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April 2nd, 2010 |

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Critical Examination Of The Financial Market Efficiency

Introduction

Any mechanism organized for trading financial assets or liabilities is termed financial market. It is a market in which financial assets and liabilities are traded (Richard & Bill, 2006). Financial assets in this context include all forms of securities ranging from common stocks to derivatives. Efficiency as it is commonly used can be seen as” the ability to achieve desired result without wasted efforts or energy” (Encarta dictionary, 2009). In other words, it has to do with how resources are productively utilized, the extent to which something is done well. Efficiency of financial market can thus be said to encompass how financial assets and liabilities are productively exchanged and funds effectively invested in Financial Market Instruments. However, exchange of securities for funds cannot be done except with a price willingly accepted by both parties while the price is determined mostly by the value and extent of information available to investors in the market. This paper however discusses the efficiency of financial markets exploring theories and assumptions and explaining in details, all terminologies (majorly price and information) relating to financial market efficiency.

Literature Review

Extensive findings have been conducted on the efficiency of financial market. This has led to the development of different theories such as; determination of values of securities, effect of information on share prices, dividend policies to mention a few.

Definition of Financial Market

Financial market, according to Olowe, 1997, is a mechanism by which surplus and deficit units of an economy can be brought together through the buying and selling of financial claims. He further asserts that the primary function of financial markets is to enable funds to be effectively allocated from the surplus units in the economy to the deficit units for productive investments. Richard and Bill, 2006, view financial market as any mechanism for trading financial assets and securities. They further explain that frequently, there is no physical market place; transactions are being conducted via telephone or computer. It is any market in which financial assets and liabilities are traded and a mechanism through which corporate financial managers have access to a wide range of sources of finance and instruments. Capital markets however function in two important ways:

Primary markets – providing new capital for business and other activities, usually in the form of share issues to new or existing shareholders or loans. It provides the focal points for lenders and borrowers to meet. Primarily, new finance is raised in this market.
Secondary markets – trading existing securities, thus enabling existing investors to dispose their holdings at will. An active secondary market is a necessary condition for and effective primary markets, as no investor will want to stick to an investment that cannot be realized when desired.

The Institute of Chartered Accountants of Nigeria describes financial market as the facilities and institutions provided by financial system for the creations, custody and distribution of financial assets and liabilities. The market according to the institute, has two major segments; the money and capital markets.

Money market creates opportunity for raising or investing short term funds. The tenor of which ranges from overnight to about one or two years. The financial instruments exchange in this market includes treasury bills, bill of exchange, treasury certificates, commercial papers etc. Capital market on the other hand are mechanisms, institutions and structures where medium term and long term funds are pooled and made available to businesses, government and individuals. It is in the capital markets that instruments which are already outstanding are transferred.

Financial Market Instruments

These are securities or financial assets traded in the financial markets and as mentioned earlier, financial markets has two major segments – money and capital market, the instruments traded in the money market are as follows:

Treasury Securities – these are short term obligations of the federal government to the bearer a fixed sum of money after a specified number of days from the date of issue. Treasury securities are of two types depending on their face values and maturities. While treasury bills usually have a low fixed return and matures in about 91 day of issue, treasury certificate share similar features with it but has a longer maturity period and a higher fixed return.
Certificate of Deposits (CDS) – these are receipts from banks for deposit of funds for a specified period of time at a specified interest rate. CDS is an interbank instrument and serve as a means for channelling commercial banks’ cash surpluses to merchant banks who are main issuers of this type of instrument. When the bank promises to pay the principal and interest at maturity, usually within 3 – 36 months, it is called negotiable certificate of deposits. However, when CDS have features of a time deposit receipt and are normally held till maturity, they are termed non-negotiable certificates of deposits. Non negotiable certificates of deposits also have maturity ranging from 3 to 36 months.
Commercial Paper – this is a short term unsecured promissory note issued by a company at a discount to an interested investor for cash for a specific maturity period. The investors in commercial papers are usually credit worthy individual or institutional investors. It usually has a maturity ranging from 30 to 270 days. Commercial paper can however be categorised into dealer papers and directly placed papers. Dealer papers are commercial paper placed with investor through a dealer which may be a bank while directly placed papers are commercial notes placed directly with investors by company issuing the papers which will require the issuing company to maintain an outfit with trained personnel who have a good knowledge of financial market and have good contacts in the markets. In any case, commercial papers are invested in by investors who can borrow in the loans market without security or even with a negative pledge. Commercial papers are traded only in the primary markets.
Bankers Acceptances – also known as bill of exchange are drafts accepted by the drawee bank specifying that a certain amount will be paid after a specified period of time. The acceptance is done by writing the word “accepted” across the face of the draft together with authorised signature. Once this is done, the bill can then be discounted by the payee at a discount rate. It is used for financing international trade through letters of credit. It is also used for financing of commodities trade especially with respect to bonded warehouses and the credit created through bankers acceptance are self liquidating short term credits. The maturity ranges from 90 – 180 days or sometimes 30 – 270 days.
Bank Deposits – this is a placement of fund by investors/depositors with bank at an agreed rate of interest. Bank deposits are divided into call deposits/savings account deposit and fixed deposit. Call deposits are made with no specified maturity period and can be terminated by any both parties by given notice to the other party based on the agreed notice period, fixed deposits are deposit of funds with a bank for a fixed period of time at a specified rate of interest which could be fixed or floating. The maturity of deposits can vary from a few days to number of years. The deposit may or may not be certified with a deposit receipt or certificate.
Derivatives – these are means of gaining or losing from hedging or speculating against movements in currencies and interest rates. They are financial instrument whose value derives from underlying assets, they are securities that allows an investor to gain exposure to the performance of an underlying securities without physically owing it. Profitable though, there may be hidden risk in the derivatives market. Financial experts term it “financial weapon of mass destruction” and is described just like hell which may be easy to enter and almost impossible to exit. Examples of derivatives are; forward contract, future contract and options.

