Financial markets are where trading of buying and selling of assets like stocks, bonds, derivatives, commodities and foreign exchange. In this market investors make money and companies try to reduce risks with financial instrument. In this report there is brief description about money market instruments and capital market and they are influencing each other. Efficient market hypothesis has been elaborated in this report, as there are three different levels of EMH which are strong form, semi strong form and weak form of hypothesis. Efficiency of London Stock exchange has been explained with the reference of efficient market hypothesis. International trade plays an important role in economy but there are also risk involved related to it so for protecting them various methods has been discussed in this report.
Q1(a)Different levels of market efficiency
Definition of EMH:
Efficient market hypothesis is not a rule, it is a model. It gives elaboration that how markets tend to work. It does not give directions to the market that how they must work. Basically there are three forms of efficient market hypothesis: Weak form EMH, Semi strong form EMH and Strong form EMH. Every level has their own implications:
Eugene fama: Is the American economist which is best known for the development of various theories and asset pricing framework. However, he has developed the theories relevant EMH which act as a funneling agent in terms of improving the adequate knowledge relevant with the market efficiency.
Weak Efficient EMH : It is the weakest form of efficient market hypothesis. Whenever, the past information related to price is been highlighted in the current market price then it is known as weak from EMH. To earn excess return, this form of EMH cannot be used. Technical analysis cannot be used for predicting future price movements. Fundamental analysis can be used in this form of market efficiency but it does not give long term advantage. Excess return can be gained by using non-public information. For example, XYZ broker who works at London Stock Exchange. Without any prior experience he was very keen in investments. When he observed the price of L equipment falls on Tuesday and it rises on Friday. After that he purchased 200 shares of L's stock for 12 pounds per share on Monday but he was sad because price came to 10 pounds per share on Thursday. In the present scenario the market seems to be in weak form EMH because XYZ is not able to earn excess return by observing past price.
Semi strong EMH : It lies between the two forms of market, strong and weak form EMH. In this form the prices are reflects all available public information and excess return is also possible to earn through fundamental analysis. For predicting future price movements, neither fundamental analysis nor technical analysis can help. To earn excess return non public information can be used. For example, Nargis held 300 shares of PNC company which he had purchased for 30 pounds per share. Next day she came across an article which was shared by her friend on Facebook. According to that PNC company failed in a task whose net worth value in 20 million. Next day Nargis sold her holding and was so glad that she minimized the loss but on the next day stock price had climbed by 45 pounds. In the present scenario market seems to be semi strong form efficient.
Strong Form EMH : It is the strongest form of efficient market hypothesis. Prices reflect both inside information and publicly available information. By any medium it is not possible to earn access return in this form. Nothing can helps in predicting future price movements, neither technical analysis nor inside information nor fundamental analysis. For example: because of success of PNC project, the workers of that company were sure that price will increase so they purchased 200 shares of that company but they were surprised to see that even after announcement of the project's success, share price did not rise. This seems that market is strong form efficient.
Q1(b). Critical examination of London Stock Exchange market efficiency with reference to Efficiency market hypothesis (EMH)
According to Cashin, Mohaddes and Raissi, (2017), the efficiency and ability to perform the duties of London stock exchange is quiet favourable in the world. Therefore, there has been various corporations or entities which will have satisfactory capital collection through domestics as well as international investors. It was founded in 1801 which was the fourth largest stock exchange in World and Europe. The operational viability of this organisation is very capable as it has enrolment of more than 3000 companies which were over 70 countries. In relation with analysing the new opportunities for revenue and capital gains this will be fruitful for the companies and investors in the organisation. Similarly, the terms stock exchanges is comprises with the stock market on which various industries get engaged in terms of dealing in selling their marketable securities.
It has been argued in the efficient market hypothesis that describes that the efficient market on the prices will reflect all the information relevant with the stock market. Thus, it ensures that no investors will have any competitive advantages over other. Additionally, it also insists that there will not be any instances on which a return on stock prices will be predicted. Therefore, it has been ascertained here that the EMH is correct then the prices of shares on market should only changes when all the necessary information were displayed and presented publicly. The nature of EMH states that there has always been trading of the share capital on their fair value. Thus, it will be impossible for the investors in terms of obtaining the share on their undervalue or over value (Efficiency of London Stock Exchange, 2013). It comprises with the fact that, it would be impossible to outperform the overall market with the influences of experts in the market securities an analysis of the perfect timing. Therefore, it has been determined by the experts and the observations made over the security market that the only an investor who is investing in the riskier shares will become able to have higher returns over such equity.
