Investors in companies’ equity shares expect a fair return for the level of risk that they take. The more risk the higher the expected return. An investment return has two components:
. Dividend (coupon for bonds) – regular payments to compensate investors for investing;
. Capital gain – an increase in the value of the investment over a period of time. The value of a share investment will increase if it is expected that future dividends are likely to increase and hence demand for the share increases to a fair price. In the case of a bond where the future coupons are fixed, a decrease in interest rates will make a bond more valuable.
The return on an investment can be summarised in the following equation:
Period Return [pic][pic] where: [pic] dividends ([pic] coupons for a bond) over the investment period [pic] price at the start of investment period [pic] price at the end of investment period [pic] capital gain or loss
The problem that investors have is estimating a priori what the dividend and the future price may be in order to determine how much they are willing to pay for the investment. A rational decision on the worth of a company’s share must be based on information about the business of the company, its economic environment and the behaviour of the capital markets generally.
Good news is expected to lead to a rise in future dividends and hence a price rise; bad news would lead to a fall in the future dividends and hence a fall in prices. The efficient markets hypothesis is concerned with how quickly such information affects security prices.
If prices are fast to react to information then investors will not be able to consistently exploit it at the expense of others – investment could be considered to be a ‘fair game’. However, if prices are slow to react, then those with information could make superior gains over those without it – they would be able to ‘beat the market’.
The term ‘fair game’ is used to describe a condition under which it is not possible for a stock market investor to earn above normal return from buying or selling a company’s stock by making use of available information about the company at a particular point in time.
Mathematically, a fair game can be expressed as follows:
[pic]([pic] where [pic] expected value operator; [pic] the difference between actual and predicted prices of share[pic]at time [pic]; [pic]([pic] return on share[pic]at time [pic], given the information available at time [pic].
A fair game means that expectations are not biased. However, it does not imply that, on average, investors will not earn a return that is either above or below normal. Precisely what constitutes the information set at a particular time ([pic] depends on the different form of market efficiency which we shall discuss later.
If the efficient markets hypothesis is valid, a market should react quickly to new information and investment is, thus, considered to be a fair game. It is assumed that there are a large number of informed investors seeking relevant business information. This information arrives at the market randomly and on some occasions investors will gain from being the first to trade on it (make an abnormal return) and in other cases they will lose. On average, investors will make a fair (normal) return for the level of risk that they take.
The efficient markets hypothesis (EMH) advocates that there is no systematic advantage to be gained in trading on information.
Market trading strategies
Investors could adopt the following trading strategies:
1. Examine trends in past security prices to try to predict future prices. Buy securities when the prices are assumed to be lowest and sell when prices are assumed to have peaked (Technical Analysis).