Capital Market Instruments

Debt Instruments – these are long term loans raised by a company or government for which interest is paid and at a fixed rate. A debt instrument has a nominal value which is the debt owed by the issuer of the instrument and interest is paid at a stated coupon rate on this amount. In most cases, debt instrument are redeemable.
Preference Shares – this is also a major source of long term financing to a company. The holders are preferred to ordinary shareholders in terms of dividend payment. Preference shares could be cumulative when they have right to the unpaid dividend of previous periods, carried forward to another periods until it eventually paid up in which case the arrears must be paid before ordinary share dividends are paid. Just like debt instruments, preference shares may also be redeemable.
Ordinary Shares – the holders of these shares are owners of the company. They have nominal values and the memorandum and article of association of a company specifies the number of authorised ordinary shares a company can issue. The ordinary shareholders have residual claims in the company i.e. they are paid dividend only after other fixed obligations have been met.
Convertible Securities – these are hybrid securities that share both the features of a fixed income security and ordinary shares. They are securities (usually fixed interest) that are convertible into ordinary shares of the company at the option of the holder in the future.

Having explained the concept of financial market and its component, we need to examine whether its efficient or not. Before this can be done, efficiency, as it has different connotation in different environments needs to be clarified in the light of financial market.

Efficiency

The word efficiency is part of everyone’s vocabulary. To most, it means the ability to achieve a desired result without or with minimum wasted energy or effort. To Encarta dictionary, 2009, it is the ability to do something well or achieves a desired result without wasted energy or effort, i.e. to degree to which something is done well or without wasted energy or effort. Generally speaking, it is a means of increasing the well being of a particular situation given an amount of productive resources and existing state of technical knowledge in an economy, eliminating wasted effort and allowing for more production from available resources therefore achieving the desired result by avoiding wastage and also preventing the avoidance of wastage from causing any harm. (David N.H, 2005).

However, to different professions it means different things, “the economists talk about allocative efficiency – the extent to which resources are allocated to the most productive uses this satisfying society’s need to the maximum. The engineers talk about technical efficiency – the extent to which a mechanism performs to maximum capability. The sociologists and political scientists talk about social efficiency – the extent to which a mechanism conforms to accepted social and political values.” (Richard & Bill, 2006).

Financial Market Efficiency

To investment guru or financial expert, efficiency is somewhat more precise, it relates to pricing and information efficiency, the efficiency of substituting funds for financial market instruments. It has to do with how fast and convenient asset can be transformed into cash and vice versa, how prices of securities are determined and how risks inherent in such securities are managed. This can however be summarized from the roles the financial market are expected to perform in the economy which, according to Olowe, 2007, are classified into three (3);

Allocational efficiency – the role of financial market to optimally allocate scarce savings to productive investments in a way that benefits everyone.
Operational efficiency – to server as intermediary who provides the service of channelling funds from savers to investors at minimum costs that provides them with fair return for their services.
Pricing efficiency – the role in determining the values at which securities will be exchanged, where market prices are used as signals for capital allocation. The prices are set by the forces of demand and supply. Fama, 1976 (in Olowe, 1997) sees pricing efficiency as efficiency in the processing of information.

