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APC313 Financial Markets Assignment - University of Sunderland, Hong Kong

LEARNING OUTCOMES -

Knowledge-based outcomes

1. Explain the operation of financial markets and understand their importance.

2. Explain key theories and models of financial markets including the efficient market hypothesis, and understand key implications.

3. Analyse the operations and the efficiency of financial markets.

Skill-based outcomes

4. To identify and collect appropriate financial data and indices including share prices to carry out analysis of operations and efficiency of financial markets.

Question 1 - a. Distinguish between different levels of market efficiency. Give examples to illustrate your answer.

The efficient market hypothesis theorizes that the market, in general, is efficient but it has proposed 3 different forms of efficient markets namely the weak form of an efficient market , Semi strong Efficient market and the strong form of an efficient market.

Weak Form

The weak form of market is your market in which the prevailing stock prices are reflected in the form of all historical data and information related to the market and the competitive firms and analyst/ users cannot use any form of market analyzing techniques do for help the investor in making better trading decisions. The proponents of this form of market efficiency suggest that fundamental analysis has already been used and all the stocks are either found to be undervalued or overvalued and acted upon. Under this form of market efficiency investors can make a detailed financial statement analysis all the forms in the market for using the same data to make better profits than the market.

For example, a stock trader believes that the stock of Apple Inc increases on Monday and drops on Friday. He decides to by 100 stocks what's happening on Next Friday. However on the next Monday instead of increasing the stock prices of Apple Inc declines by 1%. This is an example of the weak form of market efficiency for the market will not let somebody generate high returns based on historical performance technical analysis cannot be performed in such a market (Brealey, et al., 2017).

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Semi-Strong Form

The semi strong form of market video market in which all the publicly available data has already been used for estimating the current stock prices. As a result of which investors are in no position do use either fundamental analysis or technical analysis to gain larger market returns. Under this form of the market, the participants believe that information which is not publicly available but available to some investors can help investors generate higher than market returns.

For example, stock broker came across an article in the newspaper that Apple Inc which is engaged in new research and development how to spell Nikki project involving 100 million dollars of investment. Because of this, he anticipated that stock prices of the company would fall next day morning. Immediately in the next morning, he sold all the stock C held. However in the next hour the stocks I'll be happening we're sailing at a much higher price. This is an example of semi strong farmers market efficiency because stock brokers should not have acted upon some information which is already made public. The market has already taken into consideration the information contained in the article on the day itself (Besanko & Shanley, 2016).

Strong Form

The strong form of the efficient market hypothesis these are pro pinion that all types of information including publicly known information and privately known information are already used for determining the current stock prices and any kind of manipulation cannot make it possible for investors will generate bigger returns than the general market returns (Bodie, 2012).

Mr. George who was working as an engineer in the R&D Department of Apple Inc came to know the new R&D about the development of a new and advanced chip has been successful and this is most likely to increase the stock prices of the company. Immediately on the next morning, he went on to purchase 100 stocks of the company believing that the stock prices would increase dramatically. However, the stock prices did not increase any dramatic and remain stable. This is because the market is already taken into consideration all kinds of internal information as soon as the company had started to invest in the new project and hence the stock price currently prevailing has been adjusted. This is an example of strong form of market efficiency (Peilbeim, 2009).

b. With a close reference to the efficient market hypothesis literature and by using relevant empirical evidence and financial data, critically assess the" efficiency" of the Vietnam Stock Exchange market.

Even though the Vietnamese stock market is characterised by low capitalization in the last 2 decades, the market has grown rapidly in the last ten years. As per the regulations in place, the listed companies in Vietnam are required to make sure they disclose all financial information to investors for easy decision making. Regular information's are provided to the investors and market participants in the form of quarterly reports, semi-annual reports, and financial statements audited at the end of the year. The listed firms are also required to advertise in newspapers of the detailed financial statements within 10 days form publishing audited statements. On the other hand some irregular information can be shared with the shareholders and the other market participants if they are expected to affect investor decisions from time to time (Truong, et al., 2009).

