Financial Markets: Analysis of Efficiency, Risks, and Eurocurrency

This report delves into the intricacies of financial markets, encompassing discussions on market efficiency, the London Stock Exchange (LSE), and associated risks. It begins with an introduction to financial markets and then proceeds to define and elaborate on the three levels of the Efficien...Read More

Financial Market

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Q1(a)Different levels of market efficiency.................................................................................1
Q1(b). Critical examination of London Stock Exchange market efficiency with reference to
Efficiency market hypothesis (EMH).........................................................................................3
c. London stock exchange...........................................................................................................5
Q2 (a) Money market and Capital market...................................................................................7
B Functions.................................................................................................................................8
Q3 (a) Risks involved in International transaction and Eurocurrency Market...........................9
Q3 (b) Eurocurrency Market and its importance......................................................................11
Q4(a) Explain the terms............................................................................................................14
CONCLUSION..............................................................................................................................14
REFERENCES..............................................................................................................................16

INTRODUCTION
Financial markets are where trading of buying and selling of assets like stocks, bonds,
derivatives, commodities and foreign exchange. In this market investors make money and
companies try to reduce risks with financial instrument. In this report there is brief description
about money market instruments and capital market and they are influencing each other.
Efficient market hypothesis has been elaborated in this report, as there are three different levels
of EMH which are strong form, semi strong form and weak form of hypothesis. Efficiency of
London Stock exchange has been explained with the reference of efficient market hypothesis.
International trade plays an important role in economy but there are also risk involved related to
it so for protecting them various methods has been discussed in this report.
Q1(a)Different levels of market efficiency
Definition of EMH:
Efficient market hypothesis is not a rule, it is a model. It gives elaboration that how
markets tend to work. It does not give directions to the market that how they must work.
Basically there are three forms of efficient market hypothesis: Weak form EMH, Semi strong
form EMH and Strong form EMH. Every level has their own implications:
Eugene fama: Is the American economist which is best known for the development of
various theories and asset pricing framework. However, he has developed the theories relevant
EMH which act as a funneling agent in terms of improving the adequate knowledge relevant
with the market efficiency.
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Illustration 1: Example of efficient market hypothesis
(Source: Adams and Jiang, 2017)
Weak Efficient EMH : It is the weakest form of efficient market hypothesis. Whenever,
the past information related to price is been highlighted in the current market price then it is
known as weak from EMH. To earn excess return, this form of EMH cannot be used. Technical
analysis cannot be used for predicting future price movements. Fundamental analysis can be used
in this form of market efficiency but it does not give long term advantage. Excess return can be
gained by using non-public information. For example, XYZ broker who works at London Stock
Exchange. Without any prior experience he was very keen in investments. When he observed the
price of L equipment falls on Tuesday and it rises on Friday. After that he purchased 200 shares
of L's stock for 12 pounds per share on Monday but he was sad because price came to 10 pounds
per share on Thursday. In the present scenario the market seems to be in weak form EMH
because XYZ is not able to earn excess return by observing past price.
Semi strong EMH : It lies between the two forms of market, strong and weak form
EMH. In this form the prices are reflects all available public information and excess return is
also possible to earn through fundamental analysis. For predicting future price movements,
neither fundamental analysis nor technical analysis can help. To earn excess return non public
information can be used. For example, Nargis held 300 shares of PNC company which he had
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purchased for 30 pounds per share. Next day she came across an article which was shared by her
friend on Facebook. According to that PNC company failed in a task whose net worth value in
20 million. Next day Nargis sold her holding and was so glad that she minimized the loss but on
the next day stock price had climbed by 45 pounds. In the present scenario market seems to be
semi strong form efficient.
Strong Form EMH : It is the strongest form of efficient market hypothesis. Prices
reflect both inside information and publicly available information. By any medium it is not
possible to earn access return in this form. Nothing can helps in predicting future price
movements, neither technical analysis nor inside information nor fundamental analysis. For
example: because of success of PNC project, the workers of that company were sure that price
will increase so they purchased 200 shares of that company but they were surprised to see that
even after announcement of the project's success, share price did not rise. This seems that market
is strong form efficient.
Q1(b). Critical examination of London Stock Exchange market efficiency with reference to
Efficiency market hypothesis (EMH)
According to Cashin, Mohaddes and Raissi, (2017), the efficiency and ability to perform
the duties of London stock exchange is quiet favourable in the world. Therefore, there has been
various corporations or entities which will have satisfactory capital collection through domestics
as well as international investors. It was founded in 1801 which was the fourth largest stock
exchange in World and Europe. The operational viability of this organisation is very capable as it
has enrolment of more than 3000 companies which were over 70 countries. In relation with
analysing the new opportunities for revenue and capital gains this will be fruitful for the
companies and investors in the organisation. Similarly, the terms stock exchanges is comprises
with the stock market on which various industries get engaged in terms of dealing in selling their
marketable securities.
