Homework 2 economics e napp answers

Applying Efficient Market Hypothesis (EMH) to UK & US 11

APPLYING EFFICIENT MARKET HYPOTHESIS (EMH) TO UK & US

By [Name]

Course

Professor’s Name

Institution

Location of Institution

Date

2. Literature Review

The efficient market hypothesis is an exciting area of study that has attracted the attention of many researchers. The primary objective of this chapter is to review previous studies on EMH and stock exchange market. The arguments presented in this sections give an overview of the past discoveries as well as the area of interest that the methodology part should focus on to solve the research problem. The chapter begins by reviewing studies that evaluate the nature of the stock market in both UK and UK to act as a background analysis of other aspects such as the types of EMH, signalling theory, capital market analysis and financial analysis. The studies are compared and contrasted to come up with a strong argument that is used in the discussion and conclusion sections.

2.1 Nature of Stock Exchange Market in UK and US

According to Šonje, Alajbeg and Bubaš (2011, p. 14), the Indonesian stock exchange has a direct relationship with Hong Kong stock exchange, meaning that what Brexit causes to London Stock Exchange impacts the Global capital market. The London stock exchange market is an area of concern since the capital market is affected by the action taken by the United Kingdom on the trading block they are operating. Suganda and Soetrisno (2016, p. 112) evaluate the impact of contagion integration and stock markets in ASEAN Countries following subprime mortgage and the Greek crisis. The results of the study were that PSEI and SET had contagion impact to IHSG.

Another disposition of such an event was shown during the campaigning period and election time of the current President of the United States of America, Donald Trump. Some of the stated sentiments rose by the current president of the USA show that trading with the USA was made difficult. However, this makes it hard for some companies to operate, which influence the New York Stock Exchange. The stocks prices in the stock exchange shifted from one level to the other indicating a significant correlation between the sentiments and the value of stocks.

The United States President put across that some trade blocks were not part of the USA trading constituents. According to Politi (2010, p. 13), the impacted prices of the stock fluctuated significantly but later normalized. On the other hand, the impact showed that the stock exchange market reacted to the sentiments, giving a point of application of the financial model. The point to note is that Donald Trump’s election was primarily held within the futures of stock market (Barbato 2005, p. 36). With the indication that Donald Trump was to be elected on the 9th of November 2016, the futures steeply fall.

2.2 Investment and Capital Market

Tandelilin (2010) argues that investing is a course of action of committing funds or other resources that are carried out today for a future benefit. Investors undertake investment activities for again more than the invested resources. However, it is essential to evaluate the predicted earnings concerning other underlying factors such as inflation risk and tax savings. Subsequently, Naresh (2011, p. 1`8) argues that when the underlying elements have a higher value than the benefits, the investors shy from such an investment as they welcome the commitment. Investment increases the future consumption and reducing current consumption. The involvement of resources can be done through the capital market.

According to the study conducted by (Edwards, Haugerud and Parikh 2017, p. 196) supports that capital market is defined as a financial situation where the long-term financial instruments are traded. According to the Law of Capital Market of 1995 No. 8 states, the capital market is an organization where the public offering and security trading for public companies is done. However, it offers a functional meeting point between the people with excess funds and those who need the resources. Again, the market operates in a situation where the entities need fund funds float issues securities to the public with the aim of getting funds. Investors, according to Fernandez-Bariviera (2011, p. 6), are parties who have excess reserves and purchase securities issued in the capital market. In receipt of the funds, the entities are entitled to due diligence in executing any operation using the monies shared by the investors for a profit.

2.3 Signaling Theory

Signaling theory plays a critical role in enhancing the function of EMH in both US and UK. The companies' management uses the theory uses to guide investors about how they to manage the companies' prospectus look in future (Brgham and Houston 2010, p. 23). Information asymmetry arising from signalling theory is a concept of agency. The owners of the capital who are the principals authorizes the founded company manage funds as agents. Though that is the case in execution, agency conflict arises between the principal and the agent. The company has more information than the investors, resulting in an information asymmetry. Therefore, agents providing information to the public signal the financial market participants.

4.4 Efficient Market Hypothesis
In an efficient market, the stock prices act as a reflection of the available and reliable announcement of the stocks (Westerlund, Norkute and Narayan 2014, p. 357). Efficient markets show an inability of the investors to take advantage of the arbitrage profits. The impossibility of the abnormal return being sustainable for some time as the investors exploit it setting the new trend in evaluating the selling price of the stock that will take into consideration of the same factors. The efficient market hypothesis by Fama (1970) discussed three different financial market forms (Westerlund, Norkute and Narayan 2014, p. 357). The market forms will be discussed in this chapter.