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An analysis carried out by (Phan & Zhou, 2014) suggested that the Vietnamese market is a weak market and yet to achieve apparent strong form because of a high correlation between the weekly stock price returns in between 2000-2013 and the daily stock prices of 5 selected stocks in the same period. The tracking of the stock prices in these 13 years showed that the market rarely showed any different form of market movement and the daily stock price movements in the stock market of Vietnam showed exactly the same pattern of the stock market index. The study further pointed out that not many stock market investors are professionals and they have hardly any idea about which psychological factors would affect the stock prices and the stock market index movement

The weak form of market is a market in which the prevailing stock prices are reflected in the form of all historical data and information related to the market and the competitive firms and analyst/ users cannot use any form of market analyzing techniques do for help the investor in making better trading decisions (Beechey, et al., 2000). The results obtained by (Sharma, 2018) stresses the fact that the Vietnamese stock market is a weak form of market efficiency. The study used the Autocorrelation test which if used along with run tests often provides a conflicting result as to price movements work and the same is indicative of a weak form of market efficiency. The tests conducted found a fairly high degree of correlation in stock price movements and which is an indication of strong form market efficiency.

However, it has been recommended that the Vietnamese stock markets would need to make sure the regulatory practices are strengthened more for boosting the capacity and confidence of the investors in the long term. Financial regulations can be made more robust and the regulations must be implemented strongly to increase market efficiency. It has been generally found that the share prices have already been reflected by taking all the publicly available information and hence the same can't be beaten through technical analysis.

Data has been collected for determining the form of market efficiency and HOSE: VN Index and Hose: AAA stock has been selected for the same. The correlation between the data sets has come to be .2792 which is quite higher for a market to be called a strong form of market.

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The index movement has also been shown in the form of the following diagram:

As can be seen the Index has not been able to reach 1,000 from level of 984 in July and has declined by approx. 3% owing to selling pressure. One of the factors which brought the Index down is that the pangasius experts to both US and Europe fell and which is expected to bring down the profitability of top 30 listed firms which constitutes the VN 30 large Cap Index. Also the Q3 corporate earnings season weighed heavily and negatively which affected buying behaviour negatively and making them shift attention towards firms hoping for full-year earnings growth.

If a stock market is an efficient market then it is most likely that the successive prices prevailing are quite independent of each other and therefore are more likely to show little or no correlation. The efficiency of the Vietnamese stock market was examined by (Libberton, 2010) using a variety of correlation tests. The correlation tests by (Libberton, 2010) came to a conclusion that there is a fair degree of correlation which existed in the stock prices of Vietnamese stock markets for analysed stocks and the same reflected the fact that price movements were not independent and were related. As can be vouched form the current dataset the value of the correlation coefficient is quite higher and it can be concluded that given the current strength of the correlation factor , the Vietnamese stock market is a weak form of efficient market and the strong form is yet to be achieved (Bade, 2011).

Question 2 - Compare and contrast key role and functions of the capital markets with those of the money markets. Critically explain how money markets' activities might influence asset prices in the capital markets. Give examples to illustrate your answer.

Money market and capital markets are part of the broader financial markets. The money market is a generally unorganized market in which different banks , financial institutions, etc dealing trading off short term financial instruments like T-bills commercial papers , certificate of deposits and trade credit, etc.

Capital market, on the other hand, the market which deals with products like common stocks, different kinds of bonds and debentures which generally trades over a long period of time. The capital market fills the need for big companies requiring long term funds. Generally has 2 components namely the primary market and the secondary market.

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1. Instruments involved in money market transactions are very short term in nature generally less than one year while the instruments involved in capital market transactions are of long term nature and includes stocks, bonds, debentures, etc.

2. Money market transactions involve institutions like brokers, financial institutions banks and chit funds, etc. financial market transactions involve institutions like under writers stock brokers, Stock exchanges, large and small individual investors, venture capitalists, Mutual fund, etc.

3. The money market is generally an informal market whereas the capital market is a formal market with a large set up of regulatory requirements to be fulfilled.

3. Money market provides funds for certain periods which is generally very short in nature, on the other hand, the capital market provides long-term financing to companies long term expansion and growth of a firm participating in capital markets (Damodaran, 2011).

