market efficiency and capitalisation

Topics: Stock market, Stock, Fundamental analysis Pages: 11 (2698 words) Published: May 12, 2014
Module 10: (A) Market Efficiency; (B) Capitalization Changes; (C) TSIR

Learning Objectives

On completing this module students should be able to:

Understand the concept of market efficiency
Distinguish between different types of market efficiency •Understand how to test for market efficiency and know the trends in the evidence on market behaviour •Understand the current position on the various “anomalies” un covered by the research •Explain the impact of capitalisation changes on the value of equity and on the share price.

Peirson, Brown, Easton, Howard and Pinder, Business Finance, 11th Edition, McGraw-Hill, 2012.

This module covers material from several chapters of your text PBEHP. The majority comes from Chapter 16. You covered some of the material in the early parts of this unit here we will cover the whole chapter in depth. TSIR was introduced in Module Three.

ChapterSectionStudy LevelComment
TSIR4.6 to 4.8ThoroughSee Module Three
Splits9.9.1 & 2ThoroughIncluding reverse splits or consolidations Dividends11.1.1ThoroughDividend drop-off
Bonus Issues9.9.1 & 2Thorough
Rights Issues9.6.1Thorough
Buybacks11.1.4ThoroughAlso called share repurchases

Basic: Read lightly and be aware of the issues, problems or suggested solutions. Moderate: Read and be able to replicate and perform examples set in this module. Thorough: Read and study thoroughly.

For a contrary view on market efficiency, see Robert A. Haugen, The New Finance, Overreaction, Complexity and Uniqueness, 3rd Edition, Pearson Prentice Hall, 2004.
Topic 10.1: Introduction - The Efficient Market Hypothesis [A]

An Efficient Market Defined

The primary role of the capital market is the allocation of ownership of the economy's capital stock. The ideal is a market in which prices provide accurate signals for resource allocation, ie. a market in which firms make production/investment decisions and investors choose among the securities that represent ownership of the firms' activities under the assumption that security prices at any time "fully reflect" all available information. A market, in which, prices "fully reflect" all available information is called an "efficient market".

An efficient market adjusts extremely quickly to new information (eg. profit reports). The stock market fully adjusts to profit reports so quickly after their release that an investor cannot make extra returns from the profit information.

Theory of Efficient Markets

The rationale behind market efficiency is the existence of many analysts in the market who could profit from any slow market adjustment (by arbitrage). If the market took a considerable time to adjust to a piece of information, then an opportunity would exist to buy or sell before the market adjustment was completed. If analysts decided to take advantage of those opportunities, then their efforts to buy or sell would force prices up or down immediately. This would remove the slow market adjustment. The adjustment would occur as soon as the analysts perceived it to be slow. Thus, market efficiency is a result of competition among investors.

There are several misconceptions of the efficient market hypothesis. Some are addressed below:

1.It does not claim that every scrap of information is fully reflected in prices. Obviously "inside" information is not necessarily known to the market and therefore this type of information is not reflected in price.

2.It does not mean that the market makes no mistakes, but it is one in which share prices are unbiased. It is unreasonable to claim that the share market made a mistake because, in hindsight, prices have fallen or risen. This involves using information which was not available at the time. In an efficient market, share prices reflect the full...
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