Managing Financial and Human Resources

HR 7003-Managing Financial and Human Resources for Sustainable Business Success 1

Topic 11 - Introduction to Capital Markets, Market Efficiency

and Risk Return

Contents:

1. Introduction to capital markets

2. Market efficiency

3. Risk Return

By the end of this week, you will be able to:

• Understand how the capital markets work

• Understand and discuss the efficient market hypothesis

• Understand the Risk and Return relationship

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1. Introduction to capital markets

The accumulated wealth that is available to create further wealth is described as the

Financial Capital. The places where those who require additional funds seek out others

who wish to invest their excess are defined as the capital markets (Chisholm, 2009). In

addition, according to Chisholm (2009), participants can manage and spread their risks.

The author answers the following question “Who are the users of capital?”, suggesting

that everybody is, listing the following examples:

• We borrow money to buy a house

• We borrow money to buy a car

• We save to pay school and university tuition fees, investing in the ‘human capital’

that will sustain the economic health of the country.

Further the individuals’ participation, according to Chisholm (2009), financial capital is

used by:

• corporations

• governments

• state authorities

• municipal authorities

• international agencies

That is because they aim to make investments in productive resources. When a company

builds a new factory, it is engaged in capital expenditure – using funds provided by

shareholders or lenders or set aside from past profits to purchase assets used to generate

future revenues.

Governments use tax revenues to invest in infrastructure projects such as roads.

Agencies such as the World Bank inject funds into developing countries to create a basis

for economic growth and future prosperity (Chisholm, 2009).

As the author discusses, the same applies for the suppliers of the capital. Who are the

suppliers of capital? Again, the answer is that we all are. That occurs through the buying

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of shares issued by entities and debt securities issued by governments and their

agencies.

Chisholm (2009) explains that sometimes we employ brokers to invest funds on our

behalf. We deposit cash in bank accounts, invest in mutual funds, and set aside money

in pension plans for our retirement. In addition:

• we pay taxes to the government and local authorities.

• We pay premiums to insurance companies who invest the proceeds against their

future liabilities

• Companies become sources of capital when they reinvest their profits rather than

paying cash dividends to shareholders – Retained Earnings.

The money markets are markets for borrowing and lending funds over the short term.

‘Short term’ means a maturity of 12 months or less, although in practice some money

market deals have maturities greater than one year. Major economies such as the US,

Germany, France, the UK, and Japan have highly developed domestic money markets

in which short-term funds are borrowed and lent in the local currency, subject to the

control of the regulatory authority of the central bank (Chisholm, 2009).

Regarding the participants in those markets, the author mentions the following

borrowers and investors with surplus cash to invest:

Borrowers:

• financial institutions such as commercial and investment banks;

• companies (often known as ‘corporates’ in the banking world);

• governments, their agencies, state and regional authorities.

Investors:

insurance companies, pension funds, mutual funds;

the treasury departments of large multinational corporations;

governments, their agencies, state and regional authorities.

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2. Market efficiency

A body of theory called the Efficient Markets Hypothesis (EMH) asserts that:

• stocks are always in equilibrium

• it is impossible for an investor to “beat the market” and consistently earn a higher

rate of return than is justified by the stock’s risk (Brigham and Ehrhardt, 2013).

How are stocks’ and bonds’ prices determined under the EMH?

A. Based on erratic market psychology and “Animals Spirit” that follow no logical rules?

B. Based on market sentiment?

C. Based on information flow?

The answer to the above is the option C.

Interesting case to observe relating to the above:

Morning of February 9, 2005: Hewlett Packard Company’s (ticker symbol: HPQ) CEO

resigned. The Informed investors applauded the dismissal of an unloved CEO and as a

result:

✓ Stock price up by 10%

✓ Trading volume twelve times higher than normal

However, the same day, Helmerich and Payne Inc., with ticker symbol: HP: Uniformed

investors realized that ticker symbol “HP” is not the one of Hewlett Packard!

✓ Stock price up by 3% after the announcement

✓ By end of day the stock price was dropped back below previous’ day close

Thus, the flow of information influences the prices in the capital markets.

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Eugene Fama (1970) defines market efficiency as follows:

“In an efficient market, competition among the many intelligent participants leads to a

situation where, at any point in time, actual prices of individual securities already reflect

the effects of information based both on events that have already occurred and on events

which, as of now, the market expects to take place in the future.”

Summarizing the above, in an efficient market at any point in time the actual price of a

security will be a good estimate of its intrinsic value.

As a result of SEC disclosure requirements and electronic information networks, as new

information about a stock becomes available, the analysts working for organizations such

as Morgan Stanley, Goldman Sachs, CALPERS, Prudential Financial etc. generally

receive and evaluate it at the same time. Therefore, the price of a stock will adjust almost

immediately to any new development. That, in a nutshell, is the logic behind the efficient

markets’ hypothesis (Brigham and Ehrhardt, 2013).