4. The instruments which are used in the money market are generally very liquid in nature but the instruments which are used in the capital market are less liquid. For example certificate of deposits and T-bills can easily be converted into cash anytime but the same cannot be said to be true about bonds and stocks issued by a firm in the stock market.

5. Sometimes for months risk involved in dealing with money market instruments are very low because of their liquidity ,however, the number of risks involved in dealing with capital market instruments are much higher going to the long term maturity and they were less liquid. Because of these at risk taken in the capital markets , the returns generated on capital market securities are higher and the returns generated on money market securities are lower (Brealey, et al., 2017).

Critically explain how money markets' activities might influence asset prices in the capital markets.

Money market instruments are responsible for providing the necessary liquidity to the market. It holds more investments in commercial papers which is primarily responsible for short term funding of large corporations which often issues these CPs for funding short term requirements. If short term funding requirements are not satisfied the same means the same corporations would have to brow in the firm of long term bonds and debentures etc. the fusing of short term requirements by long term instruments are often costly and thus would erode value. Thus the use of money market instruments like CPs and T bills etc would reduce costs and increase profitability and add value to any corporation which uses the same (PURI, 2012).

The short term changes in the interest rates in the money market is also likely to cause changes in the bond prices. For example if the market rates rise then the bond prices would go down and vice versa. For example a bond with face value of $2500 with a CR of 14% would have a market value of $2,500 if the coupon rate is just equal to the bonds market rate of interest. However if the market rate goes down to 12% then bond would be priced higher at $2788.5.

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If the market rate or required rate of return is 12% then

Similarly if the market rate goes up to 16%then the bond price would be lower than the face value of 2500 at $2456.90.

Similar the changes in the money market would also either drive the prices of a stock upwards or downwards. For example if the Stoke pays a dividend of $1.00 now and is expected to grow at a rate of 3% then the stock price can be estimated as follows.

V₀ = D₁/(r-g) = ($1.00*1.03)/(.10-.03)=$14.71

The required rate of return is found as follows:

CAPM = Rf + (Rm-Rf) *beta = 3% + (13-3)*.7= 10%.

However if the money market situation changes and it drives the risk free rates downwards to 2.5 % then the stock prices would be estimated as follows:

V₀ = D₁/(r-g)=($1.00*1.03)/(.095-.03)=$15.84

The required rate of return is found as follows:

CAPM = Rf + (Rm-Rf) *beta = 2.5% + (13-3)*.7= 9.5%.

So this clearly demonstrates that changes in money market if results in lowering of the market rate then the same would have a positive impact of the asset prices and vice versa.

The money market funding also controls the price line and helps in the controlling of inflation which can inflate costs and reduce profitability by reducing aggregate demand. If the money market rates are higher the same can reduce economic activities and bring recessionary conditions but a more efficient money market would keep the overall long term interest rates down and thus reduce inflation and bring higher demand to the market and increase economic activity, demand, and profitability which would increase stock prices and bring wealth creation to the fore. So even if both the constituents financial markets are different in nature and work flow the same are quite complementary for the other and money market working efficiently helps in creating value in the capital market (Hiller, 2011).

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Question 3 - (a) Critically discuss the nature of potential risks in international transactions and explain how international traders might manage such risks via forward foreign exchange markets.

If a firm operating in a particular country decides to undertake business in the international market, it has to bear both foreign exchange risk and political risk and both these risks might be very difficult to manage and can unduly affect the outcome through large scale variations.

Foreign Exchange rates risk can arise because of changes in the value of the currency in relation to another currency. for example if your firm has decided to do business with another firm in another country then the revenue from another country will have to be converted into domestic currency when the same is received . However, generally, there is a gap between when the revenue is earned and when the revenue is received. This potentially can be dangerous for the firm as the foreign exchange rate between these currencies can either go up or go down (Madura, 2013).

