The concept of capital market

1. Introduction

The concept of capital market efficiency can be said to be a research topic that has bring a lot of arguments and suggestions on the field of finance as a course of study. As such, it would only be expected that the wider implications of market efficiency would also be just as far-reaching.

Therefore, the justifications for this research undertaking may be considered to be a great task and as a result, capital market efficiency as an area of finance requires a rigorous work for scholars and as well for managers of an organization.

Order custom essay The concept of capital market with free plagiarism report

450+ experts on 30 subjects Starting from 3 hours delivery

Get Essay Help

The first time the term “efficient market “was in a 1965 paper by E. F Fama who said that in an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected “instantaneously” in actual price.The efficient market hypothesis asserts that none of the techniques used by fund managers ( i.e. forecasting, valuation techniques ) can outperform the market.

Arguably, no other theory in economics or finance generates more passionate discussion between its challengers and proponents. For example, Harvard Financial Economist Michael Jensen writes “there is no other proposition in economics which has more solid empirical evidence supporting it than efficient market hypothesis”. While investment maven Peter Lynch claims “efficient marketsThat’s a brunch of junk, crazy stuff” (Fortune, April 1995).

The efficient market hypothesis (EMH) suggests that profiting from predicting price movements is very difficult and unlikely. The main engine behind price changes is the arrival of new information. Consequently, there is no reason to believe that prices are too high or too low. Security prices adjust before an investor has time to trade on and profit from a new a piece of information.

The key reason for the existence of an efficient market is the intense competition among investors to profit from any new information. The ability to identify over- and underpriced stocks is very valuable (it would allow investors to buy some stocks for less than their “true” value and sell others for more than they were worth). Consequently, many people spend a significant amount of time and resources in an effort to detect priced” stocks. Naturally, as more and more analysts compete against each other in their effort to take advantage of over- and under-valued securities, the likelihood of being able to find and exploit such mis-priced securities becomes smaller and smaller. In equilibrium, only a relatively small number of analysts will be able to profit from the detection of mis-priced securities, mostly by chance. For the vast majority of investors, the information analysis payoff would likely not outweigh the transaction costs.

The Efficient Markets Hypothesis (EMH) over this period, has witnessed widespread recognition and has found its place amongst various scholars and researchers of finance and economics.

The empirical observations of Kendall (1953) thus came to be known as the ‘random walk model’ or in some instances the ‘random walk theory’ (ibid). However, this theory suggests that the share price at any one time reflects all available information, and will only change if new information arises. In this way, unpredictable news hitting the market causes share prices to fluctuate in a random and unpredictable manner.

The Kendall observation is based on the fact that the market is irrational world and that the price of stock has a rampant walk. However, as Bodie et al (2001: 268) point out, in a reversal of opinion, economists concluded that the unpredictable behaviour of stock prices actually indicated an ‘efficient market’ by the very virtue of such unpredictability.

Although Kendall (1953) is refer to as the father of the random walk theory, however, the actual concept of market efficiency, and indeed a ‘random walk theory’, had already been tested as many years ago as the year 1900 (Dobbins et al, 1994: 70). This was in fact the result of a doctoral thesis in mathematics written by the French economist Louis Bachelier (1900). He argues that the price of a commodity today is the best estimate of its price in the future, and therefore commodity speculation is a ‘fair game’ in which there are no winners, and wherein prices tend to follow a random walk (Pilbeam, 2005: 250-51).

Subsequently, as suggested by Dimson and Mussavian (1998: 93), the 1960’s marked a transition for research concerning the unpredictable nature of stock market prices. Leading on from the findings of Samuelson (1965) and Roberts (1967), Fama (1970) summarise a comprehensive review of the random walk literature, and proposed the idea of an informationally efficient market wherein “prices always fully reflect available information” (Fama, 1970: 383). Thus, the Efficient Markets Hypothesis (EMH) was introduce into the theory of efficient market. This theory supported the random walk theory and also created a theoretical framework in which economists could perceive the unpredictable nature of stock market prices.

More recently, Yen and Lee (2008) provide a chronological review of empirical evidence on the Efficient Market Hypothesis over the last five decades. Their survey clearly demonstrates that the Efficient Market Hypothesis no longer enjoys the level of strong support it received during the golden era of the 1960s, but instead has come under relentless attack from the school of behavioural finance in the 1990s. Besides the above broad review, there are other survey papers with a specific theme, for instance, Fama (1998) surveys the empirical work on event studies, with a focus on those papers reporting long-term return anomalies of under- and over-reactions to information; Malkiel (2003) and Schwert (2003) scrutinize those studies reporting evidence of statistically significant predictable patterns in stock returns; Park and Irwin (2007) review the evidence on the profitability of technical trading rules in a variety of speculative markets, including 66 stock market papers published over the period from 1960 to 2004.

The Efficient Market Hypothesis has over the years been accepted by various scholars since its inception nearly forty years ago; however, in more recent times the Efficient Market Hypothesis has come under criticism, and as a result has been apparently undermined by the emergence of a new introduction to finance thought which is known as Behavioural Finance. The recent discussion published in Malkiel et al. (2005) clearly indicates that there is no sign of compromise between proponents of the Efficient Market Hypothesis and advocates of behavioural finance.