It has been argued in the efficient market hypothesis that describes that the efficient
market on the prices will reflect all the information relevant with the stock market. Thus, it
ensures that no investors will have any competitive advantages over other. Additionally, it also
insists that there will not be any instances on which a return on stock prices will be predicted.
Therefore, it has been ascertained here that the EMH is correct then the prices of shares on
market should only changes when all the necessary information were displayed and presented
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publicly. The nature of EMH states that there has always been trading of the share capital on
their fair value. Thus, it will be impossible for the investors in terms of obtaining the share on
their undervalue or over value (Efficiency of London Stock Exchange, 2013). It comprises with
the fact that, it would be impossible to outperform the overall market with the influences of
experts in the market securities an analysis of the perfect timing. Therefore, it has been
determined by the experts and the observations made over the security market that the only an
investor who is investing in the riskier shares will become able to have higher returns over such
equity.
As per the views of Moloney, (2017), moreover, it can be said that, to perform the
operational tasks in relation with purchasing as well as selling equity there will be proper
observation made over the gains made by firm during a year as well as the growth of its equity.
Thus, it can be said that the perfect market analysis will help the investors in analysing the
printability of the organisation. It also ensures the capabilities of the firm in meeting the revenue
gains as well as determination of satisfactory interest rates. Similarly, there are three form of
efficiency which are within the stock exchange such as weak, semi-strong and strong. It
ascertains that the weak shares cannot be predicted and estimated as per growth and fall of the
share prices in consideration with their past records. Therefore, it comprises with the fact that
there is not stability, pattern and trend in the value of shares over the period. Thus, it is quiet
fluctuating and shifts randomly form upward to downward. Similarly, on the basis of historical
data of this proposed equity which will not have appropriate assumption of the growth of such
shares. On the contrary, in relation with the semi strong share value which comprises with the
availability of the all the relevant historical data and information relevant with the variations in
the share values. In addition, it will be fruitful to the investors to examine and analysing the
profitability of such shares as per dividends was being paid by the firm during the period.
Similarly, to examine these kinds of market there is no need of making in depth research over the
stock prices. By considering the strong form of efficiency market it can be said that there are
various public and privately available information which in turn making it helpful to the
investors to have appropriate gains. Moreover, it comprises with facilitating the insider trading in
the premises on which the external investors will feel cheated. Thus, in relation with same it can
be said that there are mainly non reliable data and information which in turn has the negative
impacts over the gains acquired by the investors of the organisation.
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c. London stock exchange
In relation with this stock exchange which comprises with all the relevant information
and operations. However, after analysing the market types and various stages of efficiency it can
be said that the London Stock market is semi-strong efficient market. Thus, to make the
investment in this market it will be helpful as to have satisfactory amount of revenue from the
returns. Moreover, it does not require in-depth research over the share value as well as all the
information presented there are reliable and valid (Tahat, Ahmed and Alhadab, 2018).
Illustration 2: London Housing prices
(Source: Toyoshima, 2018)
A). FTSE all securities
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B). Graph relevant with weak market efficiency:
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c). PT- graphs:
Q2 (a) Money market and Capital market
 Trading of short term marketable securities is called as Money market and trading of long
term marketable securities refers to Capital market.
 Money market is not organized but capital market is well organized.
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 Instruments of money market have low risk and safer investments but vice versa for
capital market.
 Capital market has low liquidity as compared to Money market (Lane and Milesi-Ferretti,
2018).
 The institutions related to money market are commercial bank, central bank and non-
financial institutions and institutions related to capital market are stock exchange, non-
banking institutions, commercial bank etc.
 Short term credit requirements are being fulfilled by money market and capital market
fulfill requirement of long term.
 Money market instruments give lower return as compared to Capital market instruments.
 Money market instruments can be redeemed within a year but capital market instruments
can be redeemed more than a year.
B Functions
Money market gives short term liquid finance for global financial system. As the interest
rate movements of money markets are directly reflecting prices of capital market. The price of
shares and bonds always represents present value of future cash flows which are discounted and
in this series interest rate is always considered as denominator but the movement of interest rate
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is opposite to prices of shares and fixed income securities which replicates that if interest rate
will rise all investors will expect high return on their investments and this will impact the prices
of shares and bonds which will be declining or vice versa. The movement of prices in short term
securities are greater than long term securities of capital market and this situation is more risky.