As per the views of Moloney, (2017), moreover, it can be said that, to perform the operational tasks in relation with purchasing as well as selling equity there will be proper observation made over the gains made by firm during a year as well as the growth of its equity. Thus, it can be said that the perfect market analysis will help the investors in analysing the printability of the organisation. It also ensures the capabilities of the firm in meeting the revenue gains as well as determination of satisfactory interest rates. Similarly, there are three form of efficiency which are within the stock exchange such as weak, semi-strong and strong. It ascertains that the weak shares cannot be predicted and estimated as per growth and fall of the share prices in consideration with their past records. Therefore, it comprises with the fact that there is not stability, pattern and trend in the value of shares over the period. Thus, it is quiet fluctuating and shifts randomly form upward to downward. Similarly, on the basis of historical data of this proposed equity which will not have appropriate assumption of the growth of such shares. On the contrary, in relation with the semi strong share value which comprises with the availability of the all the relevant historical data and information relevant with the variations in the share values. In addition, it will be fruitful to the investors to examine and analysing the profitability of such shares as per dividends was being paid by the firm during the period. Similarly, to examine these kinds of market there is no need of making in depth research over the stock prices. By considering the strong form of efficiency market it can be said that there are various public and privately available information which in turn making it helpful to the investors to have appropriate gains. Moreover, it comprises with facilitating the insider trading in the premises on which the external investors will feel cheated. Thus, in relation with same it can be said that there are mainly non reliable data and information which in turn has the negative impacts over the gains acquired by the investors of the organisation.
c. London stock exchange
In relation with this stock exchange which comprises with all the relevant information and operations. However, after analysing the market types and various stages of efficiency it can be said that the London Stock market is semi-strong efficient market. Thus, to make the investment in this market it will be helpful as to have satisfactory amount of revenue from the returns. Moreover, it does not require in-depth research over the share value as well as all the information presented there are reliable and valid (Tahat, Ahmed and Alhadab, 2018).
Q2 (a) Money market and Capital market
- Trading of short term marketable securities is called as Money market and trading of long term marketable securities refers to Capital market.
- Money market is not organized but capital market is well organized.
- Instruments of money market have low risk and safer investments but vice versa for capital market.
- Capital market has low liquidity as compared to Money market (Lane and Milesi-Ferretti, 2018).
- The institutions related to money market are commercial bank, central bank and non-financial institutions and institutions related to capital market are stock exchange, non-banking institutions, commercial bank etc.
- Short term credit requirements are being fulfilled by money market and capital market fulfill requirement of long term.
- Money market instruments give lower return as compared to Capital market instruments.
- Money market instruments can be redeemed within a year but capital market instruments can be redeemed more than a year.
Money market gives short term liquid finance for global financial system. As the interest rate movements of money markets are directly reflecting prices of capital market. The price of shares and bonds always represents present value of future cash flows which are discounted and in this series interest rate is always considered as denominator but the movement of interest rate is opposite to prices of shares and fixed income securities which replicates that if interest rate will rise all investors will expect high return on their investments and this will impact the prices of shares and bonds which will be declining or vice versa. The movement of prices in short term securities are greater than long term securities of capital market and this situation is more risky.
Q3 (a) Risks involved in International transaction and Eurocurrency Market
International trade can play vital role in developing economy but on the other hand many domestic players can perform through multinational companies and they can be forced to merge and close down. It is expensive as compared to domestic trade due to many reasons like tariffs, delay cost or any cost related to different rules and legislation etc. it has been restricted for the exchange of services and goods as it does not support exchange of all production factors which can be an advantage in many cases. Risk related to international transaction can be classified as Economic risk, Commercial risk and political risk.
- Economic risks includes risk of insolvency of the buyer, non-acceptance, concession in economic control, exchange rate and risk of the failure of the buyer to make payment of dues after 6 months after due date. The major issue is an economic stability if the transactions involve businesses in different nation.
- Political risk includes risks due to war and terrorism, non-renewal of export and import licenses, and major one is that risk of imposition of a ban after delivery of goods. Even the changes in the government policies, lack of foreign currency and exchange control regulations.
- Commercial risk like ability of bank to honor its responsibilities, failure of buyer for paying the financial institutions and failure by seller to provide the required quality and quantity of goods.
- Other risks: Cultural difference, language barrier, sovereign risk, natural risk and lack of knowledge of overseas market.
