Essay: “Explain how share prices are

affected by market conditions and

company related information.”

APPLIED AND ACADEMIC ENGLISH ADVANCED

Nicolas Theis | ENG199 | 03.01.19

Question 1

Explain how share prices are affected by market conditions and company related information.

In order to clarify the question of the influence of market conditions and corporate information
on share prices, it is necessary to explain the effective market hypothesis and financial
behaviour in more detail. In addition, we will try to explain the theory by means of an example
in order to clarify the influence.

In general, the economist speaks of allocative efficiency, which means that resources should
provide the greatest possible benefit to maximize the welfare of society. There are, of course,
other efficiency’s besides allocative efficiency, but these are not relevant to answering our
question. The most important concept of efficiency for influencing share prices is pricing or
information efficiency. The question is to what extent available information is contained in
current share prices. If the information relevant to the future earnings of the company is readily
available, the share prices are adjusted by the efficiency market. This means that all market
participants can participate in a fair market. It can therefore be concluded that the current
stock market reflects all available information. This price, which reflects all information, will be
the same for all stock markets. If this is not the case, it would be possible to carry out Arbitrage
and thereby generate risk-free profits. (Arbitrage means earning risk-free profits by buying and
selling simultaneously at two different prices in two different markets) The price will therefore
always adjust (Pike, Richard, et al. 2015: 34).

The effective market hypothesis distinguishes between three different types of information.
Historical, current and future information. While historical and current information affects most
pricing, future information is difficult to predict. This future information must be issued via ad
hoc notification and made available to all market participants simultaneously. Using insider
information for one's own benefit is prohibited. In addition to insiders in the company, there
are two outside investors. The private and institutional investors. However, one can already see
here that the effectiveness of market information has some shortcomings. Thus, institutional
Question 2

investors have a clear information advantage. Through better access to management, through
analysts who constantly evaluate the companies and through a possibly permanent place on
the board of directors, they thus receive much more and sooner information than private
investors. These differences are called "information asymmetry" (Pike, Richard, et al. 2015: 34-
35).

Market efficiency has arisen from the concept of perfect competition, which presupposes free
and immediately available information, rational investors and no taxes or transaction costs.
Since it is of course not possible to apply all these factors, the market is divided into three
different levels of effectiveness, which are explained in more detail below (Pike, Richard, et al.
2015: 35).

The first of the three forms is the "weak form" of the effective market hypothesis and this
states that current share prices fully reflect all information contained in past price fluctuations.
It is not possible to predict future prices by observing past trends. Therefore, future stock prices
are more or less random and make it too expensive to determine them. The second form is the
semi-strong form. Here not only all past price movements are reflected, but also all publicly
accessible information. Therefore, there is no point in analysing existing information, such as in
published financial statements, dividend and profit announcements, the appointment of a new
CEO or product breakthroughs after the information has been published. The stock exchange
has already included this information in its current share price. The last form is the "strong
form" of the effective market hypothesis and states that all relevant information has already
been included in the price. It is not possible to constantly beat the market or speculate
successfully. Finally, it becomes apparent that with increasing effectiveness the chance to
speculate successfully decreases and the competition between well informed market
participants leads to the price assuming its true value (Pike, Richard, et al. 2015: 35).

If the share price were to reflect the fair price through the effective market hypothesis, many
investors would be more willing to trade. This would lead to a liquid market, which would lead
Question 3

to an even more accurate price. Of course, there are several points of criticism, like the
overreaction hypothesis or similar, but due to the brevity of the work it cannot be discussed in
more detail (Pike, Richard, et al. 2015: 746).

Next, we look at the financial behaviour of shareholders and managers. To do this, it is helpful
to include the agency theory. An agency relationship arises whenever one or more individuals,
called principals, hire one or more other individuals, called agents, to perform some service and
then delegate decision-making authority to the agents. The agent usually has more information
(asymmetric information) than the principal and this leads to various problems. In our case it is
the relationship between shareholders and managers who can have completely different goals
and interests. Thus, managers often have their own personal goals and strive for the highest
possible self-interest, whereas shareholders rather strive for maximizing the cash flow and thus
for maximizing the company value. These two goals can conflict with each other (Pike, Richard,
et al. 2015: 12-13).

The question must therefore be asked how new information influences management and
shareholders. So, it is not very easy to mislead shareholders, because they know the tricks how
to polish balance sheets or similar. On the other hand, management should of course act in
such a way as to maximize the prosperity of the shareholders, but it has already been stated
above that conflicts of interest could arise here (Pike, Richard, et al. 2015: 38). In the following,
an attempt will be made to illustrate these different actions of the two actors using a historical
example of Rolls-Royce Holding plc.

On 26 October 2018 Bloomberg published a report that there would be problems and delays in
the turbine production of Rolls-Royce Holding plc. As a result, the share price collapsed by 13%.
Shortly thereafter Rolls-Royce responded to this news with the following statement. "We are
likely to fall short of our prior engine delivery projection of approximately 550 large engine
deliveries for 2018, and are now expecting to deliver approximately 500 engines," Rolls-Royce
Question 4

said. In the course of the day the price recovered again and closed with a loss of 3%. This can be
seen graphically in the figure below (BBC, 2019).

Pic. 1: Rolls Royce Holding plc Stock (Trading View, 30-minute Chart, own illustration)

Here all effects described above can be observed well. After the information was published by
the news service Bloomberg, the price slipped sharply. At that time the uncertainty was still
very high and there was no more detailed information available, so there was no support. Only
after Rolls-Royce published the above message the price recovered. It can be seen that
shareholders are very sensitive with data and that uncertainty is always a bad sign on stock
markets. This also applies to environmental influences. For example, the market must be as
free as possible from government intervention. The more secure the environment of the
market and the economy, the better markets and companies can develop. Shareholders
therefore sell in the event of bad news and thus part with their shares, buying in the event of
good news and replenishing their portfolio. Management, on the other hand, tries to eliminate
uncertainties or bad news as quickly as possible and thus support the share price.
Question 5

Another example of uncertain changes in market conditions leading to falling prices, at least in
the short term, is shown in Figure 2.

Pic. 2: Rolls Royce Holding plc Stock (Trading View, 1-hour Chart, own illustration)

Here it can be seen that within the hour, when the "Brexit" vote was published, the price
collapsed massively. This is due to the uncertainties associated with the "Brexit". Finally, it can
be seen that changes in the environment that lead to uncertainty are usually answered by
shareholders with a sell order.

It can therefore be seen that information and environmental influences have an enormous
influence on share prices and that shareholders and management react at all times to new
information and try to use it to their advantage.
References 6

References

BBC, 2019. Rolls-Royce Holdings. https://www.bbc.com/news/topics/ce1qrvlex71t/rolls-

royce-holdings.

Pike, Richard, et al., 2015. “Corporate Finance and Investment: Decisions and Strategies”,
Pearson Education Limited, ProQuest Ebook Central,
https://ebookcentral.proquest.com/lib/solent-ebooks/detail.action?docID=5174524.

Trading View, 2018, https://www.tradingview.com.