Introduction
In the existing financial market, there are various models that have been implemented and been in place facilitates the allocation of various monetary resources to the different areas of the economy. In the broad view, the financial system of a nation has several implications on the overall health of the global financial milieu as well. It is absolutely essential to comprehend the various aspects of the capital and the money market, which are two very closely related parts of the financial market of any economy and the allied system (Armeanu & Cioaca, 2014).
In this report, an attempt has been made to outline the various hypothesis and theoretical frameworks available to elucidate and elaborate on the various aspects of any given financial system. The report establishes a firm theoretical background which then entails the efficiency with which the information available- both publicly and privately- with regard to a stock is translated to a foreseeable price change (Blumeyer, 2014).
The price change that the information causes is then accumulated by the investor in lucrative arbitrage involving that particular stock thus, resulting in a sizeable or abnormal gain. Apart from the EMH hypothesis, the various other parts of the financial market such as the money market and its effect on the capital have also been elucidated in this report.
Various levels of market efficiency
The efficient markets hypothesis or EMH is one of the effective manners in which the efficiency with which any relevant information with regard to the stock or security under consideration is translated to a change (elevation or depreciation) of the price levels of the share or security is examined.
As per the Burton & Shah, in an efficient market, there are broadly three kinds of market efficiency that can be seen across various capital markets. The theory has been elucidated and supported by several empirical data from time to time and involved a lot of market domains in different stock exchanges (Burton & Shah, 2017).
An efficient market in terms of the information available and not in terms of allocation aspect of it can be characterized as one where the present market cost of the stocks and securities is in pace with the available data and information related to the same. The perceived gap between these two things is extremely small and hence the translatability of the information associated is said to be extremely high in such a case. However, Fryklund & Mlinaric said that even inside the meaning of efficient markets the event of blunders as per the valuation of the advertising cost is allowed the length of they are arbitrary.
As the deviations are arbitrary the shot of a stock being over or underestimated ought to be equivalent and they ought not to connect with certain factors like e.g. a lower or higher PE proportion (Fryklund & Mlinaric, 2016). This infers no gathering of financial specialists can reliably beat the market over a drawn out stretch of time by utilizing any speculation procedure to remembering that it is to a great degree far-fetched that all business sectors are productive to all speculators. Rather, extraordinary assessment rates and exchange costs obstruct speculators from having all similar favorable circumstances (Jain & Jain, 2013).
The idea of stock prices following a random walk is pertained to the hypotheses of efficient market based on the informational paradigm. The classification of the capital markets based on the efficiencies that they display was first formulated by Fama in 1970.The various kinds of market efficiencies that are observed in the capital market with regard to the translatability of the information –both public and private include the following:
- Strong form market efficiency: In this kind of market efficiency the market prices of the stocks imbibe and quickly incorporate all the data that is available through any channel be it private or public (Kelikume, 2016). Hence, even with some insider information, investors and fund managers do not make abnormally high profits. Due to the incorporation of all information on the asset prices, the efficiency or the translatability of the information, in this case, is said to be the highest.
- Semi-strong form market efficiency: in semi-strong form market efficiency, in addition to the past stock prices, the publicly available information is already incorporated and reflected in the current stock prices. Such publicly available information are in the form of various reports, announcements, press releases etc. on the part of the company. Hence, in order to make an abnormal profit off the stocks, the investor has to have access to private or insider information in relation to the firm or the company in question. Various considerations are made in regard to obtaining information and the information cost is high in this case and is not readily available to all. The information shows typical asymmetricity. Also, the differentiation a segregation of the useful information from the noise is an additional task that the investor has to perform in order to beat the market and achieve high gains. For example, if an investor holds 100 shares of a pharmaceutical company A where each share costs $10. But having been actively involved in the supply chain that is responsible for the supplying the raw material to the company, he gets the information that the Pharma company is partnering with another supplier in order to get sanctioned for a government project (Kliger & Gurevich, 2014).
- While this piece of information has not yet been made public by either of the involved parties, the investor can use this information to buy or sell the shares that he holds after analyzing the anticipated effect it would have on the share prices. Once the information is released, it was found that the share prices rose to $14. Hence the ideal approach for the investor would have been to buy more shares at $10 and sold the same when the stock starts rallying when the news is made public.
