TREASURY MANAGEMENT (GBFN 604) GROUP 6 PRESENTATION

LECTURER: MR CHRISTOPHER BOACHIE

MEMBERS OF GROUP 6
David Ako MBA/FIN/11/1011 Daniel Tettey MBA/FIN/11/1055 Akuvi Delali Dikah MBA/FIN/11/1034 Felicia Abboah-Offei MBA/FIN/11/0985

THE QUESTION
Financial markets, especially the long term capital markets, need to be efficient in order to effectively serve the interest of all players in the market. Rational expectations of the players are essential for efficiency of the markets. Critically assess the implications of efficient market hypothesis for capital market participants. What are the implications of rational expectation for public economic policy?

Content of the Presentation

Financial and Capital Markets Rational Expectations and Players in the Capital Market Random Walk Hypothesis Meaning of an Efficient Capital Market Degrees or Levels of Market Efficiency Implication of Efficient Capital Markets Implications of Rational Expectations for Public Economic Policy

Financial and Capital Markets

A financial market is a system or mechanism comprising of individuals and institutions, instruments, and procedures that bring together borrowers and savers regardless of their physical location. The long term capital market, as implied in the name, is a market for long term debt and corporate shares or stocks. Its The primary function is to provide the opportunity to transfer cash surpluses or deficits to future years.

Efficiency of the Capital Market

An efficient capital market is one in which security prices adjust rapidly and accurately to the arrival of new information and, therefore, the current prices of securities reflect all information about the security. (Informational Efficiency) Allocative efficiency - ability of the market to direct capital to the projects with the highest riskadjusted returns Operational efficiency ability to complete transactions on a timely basis, accurately and at low cost.

Assumptions in Efficient Capital Market

The concept of efficient capital market is based on the assumption that: A large number of profit maximising participants analyse and value securities, each independently of the others. New information regarding securities comes to the market in random fashion, and the timing of one announcement is generally independent of others. The buy and sell decisions of all those who profitmaximising investors rapidly to reflect the effect of new information Market players are rational

Major Players in a Financial Market

Savers
C E N T R A L B A N K

Households, Corporations and Government

Intermediaries
Banks, Insurance Companies, Building Societies, Trusts, Stock and Bonk Markets

G O V E R N M E N T & S E C

Investors
Small, Medium and Large Private, Public, Domestic and Foreign
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Adaptive and Rational Expectations Theory

Capital Market Expectations (CME) represent the investors expectations concerning the risk and return prospects of asset classes. Expectations may be Adaptive or Rational Adaptive Expectations - Expectations are formed on the basis of past experiences only typically as some kind of weighted average of past observations. Rational Expectations expectations guess of the future are based on all available information. Investors continuously update their expectations, or forecasts, with great frequency, as new information becomes available.

Rational Expectations: Two Basic Forms

1. Weak-Form Rational Expectations: Whatever information people have, they make optimal use of this information in forming their expectations. (Note: No restriction placed on information.) 2. Strong-Form Rational Expectations: a) People have access to all relevant available information about the structure of their environment; (Note: Strong restriction placed on information.) b) People make optimal use of this information in forming their expectations. c) Thus, their expectations will be correct up to unsystematic (unavoidable) errors. Pe = P + (unavoidable error)

Implications of Strong-Form Rational Expectations

1. If there is a change in the way a variable is determined, then people immediately change their expectations regarding future values of this variable even before seeing any actual changes in this variable. 2. Forecasts are not always exactly correct, but forecast errors are not predictable in advance and they average out to zero.

Rational Expectations and Market Efficiency

Rational expectations theory is the basis for the efficient market hypothesis (efficient market theory). It is a prerequisite for the existence of efficient capital market. Therefore, if everyone's expectations are rational and asset prices are based on all available information, then it would be logical to expect that players in the capital market should all agree on a specific valuation for a specific long term instrument.

Efficient Market Hypothesis

The theory posits that securities are typically in equilibrium and that they are fairly priced in the sense that the price reflects all publicly available information on each security. All unexploited profit opportunities are eliminated and will be impossible for an investor to consistently 'beat the market This is the bedrock of the 'random walk hypothesis'

Levels of Market Efficiency

The degree of market efficiency can be described in three forms or levels, namely: the weak form the semi-strong form the strong form.

Weak Form EMH

Current market prices already reflect all past returns and any other security information. Past rates of return and other historical market data have no relationship with future rates of return. Therefore, little will be gained by using any trading rule that decides to buy or sell a security based on past rates of return or any other past security market data.

Semi Strong Form EMH

Security prices adjust rapidly to the release of all public information Current prices fully reflect all public information. It encompasses the weak form hypothesis, because all the market information considered by the weak form hypothesis, such as stock prices, rate of return, and trading volume is public. Investors who base their decisions on any important new information after it is public should not derive above average risks adjusted profits from their transactions

Strong From EMH

Stock prices full reflect all information from public and private sources. No group of investors has monopolistic access to information relevant to the formation of prices. Therefore, no group of investors should be able to consistently derive above average risk adjusted rates of return. The strong form EMH encompasses both weak form and semi strong forms EMH. Further, strong form EMH extends the assumption of efficient markets, in which prices adjust rapidly to the release of new public information, to assume perfect markets in which all information is cost free and available to everyone at the same time.

Implications of EMH
Timing of IPOs Do Not Matter Do Not Search for Undervalued Shares and Businesses The Market Cannot be Fooled Mergers and Acquisitions Champion the Interest of Shareholders Take Note of Market Reactions Technical analysis cannot work if past stock prices cannot predict future stock prices.

Implications of EMH
Investment tips cannot help an investor outperform the market.
The information is already priced into the security.
Investment tip is helpful only if you are the first to get the information.

Stock prices respond to announcements only when the information being announced is new and unexpected.

Limitations of EMH
Behavioral Finance

Irrational behaviour of market players can cause movements in share prices that cannot be explained by market fundamentals
Small Firm Effect
Many empirical studies show that small firms have earned abnormally high returns over long periods.

January Effect
Over a long period, stock prices have tended to experience an abnormal price rise from December to January that is predictable.

Market Overreaction
Recent research indicates that stock prices may overreact to news announcements and that the pricing errors are corrected only slowly.

Limitations of EMH
Excessive Volatility
Stock prices appear to exhibit fluctuations that are greater than what is warranted by fluctuations in their fundamental values.

Mean Reversion
Stocks with low values today tend to have high values in the future. Stocks with high values today tend to have low values in the future.
The implication is that stock prices are predictable and, therefore, not a random walk.

Implications of Rational Expectations for Public Economic Policy

Anticipated economic policies have no effect on the business cycle; only unanticipated policies matter. The only way that monetary policy can reduce interest rates in the shortrun is to have a completely unexpected expansion in the money supply. Countercyclical policies should be avoided because they largely affect prices and will , on average, have little effect on output.

Implications of Rational Expectations for Public Economic Policy

Expectations affect economic behaviour and economic policymakers cannot know the outcome of their decisions without knowing the publics expectations regarding them.