Lo (2004) notes that useful insights can be gained from the biological perspective and calls for an evolutionary alternative to market efficiency. In particular, he proposes the new paradigm of Adaptive Markets Hypothesis (AMH) in which the Efficient Market Hypothesis can co-exist alongside behavioural finance in an intellectually consistent manner. In this new hypothesis, market efficiency is not an all-or-none condition but is a characteristic that varies continuously over time and across markets. The main contribution of this paper is to provide a systematic review on the empirical literature of evolving weak-form stock market efficiency, which is consistent with the prediction of Adaptive Markets Hypothesis.

Find mat on b. Finace and adaptive

The history of stock trading and trading associations can be traced as far back as the 11th century when Jewish and Muslim merchants set up trade associations. After centuries of evolution, stock markets have become the symbol of commerce in the modern world. It operates in various countries and trades a range of securities. The world stock market capitalisation is estimated to be about $ 47.7 Trillion as January, 2010. The stock market has various functions such as capital mobilisation, investing opportunities, risk distribution etc.

The major stock exchanges in the world today include New York Stock Exchange, London Stock Exchange, Frankfurt Stock Exchange, Italian Stock Exchange, Hong Kong Stock Exchange and Tokyo Stock Exchange.

Stocks can be defined as a collection of shares in a company. Therefore, a stock market is a place where buyers and sellers of stock meet to transact business. It is a place where exchange of shares takes place.

Basically, there are two types of stock markets:

• Primary Market
• Secondary Market

The primary market is the market of first sale where companies first sell their shares to the public. It is used by companies who are coming to the exchange for the first time to raise finance.

The secondary market on the other hand is a market where existing or already issued securities are traded. The activities in the secondary market are usually carried out on the floors of the Stock Exchange where investors and sellers of securities meet to consummate deals through the stock brokers who are the dealing member of the exchange.

The stock market is often influenced by the availability of information on the various securities traded on the stock exchange. The price of stock’s moves up and down reflecting the mood of the market, the price of stock move only when there is information in the market.

The concept of an efficient market is a special application where the market price is an unbiased estimate of the true value of the investment.

1.1 A Historical Overview of Capital Market Efficiency

During the 1950’s the advancement of information technology gave rise to a new founded power to analyse economic time series using various computer applications; unsurprisingly much to the fortuity of economists and business theorists alike. It was widely believed among such a community of scholars that “tracing the evolution of several economic variables over time would clarify and predict the progress of the economy through boom and bust periods” (Bodie et al, 2001: 268).

A viable candidate for such experimental analyses at the time was the behavioural pattern of stock market prices over a certain time period, which, it was hoped, could be used as an indicator of economic performance (ibid).

Subsequently, an undertaking of such an analytical study was conducted by Maurice Kendall (1953) who attempted to find recurring patterns in 22 UK security and commodity price indices. He unearthed results that were to open up a whole new dimension to the theory behind the behaviour of stock market prices. Hence, contrary to the then prevalent views among economists, he found that there appeared to be no identifiable pattern between stock price fluctuations, in that they seemed to move in an erratic fashion. He therefore concluded that stock prices appeared to follow a random walk (Dobbins et al, 1994: 71).

The empirical observations of Kendall (1953) thus came to be known as the ‘random walk model’ or in some instances the ‘random walk theory’ (ibid). In short, this theory suggests that the share price at any one time reflects all available information, and will only change if new information arises. In this way, unpredictable news hitting the market causes share prices to fluctuate in a random and unpredictable manner.

1.2 AIMS AND OBJETIVES

The aims and objectives of the study is to discuss how efficient is the stock market with particular reference to London Stock Exchange.
To establish that there exist a concept of the efficiency of the stock market which implies that at any point of time the prices of securities react to all the market information positively or negatively depending on the nature of the information.
To review all available literature on efficient market hypothesis and compile a report.
To make a report on the stock market anomalies that seems to contradict the efficient market hypothesis.
To determine the effect of insider abuse on the efficient of the stock market.
To present a comprehensive and critical analysis of the efficient of the stock market.
To arrive at a conclusion base on the report gathered on the efficient market hypothesis, insider abuse, stock market anomalies and other factors affecting stock market efficiency.

1.4 SCOPE OF THE STUDY

To achieve the objectives outlined, scope of the study and report undertaken by this dissertation extend to the following areas for an extensive research and analysis:

The study will focus on the types, needs and level of stock market efficiency.
The study extends to the analysis of the stock market operations and the relative effect of market information on the buying and selling of the securities.
The study will also examine issue of insider trading and the effect of such insider trading on the stock market efficiency
While detailing the anomalies of the stock market the report envisages to bring out the effect of those anomalies on the efficiency of the stock market

1.4 STRUCTURE OF THE STUDY

To present a comprehensive and coherent report, this dissertation adopts the following structure:

• Chapter 1: Introduction, provides a brief description on the stock market efficiency
• Chapter 2: Literature Review, this represent the body of the text covers a detailed review of the available literature on the stock market efficiency. This section will attempt to present a review of the academic works relating to the research topic.
• Chapter 3: This chapter is where the research methods to be used are developed and it will demonstrate the research methodology that has been used to carry out this study.
• Chapter 4: This såñt³în ðrîv³dås the main ñàså study of the research, the general overview of London stock exchange.
• Chapter 5: This chapter discusses the data collection and findings, the interviews and questionnaires taken from stakeholders- investment analyst, pension fund managers, brokers, and investors in the stock market.

Don't let plagiarism ruin your grade

Run a free check or have your essay done for you

Check my essay Hire Writer