Integridad del convenio

1.0 Introduction 2.0 Objectives 3.0 Main Content

3.1 Meaning of Capital Market Efficiency 3.2 Assumptions of an Efficient Capital Market 3.3 Role of Capital Market Efficiency

3.4 Forms of Capital Efficiency

3.5 Implications of Capital Market Efficiency 4.0 Conclusion

5.0 Summary

6.0 Tutor Marked Assignments 7.0 References/Further Readings

1.0 INTRODUCTION

Discussions in the preceding units are based on the fact that capital market is assumed to be efficient. We shall in this unit explain the concept of efficient capital market, its various forms and its implication on financial managers and investors.

2.0 OBJECTIVES

At the end of this unit, you should be able to:

• Explain the meaning of capital market efficiency

• Describe the various forms of capital market efficiency

• State the implication of capital market efficiency on financial managers and the investors.

3.0 MAIN CONTENT

3.1 Meaning of Capital Market Efficiency

Capital market efficiency can be defined as a market where by prices quickly and fully reflect all available information if a market will be rendered useless. In an efficient market, the same rate of return for a given level of risk should realized by all investors. Behaviour of any participant or group should not influence a price of a security in the market.

3.2 Assumptions for an Efficient Market

• No transaction cost of trading in securities. Information is freely available to all market participants

• All investors have homogeneous expectations especially as to the implication of current information for the current price and distribution of future prices of each security.

• All investors have the same time horizon.

3.3 Role of Capital Market Efficiency

Capital market efficiency, from the roles the capital markets is expected to perform in the economy, can be classified into three: Viz

1. Allocation efficiency: the role of a capital market there is to optimally allocate scarce savings to productive investments in a way that benefits everyone.

2. Operation Efficiency: A market is said to be operational, efficient if it serves as intermediates that provide the service of channeling funds from savers to investors at the minimum cost that provides them a fair return for their services.

3. Pricing Efficiency: this is market where prices are used as signal of capital allocation. The prices are set by forces of demand and supply. A market that is pricing efficient implies that capital asset anytime is based on the correct evaluation of all information available then.

3.4 Forms Market Efficiency

Market efficiency can be categorized into three forms:

1. Weak Form: this is concerned with the adjustment of security prices to historical price or return information. If the market is weak from efficient, not investor can earn any excess or abnormal return based on historical price or return. The technical analysis believe that market prices exhibit identifiably patterns believe that are bound to be repeated. The art lies in devising the proper technique to identify trends, interpret them and interpret any deviating from them. In a weak efficient market, past price and volume of data are already impounded in security prices and no amount of chart reading or any other trading device is likely to outperform the buy and hold strategy.

2. Semi-Strong for Efficiency: This is concerned with whether security price fully reflect all information whether available to the public or not. In a strongly efficient, no investor can earn abnormal returns from publicly available information.

3. Strong Form Efficiency:- this is concerned with whether security price fully reflect all information whether available to the public or not. In a strongly efficient, market no individual can earn abnormal profit from any information even if he has monopolistic access to such information.

3.5 Implications of Capital Market Efficiency

If the capital market is efficient, it will have the following implications for financial managers and investors

A. For Financial Managers

• The real financial position of a company will always be reflected in a company’s share price. If management makes a positive investment decision, provided the information is made public, security prices will always reflect the manger’s actions. Thus, managers can pursue the objective of maximizing shareholders’ wealth by making public information on positive investment decision.

• Since, strong form of efficient market hypotheses does not hold, management with unfavorable information about their companies might not release such information to the public. If it is a very adverse information, the extent in which the company can withhold such information to the public is doubtful. Sooner or later the information might leak to the public. In a country where there is no stiff action on insider trading, management with withheld unfavorable information about their firm can defraud investors.

B. For Investors

• Investors can rarely beat the market and spot securities at a bargain price that will soon increase in value. All new information will have been built in security prices. The key element to investors’ choice in an efficient market is passive portfolio strategy. Passive portfolio strategy as described by Black (1971) involves investors choosing a well –diversified portfolio that fits his objectives including his tax status and his ability to tolerate fluctuations in the value of his portfolio. Nevertheless, once the investor has a portfolio, he should make change only to keep it diversified to fit it to changing objectives, to generate cash or to release losses (Black, 1971, p22)

Passive portfolio strategy also involves emphasis on low turnover and risk control (foster. 1978)

• An efficient capital market tends to imply that the value of security analysis is zero. However, investors still need security analyst to enable them build a well-diversified portfolio and control risk.

• In a situation where the market is near efficient, the key element to investors’ choice is active portfolio management. This is an investment approach that attempts to detect and exploit perceived departures from efficiency

SELF ASSESSMENT EXERCISE