For example, a US based firm doing business with a Japanese firm and would receive 70 million yen as per current value. The current Exchange rate between the two are $1 = yen 70 and hence $ 1 million. But the Japanese firm has agreed to pay the same in 3 months and the 3 months foreign exchange rate (forward rates) is expected to be $1 = 72 Yen. if the value is received now the US firm is expected to get USD 1 million but in the next three months the firm would get only USD .9722 million. Thus the US firm is expected to lose out .0277 USD million and to reduce this exposure the firm would like to enter into a forward contract (Sercu, 2009).

The US firm thus decides to enter into a forward contract with a local bank for USD 1 and decide to pay the bank in Yens. So whether the exchange rate goes up or down in three months, the US firm would receive $1 million and pay the Yen received from the Japanese firm to the bank. In this case, the bank would have to bear losses if any and the US firms position is fully hedged.

(b) Explain how spot foreign exchange rate might be determined in a foreign exchange market. What is the relationship between a spot and a forward rate?

A spot exchange rate can be defined to be the current prevailing exchange rate of one currency put another world currency. Generally, once spot exchanges are executed the same would be finalized 2 business days after the day of the transaction day of transaction. The spot exchange rate is generally a floating exchange rate which is determined by market forces of demand for the currency on the supply of the currency in the market along with the macroeconomic factors prevailing in the market. However it doesn't mean that under floating exchange rate system the government of the country cannot intervene and manipulate the prices of the exchange rate and generally it is a practice that the central Bank of the country undertakes activities to influence the exchange rate of the currency (Vij, 2013).

The spot exchange rate can be defined do with the exchange rate which one has to pay to buy another currency on the same day. The current exchange rate is decided by market participants such as currency traders, financial institutions, banks, and other trading institutions. The foreign exchange market is one of the largest liquid markets of the world and the value of the current exchange or spot exchange keeps changing every hour.

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The Forward rate can be determined as follows:

Forward rate = spot rate x (1 + foreign interest rate) / (1 + domestic interest rate).

If the yen/$ = 50 and US interest rate is 3.5% and Japanese rate is 4% then the 3 months forward rate is determined as follows:

Forward rate (yen/$) = 50 x (1 + .04) / (1 + .035) = Y50.242/$

What is the relationship between a spot and a forward rate?

A spot rate is what the buyer and seller are required to pay or receive for making an immediate purchase or sale. On the other hand, a forward rate is something which the market expects in the future. The forward rate is believed to serve as an economic indicator as to how the market is likely to react or perform in the near future and the spot rates are starting point for undertaking several financial transactions as of today. Theoretically, the forward rates of the currency most equal to the spot rate of the currency plus any kind of earnings expected to be received from the security list of financial charges required to be made (Madura, 2013).

Question 4 - Explain what you understand by each one of the following terms:

a. Asymmetric information

b. Moral hazard

c. Adverse selection

Give examples to illustrate your answer.

With a close reference to these terms, critically discuss why there is a need for regulating financial markets.

a. Asymmetric information

In the financial markets off today, there are many cases of information not being available fully as a result of which one of the parties involved in a transaction holds an undue advantage over the other party. This is also known as information failure and most economists call it asymmetric information. In such situations one of the parties involved in a financial transaction has greater information and knowledge about the transaction and related information and benefits then the 2nd party and as a result of which takes advantage of the situation to benefit himself. Mostly the sailor in such situations has more information and benefits more. On the other hand if in the case of a transaction both the parties involved have equal quality information the same situation is known as symmetric information. Because of asymmetry of information, 2 problems arise namely moral hazard and adverse selection. Moral hazard of course when there is presence of asymmetric information and the asymmetric information results in change in behavior by one party when the deal is agreed. On the other hand the problem of adverse selection please arises when asymmetric information hampers the chances of a deal being reached between the buyer and the seller and generally occurs before the deal is struck (Hal, 2010).

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For example, in the case of health insurance markets, it is often found that buyers of insurance possess more information about their own health problems then the insurance provider. Because the buyer has more information and better information he is a Phone in a better position than the service provider to conceal health issues and information in order to lower the insurance premium to be paid. This means the service provider is at a disadvantage because if the service provider has information that the buyer has health issues before and health issues which are existent then the service provider would be able to charge higher premium from the same buyer. However only because there is no sufficient information available this situation is known as asymmetric information and the same open helps one of the parties involved in the buying and selling agreement.

