Investment

Investment is a commitment of an amount for a period of time in order to derive future earnings

What are the factors that satisfy an investment: The future earning requires the investment to compensate the investor for:
1. Time Value of Money of the period for which the funds are committed 2. Expected rate of inflation 3. Uncertainty of cash flow 4. Risk associated with investment

Risk Premium: Return over the risk free rate Why Invest? Investor invest for larger future consumption by sacrificing present consumption
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Specific Objectives of Investment

1. 2. Specific Objectives of Investment: Capital Preservation: Investors want to minimize the risk of loss of investment amount they want to maintain the purchasing power. They want to get the rate of return from the investment not less than the rate of inflation. Capital appreciation: Some investors want the investment amount to grow over time to meet some future needs. This growth occurs mainly through the capital gains. Possibility to increase your capital. E.g. investment in the stock market so capital gains might occur from appreciation of stock prices. E.g. investment in a deposit account at a fixed interest rate to achieve a desired investment amount in the future Current income: Some investors want the investment amount to concentrate on generating the current income. E.g. investment in a fixed deposit in a bank & investors get interest as income each period. Total return: Investors want to increase the investment amount by both capital gains & reinvesting the current income. E.g. Investment in deposit account, accumulated interest amount is reinvested for the next period.
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Limitations of the investors while considering investments

1. Liquidity needs: Investors may have liquidity needs that must be considered while investing. E.g. investors may require liquidity to meet various current obligations that may hamper their investment plan. Time horizon: Investors consider the length of time for which they can invest their money Risk: Investors with short term investment generally favor less risky investment because losses are harder to overcome during a short time frame. Long term investment generally carries greater risk. Long term investors can tolerate long term risk because any losses can be overcome by return in subsequent years. Tax concerns: Investors consider tax rule while planning investment. If higher tax rate is imposed on a particular investment, investor will be inclined to invest in less or no tax.

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Rate of Return from Investment

Investors go for investment if they can earn rate of return required from that investment to consume more in the future. This rate of return is the required rate of return. And there are two factors that affect the required rate of returns: 1. Inflation: If there is inflation if the value of the future returns decreases due to inflation, the investor will demand higher return to cover the expected inflation rate. 2. Uncertainty of return: If the future return from the investment is not certain, the investor will require a return to have a risk premium to cover the risk. Measures of rate of return: Holding period return Holding period yield

Holding period return

The period for which investment is committed. It is the Return from investment from the holding period. HPR =
Ending Value of Investment

Holding Period Yield = HPR 1 Annual holding Period Return Annual HPR= (HPR)1/n N= Number of periods for which investment is held or committed. Annual holding Period Yield Annual HPY = Annual HPR - 1 Measures of Historical rate of Return: Arithmetic Mean = (HPY)/n Geometric Mean = n (Product of HPR-1) Rate of Return from a portfolio investment is the weighted average of the HPYs individual investments in the portfolio.
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Investors Lifecycle
There are 4 phases of an individual investors life cycle: 1. Accumulation Phase: this phase consists of early to middle years of working career. In this phase individuals attempt to accumulate assets to satisfy short-term needs & long-term needs. Short Terms: Asset accumulation to make down-payment for house or car Long term: Childrens college education, expenses after retirement Their net worth is usually small. Considering the long term investment and ability for future earnings they make relatively high risk investment in the hope of making above average return over time. 2. Consolidation phase: this is the phase of the individuals in the past mid-point of their careers. In this phase they usually pay off much or all of their outstanding debt. They have assets to pay childrens college bills; their earnings are greater than their expenses. They can plan to use the excess amount to meet expenses after retirement. Their investment time horizon is long; usually it is 20-30 years. Time, income & expense, debt, risk preference: Individuals in this phase are concerned about the preservation of capital. So they do not want to take high risk. 3. Spending phase: this phase begins after retirement of individuals. The living expenses are covered from income from prior investment. Since their earnings are concluded in this phase, they seek greater protection of their capital. 4. Gifting phase: In this phase many individuals realize that they have sufficient income & assets to cover their current & future expenses. Excess assets can be used to provide financial 6 assistance to relatives and friends, to establish charitable trusts or to fund trusts.