Methods for managing foreign exchange risk
The main methods for avoiding risk are: Forward exchange contract, foreign currency option, perfect hedge and foreign currency bank account. In forward exchange contract business has been enabled to cure itself from adverse movements by locking price in an exchange rate which has been agreed till the date agreed. On the agreed date transaction will take place. The limitation of this method is that the price of contract has been locked with the contract and if the market is strong form and rate movement is giving advantage but then also price will be fixed. For example, Chris acquired the equipment from a company in UK, which Chris must pay for 30 days in the amount of 400000 pounds. To hedge risk, Chris enters the forward exchange contract with bank for the same amount and duration of payment. In 30 days, the exchange rate has been become worse but the Chris situation was different so he obtained the amount without loss.
Foreign currency option: In this owner has been given the right but obligation has not been given to buy or sell currency at a certain price before specific date or on that date. The buyer pays up a premium amount for this right on exchange (Wang and et.al., 2017). The income which has been earned by the seller is in the reference for the premium payment which has been received; along with this buyer has potential of unlimited profit which depends upon the exchange rate’s future direction. These options are mostly used for hedging against the possibility of losses which are formed during changes in exchange rate. For example, If XYZ enters into this option, then at the price of premium, this will give protection from the downward movements in the value of local currency as compared to other currency, but it also gives permission to importer to gain benefit from the rise in prices of local currency against other currency.
Perfect Hedge: This method can be used during uncertainty of the timing of cash flows. Any of outgoing currency payments has been matched against the inflow of foreign currency inflows which has been received exactly on that time (Tiwari, Albulescu and Yoon, 2017). Mostly inflow and outflow occurs at the same time to give a perfect hedge.
Foreign currency bank accounts and loan facilities: This is an alternative method for managing the foreign exchange risk and it is used when the timing of inflows and outflows are not matched so this issue is managed by borrowing foreign currency to pay and then using that foreign currency for the repayment of loan or by depositing foreign currency in that currency account for the later use.
Uncertainty: the future is uncertain as well as the incidents which are going to be happen in future will not have adequate and clear recognition in the current time. However, there are various terms which are needed to be consider by a firm such as Appreciation period, fluctuation period and deprecation period.
Q3 (b) Eurocurrency Market and its importance
The Euro currency market is very complex and even extensive. With the help of this market transferring of medium and short term funds can be done. This transfer is from one country to another. Whenever the funds flow and euro currency deposits from residents of US or commercial banks, transfers by them and central banks. It can be either direct or via bank for the settlements. To manage the foreign currency option banks can trade the currencies in the forward and spot exchange market and even banks can borrow or lend the currencies within interbank market. Euro can be referred as free floating currency (Best and Kleven, 2017). If there is lack in co-ordination of any policy, the exchange rate of euro will give the outcome for all the economic policies. It will observe the developments of exchange rate and it will assess overall range of financial and economic indicators which are useful for developing inflation. Euro can be used as investment currency as it can remove the currency risk, gives incentive for the market practices. It can also increase the cross border competition and reduce the transaction costs. Euro financial market offers diversifies financial instruments which were primarily available in national market of euro so this will help the investors’ especially international investors for getting scope for diversification for investments which are in euro denominated assets and without foreign exchange risk.
The major role in international financial system has been played by euro currency market. The core function is to invest and borrow in US dollars. Transfer of short and medium term funds has been performed throughout the world by increasing international capital mobility (Lane. and Milesi-Ferretti, 2018).
It offers high interest rate, flexibility for maturity and huge range of investment qualities as compared to short term capital market. Low interest rate attracts the borrowers.
Q4 (a) Explain the terms
- Asymmetric information: It can be also referred as information failure which occurs when one party in the transaction has greater material knowledge as compared to other part. It is the major reason for market failure in different arenas. For example, in doctor and patient, doctor has more material knowledge as compared to patient.
- Moral hazard: This situation arises when both parties have incomplete and wrong information about each other, one party performs in a risky event and he knows that it is cured against risk and other will incur loss. For example, Alice driving the vehicle very carelessly was passing the risk to her insurance company to pay for all her bad decision in how she parked the car.
- Adverse selection: it usually refers to a situation whew any one party is having information that other do not have. The best example is of insurance.
The need of regulating financial market is to balance interests of consumers who are unsophisticated sellers.
To conclude this report it has been cleared that financial market plays important role in the economy. Efficient market hypothesis does not give directions to the market that how they must work but justifies that how market tends to work. Every level of EMH has their own implications. Capital market and money market both are very important for financial regulations with their different functions. Eurocurrency market is very complex and extensive but plays a major role in international financial system.
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