2.4.1 Weak Form Efficient Market
The argument presented by company Mak (2006, pp. 757) supports that the weak form of the efficient market hypothesis poses an attribute that its securities' prices reflect the full past information. The weak type of the model assumes that all the information that was availed in the market makes part of the stock value in the market (Mak 2006, p. 757). Investors who believe in this form of the efficient market hypothesis value their financial instruments based on the information available in the market with minor consideration of what the company holds within it and what would later happen to the company (Mak 2006, pp. 757). However, it is considered as the weakest form since it addresses what is known by the majority of traders. In the case of the market hypothesis, it states that past news is all the information relating to what has been happening in the past. Investors at this level of efficiency believe in the Technicians observations and statements (Mak 2006, p. 757). The form of ability goes ahead stating that the past data doesn't relate to the present value thus known as the random walk theory.

2.4.2 Semi-strong Form Efficient Market
The study by Mak (2006, p. 757) identified that the market's stocks show all the information published including the financial statements performance disclosure. Under this form of the EMH, the model states that semi-strong state always considers the past information availed to the market participants through financial statements as well as what is availed crudely to the public through Annual General Meetings. Based on Frahm (2013, p. 112) arguments, the semi-strong form explains why the stocks’ value change immediately the financials are released by Auditors. In the UK, the model goes on and states that financials of an institution indicate the profitability of the company that gives a signal on how the company is creating wealth for the Investors.

The release of the financials also contains dividends and payout ratio held by company policy. When the financials indicate a significant assurance of profits, a lot of investors are attracted, and the share prices shoot in the market making an abnormal shift in the stock exchange market. The opposite change of the stocks’ prices by lack of confidence determines whether the company can pay shareholders dividends. The published report takes the following; the information published with regards to some specific securities prices (Jogiyanto 2013, p. 46). The market's investors do not have the chance to utilize the available information on their abnormal benefit in the long run.

2.4.3 Strong Form Efficient Market
Accordinmg to Mak (2006, p.788), the stocks prices reflect all the available information such as private information. In this case, no investor makes any abnormal profit since all the secret information is available. The stock price indicates all the intrinsic and extrinsic values of the data within an entity (Paulos 2003, p. 93). In the strong form in EMH the model states that the cost of stocks includes the information that was historically provided, the current and even the intended strategic move planned by the company.

The study by Jouini and Napp (2009, p. 11) concludes that the form of EMH, in this case, assumes that every investor uses a rational ideology in making an investment decision. Subsequently, investors not only uses the chartist argument but goes further to speculate what will happen in future based on the current information available as well as what the company intends to do (Paulos 2003, p. 93). The model assumes that no a single investor has the advantage over the other and as such, the model shows little or no arbitrage profit gained by any of the market participants in case of trading the stocks.

2.5 Evaluation of the Model
Studies argue that it is difficult for an investor to use only the past information to make an investment decision and at the same time, they will lack some inside natural choices of the company stocks they are dealing with in the stock exchange market (Paulos 2003, p. 87). However, with that being the case it paves the way that the only practical analysis of a company stocks can only be in the semi-strong type of an efficient market hypothesis. Subsequently, the segment incorporates the present and the past information that is available to all the stock exchange market participants (Paulos2003, p. 93). The reason was making it the most valuable form of the model.

2.6 Abnormal Return
Actual excess return that is above the average gains in a capital market is known as the abnormal return. The stock prices indicating the information that has aspects of the tradeoff between risks and profits for the future is known as the efficient market. However, any return over and above the standard return is the abnormal return (Jogiyanto 2013, p. 69). On the other hand, regular returns are returned investors expect when they invest in a normal operating financial market state. Conclusively, the variance existing between actual returns and the average returns result in abnormal returns (Paulos 2003, p. 87). Performances may take two shapes which are positive or negative. In inefficient markets, the stocks yield a more significant deviation from the normal than in an efficient market. According to Suganda & Soetrisno (2016, p. 262) findings, mean the adjusted model is used as a primary tool to assess the variance between returns.

The efficient market hypothesis is a financial model that explains the disposition of an occurrence how it reflects in the stocks prices of such a time. The costs of stocks are determined by the type and nature of information available at such a time (Naresh 2011, p.18).Subsequently, any occurrence that triggers the decision that investors hold to tend to alter the stock’s price and as such lead to day to day price variations. Whenever change impounds the environment, the model suggests that the exchanging prices of the stocks take shape based on the shift insinuate (Zubairu Kofarbai and Zubairu 2016, p. 768). Political, social, economic, among other factors impound a shift in thought by the investors and as such a new price is set to fit the situation. From this, any sought of environmental change in the economies sends a signal to the companies’ stocks.

