Market matters

by Anthony Head
21 Nov 2003  

Capital markets, efficiency and fair prices

Investors in capital markets want to be sure that the prices they pay for securities, such as
ordinary shares and bonds, are fair prices. In order for security prices to be fair, the capital
markets must be able to process relevant information quickly and accurately. Relevant
information is anything that could affect security prices e.g. previous movements in security
prices, newly-released company financial statements, changes in interest rates or details of sales
of their own company’s shares by company directors. We say that a capital market is efficient
when we are confident that security prices are fair. A capital market can be efficient when share
prices in general are falling (a bear market) or rising (a bull market).

Types of efficiency
It is usual to identify four types of capital market efficiency1:

1. Operational efficiency requires that transaction costs are low and do not hinder investors
in the sale or purchase of securities.
2. Informational efficiency means that relevant information is widely available to all
investors at low cost.
3. Pricing efficiency refers to the ability of capital markets to process information quickly
and accurately, and arises as a consequence of operational efficiency and informational
efficiency.
4. Allocational efficiency means that capital markets are able to allocate available funds to
their most productive use and arises as a result of pricing efficiency.

Most of the research into market efficiency has been into pricing efficiency.

Forms of efficiency
In order to decide whether a capital market exhibits pricing efficiency, research must be
undertaken into security price movements and whether it is possible to make abnormal gains by
acting on different kinds of information. Most of this research has been based on ordinary share
price movements and three forms of efficiency can be described.

Weak form efficiency refers to a market where share prices fully and fairly reflect all past
information. In such a market, it is not possible to make abnormal gains by studying past share
price movements. Research has shown that capital markets are weak form efficient and that
share prices appear to follow a ‘random walk’, the random changes in share prices resulting
from the unpredictable arrival of favourable and unfavourable information on the market.

Semi-strong form efficiency refers to a market where share prices fully and fairly reflect all
publicly available information in addition to all past information. In such a market it is not
possible to make abnormal gains by studying publicly available information such as the
financial press, company financial statements and records of past share price movements.
Research has shown that well-developed capital markets such as the London Stock Exchange
and the New York Stock Exchange are semi-strong form efficient.

Strong form efficiency refers to a market where share prices fully and fairly reflect not only all
publicly available information and all past information, but also all private information (insider
information) as well. In such a market, it is not possible to make abnormal gains by studying
any kind of information. Since it is always possible to make abnormal gains by using insider
information (even if governments have made this illegal), even well-developed capital markets
cannot be described as strong form efficient. However, investors and analysts are often accurate
in their estimates of what is happening inside companies and financial management theory
considers well-developed capital markets to be highly efficient.

The consequences of market efficiency

What does it mean for companies if research has shown that capital markets are highly
efficient? One consequence is that theoretically at least, there is no right or wrong time to issue
new shares since share prices are always fair. Other considerations than share price must be
used to decide on the best time to issue new ordinary shares, such as the number of shares that
will need to be issued to raise the required amount of finance, the effect of the new share issue
on earnings per share, any dilution of control that might arise, the effect on gearing and
financial risk, and so on.

Another consequence for companies is that it is pointless for company managers to try to
manipulate information given to the capital markets in order to present their companies in a
more favourable light, since an efficient capital market will see through this as it ‘fully and
fairly reflects all relevant information’ in the process of providing fair prices.

A further consequence for both companies and investors, again from a theoretical point of view,
is that there are no bargains to be found in capital markets. There are no incorrectly priced
shares from which to make a quick profit and no undervalued companies to take over in order to
produce an instant increase in market capitalisation.

In fact, if capital markets are highly efficient, all that managers need to do (again theoretically)
is to make good financial management decisions (such as investing in all projects with a
positive net present value). This is in order to maximise the market values of their companies
and hence to maximise shareholder wealth, which is the primary financial management
objective. It is easy to see, therefore, why financial management attaches so much importance to
capital market efficiency.

Product markets and the problem of monopoly

Another market matter is regulation of business. One example is pricing restrictions. This can
be illustrated by looking at the problem of monopoly in product markets and how to respond to
it.

One possible result of a company being successful in its chosen market is that it gains
increasing market share. This may be due to its competitors going out of business or as a result
of taking over its competitors. If the trend continues, a successful company may end up with no
real competition at all. It is then in a position to earn monopoly profits by selling at prices
higher than would be found in a more competitive market.

The positive consequences of monopoly

There may be a circumstance in which a monopoly may be desirable, for example when size is
necessary for efficient production of a particular product, i.e. through economies of scale2. This
has been claimed to be true of utilities such as water distribution and electricity production.