Other examples of such markets for asymmetric information prevails page the used car market. In such markets, the seller knows the problems are associated with the cars being sold but he would decide to conceal the same so that he is able to charge higher from the buyer. The situation is known as asymmetric information and it is expected to cause market failure in most cases. Asymmetric information gives rise to both moral hazards an adverse selection (Bade, 2011).

b. Moral hazard

Moral hazard can be defined as an adverse behavior in the market which is brought in buy some service providers like insurance companies which allow people Dubai different kinds of insurance to meet adverse events sometimes in the future. The insurance services provided 2 the buyers even if the insurance provider doesn't have any sufficiency of information regarding the buyers state of conditions. This also happens in the job market as well. The moral hazard which occurs in the job market is also known as principal agent problem. Under this kind of moral hazard the owner or the stockholders allow the managers to act on their behalf for an agreed compensation but the problem arises when there is no sufficient information available to know if the agents or the managers would act for their benefit or for the benefit of the stockholders. Stockholders might perceive that the managers are shirking responsibility are not acting as hard as they could if it is for their own benefit. In many cases it has been found out that the managers are often working for their own benefit instead of working for the benefit of the principles who is there supposed to do.

Take another example of moral hazard in case of homeowners buying insurance like explored insurance or fire insurance. Normally when the home is not insured it is most likely that the homeowner would install an anti-theft system and is prepared to spend quite a lot for preventing any theft. However, once the house is insured the general tendency changes by the buyer and the homeowner becomes very lax and he doesn't generally take any steep to prevent theft or burglary as he knows any kind of Loss to the properties now fully insured. In many cases, it would be almost impossible for the insurance provider to prove that the house owner was lax in taking steps to prevent theft. The problem of moral hazard arises in this case because the insurance service provider company has to face most of the losses because of lapses by the house owner and the house owner takes undue advantages off the insufficiency of information (Besanko & Shanley, 2016).

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c. Adverse Selection

Adverse selection is a problem in in which one of the parties involved to an agreement has more information and more accurate information than other party involved in the argument. As a result of which the party which has less accurate information is disadvantaged in such a case. Situation affects both the equilibrium price and equilibrium quantity. Because of hardware selection and asymmetry of information, the market tends to provide price signals which are ineffective and inaccurate.

Example of adverse selection includes the cases for parties or individuals are compelled to take life insurance policies. In these cases, the individuals don't know the exact adversity that they're going to face any eventual health issues arise. Because they have no concrete information about the future and they're pressurized by the insurance agents, they will often agree to take an insurance policy and pay insurance premiums. If they have more information which can accurately describe their future health needs do you be in a position to take the desired insurance policies and might be able to calculate lower insurance premiums? As a result of which adverse selection problems arise also because the insurance service provider is not in a position to know if somebody has particular health problems or not and in order to reduce the insurance premium the potential buyers would not disclose the accurate information (Astara & Butters, 2018).

With a close reference to these terms, critically discuss why there is a need for regulating financial markets. (How regulation can help? This part is here dilated in following paragraph)

The problem of moral hazard and adverse selection arises because of lack of information and gives rise to market failure. As such the market failure can be avoided by compelling both parties to provide more information and more accurate information. It's more accurate information is made available to both the buyers and the sellers, then it is possible to reduce the discrepancy in the same and which eventually will lead to equilibrium price being established in the market. As such I believe that there is a need to regulate the financial markets by having market regulators like insurance market regulators and banking regulators to make your both buyers and sellers in the market provide ID create an accurate information to the other party which will reduce the moral hazard Ann Arbor selection issues and make sure the best market outcome can be achieved. This can also be done in a way that the party which does not provide adequate information and conceals information which could have been used reduce information asymmetry would be penalized and the benefits of insurance would not be poorly made available to such a party. So most of the issues of adverse selection and moral hazard can be eliminated through making available the right kind of information which is both accurate and adequate (Hal, 2010).

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