Asset Allocation Decisions

Asset allocation decision- It is the process of deciding how an investor allocates the assets among different asset classes for investment purposes. Asset class: Asset class is the composition of related securities having similar characteristics. For example, broad class bonds and these bonds can be divided into groupsi. Government bond (3 years, 5 years, 30 years bond) ii. Corporate bond (coupon bond, income bond) Investors strategy for asset allocation Investors strategy for asset allocation depends on some decisionsi) What asset classes to consider for investment. ii) What weights to assign to each asset class for investment. iii) What amount to allocate in each asset class based on assigned weight. iv) What specific securities in each asset class to purchase for the portfolio.

Asset allocation process

Developing Investment Policy Statement: Policy Statement is the road map for the investor that guides his investment Objectives & Constraints to be faced by the investor for making investment. It also includes the standards for evaluation of the performance from investment to find out whether the investment is appropriate for the investor

Examine the financial & economic condition: Before investing it is required to study the short term & long term expected financial & economic conditions forecast future trends of these condition. Investors expectation from the financial market & his needs jointly determine the investment strategy of the investors
Implementing the investment Plan: Considering the policy statement & the financial forecast the investor determine how to implement the investment plan & allocate available fund across different asset classes & securities Asset class consists of securities having similar characteristics e.g. corporate bonds Bonds: i) Government ii) Corporate This constitute the portfolio of the investor to reduce the risk of the investor. Monitoring & Updating investment plan: Investors needs might change over time so it requires continuous monitoring. Investors needs & capital market conditions. Investor also requires evaluating the portfolios performance & comparing the performance to the expectations & requirements of the investor. If it does not meet the investors requirements & expectation, it also requires updating the investment portfolio. The policy statement of the investor should be modified accordingly.
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Investment Opportunities: Choices for Investors

There are various investment opportunities in the global market. Investment opportunities of investor depend on two factors: 1. Growth & development of local & foreign financial market 2. Advances in telecommunication technology Advances in telecommunication technology allows investors to get investment easily & quickly There are various Investment choices in global market

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Fixed Income investment

A. Certificate of Deposit: Deposit of money in bank for a specified period of time. It pays higher interest rates than saving accounts. Penalties imposed on early withdrawal of money from the account B. Treasury bill: It is a short-term money market instrument issued by the govt. treasury regularly: Regular Bills (will) Irregular bills Major buyers are financial institutes; duration: less than 1 year; It is issued at a low discount rate. It is the obligation of the govt. so there is no risk in the investment.
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C. Commercial paper: It is a short term unsecured promissory note. It is not backed by any asset. Issued by well known & financially strong corporation. It pays higher interest rates than bonds & other securities D. Treasury security: these are issued by govt. treasury. There are two types of treasury security: Treasury note Treasury bond These are notes/bonds depending on their maturity T-Notes mature within 1-10 years; T-Bonds mature in over 10 years Advantages of T-Bill & T-Note: These are default free, offer high liquidity to the investor. These are backed by the full faith & credit of the govt. It is not backed by any assets E. Govt. agency securities: These are issued by govt. organizations and not the govt. (Notes & bonds by not the treasury) Such as: i) National mortgage bonds ii) National home loan bank, iii) National Housing Authority These are not the direct obligations of the treasury, but they are considered default free investments.

F. Corporate bonds: Basic characteristics and features of corporate bonds, issued by corporations:
Have a specific maturity Investors get fixed interest income each period Principal amount is repaid after maturity- investors get principal amount at the end of the maturity.
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There are various types of corporate bonds a) Coupon bond (bearer bond) it is owned by person who has physical possession of the bond. They are highly negotiable. Can be sold easily to other party. These bonds are attached with coupons that represent interest payments on a specific date. BD govt. are coupon bonds. BD govt. quarterly: these bonds are highly negotiable; meaning they can easily be sold or transferred to other persons. b) Income bond: Issued by financially troubled company for its reorganization. Interest on these bonds does not have to be paid unless the firm earns sufficient income to cover the interest payment. Generally, these bonds pay higher interest rate. Reputed companies also (issued by well-reputed but financially troubled firms for its reorganization) c) Convertible bond: these bonds can be converted to common stock or other security of the same company at a stated price at an option of the bondholder. The price is fixed by the corporation. This price is close to the market price. The conversion price is usually higher than the issued price. It requires to pay less interest. d) Bond with warrant: Warrants are attached with the bond. Warrant gives the right to buy common stock of the firm during a stated time period at a stated price. Warrants are traded in the stock market. And interest rate on the bond in usually lower than other bonds. Such warrants are listed in major stock exchanges e) Callable bond: it allows the corporation to retire this type of bond at a fixed price prior to maturity. The call price is normally higher than the issued price. Bondholder can cover the bond into common stock during the period between call date and the retirement date f) Zero coupon bond: This bond pays no interest during the life of the bond only the principal amount is repaid at maturity. It offers a high discount from the face value 11