We are interested in market efficiency as for funds to be allocated to the most efficient

firms, the market must be able to process and incorporate information (loan signals,

forecasts & revisions, various announcements, etc): quickly and accurately!

As the managers’ objective is to maximize the firms’ value, they must know how

markets behave to issues securities, determine discount rates etc.

If that mechanism works correctly, in the long run the efficient firms will dominate the

market and as a result the economy will prosper.

Brigham and Ehrhardt (2013) mentions the following forms of market efficiency:

1. weak form efficient

2. semi strong form

3. strong form efficient

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The weak form

The weak form of market efficiency says that ‘no investor can earn excess returns by

developing trading rules based on historical price or return information’.

The weak form of the EMH says that past prices, volume, and other market statistics

provide no information that can be used to predict future prices.

Because this kind of information is available to all, and thus, already incorporated in

market price (thus no recurring patterns in stock prices).

The semi strong form

The semi strong form of market efficiency says that ‘no investor can earn excess returns

from trading rules based on any publicly available information and expectations about the

future’.

If a market is semi strong efficient, then picking stocks based on publicly available

information, should not yield profits greater than what could be obtained using a simple

buy and hold strategy.

The strong form

The strong form of market efficiency says that ‘no investor can earn excess using any

information, whether publicly available or not’.

Prices would reflect all information relevant to the firms’ prospects, even inside

information.

The discussion of Brigham and Ehrhardt (2013) presented above can be accurately

summarized by the below figure:

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3. Risk Return

It is generally accepted that investors like returns and dislike risk. Investors will invest in

risky assets only if those assets offer higher expected returns.

Risk can be measured in different ways, and different conclusions about an asset’s

riskiness can be reached depending on the measure used. Risk analysis can be

confusing, and Brigham and Houston (2015) suggest keeping the following points in mind:

➢ All business assets are expected to produce cash flows, and the riskiness of an

asset is based on the riskiness of its cash flows. The riskier the cash flows, the

riskier the asset.

➢ Assets can be categorized as financial assets, especially stocks and bonds, and

as real assets, such as trucks, machines, and whole businesses. In theory, risk

analysis for all types of assets is similar, and the same fundamental concepts apply

to all assets. However, in practice, differences in the types of available data lead

to different procedures for stocks, bonds, and real assets.

➢ A stock’s risk can be considered in two ways: (a) on a stand-alone, or singlestock,

basis, or (b) in a portfolio context, where a number of stocks are combined and

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their consolidated cash flows are analyzed. There is an important difference

between stand-alone and portfolio risk, and a stock that has a great deal of risk

held by itself may be much less risky when held as part of a larger portfolio.

➢ In a portfolio context, a stock’s risk can be divided into two components: (a)

diversifiable risk, which can be diversified away and is thus of little concern to

diversified investors, and (b) market risk, which reflects the risk of a general stock

market decline and cannot be eliminated by diversification (hence, does concern

investors). Only market risk is relevant to rational investors because diversifiable

risk can and will be eliminated.

➢ A stock with high market risk must offer a relatively high expected rate of return to

attract investors. Investors in general are averse to risk, so they will not buy risky

assets unless they are compensated with high expected returns.

➢ If investors, on average, think a stock’s expected return is too low to compensate

for its risk, they will start selling it, driving down its price and boosting its expected

return. Conversely, if the expected return on a stock is more than enough to

compensate for the risk, people will start buying it, raising its price and thus

lowering its expected return. The stock will be in equilibrium, with neither buying

nor selling pressure, when its expected return is exactly sufficient to compensate

for its risk.

➢ Stand-alone risk is important in stock analysis primarily as a lead-in to portfolio risk

analysis. However, stand-alone risk is extremely important when analyzing real

assets such as capital budgeting projects.

As investors like returns and dislike risk, there is a fundamental trade-off between risk

and return: to entice investors to take on more risk, you must provide them with higher

expected returns.

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The Individual Investor’s Perspective

In the above figure presented by Brigham and Houston (2015) the slope of the risk-return

line depends on the individual investor’s willingness to take on risk. A steeper line

indicates that the investor is more risk averse.

Perspective of a Company Raising Money to Invest in Risky Projects

In the above figure presented by Brigham and Houston (2015) the slope of the cost of

capital line depends on the willingness of the average investor in the market to take on

risk. A steeper line indicates that the average investor is more risk averse.

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References:

Brigham, E.F. and Ehrhardt, M.C., 2013. Financial Management: Theory & Practice.

Cengage Learning.

Brigham, E.F. and Houston, J.F., 2015. Fundamentals of financial management. Nelson

Education.

Chisholm, A.M., 2009. An introduction to international capital markets: products,

strategies, participants (Vol. 450). John Wiley & Sons.

Fama, E.F., 1970. Efficient market hypothesis: A review of theory and empirical

work. Journal of Finance, 25(2), pp.28-30.