Traditional Finance Theory and Implications of Political and Economic Events on Capital Markets

This assignment reviews the Traditional Finance Theory and analyzes the impact of political and economic events on capital markets. It discusses the rationale behind stock market movements in the UK, US, and Europe.

Running head: FINANCE AND INVESTMENT
Finance and Investment
Name of the Student:
Name of the University:
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2FINANCE AND INVESTMENT
Executive Summary
The aim of the assignment is to conduct a review on the Traditional Finance Theory and the
implication of the various political and economic events on the capital markets. The rationale
behind the movement in the stock market in the UK, US and in Europe were taken into account
after assessing the political and social events revolving in the respective markets.

3FINANCE AND INVESTMENT
Table of Contents
Introduction......................................................................................................................................4
Discussion........................................................................................................................................4
Traditional Finance Theory.........................................................................................................4
Political Events............................................................................................................................5
Empirical Evidence......................................................................................................................8
Conclusion.....................................................................................................................................15
References......................................................................................................................................16

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Introduction
The traditional finance theory deals with the normative approach explaining the rationale
behind how individuals act rationally for maximising utility. The traditional finance treats
individuals as a “rational economic men”. The security market or the capital market reflects all
available relevant information in the prevailing stock prices1. The stock market reflect all
available information that might be useful for the investor for the purpose of investment. The
stock market reflects all the available information in the share price of the company2. The notion
of the evaluation of the share prices and the outlook for the share price movement is completely
based on the belief and the research done by the investor for the particular stock. Sentiments and
beliefs of the investors regarding the stock price and the outlook. The pricing volatility in the
stock market is varied and is dependent on various macro-economic and political factors that
influences the prices and the valuation of the stocks in the capital market3.
Discussion
Traditional Finance Theory
The traditional finance theory shows the rationale behind the reaction of the individuals
who try to act rationally. The Concept of the traditional finance is based on neoclassical
economics assuming that the individuals are risk averse and have a perfect knowledge about the
stock market. A rational investor is one, which is having a completeness, transitivity,
1 "Traditional Finance vs. Behavioral Finance?", in Financial Analyst Warrior, , 2019,
<https://www.financialanalystwarrior.com/difference-traditional-finance-behavioral-finance/> [accessed 18
February 2019].
2 Andriof, Jörg, and Sandra Waddock. "Unfolding stakeholder engagement." Unfolding stakeholder thinking.
Routledge, 2017. 19-42.
3 "Investor’s Sentiments and Stock Market Volatility", in Jespk.net, , 2013,
<http://www.jespk.net/publications/108.pdf> [accessed 18 February 2019].

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independence and continuity. The traditional finance theory assumes that the investors are
having an unlimited perfect knowledge about the various aspects of capital markets. The
investors has capacity limitations of knowledge, utility maximisation and assumes that they
makes a full rational decision-making4. The traditional finance does not incorporates the current
economic scenario and various other business factors that are important part of the movement in
the stock market.
Political Events
The political events in the United Kingdom and the impact on UK Equity market after the
Brexit is one of the crucial events whose implications and analysis needs to be studied. Various
political events and economic events affect the stock market on an overall basis, it is necessary to
understand the impact of each of the factors and the implication it can create on the stock market.
Equity Markets in the world have been highly volatile and is quite sensitive to various political
and economic activity happening all around the UK, US and Europe5.
Emmanuel Macron’s Victory in France: The victory of Emmanuel Macron’s Victory in the
France in the first round of voting in France has seen a high confidence in the investors and
voters, which lead to the increase in the equity market6. The strengthening of the Euro dollar
against major currencies like dollar and pound was some of the key highlight of the political
4 Thaler, Richard H. "Behavioral economics: past, present, and future." American Economic Review 106.7 (2016):
1577-1600.
5 Shu, Hui-Chu, and Jung-Hsien Chang. "Investor sentiment and financial market volatility." Journal of Behavioral
Finance 16.3 (2015): 206-219.
6 Hassan, Tarek A., and Thomas M. Mertens. "The social cost of near-rational investment." American Economic
Review 107.4 (2017): 1059-1103.

