CAPITAL MARKETS AND

INFORMATION
LECTURE 8

LEARNING OBJECTIVES
Understand the way stock market and its participants
operate
Discuss various factors that affect share prices
Analyse the concept of efficient markets and its
significance to investors

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Reactions to arrival of information

Understand the efficient market hypothesis and its

various forms
Discuss the anomalies ((deviations from EMH)) in modern
stock markets

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Panagiotis Dontis Charitos

WBS, 2013-14

IN TODAYS LECTURE...
Topics

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Role and uses of financial markets

Stock prices and information
Efficient markets
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Efficient market hypothesis

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Forms
off efficiency
ffi i
Implications of EMH
Anomalies and behavioural finance

Conclusions

Panagiotis Dontis Charitos

WBS, 2013-14

ROLE OF FINANCIAL MARKETS

Help firms and governments raise capital by selling claims
against themselves

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Share issues
Bond issues

Provide a place where investors can act on their beliefs

Help allocate cash to where it is most productive
Help
p lower the cost of exchange
g

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Panagiotis Dontis Charitos

WBS, 2013-14

ROLE OF FINANCIAL MARKETS

Primary markets

New securities are issued in a primary market

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Initial public offerings (IPOs)

Issue facilitated by investment banker
Intermediaries between issuer and investor

Secondary markets

Markets where investors trade previously issued securities

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Stock Exchanges

London Stock Exchange (LSE)

New York Stock Exchange (NYSE)

Panagiotis Dontis Charitos

WBS, 2013-14

STOCK EXCHANGES
Secondary, auction markets in equity shares

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Provide the platform for securities trading

Listing requirements for traded firms
Specialists assigned to each traded equity to make a market
in that stock
S
Some
stockk exchanges
h
are listed
li d themselves
h
l

Panagiotis Dontis Charitos

WBS, 2013-14

STOCK MARKET INDICATORS

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Composite report of market behavior on a given day

Facilitate measurement of share price performance

Dow Jones Industrial Average

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Composed
p
of 30 blue-chip
p stocks
Price-weighted index: Essentially adds the prices of 30 stocks,
divides by 30
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Oldest, most well-known measure

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Adjusted for stock splits, stock dividends

Used since 1st October, 1928

Panagiotis Dontis Charitos

WBS, 2013-14

STOCK MARKET INDICATORS

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Composite report of market behavior on a given day

Facilitate measurement of share price performance

FTSE 100

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The Financial Times Index

C
Composed
d off 100 blue-chip
bl
hi stocks
k
Value-weighted index
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Weights based on market capitalization

Adjusted for stock splits, stock dividends

Expressed as index number relative to a base index value of

1000 (3rdd January, 1984)
Most widely used measure of UK share performance
Panagiotis Dontis Charitos

WBS, 2013-14

STOCK MARKET INDICATORS

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Composite report of market behavior on a given day

Facilitate measurement of share price performance

The list goes on

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FTSE 250
FTSE ALL SHARE
S&P 500
DAX (30 blue-chip
blue-chip stocks)
CAC 40
IBEX 35
NIKKEI
ASX 200
Panagiotis Dontis Charitos

WBS, 2013-14

BUT...W
WHAT INFLUENCES STOCK PRICES??

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Panagiotis Dontis Charitos

WBS, 2013-14

EFFICIENT MARKETS: INFORMATION

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Past information
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Current information
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Company related factors

` Profits, dividends, cash flows, P/E ratios, profitability, efficiency,
growth, quality of management ,etc.
Economy related factors
` GDP,
GDP interest
i
rates, exchange
h
rates, unemployment
l
figures,
fi
status of economy, oil prices etc.
Events

I f
Information
ti that
th t can be
b reasonably
bl inferred
i f
d
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Investor expectations
Panagiotis Dontis Charitos

WBS, 2013-14

EFFICIENT MARKETS: QUESTIONS

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How well do markets respond to new information?

Should it be p
possible to decide between a pprofitable and
unprofitable investment given current information?

Efficient Markets
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The prices of all securities quickly and fully reflect all available
information

Panagiotis Dontis Charitos

WBS, 2013-14

EFFICIENT MARKETS: ASSUMPTIONS

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Investors value stocks based on expectations for future

cash flows and risk involved
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Information is a central issue

Efficient Markets
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The prices of all securities quickly and fully reflect all available
information and offer an expected return consistent with level
of risk

Panagiotis Dontis Charitos

WBS, 2013-14

EFFICIENT MARKETS: CONDITIONS

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Large number of rational, profit-maximizing investors

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Information is costless and widely available to all

participants simultaneously
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Actively participate in the market

Individuals cannot affect security prices

Is information indeed free?

Information is ggenerated randomly,

y no leaks
Investors react quickly and fully to new information
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What about the marginal

g
benefits of actingg on information
vs. the marginal costs?

Panagiotis Dontis Charitos

WBS, 2013-14

EFFICIENT MARKETS: CONSEQUENCES

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Quick price adjustment in response to the arrival of

random information makes the reward for analysis low
Prices reflect all available information
Price changes are independent of one another and move
in a random fashion
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New information is independent of past

Panagiotis Dontis Charitos

WBS, 2013-14

EFFICIENT MARKETS: EMH

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Efficient market hypothesis (EMH)

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To what extent do securities markets quickly and fully reflect

different available information?