G. Preferred Stock There are some features of preferred stock. The following are the features a) Preference to Dividends: Preferred stock holders have preference to dividend over common stock holders when dividends are distributed. So, preferred shareholders must receive dividends before dividend is paid to the common shareholders. b) Preference to Assets of the Corporation (e.g. land, building, equipment): There are three main parties who have claims on these assets: creditors, common shareholders and preferred shareholders. In the event of liquidation of the asset of the corporation, the claims of preferred shareholders stand between creditors and common shareholders. After the liquidation, creditors are paid first. If any money is left after paying the creditors, preferred shareholders are paid next. They can only receive assets equal to the face value of the stock. If money still remains, it is proportionately distributed among the common shareholders. c) Fixed Dividend: The rate of dividend on preferred stock is fixed and specified in the stock certificate. For example, if the dividend rate is 12% and the price (face value) of the share is BDT 100, preferred shareholders will get BDT 12 per share per year. d) Participating Feature: This feature allows the preferred shareholders to share in dividends above the specified rate. This feature states that if the common stock dividend is higher than the preferred stock dividend, the additional amount of dividend is equally distributed among the preferred shareholders and common shareholders.
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e) Call Feature: Call feature allows the firm to retire and issue of the preferred stock if the firm thinks that the preferred stock has become too expensive or outlived its usefulness. f) Voting Feature: Preferred shareholders do not have voting right or any voice in the management of the firm. Sometimes exception is stated in the stock certificate. The preferred shareholders may become entitled to vote if the firm is failed to pay a specified number of consecutive dividends. g) Cumulative Dividends: Unpaid dividend in any year is carried forward to the next and it has the credit implication on unpaid dividend. These accumulated dividends must be paid before paying any dividend to the common shareholders. h) Convertible Feature: With a provision in the stock certificate, preferred stock holder can convert his stock into common stock. The conversion price is close to the market price. H. International bonds: This type of bonds offer fixed income outside the country& also offers additional opportunity for investment. Some identification characteristics

Characteristics of country of origin Location of primary trading market Home country of major buyers Currency of the security denomination

There are 3 types of international bonds: a. Euro bond: issued by Europe. It is an international bond denominated in a currency not native to the country it is issued from b. Yankee Bonds: Usually it is sold in US & Denominated in US dollar. Issued by foreign corporations or govt. It eliminates the exchange risk for US investors. c. International Domestic bond: sold by the corporation or govt. Within its own country denominated in that countrys currency. But foreign buyers can buy this bond.
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II. Equity Investment A. Common Stock: It represents ownership of a firm. Investors return depends on the performance of the company & might result of loss or gain B. Stock of foreign companies: Investors can invest directly in foreign equity market. But it is often difficult and complicated to invest in the foreign market due to administration information, taxation, exchange rates, problems III. Special Equity Investment Investors have opportunities to invest in equity securities indirectly through investment companies. Investment companies sell shares to the public & uses proceeds from sales to buy securities of different companies. E.g. Mutual funds. Investors can acquire shares of issuing company indirectly through purchasing shares of an investment company. Investment companies maintain different types of funds. A. Money market funds: Money Market (T-bills): MM funds are invested in short term high quality assets such as T-Bills, Certificate of Deposits (short-term), and bankers acceptance. Bankers acceptance is an L/C is used to invest in export goods abroad B. Commercial Paper: : It is a short term unsecured promissory note. It is not backed by any asset. Issued by well known & financially strong corporation. It pays higher interest rates than bonds & other securities C. Bond Funds: These funds are invested in Long-term govt. & corporate bonds. And the amount of bond funds invested vary in quality D. Sector Fund: Sector funds are invested in security in companies of a particular industry E. Balanced funds: Balanced funds are invested in a combination of stocks & bonds depending on the objectives of the invested companies There are two main objectives: 14 Funds are invested in stocks for capital gains & invested in bonds for current income