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event, which took place. After the results of the election were announced in France, the France
CAC Benchmark Index showed an improvement in the index where the index moved up by
around 4% a nine year high. The German’s Dax Index also showed a movement up by around
3.3% and the FTSE Index of the UK market showed a recovery by around 2.1%7. The confidence
of the investors in the French Elections and Emmanuel Macron’s victory was the key reason
behind the increase in the stock market.
US Presidential Elections: The US Presidential election was also one of a major event where
the Republican Party beating the Democrat Party in the US Presidential elections in the 2016.
The victory of Donald Trump over Democrat Hillary Clinton surprised the experts and the US
market giving way to ‘Trumponomics’. The planning and policies of the Trump including
bold economic plans like cuts in personal and corporate tax rates, protectionism attitude towards
the US citizens and a motto of ‘America First’ was some of the key highlight of the
Trumponomics. Restructuring of Bilateral Trades and implementation of various policies and
programmes helped the Trumponomics gained victory in the US Presidential Elections8. The
Dow Jones Industrial average Index showed a decline with the victory of the Republican Party
Donald Trump where the Dow rose by around 257 points on the respective day. The NASDAQ
Index and the S&P 500 Index increased by around 1.1%. The Dow Jones increased by around
257 points with the US Presidential Elections showed the Republican Party winning in the
elections9.
7 "Stock Markets", in The Independent, , 2016, <https://www.independent.co.uk/topic/stock-markets> [accessed 20
February 2019]. ma
8 Shen, Dehua, and Shu-Heng Chen. "Big Data Finance and Financial Markets." Big Data in Computational Social
Science and Humanities. Springer, Cham, 2018. 235-248.
9 "How has the Brexit vote impacted UK stocks? - Institutioneel - Schroders", in UK View: The UK equity market
after Brexit, , 2017, <https://www.schroders.com/nl/nl/institutioneel/nieuws-marktinformatie/brexit/uk-view-the-uk-

7FINANCE AND INVESTMENT
Brexit: The Britain vote for leaving the European Union with around 51.9% voters in a historic
referendum was followed with the voters voting for the Britain to exit the European Union. The
resignation of UK Prime Minister David Cameron was followed after UK votes to leave the
European Union. Various policies and regulations needs to be discussed taken into consideration
for the overall workings and implication of the various policies on the economies. The
negotiation between the UK and European Union may take up several years of time for the UK
to disentangle with the European Law, trade and other financing activities and various other
policies, which may create a material impact on the overall UK Economy. The impact of the
Brexit was found to be spread across overall on all major market affecting the equity and stock
markets in the major economies10. The major equity indices saw a fall of about 2-10% in the
leading stock markets in the leading economies. After the British vote to leave the UK in the year
2016, the stock market reacted with a fall in the major index showing increase in global political
equity-market-after-brexit/> [accessed 20 February 2019].
10 Hobolt, Sara B., T. Leeper, and James Tilley. "Divided by the vote: Affective polarization in the wake of Brexit."
American Political Science Association, Boston (2018).

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tension and rising volatility globally11. The Pound saw a major decline and felt sharply against
the dollar to a 31 year all time low ending at around $1.29. On the day of UK Referendum itself,
the FTSE Index fell sharply and ended around 6,338.10. The FTSE 250 Index slumped around
7% on the day when the UK Referendum was confirmed.
Figure 1: Economist Forecast for Inflation and GDP Growth
(Source: "How has the Brexit vote impacted UK stocks - Institutioneel - Schroders". in , , 2017)
Empirical Evidence
The Britain voted to leave the European Union in a Referendum in the year 2016 June.
The Euro dollar was the most affected with the Brexit where the rise in the value of the US
Dollar adversely affected the US Manufacturing Sector. The same will affect the growth of the
US markets putting a downward pressure on the US Industry growth. The exiting of the Britain
11 Oliver, Tim, and Michael John Williams. "Special relationships in flux: Brexit and the future of the US—EU and
US—UK relationships." International Affairs 92.3 (2016): 547-567.

9FINANCE AND INVESTMENT
from the European Union nation will also affect the capital flows of the economy pushing the
European Union away from Eurozone and directing the same towards safer instruments for
investing among the investment class available. US Treasuries and Bonds will be the safe haven
for investment, which ultimately would increase the value of the US Dollar. The relative interest
rates in the market did fall and overall affected the value of the currencies. The strengthening of
the US Dollar against the Chinese Yuan Currency will also allow the Chinese Yuan currency to
float lower between the two largest export markets the US and the European Union12.
Figure 2: Sterling versus the USD Exchange Rate
(Source: "How has the Brexit vote impacted UK stocks - Institutioneel - Schroders". in , , 2017)
12 Cox, Justin, and Todd Griffith. "Political Uncertainty and Market Liquidity: Evidence from the Brexit
Referendum and the 2016 US Presidential Election." Available at SSRN 3092335 (2018).