- Weak-form market efficiency: weak form market efficiency that specifically relates to the concept of random walks which basically refers to the fact that in order to make abnormal profits off the shares that the investor owns he must obtain the information that is not available to the other investors. In such form of market efficiency, the traditional trading rules often don’t apply and the share prices can be derived from the past price and history that the stock has. This is the instance when all the past price information pertaining to the stock is already reflected in the current price and hence it is impossible for the investor to beat the market using the past trends only. The stock prices are known to follow an exponential random walk trend with regard to their prices
Figure 1: Random Walk
Source: (Le, 2015)
In the figure above, a typical random walk scenario for a stock market has been depicted, where even though there are way too many price fluctuations but the average price of the stocks has increased over time thus signifying that the buy and hold strategy works efficiently in this case.
Emerging stock exchange market efficiency
In the majority of economies where the intermediation of the long-term investments in various trade and business activities forms an important part of the financial resource mobilization, the capital and money market, as a part of the financial market play an extremely important role.
Public, as well as private business entities, use the funds raised via the capital market to meet their short-term as well as long-term needs whereas the funds raised through the money market is made use for satisfying short terms requirements only (Nwosu, Orji & Anagwu, 2013).
One of the main roles of the capital market is that it mobilizes long-term debt and equity finance for investments in long-term assets that are held by different trading entities in the economy. Undoubtedly, these ultimately help the corporate financial sector to grow and strengthen their micro financial system and thereby contribute to the growth of the economy. As per Ojo, by means of the various designated instruments that are used for operating in the money or the capital market individuals or entities such as the various investment banking institutions, investors, stockbrokers, venture capitalists etc. mobilize their liquid assets in the prospect of achieving a foreseeable gain in the future (Ojo, 2016).
The gains that are made rely on a lot of factors and are a resultant of a lot of decision on the part of the owner himself. In order to make the decisions, the investor relies on the various information sources that are available in conjunction with the stocks or shares that he owns of any particular business firm. Knowing how the stocks are going to perform in the future, leads the investor into deciding when to hold the stocks and when to trade them off.
The information that is available in this regard can be of various types such as public, i.e. in the form of various press releases, public announcements made by the firm, reports, independent studies etc. that are or can be known to the investor at any instant of time, and the other being the private information which includes the knowledge sources that give the investor an advantage with regard to his arbitrations with the shares that he holds. This kind of the information is vital to the understanding and application of the EMH on the existing market conditions in any capital market (Rao, 2014).
An Emerging stock market can be defined as the stock market that operates in an economy where the system sees low to middle per capita income. Additionally, sometimes the stock markets that show consistently low levels of liquidity can be categorized as emerging stock markets. Some of the examples of emerging stock market include India, Croatia, and Poland etc. Here, the case of Warsaw Stock exchange has been considered for assessing the overall market efficiency shown by the capital market.
The measure and quantification of the market efficiency for the Polish Stock exchange have been done using a variety of methods such as the Jensen Alpha, Treynor ratio, Sharpe ratio, informational ratio etc. These ratios have been calculated for each of the indices, which again have served as the portfolios for the investments made. But in the context of the Informational efficiency of the Polish Stock Market, the Information ratio has been used to determine the overall efficiency of the capital market (Salam, 2013). As per the empirical data that is available, Warsaw stock exchange displays strong-form efficiency in case of most of the indices that were considered for the portfolio. In other words, the information that is available with regard to most of the stock indices does not allow most of the investors and fund managers to beat the market and allow abnormally high returns. Even though the cost factor associated with the access to the private information which has a little effect on the price of the stocks and hence allowing the investor to make profits off the arbitrage, is not known exactly in this case for the various indices, yet the studies show a case of strong form market efficiency in case of the Warsaw Stock exchange. In such case, it is suggested that building passive portfolios is the best investment strategy (Wójcik, Kreston & McGill, 2013).
Vital role and functions of the capital markets
A financial market in any nation’s economy includes two very closely interrelated markets which are namely- the money market and capital market. It has been held by the theoreticians that the distinctive feature of the two markets is the maturity of financial claims and obligations i.e. upon expiration of a fixed time period called the maturity period, the various financial instruments that are held by an individual are liable to be liquefied in order for the individual to make profits off the same (Woolley, 2014).
The major distinction between these two parts of the financial system lies in the fact that all securities and loans with the maturity shorter than one year are considered to be money market financial instruments, and the instruments that are designated for long-term credit facilities for trades and businesses and investment for fund managers and investors are defined as capital market financial instruments.
In addition to these two, there is a third segment of financial markets as well which is called as the financial derivative market. The financial derivative market has its foundation on the capital and the money markets. This category of the financial markets includes securities and instruments in the form of forwards, options and futures. In several emerging economies, the financial derivative market is considered one of the most lucrative markets in the entire financial systems (Woolley, 2014).
