Advanced financial management revision question and answer

(a) Explain what you understand the term Market efficiency and discuss its implications to the finance manager.

(b) Discuss the major theories that explain the behaviour of the yield curve and discuss the implication of yield curve analysis in financial management.
ANSWER
Market efficiency and its implications
Market Efficiency
Efficient markets are those markets that operate at low costs, prices security efficiently and allocates funds to firms and organizations with the most promising real investment opportunities.

From the above definition there are three types of market efficiency:

1. Operational efficiency – (low costs)
2. Pricing efficiency – (efficient price)
3. Allocation efficiency – (allocates funds)

Operational Efficiency
These market prices transaction services and cost which are as low as possible given the efforts associated with having these services provided.

Pricing efficiency (fair game)
These implies that the market prices security i.e security price reflect all the available information security prices adjust quickly and in an unbias manner to incorporate any new information as it becomes available. Since new information is not predictable the security prices will follow a random-walk.

Allocation efficiency
These implies that the markets allocates fund to firms with the most promising real investments opportunities. Allocation efficiency assumes operational and pricing efficiency.

The most important efficiency to F.M is the pricing efficiency to enable him to maximize shareholders wealth.

Forms of market price efficiency
• Weak for
• Semi-strong form
• Strong form

Weak form
In this form the current security prices reflect information regarding the historical pattern of price movement. Therefore no trading strategy based on historical prices can yield above normal return.

Semi-Strong form
In this form, the current security prices incorporate historical pattern of price movements as well as all public available information about the company. An investor cannot out perform (do better) than the market analyzing any public available information about any company.

Strong form
In this form, the current security prices already incorporate all public as well as privately held information. It implies that even those accessible to confidential (price sensitive) information cannot use it to derive superior returns or results.

Implications of market efficiency
1. Timing of financial policy e.g issue of redemption of shares. In an efficient there is no need of timing financial policy e.g issue or sale of share since nobody knows the direction that the market will take e.g today‟s low may be the highest in the next ten years.

2. Issue of shares at a discount –In an efficient market, the current security price reflect all available/relevant information. There is therefore no need for significant price discount to encourage investors to buy. If a firm issues shares at the current market prices it raises funds at a fair cost and investors also obtain a fair return of the risks assumed.

3. Creative Accounting –(basically manipulation of P/s data).
In an efficient market there is no need to manipulate financial statement calculations to influence share prices since security prices only respond to fundamental information. Efficient market cannot be fooled.

4. Merger as an investment decision –In an efficient market, purchase of a share is zero NPV transaction. This implies that if the firm acquires another at its current market capitalization, it simply breaks even. This question a rationale behind many mergers.

5. Use of NPV as an appraisal technique –NPV analysis assumes market efficiency i.e the returns offered the investments are commensurate with the risks assumed. Use of NPV in an efficient market can provide misleading results.

Theories that explain the behaviour of yield curve

Yield Curve is a curve basically that shows the trade off between the yield of a debt (Kd) instrument and its term (period to marketing).

Term structure of interest rates refers to the relationship between the yield to maturity and the terms of the debt instrument.

Theories – Term Structure theories

1. The expectation theory
2. The liquidity preference theory
3. The market segmentation theory

1. The expectation theory
This states that the shape of the yield curve depends on the markets expectations about future interest rates. If future interest rates are expected to rise, the shape of the yield curve will be upward sloping.

2. Liquidity preference theory
This states that investors normally prefer liquidity (cash) to other investments even the low risky one like Treasury bills. Investors therefore expect to be paid a high premium for being deprived of their liquidity for longer periods. The normal upward rising shape of the yield curve can be explained this theory.

3. Segmental Market Theory
This states that the market short term and long term debt instruments are separate and distinct. The shape of the yield curve depends on the demand and supply forces in each market. There is a
„wiggle‟ (form of disturbance) in the yield curve where the two markets meet.

The forces in each market are weakest where the wiggle occurs.

Implications
The current shape of the yield reflects ( ) the market expectation about future interest. There is need to inspect current shape of the yield curve on designing lending and borrowing schemes.

e.g an upward rising yield curve indicates that interest rates are expected to rise. The firm should therefore avoid long term on variable rates, instead it can borrow long term at fixed rate or short term on variable rates.

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