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Everything you wanted to know about Capital Markets

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Ever wondered why at sometimes your investments soar while at other times they fall downhill? The reason could lie with the relative health of capital markets. That’s why you need to know about the financial health and efficiency of capital markets.

 

Overview

Basically, the governments as well as private institutions work together via capital markets to raise funds on a long term basis. The stock market and bonds are ways for you and me to multiply revenues. No matter which country you reside in, there is a designated financial regulator who supervises the operation of the capital markets (Wikipedia, nd [online]). This is to ensure that no fraudulent activities or transactions can occur. There are two main components of capital markets – the primary which consists of new issues and the secondary market where current securities are traded (SFB 504, 1997[online]).

 

What defines its efficiency?

If investors are to be goaded into investing in capital markets, what really is an indicator of their relative health? In purely technical terms, today’s economy and financial market is far more ‘efficient’ in that it is able to integrate information into the prices of securities. There are 3 primary types of capital markets efficiencies:

Weak: where the information from past patterns and historical stock prices are reflected in current security prices. Only a trained analyst who can discern this public information, to uncover potential aspects, can benefit from such capital markets.

Semi-strong: where current security prices are indicative of all available public information. In this situation only those capital markets traders who have access to non-public information can gain maximum profits.

Strong: where all information (even insider company information) is integrated into current security prices. In this situation since all information is accessible by everyone no trader can make extra profit from such capital markets (Jones & Netter, nd[online]).

 

In the truest sense, efficient capital markets are able to give a glimpse about a security value just by its price. Any security for that matter is essentially a foretaste of the future cash flow. Based on the expected dividends, the current unit price and other factors, future capital markets cash flow can be anticipated. However, usually it is the interest rate which eats into the profits obtained from investing in capital markets.  It’s because interest rates are directly proportional to the risk quotient of cash flows. The higher the risk the greater is the interest rate.

 

Valuation of stocks

Many times, a common strategy used to hurtle stock prices to acceptable levels, is by overvaluing and under-pricing stocks. This leads to a more competitive environment where investors in capital markets are coaxed into trading. Most seasoned investment analysts will hunt for wrongly priced stocks to ascertain capital markets efficiency. They will also typically suggest mechanisms to make current stock prices reflect the fundamental value (Jones and Netter, nd [online]).

 

Why the hype over efficiency?

Capital markets efficiency is crucial. It’s because most if not all finance projects are funded by this route. Any business savvy shareholder or investor will always want to maximize the profit from their stocks. Hence, they will most likely be partial to projects which will increase stock values. This is why efficiency of information access is so vital to ensuring the health of capital markets. In truly efficient capital markets scenarios, there is no need to funnel funds towards profitable short term projects. All projects can be funded in a uniform manner.

 

Myopic considerations

Surprisingly, while the general belief is that capital markets when under-efficient make management take short term decisions, is untrue. In fact, this myopic tendency to look at short term, high impact projects, can occur even in an efficient capital markets scenario. Many times, a management has made disastrous mistakes in the hope or procuring projects that boost current accounting. They may even overlook potentially profitable investments – simply because they are more long-term in their results. This phenomenon continues even under ‘theoretically efficient’ capital markets (Stein, 1989 [online]).

 

 

References:

 

<URL: http://en.wikipedia.org/wiki/Capital_market>

 

Stein, C, (1989) ‘Efficient Capital Markets, Inefficient Firms: A Model of Myopic Corporate Behavior’, The Quarterly Journal of Economics, 104:4 [online] (cited 23rd October 2007) Available from <URL: http://links.jstor.org/sici?sici=0033-5533(198911)104%3A4%3C655%3AECMIFA%3E2.0.CO%3B2-S>

 

Jones, L, and Netter, M (nd) ‘Efficient Capital Markets’, Available from <URL: http://www.econlib.org/LIBRARY/Enc/ EfficientCapitalMarkets.html>

 

SFB 504 (1997), ‘Efficient Capital Markets’, Available from <URL: http://www.sfb504.uni-mannheim.de/glossary/efcapm.htm>

 [17th November 1997]

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