Based on the fore going, we can conclude that pricing and information are the two major determinant of efficient financial market. Thus we can define financial market efficiency as a market where security prices quickly and fully reflect all available information. A market in which any device intended to outperform the market will be rendered useless. Therefore in an efficient financial market, the same rate of return for a given level of risk should be realised by all investors.

Pricing of securities

Pricingas a Major Determinant of Financial Market Efficiency – pricing of security can however be discussed in relation to Risk and return. Risk, which is created by wide range of factors as general economic condition, economic factors peculiar to securities, competition, technological development, investor preferences, and all other sorts of circumstances, is defined, according to Van horne, 1986, as the variability of possible returns on investments. Olowe, 1997, also sees risk as the probability of the deviation of the return expected from holding a security from the actual return from the holding of such securities. With the introduction of risk, an investor will be indifferent as to which security to invest in when there are availability of investment having similar returns. The conceptual framework for examining the relationship between risk and return as they affect security pricing is discussed under the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Model (APM).

1. Capital Asset Pricing Model (CAPM)

This model was developed by Sharpe (1964), Linter (1965) and Mossin (1966). It shows the relationship between expected return of security and its unavoidable risk. It provides framework for the valuation of securities and can be used to find an entity’s cost of equity.

CAPM are however developed on the following assumption;

CAPM is a one period model and assumes that investors are risk averse.
Investors are rice takers and have homogenous expectation about securities.
There exist a risk-free security such that investors may borrow or lend unlimited amounts at the risk fee rate.
All securities are marketable and perfectly divisible. More so, their quantities are fixed.
Information is freely available to all investors.
There are negligible restrictions on investment and no investor is large enough to affect the market price of stock.

The foregoing assumptions summarily assume that there exist a perfect market and that the financial market is efficient. Therefore, given the assumptions, we will price every asset that falls on security market line while the security market line equation is given as;

E(R1) = RF + [E(RM) - RF]β1

Where β1 = COV(R1RM)

σ2m

E(R1) = expected return on security

RF = risk – free rate

E(RM) = expected rate on market portfolio

β1 = beta of security i

COV(R1RM)= covariance of return on security i with the returns on a market portfolio.

σ2m = variance of returns on the market portfolio

Illustration; if the expected return on security is 24% and its beta is 1.8. show whether the security is under or over valued if the risk – free rate is 13% and return on market portfolio is 18%.

Solution;

E(R1) = RF + [E(RM) - RF]β1

= 0.13 + [0.18 – 0.13]1.8

0.22 i.e. 22%.

We conclude that it is undervalued as the expected return is 2% less than the predicted. i.e. 24% > 22%.

Characteristics of CAPM

For the fact that not all risk of security return is of concern to risk averse investor, asset must be priced so that its risk adjusted required rate of return falls exactly on the security market line. Thus the only risk which investors will pay a premium to avoid is market risk hence the division of total risk of any individual security into systematic and unsystematic risk. Whereby systematic risk is general and affects the entire market and unsystematic is peculiar to factors that are unique to a particular entity. Efficient diversification, however, reduces the total risk of the portfolio to the point where only systematic risk remains.
Risk portfolio as measured by beta is the weighted average of the betas of individual securities in the portfolio. The proportion of portfolio funds represents the weights allocated to individual securities in the portfolio and it is mathematically denoted as;

n

βP = ∑ wi βi

i=1

where βp = beta of portfolio p

βi = beta of security

Wi = proportion of security in portfolio p

Conclusively. CAPM has been derived based on some simplifying assumptions, most of which do not conform to reality. For this reason, it has been criticised on the ground that it assumes the market portfolio to consist all assets – stocks, bonds, properties and human capital. In real life situation, empirical tests of CAPM tend to use proxies such as stock market indices as a measure of market portfolio.

The Arbitrage Pricing Model

This was suggested by Rose (1976) because of the dissatisfaction with the CAPM on both theoretical and empirical grounds. It is a multi-factor model (multiple beta model) as opposed to CAPM which is a single factor model. A security’s actual return in a factor generating mode is given as;

n

Ri = E(Ri) + ∑ bijFj + ej

J=1

This can be restated as Ri = E(Ri) + bi1F1+bi2F2 + ………. + binFn + ei

Ri = actual return on security

E(Ri) = expected return on security i

Fj = the (uncertain) value of factor j

bij = sensitivity to factor j

ei = the error term. It is also the security-specific return.

