Any mechanism organized for trading financial assets or liabilities is termed financial market. It is an economy in which financial assets and liabilities are traded Richard and amp; Bill, 2006. Financial assets in this context with all forms of securities ranging from common stocks to derivatives. Efficiency as it is commonly used should be seen as the ability to achieve desired result without wasted efforts or life 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 spoke about 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 cost willingly accepted by most parties while the cost is determined mostly by the cost and extent of details available to investors within the market. This cardboard subsequently discusses the efficiency of financial markets exploring theories and assumptions and explaining in details, all terminologies majorly cost and details relating to financial market efficiency. Extensive findings have been conducted on the efficiency of financial market. This has led to development of different theories such as; determination of values of securities, effect of details on share prices, dividend policies to mention a few.
Definition of Financial Market. Financial market, regarding to Olowe, 1997, is a mechanism by which surplus and deficit units of an economy should be brought together through the buying and selling of financial claims. He distant asserts that the primary function of financial markets is to enable funds to be effectively allocated from the surplus units within the economy to deficit units for productive investments. Richard and Bill, 2006, view financial market as any mechanism for trading financial assets and securities. They distant 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 large section of sources of finance and instruments. Capital markets subsequently function in 3 important ways:. Primary markets providing new capital for business and other activities, usually within the shape of share issues to new or existing shareholders or loans. It sends 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 compulsory condition for and effective primary markets, as no investor shall need 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 regarding to institute, has 3 primary segments; the money and capital markets. Money market creates opportunity for raising or investing brief term funds.
The tenor of which ranges from overnight to about one or 3 years. The financial instruments exchange in this market includes treasury bills, bill of exchange, treasury certificates, commercial papers etc. Capital market on the other paw are mechanisms, institutions and structures where moderate term and long term funds are pooled and created available to businesses, government and individuals. It is within the capital markets that instruments which are already outstanding are transferred. Financial Market Instruments.
These are securities or financial assets traded within the financial markets and as mentioned earlier, financial markets has 3 primary segments money and capital market, the instruments traded within the money market are as follows:. Treasury Securities these are brief term obligations regarding the federal government to bearer a fixed sum of money subsequent to a specified many days from the date of issue. Treasury securities are of 3 categories depending on their face values and maturities. While treasury bills usually hold a little fixed return and matures in about 91 day of issue, treasury certificate share similar features with it but has a detailed 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 deliver like a means for channelling commercial banks' cash surpluses to merchant banks who are first issuers of this kind of instrument. When the bank promises to pay the principal and interest at maturity, usually within 4 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 can be termed non-negotiable certificates of deposits. Non negotiable certificates of deposits also have maturity ranging from 4 to 36 months. Commercial Cardboard this is a brief term unsecured promissory note issued by a business at a discount to an interested investor for cash for a critical maturity period.
The investors in commercial papers are usually credit worthy lone or institutional investors. It usually has a maturity ranging from 30 to 270 days. Commercial cardboard can subsequently be categorised into dealer papers and directly placed papers. Dealer papers are commercial cardboard placed with investor through a dealer which should be a bank while directly placed papers are commercial notes placed directly with investors by business issuing the papers which shall want the issuing business to maintain an outfit with trained personnel who hold a good knowledge of financial market and have good contacts within the markets. In any case, commercial papers are invested in by investors who can borrow within the loans market without security or even with a negative pledge.
Commercial papers are traded only within the primary markets. Bankers Acceptances also known as bill of exchange are drafts accepted by the drawee bank specifying that a sure quantity shall be paid subsequent to a specified period of time. The acceptance is done by writing the phrase accepted throughout the face regarding 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 worldwide trade through letters of credit.
It shall also be used for financing of commodities trade mostly with respect to bonded warehouses and the credit created through bankers acceptance are self liquidating brief term credits. The maturity ranges from 90 180 days or sometimes 30 270 days. Bank Deposits this is a placement of fund by investors or depositors with bank at an agreed rate of interest. Bank deposits are divided into call deposits or savings account deposit and fixed deposit. Call deposits are created with no specified maturity period and should be terminated by any most parties by provided notice to 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 should be fixed or floating.
The maturity of deposits can vary from a little days to many years. The deposit shall or shall 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 can be financial instrument whose cost derives from underlying assets, they can be securities that allows an investor to gain exposure to performance of an underlying securities without physically owing it. Profitable though, there should be hidden risk within the derivatives market.
Financial experts term it financial weapon of mass destruction and is described just like hell which should 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 business or government for which interest is paid and at a fixed rate. A debt instrument has a nominal cost that is the debt owed by the issuer regarding the instrument and interest is paid at a stated coupon rate on this amount.
