued that traders who are risk averse react doubtfully to any surprising modification in exchange-rate such that the entire productivity and trade movements could result in a reduced outcome. For instance, Cerutti, Claessens, and Puy (2019) wrote that the operations of risk-averse traders are determined by ambiguity under the floating exchange management. By integrating the element of doubt into the foreign exchange market, the authors authenticated the assumption that adverse impacts of exchange-rate volatility on global trade. Fernandez, Klein, Rebucci, Schindler, and Uribe (2016, p. 550) added that the negative reaction from traders due to ambiguity in the exchange rate has a huge effect on international trade. On the contrary, Fernández et al. (2015) argued that the prospects of investors with a motive of maximising their profits could be more of conserving and would enhance the volume of goods being traded to balance any decrease in the upcoming revenue, which is an outcome of the exchange-rate instability. Munyan (2017, p.17) argued that states with considerably low levels of financial development are extremely affected by exchange rate volatility, while financially advanced states do not feel the effects of exchange rate volatility in regards to international trade.

Explain what you understand by each of the following financial terms

The yield of a Bond

Yield is a fundamental notion in bond investment since it is an instrument that investors can use to quantify the profitability of one bond compared to the other. In short, the profit of a bond is the percentage of return on the bond venture. Even so, it is not static like in the case of a bond’s quantified interest percentage. The yield of a bond is likely to change to replicate the price arrangements in a bond instigated by the changeable interest rates.

LIBOR

LIBOR is the yardstick of interest rate at which primary international lend to the other in the intercontinental interbank market, in the case of a short loan. LIBOR is an initial for the London Interbank Offered Rate and has developed to become an internationally accepted benchmark interest percentage that directs borrowing expenses between financial institutions. LIBOR is mainly based on five coinages, which are the US dollar, the Euro, UK pound, Swiss franc and the Japanese yen, and is applied in seven diverse maturities (Chung and Ariff 2016). The integration of the five different notes and seven maturities leads up to a sum of 35 dissimilar LIBOR rates that are premeditated and documented on every working day. The most prevalent cited rate is the three month US dollar percentage, which is commonly denoted to as the existing LIBOR rate.

Asymmetric information and moral hazard

Asymmetric information also referred to as information failure, it occurs when one principle to a transaction has more material knowledge than the other signatory. In most situations, sellers are always a knowledgeable party. The opposite of asymmetric information is symmetric information, which means that both parties to an agreement have equal knowledge. On the other hand, moral hazards take place when a party agrees to a transaction, after being misleading information; this means that a moral hazard can only take place in the presence of asymmetric information between the principles. An example of asymmetric information and moral hazard include; let us take a fictional example where one lives in an unsafe neighbourhood, and therefore has subscribed to home security systems to protect his property from burglary, to further reinforce the security of his property, the property owner decides to take an insurance cover for his property. When signing the insurance document, the owner of the property cites his security systems and therefore, the insurance company considers the security systems when establishing the monthly premium for the property owner. However, upon reaching an insurance agreement, the property owner withdraws his home security plan and no longer cares for his property, which makes the property vulnerable to theft. In such a case, the security company has experienced a moral hazard due to the asymmetric information that was given by the property owner.

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Policy rate of interest

The policy interest rate is described as the interest rate that the chief financial institution in the country, for example, the central banks, establishes to impact on the development of major financial variables in the economy such as customer values, credit development, exchange rates among others. The policy interest rate determines the levels of other interests in the economy because it comprises of the value at which private agents- who are mostly privately-owned monetary institutions acquire money from the central bank. The same banks will then give monetary products to their customers at an interest rate that is usually created on the policy rate (Farboodi and Veldkamp 2017). Different states have established their preferred policy interest according to their respective inflation rates among other factors. Usually, central banks apply the policy interest to conduct contractive or extensive financial procedure. The increase in interest rate is a common strategy used by various countries to prevent inflation or as a remedy to inflations.

References

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