2.7. Efficient market hypothesis and Financial Analysis

The efficient hypothesis is closely correlated with other financial tools as well as axioms in the stock exchange market. The effectiveness of the market is determined by the absolute are biased rationality of the members of the market. According to Zubairu Kofarbai and Zubairu (2016, p. 768), all participants in the capital market are reasonable based on the systematic analysis of the market. Contrary, arbitrary traders are considered unreasonable, and their market participation does not influence prices of financial markets. For instance, random purchase plays a vital role in the modification of share value. The process is considered sceptical since it negatively influences the fortuitous sale, due to the occurrence of unplanned casual selling acquisition (Shiller 1987, p. 36). On the other hand, investors are categorized into knowledgeable investors and noisy traders. Knowledgeable investors utilize different tools to ensure that they make an informed decision during investment, while boisterous traders actively participate in the market, but often make wrong investment decisions.

The study conducted by Goedhart, Koller, Wessels (2010, p 585) noted that there is a significant influence on securities by the intrinsic value investors since the prices are centralized. Subsequently, regardless of the existence of irrational investors, the effect on the stock price is negligible. Based on (Zubairu, Kofarbai and Zubairu (2016, p. 768) argument, sophisticated investors are able to identify to facilitate elimination of unreasonable prices from mispriced securities trading. EMH is extensively used as a link between capital asset pricing model (CAPM) and stock substitution.

In summary, the literature reviewed shows how different researchers present their arguments based on the relationship between EMH as well as the stock market in the UK and US. The research evaluates various factors influencing EMH such as the victory of Trump as the President of the United States. The findings from the studies are connected to the nature of the stock exchange market in the UK and US. The research on the factors influencing EMH help in identifying aspects such as capital market that help in evaluating how investors commit themselves to particular investments. Signaling theory is also assessed, which play a significant role in improving the functionality of EMH in the UK and US. The types of efficient market hypothesis dominate the entire section. The primary focus of addressing kinds of EMH was to ensure that all elements influencing its functionality are treated. The next chapter is research methodology that gives the framework of the approaches used to develop the study.

3. Research Methodology

Bibliography

Barbato, F., 2005. Efficient Market Hypothesis: Limiti della Teoria Classica (Efficient Market Hypothesis: Limits of the Classical Theory).

Edwards, J., Haugerud, A. and Parikh, S., 2017. Introduction: The 2016 Brexit referendum and Trump election. American Ethnologist, 44(2), pp.195-200.

Fernandez-Bariviera, A., 2011. Revisiting the Efficient Market Hypothesis in the Thai Stock Market. SSRN Electronic Journal.

Frahm, G., 2013. A Modern Approach to the Efficient-Market Hypothesis. SSRN Electronic Journal.

Jogiyanto, H., 2013. Teori Portofolio dan Analisis Investasi (Edisi 8). Yogyakarta: BPFE.

Jouini, E. and Napp, C., 2009. Unbiased disagreement and the efficient market hypothesis.

Khan, A.Q. and Ikram, S., 2010. Testing semi-strong form of efficient market hypothesis in relation to the impact of foreign institutional investors'(FII's) investments on Indian capital market. International Journal of Trade, Economics and Finance, 1(4), p.373.

Kofarbai, H.Z. and Zubairu, M., 2016. Efficient Market Hypothesis in Emerging Market-a Conceptual Analysis. European Scientific Journal, 12(25).

Lee, A.C., Lee, J.C. and Lee, C.F., 2009. Financial analysis, planning and forecasting: Theory and application. World Scientific Publishing Co Inc.

Mak, D., 2006. Mathematical Techniques in Financial Market Trading. Singapore: World Scientific Publishing Company.

Naresh, E., 2011. Market Efficiency in Indian Cement Industry : An empirical study on Efficient Market Hypothesis. Indian Journal of Applied Research, 3(5), pp.18-19.

Paulos, J.A., 2003. A Mathematician Plays the Stock Market. Science News, 163(24), pp.383-383.

Politi, M., 2010. Optimizing a basket against the efficient market hypothesis (No. 1006.5230).

pp. 45 – 69.

Rozeff, M.S., 2006. Market Pricing Beyond the Efficient Market Hypothesis.

Schwert, G., 2001. “Anomalies and Market Efficiency,” in G. Constantinides, et. al.,Handbook of the Economics of Finance, North Holland.Shareholders,” Journal of Economic Perspectives, Summer. pp. 1013-1024

Šonje, V., Alajbeg, D. and Bubaš, Z., 2011. Efficient market hypothesis: is the Croatian stock market as (in) efficient as the US market. Financial Theory and Practice, 35(3), pp.301-326.

Vinh, V.X. and Thao, L.D.B., 2013. Empirical Investigation of Efficient Market Hypothesis in Vietnam Stock Market. SSRN Electronic Journal, 3, p.2013.

Westerlund, J. and Narayan, P., 2013. Testing the efficient market hypothesis in conditionally heteroskedastic futures markets. Journal of Futures Markets, 33(11), pp.1024-1045.

Westerlund, J., Norkute, M. and Narayan, P.K., 2015. A factor analytical approach to the efficient futures market hypothesis. Journal of Futures Markets, 35(4), pp.357-370.