In most cases, debt instrument are redeemable. Preference Shares this shall also be a primary source of long term financing to a company. The holders are preferred to ordinary shareholders in terms of dividend payment. Preference shares should be cumulative when they have right to unpaid dividend of previous periods, carried forward to another periods until it eventually paid up in which case the arrears should be paid prior to ordinary share dividends are paid. Just like debt instruments, preference shares shall also be redeemable.
Ordinary Shares the holders of these shares are owners regarding the company. They have nominal values and the memorandum and story of association of a business specifies the many authorised ordinary shares a business can issue. The ordinary shareholders have residual claims within the business i. they can be paid dividend only subsequent to other fixed obligations have been met. Convertible Securities these are hybrid securities that share most the features of a fixed income security and ordinary shares.
They can be securities usually fixed interest that are convertible into ordinary shares regarding the business at the choice regarding the holder within the future. Having explained the concept of financial market and its component, we need to examine whether its efficient or not. Prior to this should be done, efficiency, as it has different connotation in different environments wants to be clarified within the light of financial market. The phrase efficiency is component of everyone's vocabulary. To most, it means the ability to achieve a desired result without or with minimum wasted life or effort.
To Encarta dictionary, 2009, it is the ability to do something well or achieves a desired result without wasted life or effort, i. to degree to which something is done well or without wasted life or effort. Generally speaking, it is a means of increasing the well being of a critical situation provided an no. of productive resources and existing state of technical knowledge in an economy, eliminating wasted effort and allowing for more production from available resources that is why achieving the desired result by avoiding wastage and also preventing the avoidance of wastage from causing any harm. However, to different professions it means different things, the economists talk about allocative efficiency the extent to which resources are allocated to most productive uses this satisfying society's need to maximum.
The engineers talk about technical efficiency the extent to which a mechanism performs to maximum capability. The sociologists and political scientists talk about corporate efficiency the extent to which a mechanism conforms to accepted corporate and political values. Richard and amp; Bill, 2006. Financial Market Efficiency. To investment guru or financial expert, efficiency is somewhat more precise, it relates to pricing and details efficiency, the efficiency of substituting funds for financial market instruments.
It has to do with how fast and convenient asset should be transformed into cash and vice versa, how prices of securities are determined and how risks inherent in such securities are managed. This can subsequently be summarized from the roles the financial market are expected to perform within the economy which, regarding to Olowe, 2007, are classified into 3 3?. Allocational efficiency the role of financial market to optimally allocate scarce savings to productive investments in a method that benefits everyone. Operational efficiency to server as intermediary who sends the service of channelling funds from savers to investors at minimum costs that sends them with fair return for their services. Pricing efficiency the role in determining the values at which securities shall 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 within the processing of information. Based on the fore going, we can conclude that pricing and details are the 3 primary determinant of efficient financial market. Thus we can define financial market efficiency like an economy where security prices quickly and fully reflect all available information. A market in which any device intended to outperform the market shall be rendered useless.
That is why in an efficient financial market, similar rate of return for a provided position of risk should be realised by all investors. Pricing of securities. Pricingas a Primary Determinant of Financial Market Efficiency pricing of security can subsequently be discussed in relation to Risk and return. Risk, that is created by large section of factors as general economic condition, economic factors peculiar to securities, competition, technological development, investor preferences, and all other sorts of circumstances, is defined, regarding to Van horne, 1986, as the variability of likely returns on investments. Olowe, 1997, also sees risk as the probability regarding the deviation regarding the return expected from holding a security from the actual return from the holding of such securities.
With the introduction of risk, an investor shall be indifferent as to which security to invest in when there exists availability of investment possessing similar returns. The conceptual framework for examining the relationship between risk and return as they affect security pricing is discussed below the Capital Asset Pricing Model CAPM and the Arbitrage Pricing Model APM. 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 sends framework for the valuation of securities and should be used to retrieve an entity's cost of equity. CAPM are subsequently developed on the following assumption;. CAPM is a one period model and assumes that investors are risk averse. Investors are pasta takers and have homogenous expectation about securities. There exist a risk-free security such that investors shall 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 huge enough to affect the market cost of stock. The foregoing assumptions summarily assume that there exist a done market and that the financial market is efficient.
Therefore, provided the assumptions, we shall cost every asset that falls on security market line while the security market line equation is provided as;. E R1 = RF + [E RM - RF]1. E R1 = expected return on security. E RM = expected rate on market portfolio. 1 = beta of security i.
COV R1RM = covariance of return on security i with the returns on an economy portfolio. 2m = variance of returns on the market portfolio. Illustration; if the expected return on security is 24% and its beta is 1. display whether the security is below or over valued if the risk free rate is 13% and return on market portfolio is 18%. E R1 = RF + [E RM - RF]1.