There are other special equity investment: A. Mutual Funds B. Warrants: these are options issued by company that gives holders the right to common stock from the company at a specified price within a designated time period. The warrant does not represent the ownership of the stock if represent only the option to buy the stock. Warrants are traded in the stock market.
a) Call option is the right to buy the common stock of a company at a specified price within a specific time. It differs from call option. Warrant is issued is by the company & call option is issued by another investor who is willing to sell the security Put option: The holder option gives the right to sell given stock within a certain period at a specified price. Put option are useful for investor who expected the stock price to decline during the period or who own the stock & want protection from price decline during the period or who won the stock & want protection from price decline.

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IV. Future Contract: Exchange of a particular asset at a specified future delivery date at a stated price paid at the time of delivery. A deposit is made by the buyer at the time of contract to protect the seller. Usually commodities are traded largely in futures contract A. Financial Futures: these are contracts on financial instruments such as T-Bill & T-Bonds, Euro bonds & other similar types of financial securities. These allow investors to protect against volatile interest rates. B. Currency Futures: Allow investors to protect against changes in exchange rates. These are all special equity investment. 15

V. Real Estate investment: These are investments in a variety of real estate properties. Commercial/ Residential; Residential estate have lower risk & return than commercial real estate. In short term real estate show higher return than common stock with lower risk But in long term returns from real estate are lower than the common stock Types of real estate investment: A. Purchase of a home: Investor purchases home hoping that they can sell the home at cost plus B. Purchase of raw land: Investors have intension of selling the land at a high profit in the future. Risk arises because of uncertain price & there is low liquidity. C. Land development: Investors buy raw land they divide the land into individual plot & build residential houses or shopping mall. Returns can be significant from this investment from successful development. D. Antics: Serious collectors may enjoy good returns. Individuals buying few pieces to decorate a house may have difficulty to overcome the cost/to enjoy profit. E. Art: Investors require substantial knowledge of the art and the art world. Acquisition of work from a well-known artist requires large capital commitment & patient F. Coins & Stamps: Enjoyed by many as hobby & also as an investment. Market is more fragmented than stock market. But more liquid than art & antics markets. G. Diamond & Gold: Investors require substantial investment grading of diamond & gold determine value but it is subjective. No positive cash flow until sold. There are huge costs are involved for insurance & storage of these materials.

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Market
What is market? Market brings buyers and sellers together to aid in the transfer of goods and services. Here are some specific aspects of market: Does not require any physical location. It only requires that buyers and sellers can communicate regarding the relevant aspects of transaction. It provides smooth transfer of goods and services. It provides facilities to transfer the ownership of goods and services. Characteristics of a good market: In a good market buyers and sellers must get timely and accurate information on the volume and prices of past transactions and all currently outstanding offers and their sizes. A good market provides marketability of goods and services. In a good market goods and services can be properly and easily transferred to the other party. It ensures price stability of goods and services. Prices are relatively stable in a good market. That means prices do not change abruptly in a good market. A good market provides liquidity to the owners of goods and services. In a good market the transaction cost is low which makes the market more efficient. It provides rapid adjustment of prices to the new information. In an efficient market prevalent market prices reflect all available information about the asset.

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There are two types of security market: 1. Primary market It is the market where new issues are sold by the government or corporations to raise new capital. Funds from selling new securities go to the issuing unit of securities. Corporations issue securities through underwriters and they are usually called investment bankers. Investment bankers compete with each other to lead the underwriting business. Underwriting functions: Underwriters purchase the entire issue of securities from the issuing company and re-sell them to the investors., and this underwriting functions involve 3 services. 1. It involves the design of the issue which includes the date of the announcement, design of the advertisement, date of the advertisement, the period within which applications are to be received, selection criteria, announcement of final selection. 2. Underwriters acquire the total issue at a price set in a competitive bid or through negotiation. 3. It involves selling new issues to investors with the help of other investment bankers or commercial banks. There are two types of new issues in the primary market: 1. Seasoned new issues: There are new issues offered by the firms that already have stocks in the market. For example, a company which has stock in the market and sell additional shares to the public at a price very close to the current market price of the firms stock. 2. IPO: It involves selling of companys common stock to the public for the first time and these new issues are underwritten by investment bankers who acquire the total issue from the company and sell to the interested investors. 18