Three levels/forms of market efficiency (Fama, 1970)

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Weak form
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Semistrong form
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P blic information
Public
inf rmati n

Strong form
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Market level data

All information (including private information)

Panagiotis Dontis Charitos

WBS, 2013-14

EMH: WEAK FORM

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Prices reflect all past price and volume data

Technical analysis,
y which relies on the ppast historyy of
prices, is of little or no value in assessing future changes in
price

Market adjusts
j
or incorporates
p
this information qquicklyy
and fully

Aggressive investors believe in weak form!

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Panagiotis Dontis Charitos

WBS, 2013-14

EMH: SEMISTRONG FORM

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Prices reflect all publicly available information

Investors cannot act on new p

public information after its
announcement and expect to earn above-average, riskadjusted returns

Encompasses
p
weak form as a subset

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Panagiotis Dontis Charitos

WBS, 2013-14

EMH: STRONG FORM

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Prices reflect all information, public and private

No ggroupp of investors should be able to earn abnormal

rates of return by using publicly and privately available
information

Encompasses
p
weak and semistrongg forms as subsets

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Panagiotis Dontis Charitos

WBS, 2013-14

EMH: IMPLICATIONS
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Technical analysis
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In contrast with weak form EMH

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Conflicting underlying assumptions:

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If EMH holds, technical analysis has no value

Empirical evidence cannot categorically refute technical analysis
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M k data
Market
d already
l d reflected
fl
d vs. trends
d that
h persist
i gradual
d l adjustment
dj

Nevertheless, it is extremely difficult to assess all techniques of

technical analysis

Panagiotis Dontis Charitos

WBS, 2013-14

EMH: IMPLICATIONS
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Fundamental analysis
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Again in contrast with EMH if semistrong form holds

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Only superior fundamental analysis can work

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No form of analysis based on publicly available information is useful

Intrinsic values already reflected in stock prices
Only investors with better estimates can earn above average results
Others that make same interpretations will experience average
results

Panagiotis Dontis Charitos

WBS, 2013-14

EMH: THE PARADOX

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Technical and fundamental analysts believe that they can

beat the market...
The paradox is that this belief facilitates market efficiency
Intuition
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Investors search for mispriced securities

Upon discovery they act immediately
Information is conveyed into the market
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Through buying and selling process

If enough of this activity occurs, all information is reflected in

stockk prices
i

Panagiotis Dontis Charitos

WBS, 2013-14

MARKET ANOMALIES & BEHAVIOURAL FINANCE

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Anomalies: Exceptions that appear to be contrary to

market efficiency
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Earnings announcements affect stock prices

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Low P/E ratio stocks tend to outperform high P/E ratio stocks
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Low P/E stocks generally have higher risk-adjusted returns

But P/E ratio is public information

Should portfolio be based on P/E ratios?

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Adjustment occurs before announcement but significant amount after

Contrary to efficient market because the lag should not exist

Could result in an undiversified portfolio

Panagiotis Dontis Charitos

WBS, 2013-14

MARKET ANOMALIES & BEHAVIOURAL FINANCE

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Anomalies: Exceptions that appear to be contrary to

market efficiency
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Size effect
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January effect
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Tendency for small firms to have higher risk-adjusted returns than

large firms
Tendency for small firm stock returns to be higher in January
Of 30.5% size p
premium, half of the effect occurs in JJanuaryy

Panagiotis Dontis Charitos

WBS, 2013-14

MARKET ANOMALIES & BEHAVIOURAL FINANCE

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Anomalies: Exceptions that appear to be contrary to

market efficiency
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The Value Line ranking system

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The largest investment advisory service in U.S.

Roughly 1700 stocks are ranked (1 to 5 scale, best to worst)
Relative performance of five rankings has been very strong

Other anomalies are present

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Category 1 outperforms category 2 and so on...

Holiday effect, turn of month, day of week etc.

Panagiotis Dontis Charitos

WBS, 2013-14

MARKET ANOMALIES & BEHAVIOURAL FINANCE

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Behavioural finance
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Rationality as a principle of behavior

Are there systematic deviations from the norms of rationality?
How do human beings make decisions?
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Distortion throughout the process of decision-making

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I making
In
ki predictions,
di ti
perceiving
i i th
the environment
i
t

In essence, behavioral finance is the marriage of psychology and

finance

Panagiotis Dontis Charitos

WBS, 2013-14

CONCLUSIONS I
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Role and use of financial markets

Information flow in markets
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Market efficiency and EMH

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Factors affecting stock prices

Forms - assumptions
p
Implications

Behavioural finance and anomalies

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Anomalies do exist!

Panagiotis Dontis Charitos

WBS, 2013-14

CONCLUSIONS II

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Panagiotis Dontis Charitos

WBS, 2013-14

READING LIST
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Core reading
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Perks and Leiwy

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Chapter 5

Further reading
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Jones*
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Chapter 12

*Jones C.P. Investments: Principles and Concepts 11th ed. John Wiley & Sons

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Panagiotis Dontis Charitos

WBS, 2013-14

FOOD FOR THOUGHT...

Are markets rational and/or efficient??

Can large corporations affect the market? Any examples?
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Panagiotis Dontis Charitos

WBS, 2013-14