Question

a) Efficient market hypothesis (EMH) states that the price of a security (such as a share) accurately reflects the information available. When information arrives, how fast will an information about a share be captured and reflected in the share price depends on the degree of competition among market investors. List and briefly explain, in your own words, two variations of information.

(b) Modigliani and Miller (1958) outline the most authoritative work on the theory of capital structure in a perfect market setting. However, capital markets are imperfect. With the presence of imperfections, managers must balance the costs of benefits of introducing debt into a company’s capital structure. List and briefly explain ONE cost and ONE benefit of debts that must be considered in forming the optimal debt level.

(c) Fama (1976) finds that the portfolio standard deviation decreases with the number of shares included in the portfolio, at a diminishing rate, to a positive and constant level of standard deviation. Explain briefly, in your own words, (i) why the portfolio standard deviation decreases; and (ii) why the decreasing rate of portfolio standard deviation stop after reaching a positive and constant level.

(d) From a theoretical perspective, define the market portfolio. In your answer, elaborate how a market portfolio could be proxied by.

Answer 1

Efficient Market Hypothesis (EMH)

The efficient market hypothesis (EMH) is a financial economics theory suggesting that asset prices reflect all the available information. The efficient market hypothesis meaning suggests that stocks on stock exchanges always trade at their fair value, providing investors with the opportunity to either buy undervalued stocks or sell stocks for inflated prices. There are 3 forms of efficient market hypothesis: strong, semi-strong and weak.

Strong: Expresses confidence that any information is priced into stocks investors won’t gain any advantage over the market in general.

Semi-strong: Analysis can give an advantage for the investor and expresses confidence that new information is priced into stocks.

Weak: Information from the past is already reflected in the stock’s price. According to the weak EMH theory, fundamental and technical analysis will be inefficient in a log run.

Modigliani and miller theory

It is used in financial and economic studies to analyse the value of a firm such as a business or a corporation. It is affected by a operating income apart from the risk involved in the investment.

Proposition without taxes – With the rise in debt, the equity shareholders perceive a higher risk.

Proposition with taxes – Change in debt component can affect value of a firm.

Portfolio Standard Deviation is the standard deviation of the rate of return on an investment portfolio. It measures the investment’s risk and helps in analysing the stability of returns of a portfolio.

Market portfolio

A market portfolio is a theoretical bundle of investments that includes every type of asset available in the investment universe, with each asset weighted in proportion to its total presence in the market.