10FINANCE AND INVESTMENT
The FTSE Index and the FTSE 250 Index felt around by 9% and 12% in the year 2016
after the results of the UK referendum before showing a spur increase later that day on the UK
referendum day 24th June 2016. The major companies like Travel and Leisure, Food Retailers are
some of the common aspect impacted by the sense that consumer spending would be affected
after the UK Referendum. The slowdown of the economy and the fall in the prices of the assets
were some of the key implications observed in the UK and US Stock markets. Some of the key
areas where a sharp fall in major financial areas and institutions like Real Estate Investment
Trusts, Financial Advisory Services and Banks were the most affected in these scenarios. The
defensive stocks industry like the Pharmaceutical, Healthcare Equipment’s and Tobacco
increased on an overall basis than the benchmark index and market.
The uncertainty and weakness in the sterling caused due to referendum vote did expect
that the rise in inflation and downgrade in the growth of the economy would be the key
highlights. Delay in investments, difficulties in implementation of policies & programmes and
quantifying the effects of these on the economies are some of the key factors that needs to be
studied for understanding the overall impact of the factors on economies.

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Figure 3: Investment flow and Risk Ability of Investors
(Source: "How has the Brexit vote impacted UK stocks - Institutioneel - Schroders". in , , 2017)
While surveying data on corporates it was seen that there was an overall weakening
observed in the capital investment decision by the investor due to the uncertain political and
economic events. The rise in the uncertainty and rise in global volatility of the stock of the equity
markets lead to a fall in the confidence of investors for investment. The Scottish Referendum and
UK General Elections were some of the key driven political events, which gave rise to the
increase in the global political tension. The above figure investment flow shows the volatility on
the cash flows and the effect on the investor’s confidence in investment from the trend period
2007-2016. From the year 2015-16, the United Kingdom saw the major fall in the capital
investment and increasing risk in the equity market with the rise in geo-political tensions and
spike in global volatility. It is important for the investor to asses various other information and
aspects that can significantly affect the operations of the stock market.

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Figure 4: Cap-ex and Employments by Corporates
(Source: "How has the Brexit vote impacted UK stocks - Institutioneel - Schroders". in , , 2017)
The above figure shows the reaction shown by the corporate world and various other
companies in the trend period of 2010-2016 where the fall in the capital expenditures and the
employment rate was found to be correlated. The volatility in the capital expenditures and the
employment rate in the economy overall affects the volatility and sustainability in the equity
markets. The UK Composite Purchasing Manager’s Index also showed a downfall in the trend
period 2013-1613.
13 Hobolt, Sara B. "The Brexit vote: a divided nation, a divided continent." Journal of European Public Policy 23.9
(2016): 1259-1277.

13FINANCE AND INVESTMENT
Figure 5: UK Composite Purchasing Managers Index
(Source: "How has the Brexit vote impacted UK stocks - Institutioneel - Schroders". in , , 2017)
It is the investor perception and the perception taken by them for the reaction of the stock
market. Every investor has their own perception, thinking and ways for addressing an event and
the same may affect and influence the valuation of the stock and the overall functioning of the
stock markets. Thus, it is important for the investors to understand the materiality of the
information and the impact of the same on along term basis on the value and the growth of the
stocks. There are various political and economic events, which occurs, but it is important for
assessing the materiality and importance of the same and the extent by which it can affect the
overall development and growth of companies and economy. The Return on US stock has been
volatile during the election years.
Figure 6: US Stocks Return during Election Year
(Source: U.S Global Investors14)
14 "This Election Year Could Have a “HUGE” Effect on Markets - U.S. Global Investors", in Usfunds.com, , 2016,
<http://www.usfunds.com/investor-library/frank-talk/this-election-year-could-have-a-yuge-effect-on-markets/>
[accessed 20 February 2019].