It is worth noting in this respect that successive UK governments have felt the need to
artificially maintain competition in the markets served by privatised UK utilities, implying that
utilities naturally tend towards a monopoly. It has also been suggested that monopoly may be
the natural reward for entrepreneurial activity by businesses, or the logical consequence of a
focus on shareholder wealth maximisation.

The negative consequences of monopoly

The negative consequences of monopoly are usually felt to outweigh any positive outcomes.
Society and the public can suffer as a result of monopoly. Not only do consumers pay higher
prices in order to support monopoly profits, but they may be offered a reduced product range.
Society can also suffer through the inefficient use of economic resources in the production
process, a decrease in innovation and product development, and a lack of incentives for a
monopoly to reduce managerial and other inefficiencies.

Government regulation of monopoly

Consumers cannot deal with monopolies and so this regulatory role is usually assumed by
governments. Many governments, including those of the UK, EU and USA, have long histories
of regulatory intervention in product and consumer markets. Their aims can be to stop
monopolies arising, to prevent abuse of a dominant position in a particular market, to prevent
the creation of price-fixing cartels, and to preserve and maintain competition.

In the UK, these objectives are achieved through the actions of the Office of Fair Trading and
the UK Competition Commission, which are required to monitor, investigate and make binding
recommendations in situations where a potential monopoly may arise. The criteria used to
initiate an investigation can be quite broad: UK legislation, for example, considers that a
monopoly position may arise when a company has a market share of 25 per cent or more, of a
particular market3.

Product markets and the problem of externalities

Excessive profits can be gained by companies which do not pay the full economic cost for their
production processes. For example, a company which causes environmental pollution does not
bear the full cost of its inefficient production process, but transfers the cost of cleaning up its
waste products as an externality to society as a whole. Externalities are social costs or benefits
arising from economic decisions of individual economic agents such as companies4.
Governments may need to intervene in product markets to require companies to bear more of
the cost of the externalities they produce. In other words, they may adopt green policies, another
example of regulation of business suggested in Section 2 of the Paper 2.4 syllabus.

Green policies can result in increased production costs as companies are required by legislation
to reduce the environmental impact of their business operations. These increased costs will
reduce company profits unless they are passed on to customers through increased prices. If price
increases occur, green policies can result in the reduction of externalities and the transfer of
their costs from society to consumer.

Green policies can therefore be seen as leading to fairer prices in particular product markets
since these prices reflect more completely the economic resources consumed in the production
of the products offered for sale.

Money and capital markets and the cost of money

The syllabus also refers to rates of interest and yield curves. Both interest rate and yield can be
seen as the cost of money, ie the price of money set by the interaction of the supply of funds and
the demand for funds in a particular market.

It is important to recognise that interest rate and yield have different meanings. Interest rate is
the percentage return on the nominal (or money) amount of debt issued. Yield can either mean
interest rate divided by market price (often referred to as running yield), or it can mean the
discount rate that makes the present value of future interest payments and redemption value
equal to the current market price (referred to as the redemption yield or the cost of debt).

Consider a bond with a market value of £102.53 that pays 10 per cent per year for three years
before being redeemed at par. Its interest rate (or coupon) is 10 per cent. Its running yield is 100
x (10/102.53) = 9.75 per cent. Its redemption yield or cost of debt (found by linear
interpolation) is 9 per cent.

The longer the period over which debt is offered, the greater is the risk to the lender that the
borrower may be unable to meet interest payments, or be unable to repay the principal amount
borrowed. This means that as the time to redemption or repayment increases, the risk of default
also increases, and we expect that lenders would require a higher return to compensate for this
increased risk. If we consider default risk alone, we would expect long-term debt to be more
expensive than short-term debt.

There are other factors to consider in discussing the relative risk and cost of long-term and
short-term debt. The important point to grasp, however, is that long-term debt is usually
expected to be more expensive than short-term debt (i.e. the yield curve slopes upwards), unless
other factors arise which act to change the normal state of affairs. Expectations theory, market
segmentation theory and liquidity preference theory consider the different costs of debt of
differing maturities, and students should consider these as possible explanations of yield curves
which do not slope smoothly upwards5.
References

1. Watson, D and Head, A (2001) Corporate Finance: Principles and Practice (Financial
Times Prentice Hall), p29
2. Griffiths, A and Wall, S (2001) Applied Economics (Financial Times Prentice Hall),
pp103-6
3. Griffiths, A and Wall, S (2001) Applied Economics (Financial Times Prentice Hall),
p108
4. Griffiths, A and Wall, S (2001) Applied Economics (Financial Times Prentice Hall),
p178
5. Arnold, G (2002) Corporate Financial Management (Financial Times Prentice Hall),
pp495-9