There are three forms of underwriting of corporate stock issues: 1. Negotiated form: It involves the contractual agreement between the issuing company and the underwriter. The underwriter helps the issuing company to prepare the design of the stock issue and has the exclusive right to sell the issue. 2. Competitive form: Various investment bankers compete with each other and offer to get the underwriting business from the issuing company. The issue is sold to the bidder which submits the bid with the lowest cost. 3. Best effort form: Individual investment banker act as a broker to sell whatever it can by giving the best effort. 2. Secondary market It is the market where outstanding securities are bought and sold by investors. Issuing company does not get any fund from the secondary market transaction. Importance of the secondary market: 1. It provides the liquidity to investors who acquire securities in the primary market. Liquidity provided in the secondary market benefits the primary market because investors tend to hesitate to buy securities in the primary market if they think that they cannot sell the securities subsequently in the secondary market. 2. It helps determine the market price for the new issues. Further new issues of securities in the primary market depend on prices & yields in the secondary market. 3. Liquidity provided by the secondary market benefits the primary market because investors who hesitate to buy securities in primary market if they think that they could not sell the security subsequently in the secondary market
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There are various types of markets operated in the trading system of the secondary market. 1. Auction Market: Interested buyers and seller offer bid and ask prices for a given stock of shares. This market is called the price driven market. Because shares of stock are sold to the highest bidder and bought from the seller who offers lowest selling price. 2. Dealer market: There are various dealers in the stock market. They compete with each other to offer the highest bid price to the seller and lowest ask price to the buyer. The stock exchange can use any one or combination of auction market or dealer market. Another type of market is call market. 3. Call market: Usually this market gathers all bids and ask offer at a point in time to determine a single price to satisfy most of the orders. All orders are transacted at this price. At this market is used during the early stage of development of an exchange in which there are a few stocks listed with the exchange and small number of investors. It can be used to handle various situations. A. It used at the opening of an exchange if there is an overnight build up buy & sell orders in which case the opening price of a stock differs from previous day's closing price. B. It is used if trading is suspended during the day because of some significant new information and events. In either case stock market attempts to derive a new equilibrium price using the call market approach. 4. Continuous market: In a continuous market trading occurs at any time the market is open where stocks are traded and priced by either auction or dealer. In this market enough buyers and sellers that makes the market continuous. When an investor comes to buy a stock there is another investor available in the market and is willing to sell the stock.
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Capital Market
Efficient capital market In an efficient capital market security prices adjust quickly to the arrival of new information. So the current prices of securities reflect all information about the security. And there are some assumptions of efficient capital market. 1. Investors in the capital market compete with each other to maximize the profits from the capital market. They independently analyze the market and value securities. 2. New information regarding securities comes to the market in a random manner. Timing of the arrival of information is independent. 3. Profit maximizing investors adjust security prices quickly to reflect the effect of the new information. Investors try to adjust security prices and compete with each other to maximize profit from the new information. 4. Current market price of a security fully reflects all available information about a security and the expected return from the security is based on this price and is consistent with its risk. 5. Researchers make hypotheses on the capital market and all hypotheses can be divided into three sub hypotheses depending on the type of information.