Q3 (a) Risks involved in International transaction and Eurocurrency Market
International trade can play vital role in developing economy but on the other hand many
domestic players can perform through multinational companies and they can be forced to merge
and close down. It is expensive as compared to domestic trade due to many reasons like tariffs,
delay cost or any cost related to different rules and legislation etc. it has been restricted for the
exchange of services and goods as it does not support exchange of all production factors which
can be an advantage in many cases. Risk related to international transaction can be classified as
Economic risk, Commercial risk and political risk.
 Economic risks includes risk of insolvency of the buyer, non-acceptance, concession in
economic control, exchange rate and risk of the failure of the buyer to make payment of
dues after 6 months after due date. The major issue is an economic stability if the
transactions involve businesses in different nation.
 Political risk includes risks due to war and terrorism, non-renewal of export and import
licenses, and major one is that risk of imposition of a ban after delivery of goods. Even
the changes in the government policies, lack of foreign currency and exchange control
regulations.
 Commercial risk like ability of bank to honor its responsibilities, failure of buyer for
paying the financial institutions and failure by seller to provide the required quality and
quantity of goods.
 Other risks: Cultural difference, language barrier, sovereign risk, natural risk and lack of
knowledge of overseas market.
Methods for managing foreign exchange risk
The main methods for avoiding risk are: Forward exchange contract, foreign currency
option, perfect hedge and foreign currency bank account. In forward exchange contract business
has been enabled to cure itself from adverse movements by locking price in an exchange rate
which has been agreed till the date agreed. On the agreed date transaction will take place. The
limitation of this method is that the price of contract has been locked with the contract and if the
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market is strong form and rate movement is giving advantage but then also price will be fixed.
For example, Chris acquired the equipment from a company in UK, which Chris must pay for 30
days in the amount of 400000 pounds. To hedge risk, Chris enters the forward exchange contract
with bank for the same amount and duration of payment. In 30 days, the exchange rate has been
become worse but the Chris situation was different so he obtained the amount without loss.
Foreign currency option: In this owner has been given the right but obligation has not
been given to buy or sell currency at a certain price before specific date or on that date. The
buyer pays up a premium amount for this right on exchange (Wang and et.al., 2017). The income
which has been earned by the seller is in the reference for the premium payment which has been
received; along with this buyer has potential of unlimited profit which depends upon the
exchange rate’s future direction. These options are mostly used for hedging against the
possibility of losses which are formed during changes in exchange rate. For example, If XYZ
enters into this option, then at the price of premium, this will give protection from the downward
movements in the value of local currency as compared to other currency, but it also gives
permission to importer to gain benefit from the rise in prices of local currency against other
currency.
Perfect Hedge: This method can be used during uncertainty of the timing of cash flows.
Any of outgoing currency payments has been matched against the inflow of foreign currency
inflows which has been received exactly on that time (Tiwari, Albulescu and Yoon, 2017).
Mostly inflow and outflow occurs at the same time to give a perfect hedge.
Foreign currency bank accounts and loan facilities: This is an alternative method for
managing the foreign exchange risk and it is used when the timing of inflows and outflows are
not matched so this issue is managed by borrowing foreign currency to pay and then using that
foreign currency for the repayment of loan or by depositing foreign currency in that currency
account for the later use.
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Illustration 3: UK and US currency exchange rate graphs
(Source: Moloney, 2017)
Uncertainty: the future is uncertain as well as the incidents which are going to be happen
in future will not have adequate and clear recognition in the current time. However, there are
various terms which are needed to be consider by a firm such as Appreciation period, fluctuation
period and deprecation period.
Q3 (b) Eurocurrency Market and its importance
The Euro currency market is very complex and even extensive. With the help of this
market transferring of medium and short term funds can be done. This transfer is from one
country to another. Whenever the funds flow and euro currency deposits from residents of US or
commercial banks, transfers by them and central banks. It can be either direct or via bank for the
settlements. To manage the foreign currency option banks can trade the currencies in the forward
and spot exchange market and even banks can borrow or lend the currencies within interbank
market. Euro can be referred as free floating currency (Best and Kleven, 2017). If there is lack in
co-ordination of any policy, the exchange rate of euro will give the outcome for all the economic
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policies. It will observe the developments of exchange rate and it will assess overall range of
financial and economic indicators which are useful for developing inflation. Euro can be used as
investment currency as it can remove the currency risk, gives incentive for the market practices.
It can also increase the cross border competition and reduce the transaction costs. Euro financial
market offers diversifies financial instruments which were primarily available in national market
of euro so this will help the investors’ especially international investors for getting scope for
diversification for investments which are in euro denominated assets and without foreign
exchange risk.