Similar to the CAPM, we diversify the unsystematic risk away but in addition, we arrive at the market equilibrium as individuals eliminate arbitrage profits across multiple factors. The model does not specifically indicate what the factors are or the economic or behavioural importance of the factors. However market return as in the case of CAPM might be one of the factors. The APM, thus, suggests that there is a linear relationship between security return and some factors. In equilibrium, according to this model, expected return on security i E(Ri) will be given by:

E(Ri) = Rf +ƛ1 bi1 + ƛ2 bi2 + ……..+ ƛn bn

Where Rf = risk – free rate

ƛn = risk premium for the types of risk associated with particular factors. Its equation can be rewritten as: ƛn = En – Rf

where En is the expected return of a portfolio which has unit response to other factors.

Illustration

The return of stock company is related to two factors as follows.

E(Ri) = Rf +0.7ƛ1 + 1.6 ƛ2 + 1.3 ƛ3

Where 0.7,1.6 and 1.3 are sensitivity coefficients associated with each factor. If the risk – free rate is 12%, ƛ1 is 7%, ƛ2 is 4% and ƛ3 is 6%. Calculate the expected return on the company’s stock.

Solution;

E(Ri) = 0.12 + 0.7(0.07) + 1.6(0.04)+1.3(0.06)

= 0.311 i.e. 31.1%

In conclusion the APM is seen as superior to CAPM as CAPM allows a risk averse investor to focus more attention on systematic risk in pricing securities and diversify away the unsystematic risk. Under the APM on the other hand, individuals arbitrage across multiple factors so that when arbitrage opportunities cease to exist, the market is in equilibrium. However, there is yet to be agreement factors in the APM and whether it is testable. Thus CAPM can still be used in security pricing.

Information on Securities

Information can be classified as historical, current or forecast. Only current or historical information is certain in its effect on price. The more information that is available the better the situation meaning that informed decisions are more likely to be correct. Security prices are characterized with random and unpredictable movements. The movement of security prices may be interpreted to imply that investors in the market take a quick cognizance of all the information relating to security prices and the prices quickly adjust to such information. Thus the efficiency of the security prices depends on the speed of price adjustment to any available information. The more the speed of adjustment the more efficient the prices. Market efficiency as regards the availability of information is however reflectec in Efficient Market Hypothesis (EMH) in three basic forms;

Weak form
Semi – strong form and;
3. Strong form.
1. Weak form of EMH states that the current share prices fully reflect all information contained in the past price movements which makes it impossible for an investor to predict future security prices by analysing historical prices and achieve a better result than the stock market itself. Therefore for a market to be efficient at this form, significant correlation should not exist between securities prices aver time. More so, if an investor’s trading strategy could not beat the market based on the information available to him, we conclude that the market is efficient at weak form. Olowe, 1997 puts that Nigerian capital market is efficient at weak form.
2. Semi – strong form of efficiency is concerned with whether securities fully reflect all publicly available information. This implies that an investor will not be able to outperform the market by analysing the existing company – related or other relevant information available. This form implies that the share prices reflects an event or information very quickly, and therefore, it is not possible for an investor to beat the market using this information.
3. Strong form of efficiency is concerned the fact that securities prices reflect all published and unpublished public and private information. This implies that people with private or inside information will be able to outperform the market at this form.

Conclusively, Olowe, 2007 asserts that the following assumption are sufficient for an efficient market;

No transaction cost of trading in securities.
Information is freely available to all market participants.
All investors have the same time horizon
All investors have homogenous expectation especially as to the implication of current information for the current price and distribution of future prices of each security.

The general assumption underlying an efficient market therefore implies that prices of securities in the market must reflect sufficiently enough information to allow investors make informed decisions about investment in such markets.

References.

David N. H., (2005), Public Finance and Contemporary Application of Theory to Policy, 8th edition, U.S.A Library of Congresss.

ICAN Study Pack on Strategic Financial Management. VI publishing, Lagos, 2006

Linus E. A. and Kalu I.U., “State Government Finances and Real Asset Investments: The Nigerian Experience,” African Journal of Accounting, Economics, Finance and Banking Research Vol. 4. No. 4. 2009.

Microsoft Encarta, Encarta Dictionary, Microsoft corporation, 2009.

Olowe, R.A (1997). Financial management: concepts, analysis and capital investments. Brierly Jones Nig. Ltd., Lagos, 1997

Pandey, I.M. (2004). Financial Management, 8th edition. Vikas Publishing, New Delhi, 2004.

Richard k & Bill N, (2006) corporate finance and investment decisions and strategies, 5th edition. Pearson education ltd. London.

Van Horne, J.C. (1968), Financial management and policy, 7th edition. Englewood cliffs N.J.: Prentice Hall.

About the Author

Ahmad Bukola Uthman

ahmadbukola@yahoo.com

Department of Accounting

AL-Hikmah University, Ilorin

Kwara State,

Nigeria.

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