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Weak form efficient market hypothesis It assumes that current prices reflect all security market information or market generated information. These information include historical sequence of prices of securities, rates of return from the security, trading volume of securities. It is hypothesized that investors could not derive abnormal profits based solely on the past market information. It assumes that current market prices already reflect all past information. So past rates of return should have no relationship with future rates of return. That means the investors could gain little from buying or selling security based on past rates of returns or any other past security market information. There are two sets of tests to test weak form hypothesis. Auto correlation test: Auto correlation test measures the significance of correlation between the rates of return over time. Whether rate of return on day t correlate with the rate of return on days t-1, t-2 and so on. Various studies indicate that there is insignificant correlation in the short run that supports the weak form efficient market hypothesis. Several studies indicate that correlation is stronger for stocks of small sizes that show evidence against weak form hypothesis. Run test: This test examines positive and negative price changes over time. Studies observe the direction of price changes such as whether a negative price change is followed by a positive price change. This test confirms that there is independence of stock price changes over time. That supports the weak form hypothesis. Semi-strong form efficient market hypothesis It assumes that current security prices rapidly adjust all public information including market and non-market information. Market information includes stock prices, rates of return, trading volume. Non-market information include periodic earnings, announcement of dividends, price to earnings ratio, price-book value ratio, stock splits, news about the economy, political events. There are two sets of studies conducted to test this hypothesis.
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1. Time series analysis: It assumes that in an efficient capital market the estimation of future returns depends on the long run historical rates of returns. The objective of the study is to determine whether any public information provides superior returns for short term or long term horizons. Public information considered in time series analysis include dividend yield, quarterly earnings report, January anomaly, other calendar effects. A. Dividend yield: Studies found a positive relationship between the historical dividend yield and the long run returns from the stock market. But it has limited success in the short run. When dividend yield is high, investors expect high return on the stock, when it is low investors expect low risk premium and low rate of return. These results indicate that investors can predict abnormal returns using public information that show evidence against efficient market hypothesis. B. Quarterly earnings report: Studies showed that it is possible to predict future returns on a stock based on publicly available earnings reports. Some studies indicated abnormal returns following the announcement of large unanticipated earnings. Some researchers made analysis using data from 20 days before the announcement of earnings report to 90 days after the announcement. Studies revealed that 31% of change in stock returns came before the earnings announcement, 18% on the day of the announcement and 51% afterwards. These results suggest that announcement of these earnings is not reflected much in stock price as fast as expected by the semi-strong market hypothesis. It is reflected in major stocks after the announcement. It implies that these earning surprises can be used to predict future returns of individual stocks that show evidence against efficient market hypothesis.
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C. July anomaly: Investors tend to engage in tax selling (selling of stock to avoid high tax) toward the end of the fiscal year to establish losses from stocks that have declined in prices. After the beginning of the new year, the tendency is to reacquire these stocks or to buy similar stocks that look attractive. This scenario would produce downward pressure on stock prices in late May and June and positive pressure in early July. Such a seasonal pattern of stock prices is inconsistent with the semi-strong efficient market hypothesis. D. Other calendar effects: It includes the monthly, weekend or day effect on stock prices. A study found that markets cumulative advance occurs during the first half of trading month. Another study found that Sunday or Weekend returns were significantly negative. In contrast average returns for other four days were positive. For large firms negative effect occurred during the weekend whereas for smaller firms most of the negative effect occurred on Sunday. There are other public information considered by researchers to predict whether stocks will provide above average or below average risk adjusted returns. In an efficient market all securities should have equal risk adjusted returns because all security prices adjust all available public information that influence securities return and risk. Public information areE. Price earning ratio: Many studies examined the relationship between historical price earning ratios and returns on the stock. Low price earning ratio experienced superior risk adjusted returns relative to the market whereas high price earning ratio stocks had significantly inferior risk adjusted returns. This relationship between historical price earning ratios and subsequent risk adjusted returns show evidence against efficient market hypothesis. F. PEG ratio: It is the ratio of price earning ratio to the firms expected growth of earnings. Many studies found that there is inverse relationship between the PEG ratio and the subsequent rates of returns. That means the stock with relatively low PEG ratio (less than 1) will experience above average rates of returns while stocks with relatively high PEG ratios will have below average rates of returns. So this is inconsistent with the efficient market hypothesis. 24