We conclude that it is undervalued as the expected return is 2% fewer than the predicted. Characteristics of CAPM. For the fact that not all risk of security return is of concern to risk averse investor, asset should be priced such that its risk adjusted compulsory rate of return falls exactly on the security market line. Thus the only risk which investors shall pay a premium to stay away from is market risk hence the division of total risk of any lone security into systematic and unsystematic risk. Whereby systematic risk is general and affects the entire market and unsystematic is peculiar to factors that are special to a critical entity.
Efficient diversification, however, reduces the total risk regarding the portfolio to spot where only systematic risk remains. Risk portfolio as measured by beta is the weighted average regarding the betas of lone securities within the portfolio. The proportion of portfolio funds represents the weights allocated to lone securities within the portfolio and it is mathematically denoted as;. where p = beta of portfolio p. Wi = proportion of security in portfolio p.
CAPM was derived based on some simplifying assumptions, most of which not ever conform to reality. For this reason, it was criticised on the ground that it assumes the market portfolio to consist all assets stocks, bonds, properties and person capital. In real life situation, empirical tests of CAPM tend to use proxies for example stock market indices like a measure of market portfolio. The Arbitrage Pricing Model. This was suggested by Rose 1976 due to the fact that regarding the dissatisfaction with the CAPM on most theoretical and empirical grounds.
It is a multi-factor model multiple beta model as opposed to CAPM that is a lone factor model. A security's actual return in a factor generating mode is provided as;. Ri = E Ri + bijFj + ej. This should be restated as Ri = E Ri + bi1F1+bi2F2 +. Ri = actual return on security.
E Ri = expected return on security i. Fj = the uncertain cost of factor j. bij = sensitivity to factor j. It shall also be the security-specific return. Similar to CAPM, we diversify the unsystematic risk distant but in addition, we arrive at the market equilibrium as individuals eliminate arbitrage profits throughout multiple factors.
The model does not specifically indicate what the factors are or the economic or behavioural importance regarding the factors. Subsequently market return as within the case of CAPM may be one regarding the factors. The APM, thus, suggests that there is a linear relationship between security return and some factors. In equilibrium, regarding to this model, expected return on security i E Ri shall be provided by:. E Ri = Rf +1 bi1 + 3 bi2 +.
Where Rf = risk free rate. n = risk premium for the variations of risk associated with critical factors. Its equation should be rewritten as: n = En - Rf. where En is the expected return of a portfolio which has unit response to other factors. The return of stock business is related to 3 factors as follows.
3 are sensitivity coefficients associated with each factor. If the risk free rate is 12%, two is 7%, 3 is 4% and 4 is 6%. Calculate the expected return on the company's stock. 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 distant the unsystematic risk. Below the APM on the other hand, individuals arbitrage throughout multiple factors such that when arbitrage opportunities cease to exist, the market is in equilibrium.
However, there is yet to be agreement factors within the APM and whether it is testable. Thus CAPM can still be used in security pricing. Details on Securities. Information should be classified as historical, current or forecast. Only current or historical details is sure in its effect on price.
The more details 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 should be interpreted to imply that investors within the market take a quick cognizance of all the details relating to security prices and the prices quickly adjust to such information. Thus the efficiency regarding the security prices depends on the velocity of cost adjustment to any available information. The more the velocity of adjustment the more efficient the prices.
Market efficiency as regards the availability of details is subsequently reflectec in Efficient Market Hypothesis EMH in 3 simple forms;. Semi tough shape and;. Weak shape of EMH states that the current share prices fully reflect all details contained within the past cost movements which creates it impossible for an investor to predict future security prices by analysing historical prices and achieve an improved result than the stock market itself. That is why for an economy to be efficient at this form, significant correlation should not exist between securities prices aver time. More so, if an investor's trading strategy should not beat the market based on the details 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. Semi tough shape of efficiency is concerned with whether securities fully reflect all publicly available information. This implies that an investor shall not be can outperform the market by analysing the existing business related or other relevant details available. This shape implies that the share prices reflects an function or details very quickly, and therefore, it is not likely for an investor to beat the market creating use of this information. Tough shape 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 details shall be can 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 similar time horizon.
All investors have homogenous expectation mostly as to implication of current details for the current cost and distribution of future prices of each security. The general assumption underlying an efficient market that is why implies that prices of securities within the market should reflect sufficiently enough details to let investors make informed decisions about investment in such markets. , 2005, Public Finance and Contemporary Application of Theory to Policy, 8th edition, USA A Library of Congresss. ICAN Learn Pack on Strategic Financial Management. VI publishing, Lagos, 2006 Linus E.
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Vikas Publishing, New Delhi, 2004. Richard k and amp; Bill N, 2006 corporate finance and investment decisions and strategies, 5th edition. 1968, Financial management and policy, 7th edition.
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