Money market is the part of the financial market that includes holding financial instruments as debt securities with the maturity less than one year including government securities, negotiable certificates of deposit, commercial paper, bankers’ acceptances, Eurodollar certificates of deposit, etc. Various securities such as preferred shares and all types of bonds that endorse a maturity period in excess of one year are also included in this category.
The interrelation between the money market and the capital market arises from the fact that money market is often responsible for the amount of liquidity in the financial system. Any adverse condition that prevails in the money market would result in the decrease of performance of the stocks in the capital market. As the behavioral and sentimental aspect of the investors is one of the key reasons for the unforeseeable price changes in the assets, the low-interest rate in the money market can be one of the contributing factors to a more favorable investment condition in the capital market. On the other hand, high-interest rates in the money market can have a negative impact on the capital market investments by the investors and fund managers.
Figure 2: Overnight and Share Price
Source: (Woolley, 2014)
The above figure depicts the share price and overnight interest rate in the USA in 1994-2008. It is quite evident that the share prices have shown a remarkable correlation with the existing interest rates in the money market.
The net market capitalization of the new market in the European countries witnessed a growth from EUR 7 billion to EUR 167 billion from the beginning of 1998 to December 2000. While most of the increase can be associated with the overall rise in the prices of the shares, the number of listed companies continued to grow in almost per month. The numbers of companies that are listed in the new markets regarding the euro area have increased from 63 to 564 from the beginning of 1998 to the end of 2000. Growth for the last years has been dismissed. It is the characteristics of the new markets that there will be uncertainties in the future developments for the companies that are listed on the market and they would be exhibiting more volatility than the already established markets.
The nature of potential risks in international transactions
With the advancement of communication, technology, and transportation, the development of international business is enforced. The era of globalization has broken the difference between the domestic and foreign investments. This has also led to various risks by investing in the foreign markets which also exposes to various opportunities as compared to other investors who invest at home (Ojo, 2016). These risks denote to the uncertainties that have the probability to arise in the future. These risks pose as threat or challenge to the operation or functionality of the business which has eventual implications on the profitability.
1) The risk of Currency exchange rate:
Currency exchange rate risk is a financial risk that is posed by an exposure to unpredictable alterations on the rate of exchange between two currencies. The rate of exchange between the currencies fluctuates with changes in time and this can lead to the unpredictable losses or gains. The currency exchange rate risk also includes the exposure regarding transactions, exposure regarding the economy, and the translation exposure.
2) The risk of Country:
These risks include the economic and political risk that has the possibility of affecting the business and outcomes in the losses in investments. These risks include:
The risk of Political:
Political risks include the risks of losses of money due to alterations that occur in a government of a country or regulatory environment. Acts of terrorism, war, military coup, and trade barriers are all extreme examples of political risks.
The risk of Economic:
The economic risks include the financial condition of a country and the ability to repay the debts. Movements regarding the economic indicator in the foreign country such as unemployment, GDP, inflation, purchasing power, etc. are primary measurements for risks related to the economy.
Buyer’s insolvency or Credit risk:
The credit risks or buyer’s insolvency refers to the inability of the buyer to recognize the full payment for the services or goods rendered on the due date (Nwosu, Orji & Anagwu, 2013). This risk on the seller is associated with the supplying or selling a service or product without the experienced late payment or collecting full payment.
The risk of acceptance of Buyer:
Buyer’s acceptance risk denotes to the non-acceptance of service that is rendered or foods that are delivered. Unaccepted service or goods may result in barriers for the seller to the disposal of the goods to another buyer or confronting problems related to working capital.
The risk of Documentation:
The documentation risks are the risks of non-conformance to the requirements associated with categorical documentation under the documentary credit or sales contract. The failure in fulfilling the requirements regarding the fulfilling the documentation may lead to the delay or inability of the seller in achieving the payment for the service rendered or goods delivered (Kliger & Gurevich, 2014).
The risk associated with legalities:
The legal risk denotes to the financial losses that have the probability to arise from the uncertainty of the proceedings regarding the legal matters or the alterations in legislation, like a policy associated with a foreign exchange control. Investments in the international market can be at risks due to the frustrating in the regulations and laws.
Characteristics of the risks:
The impact due to the commercial risks that exist in the domestic market is very different than the risks that exist in the international market. At the global level, the implications are magnified. The alteration in the international market is hazardous and difficult to predict. Acceptability and suitability of the international market for a product are very difficult to measure. Variations in the supply and demand conditions are very much unpredictable.