G. Size of the firm: Total market value = Current price per stock X Number of stock outstanding. Some studies indicated that small firms consistently experienced significantly larger risk adjusted returns than large firms. This statement is inconsistent with the efficient market hypothesis. But this result was disputed by many researchers. Some researchers found that abnormal returns on stock of small firms could occur because Analytical model was not properly used and so provided incorrect estimates of risk and expected returns Risk measure technique showed that the small firms had higher risk but these higher risks were not considered for large variations in rates of returns Transaction costs can have significant impact on returns on stocks for small firms but were not considered. Studies also found that transaction cost small firms was much higher than that for large firms. H. Effect of neglected firms: Studies measure attention in terms of number of times investors and analysts regularly follow stock. They divide stocks into three groups Highly followed stocks Moderately followed stocks Neglected stocks The neglected firm effect is caused by the lack of information and limited interest of the investors and analysts. Studies found no evidence of premium returns of a neglected firm effect after controlling for capitalization. It is consistent with the efficient market hypothesis.
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I. Trading activity: Studies found the impact of trading activity or trading volume on returns and stock prices. They found no significant difference between returns or mean returns of the highest and lowest trading activity. So it is consistent with the efficient market hypothesis. J. Book value to market value ratio: It is the ratio of the book value of firms equity to the market value of firms equity. Studies found significant positive relationship between this ratio and the future stock returns. This is inconsistent with the efficient market hypothesis. 2. Event studies: There are various events that are considered by researchers to test semi-strong efficient market hypothesis. The following events have been examined. A. Stock splits: Stock is divided into small units. Many investors believe that the prices of stocks that split will increase in value because the shares are prices lower and demand will increase. But most studies found that stock splits do not have impact on security returns. This supports the semi strong efficient market hypothesis because it indicates that investors can not earn abnormal returns from the announcement of stock splits. B. Initial public offerings: Because of uncertainty about the selling price of a stock and the risk involved in underwriting such stocks, underwriters tend to underprice these new stocks. Studies found that the price is adjusted within one day after the offering and this quick price adjustment of the initial underpricing support the semi strong efficient market hypothesis.
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C. Listing of stock on an exchange: Many studies found whether an investor can earn abnormal return from investing in the stock when a new listing is announced or around the time of actual listing on a stock exchange. It is found that stock prices increased before any listing and consistently declined after the actual listing. Studies provide evidence of short term profit opportunities for investors could not support the semi strong efficient market hypothesis. D. Unexpected world events: Studies on response of stock prices to unexpected world events supports the semi strong efficient market hypothesis. For example, attack on world trade center or any political events such as winning the presidential election by a particular candidate or assassination of a president or military action on any country affects stock prices but prices adjust quickly to these events. This supports the semi strong efficient market hypothesis. E. Economic events: Analyses found that announcement of inflation or money supply has impact on stock prices but did not persist beyond the announcement day. It is found that stock prices adjust within an hour of the announcement and this supports the semi strong efficient market hypothesis. F. Announcement of significant accounting changes: When a firm changes depreciation method it should experience a change in reported earnings that can affect the economic value of firm. It is found that these accounting changes support the semi strong efficient market hypothesis because the security market reacts quickly to accounting changes and adjusts security prices. G. Corporate events: Many studies found the impact of many corporate events such as mergers, acquisition, and reorganization on stock prices. Under these circumstances the investors may expect premium returns from the organization that could increase the stock price but evidences indicate that there are rapid adjustment of stock prices that support the semi strong efficient market hypothesis.
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Strong form efficient market hypothesis: Strong form efficient market hypothesis assumes that stock prices fully reflect all information from public and private sources. It also assumes that the market is the perfect in which all information is cost free and available to everyone at the same time. No group of investors has monopolistic access to information relevant to the stock prices and no group of investors should be able to earn above average rates of returns. There are various investment rules in the stock market such as, A. Corporate insiders: Corporate insiders include corporate officers, members of the board of directors and owners of 10% or more of securities. Such groups have access to important private information or have the ability to act on public information before other investors. They generally experience above average returns that do not support the strong form efficient market hypothesis. B. Stock exchange specialists: They have monopolistic access to information about unfilled limit orders (the number of orders to sell/buy within a specified time period at a specified price). They would expect to derive above average returns from these information because they can buy these shares at a lower price and have the opportunity to sell at higher price that do not support the strong form efficient market hypothesis. C. Security analysts: They are trained full time investment professionals and have the ability to identify undervalued stocks. Studies found that if this information is made known to the analyst investors who follow recommendations of these analysts can earn abnormal returns. Investors try to act using these recommendations but prices are adjusted quickly that support strong form efficient market hypothesis. D. Professional money managers: They are trained professionals working full time at investment management. For example, brokers. Their studies are more realistic and widely applicable than analysis of insiders and specialists. They are non-insiders but can obtain inside information because they conduct extensive management interviews. They can achieve above average returns that are not consistent with the efficient market hypothesis.
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