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The rise in volatility in the UK Stock market due to uncertain political events and rise in
the equity risk premium can be well seen by the depicted graph below in Figure 6. The graph
reflects the movement of the Equity Risk Premium with the increase in the uncertainty in the UK
Economic Policy15.
Figure 7: Movement in Equity Risk Premium and Economic Policy of UK
(Source: "How has the Brexit vote impacted UK stocks - Institutioneel - Schroders". in , , 2017)
15 Hanke, Michael, Rolf Poulsen, and Alex Weissensteiner. "Event-Related Exchange-Rate Forecasts Combining
Information from Betting Quotes and Option Prices." Journal of Financial and Quantitative Analysis 53.6 (2018):
2663-2683.

15FINANCE AND INVESTMENT
Conclusion
The rationale behind the movement in the stock market in the UK, US and in Europe
were taken into account after assessing the political and social events revolving in the respective
markets. Thus, after assessing the political and economic events it was reviewed that these events
discussed above can affect the stock market and the extent and the percentage of the implications
of the same depends on the perception taken by the investors and the market forces. However, it
was also reviewed that there are various events and extents that could be taken into consideration
for the evaluation of the stock market volatility. The assumptions taken by the traditional
finance theory and says that investors are having an unlimited perfect knowledge about the
various aspects of capital markets. The investors has capacity limitations of knowledge, utility
maximisation and assumes that they makes a full rational decision-making. Thus on an overall
basis there were wide aspects of events and factors taken into consideration describing the
changes and movements observed in the Europe, UK and US Economies.

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References
"How has the Brexit vote impacted UK stocks? - Institutioneel - Schroders". in , , 2017,
<https://www.schroders.com/nl/nl/institutioneel/nieuws-marktinformatie/brexit/uk-view-the-uk-
equity-market-after-brexit/> [accessed 20 February 2019].
"Investor’s Sentiments and Stock Market Volatility". in , , 2013,
<http://www.jespk.net/publications/108.pdf> [accessed 18 February 2019].
"Stock Markets". in , , 2016, <https://www.independent.co.uk/topic/stock-markets> [accessed 20
February 2019].
"This Election Year Could Have a “HUGE” Effect on Markets - U.S. Global Investors". in , ,
2016, <http://www.usfunds.com/investor-library/frank-talk/this-election-year-could-have-a-
yuge-effect-on-markets/> [accessed 20 February 2019].
"Traditional Finance vs. Behavioral Finance?". in , , 2019,
<https://www.financialanalystwarrior.com/difference-traditional-finance-behavioral-finance/>
[accessed 18 February 2019].
Andriof, Jörg, and Sandra Waddock. "Unfolding stakeholder engagement." Unfolding
stakeholder thinking. Routledge, 2017. 19-42.
Cox, Justin, and Todd Griffith. "Political Uncertainty and Market Liquidity: Evidence from the
Brexit Referendum and the 2016 US Presidential Election." Available at SSRN 3092335 (2018).
Edwards, Jeanette, Angelique Haugerud, and Shanti Parikh. "Introduction: the 2016 Brexit
referendum and Trump election." American Ethnologist 44.2 (2017): 195-200.

17FINANCE AND INVESTMENT
Hanke, Michael, Rolf Poulsen, and Alex Weissensteiner. "Event-Related Exchange-Rate
Forecasts Combining Information from Betting Quotes and Option Prices." Journal of Financial
and Quantitative Analysis 53.6 (2018): 2663-2683.
Hassan, Tarek A., and Thomas M. Mertens. "The social cost of near-rational investment."
American Economic Review 107.4 (2017): 1059-1103.
Hobolt, Sara B. "The Brexit vote: a divided nation, a divided continent." Journal of European
Public Policy 23.9 (2016): 1259-1277.
Hobolt, Sara B., T. Leeper, and James Tilley. "Divided by the vote: Affective polarization in the
wake of Brexit." American Political Science Association, Boston (2018).
Oliver, Tim, and Michael John Williams. "Special relationships in flux: Brexit and the future of
the US—EU and US—UK relationships." International Affairs 92.3 (2016): 547-567.
Shen, Dehua, and Shu-Heng Chen. "Big Data Finance and Financial Markets." Big Data in
Computational Social Science and Humanities. Springer, Cham, 2018. 235-248.
Shu, Hui-Chu, and Jung-Hsien Chang. "Investor sentiment and financial market volatility."
Journal of Behavioral Finance 16.3 (2015): 206-219.
Thaler, Richard H. "Behavioral economics: past, present, and future." American Economic
Review 106.7 (2016): 1577-1600.