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Illustration 4: USD to GBP exchange rate
(Source:Wang and et.al., 2017)
The major role in international financial system has been played by euro currency market.
The core function is to invest and borrow in US dollars. Transfer of short and medium term
funds has been performed throughout the world by increasing international capital mobility
(Lane. and Milesi-Ferretti, 2018).
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It offers high interest rate, flexibility for maturity and huge range of investment qualities as
compared to short term capital market. Low interest rate attracts the borrowers.
Q4(a) Explain the terms
 Asymmetric information: It can be also referred as information failure which occurs
when one party in the transaction has greater material knowledge as compared to other
part. It is the major reason for market failure in different arenas. For example, in doctor
and patient, doctor has more material knowledge as compared to patient.
 Moral hazard: This situation arises when both parties have incomplete and wrong
information about each other, one party performs in a risky event and he knows that it is
cured against risk and other will incur loss. For example, Alice driving the vehicle very
carelessly was passing the risk to her insurance company to pay for all her bad decision in
how she parked the car.
 Adverse selection: it usually refers to a situation whew any one party is having
information that other do not have. The best example is of insurance.
The need of regulating financial market is to balance interests of consumers who are
unsophisticated sellers.
CONCLUSION
To conclude this report it has been cleared that financial market plays important role in
the economy. Efficient market hypothesis does not give directions to the market that how
they must work but justifies that how market tends to work. Every level of EMH has their
own implications. Capital market and money market both are very important for financial
regulations with their different functions. Eurocurrency market is very complex and
extensive but plays a major role in international financial system.
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REFERENCES
Books and Journals
Cashin, P., Mohaddes, K. and Raissi, M., 2017. China's slowdown and global financial market
volatility: Is world growth losing out?. Emerging Markets Review. 31. pp.164-175.
Moloney, N., 2017. Financial services, the EU, and Brexit: an uncertain future for the
city?. German Law Journal. 17. pp.75-82.
Tahat, Y. A., Ahmed, A. H. and Alhadab, M. M., 2018. The impact of intangibles on firms’
financial and market performance: UK evidence. Review of Quantitative Finance and
Accounting. 50(4). pp.1147-1168.
Adams, M. and Jiang, W., 2017. Do Chief Executives’ Traits Affect the Financial Performance
of Risk‐trading Firms? Evidence from the UK Insurance Industry. British Journal of
Management. 28(3). pp.481-501.
Lane, P. R. and Milesi-Ferretti, G. M., 2018. The external wealth of nations revisited:
international financial integration in the aftermath of the global financial crisis. IMF
Economic Review. 66(1). pp.189-222.
Best, M. C. and Kleven, H. J., 2017. Housing market responses to transaction taxes: Evidence
from notches and stimulus in the UK. The Review of Economic Studies. 85(1). pp.157-193.
Tiwari, A. K., Albulescu, C. T. and Yoon, S. M., 2017. A multifractal detrended fluctuation
analysis of financial market efficiency: Comparison using Dow Jones sector ETF
indices. Physica A: Statistical Mechanics and its Applications. 483. pp.182-192.
Toyoshima, Y., 2018. Testing for Causality-In-Mean and Variance between the UK Housing and
Stock Markets. Journal of Risk and Financial Management. 11(2). pp.1-10.
Kutan, A. M., Naz, I. and Shah, S. M. A., 2018. Are top managers important for firm
performance and idiosyncratic risk? Evidence from sharia vs non‐sharia‐compliant firms in
the UK and Pakistan. The World Economy. 41(3). pp.763-780.
Mumtaz, H. and Theophilopoulou, A., 2017. The impact of monetary policy on inequality in the
UK. An empirical analysis. European Economic Review. 98. pp.410-423.
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Afonso, A., Baxa, J. and Slavik, M., 2018. Fiscal developments and financial stress: a threshold
VAR analysis. Empirical Economics. 54(2). pp.395-423.
Wang, G. J. and et.al., 2017. Stock market contagion during the global financial crisis: A
multiscale approach. Finance Research Letters. 22. pp.163-168.
Online
Efficiency of London Stock Exchange. 2013. [Online]. Available through
:<http://sarahellis1.blogspot.in/2013/02/efficiency-of-london-stock-exchange.html>.
Efficient Market Hypothesis, 2018[Online], Available through <
http://www.morningstar.com/InvGlossary/efficient_market_hypothesis_definition_what_is.aspx
>
The Role of Euro in Global Capital Market. 2017[Online].Available through<
https://www.ecb.europa.eu/press/key/date/2002/html/sp020530.en.html>
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