The international traders adopt strategies for the management and mitigation of forwarding foreign currency exchange risk. The traders opt to select the pricing and billing currency along with considering the national currency for the conduction of the business. This way the traders eliminate the exchange risk, however, the organizations may have rare options (Fryklund & Mlinaric, 2016).
They add a margin buffer to the invoice created in a contract by which the investors share the risk of considerable fluctuations in the foreign exchange rates between the date and the time of generation of the invoice when the payment is made. The traders also use the financial instruments like foreign exchange forward, currency option, and currency future along with other options to mitigate the risk.
The spot exchange rate Vs Forward exchange rate
A spot contract can be described as the contract associated with the sales of an asset, rights or commodity under the terms and conditions of which the delivery and payment is already scheduled. The delivery and payment schedule is fixed within the longer period either between two days of trade or the period that is generally accepted for the asset, right or commodity in the markets the standardized delivery period. A contract is, however, not considered as a spot contract under the circumstances where in spite of the explicit terms, there arises an understanding among the parties regarding the delivery of the contract to be not performed within the above mentioned period and made to be postponed. A spot contract can also be considered as the most common type of currency contract which is used during transferring money internationally. These contracts are appropriate for the businesses and individuals who require making quick overseas payment. For an instance, an assumption is made regarding an investor who believes orange juice to be more expensive in the cold season due to the demand and supply (Burton & Shah, 2017). Furthermore, the investor is not privileged to buy a spot contract for the delivery in the month of December as the commodity will be spoiled. In this scenario, a forward contract is more appropriate for the investment.
On the other hand, a forward contract denotes to the contract which includes an agreement to the terms of a contract on the current date with the payment and delivery at a particular future date. In contradiction to a spot rate, a forward rate is used in order to quote a financial transaction which is about to take place on a date in future and in the price of the settlement of a forward contract. Depending on the trade of security, the forward rate can be anticipated by using the spot rate.
The relation and advantage of using the spot rate and forward foreign exchange rate is that the spot rate refers to the settlement of a price of a spot contract while the forward rate refers to the settlement price of a forward contract. However, the relationship between the spot and forward has a probability of being affected by the financial and exchange market efficiencies in-between two countries. Restrictions, controls and other interventions which can impact the adjustments in the interest, inflation and exchange rates differential also affect the spot and forward rates.
Regulation of the financial markets
In the domain of capital market, Asymmetric information is also termed as information failure which refers to the condition when one party has access to more information in relation to a certain economic transaction as compared to the other affected parties. This is a common case in case of most Semi-strong form efficient market where the publically available information is not sufficient to outperform the market. Asymmetric information can have a lot of adverse effect on the entire financial market scenario. It is often one of the reasons why investors lose money over the assets that they have bought and held (Burton & Shah, 2017).
Moral and value hazard: A condition of moral hazard is said to have cropped when one of the parties involved in a certain economic transaction does not have good intention or bears certain kind of ill will to the other parties. Some of the instances that come within the purview of moral hazards include sharing of misinformation about a certain asset. It usually happens when one party tries to make an unfair gain which is in excess of what it is already making by willingly jeopardizing the interests of the other party involved. For instance, the fund manager receiving the funds from the investing party without clarifying all the risks that are involved with the high-risk asset can be called as a Moral hazard.
Selection in Adverse: when one of the parties involved in the economic transaction has access to a more detailed account of the asset or product due to prior exposure or any other factor, which other parties don’t have access to and the same is used by the former to outperform other investors can be called as adverse selection. Here, the gain by the first party was made possible due to the availability of relevant information and hence led to better decision making as compared to the other parties involved (Burton & Shah, 2017).
The regulation of the financial markets is an important aspect of any economy. Given the extent of the impact that it has on not only the national wealth but also on a much more globalized scale, it is necessary that adequate transparency and accountability be maintained in the system. In the presence of the regulatory body, various negative elements in the system such as asymmetric information and moral hazard, which by their very nature can be eliminated, are certainly minimized and the interests of the consumers and investors are preserved. This gives a more sustainable and healthier financial system.
Conclusion
In conclusion, it can be said that the financial market and its various parts such as the capital market that involves the transaction and trading of various financial securities like shares and bonds, and money market form an important aspect of any economy. The interrelation between the parts of the financial system in any nation’s economy has also been elaborated upon and how the changes in one lead to changes in another has been outlined. The report also furnished the various details pertaining to the need for the financial market to be regulated by various regulatory or governing bodies. Apart from this, various instances and examples were used to understand the nuances of the EMH theory that has been used to understand the foreseeable nature of any capital market. The Polish stock exchange has been considered for the application of the EMH theory and to study how for it presents the empirical data in support of the same.
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