Chapter: 2 Efficient Capital Market

01. Define effective capital market? what are the three forms of market efficiency?
An efficient capital market is a market where the share prices reflect new information accurately and in real time.
Capital market efficiency is judged by its success in incorporating and inducting information about the basic
value of securities, into the price of securities.
According to [Link], “It is a market where information regarding the value of securities are
incorporated into its prices accurately and in real time.” Since, the value of securities fluctuates depending on the
present value of future cash flows, an efficient capital market enables these fluctuations to be reflected in the
securities' current price.
Three Forms of Market Efficiency
1. Weak form:- Prices reflect all past market information such as price and volume. In other words, technical
analysis is of no use.
If the market is weak form efficient, then investors cannot earn abnormal returns by trading on market
information.
Implies that technical analysis will not lead to abnormal returns.
Empirical evidence indicates that markets are generally weak form efficient.
2. Semi-strong form:- Prices reflect all publicly available information including trading information, annual
reports, press releases, etc. In other words, fundamental analysis is of no use.
If the market is semi strong form efficient, then investors cannot earn abnormal returns by trading on public
information
Implies that fundamental analysis will not lead to abnormal returns
3. Strong form:- Prices reflect all information, including public and private. In other words, even insider
information is of no use.
If the market is strong form efficient, then investors could not earn abnormal returns regardless of the
information they possessed
Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal
returns.

02. Efficient Market Hypothesis (EMH): The efficient market hypothesis states that at any given time, security
prices fully reflect all available information.
03. Efficient Market: An efficient market is defined as a market where there are large numbers of rational, profit-
maximizers actively competing, with each trying to predict future market values of individual securities, and
where important current information is almost freely available to all participants.

04. The Efficient Markets Theory

The efficient markets theory assumes that asset prices (particularly stock prices) reflect all available information.
For example: Microsoft's stock price on 08/01/2023 was about $26 . Under the efficient markets theory, the share
price of $26 reflects all past relevant info about Microsoft (such as their profits, sales, litigation, etc) as well as
forecasts about future earnings, sales, market share, new products, etc. People who buy and sell Microsoft stock
have an incentive to use all of this information to make a profit, so the price set by buyers and sellers will reflect
this information.
Furthermore, under the efficient markets theory, a security's return always reverts to some equilibrium return that
reflects its fundamental value, its expected future earnings and risks. Why? Well, if Microsoft stock is earning an
abnormally high return, people will buy the stock, bidding up the price. The higher price will drive down the
return to some equilibrium level. If Microsoft stock is earning an abnormally low return, people will sell the
stock, driving down its price. The lower price causes the return to rise to some equilibrium level.
Keep in mind that not everyone needs to use all available information to price a security for this to work. If
enough buyers and sellers are behaving rationally, then the security price will reflect that.
05. Explain the terms technical analyst and fundamental analyst?
Technical Analysts: Investors who attempt to identify over or undervalued stocks by searching for patterns in
past prices. They look for patterns, trends, and chart formations to forecast future price movements. They
believe that history repeats itself in the markets and all known information is already reflected in prices—so
patterns and trends provide insights into future behavior. This analysis is Ineffective in weak form efficient
markets, because all past price data is already reflected in current prices.

Fundamental Analysts: Investors who attempt to find over or undervalued securities by analyzing fundamental
information, such as earnings, asset values, and business prospects. They analyze Financial statements (like
income statements, balance sheets) Earnings forecasts, Industry conditions, Economic indicators, Management
quality and competitive positioning. This analysis is ineffective in semi-strong form efficient markets, because
all publicly available fundamental information is already priced in.

06. Behavior of share prices / explain the random walk theory of share price changes. why most economist
criticized the said theory? what was their opinion?
In economics and financial theory, analysts use random walk techniques to model behavior of asset prices, in
particular share prices on stock markets, currency exchange rates and commodity prices.
This practice has the assumption that investors act rationally and without bias, and they estimate the value of an
asset based on future expectations. Under these conditions, all existing information is already reflected in the
current price, then prices will only change when new information is released. By definition, new information
appears randomly and influences the asset price randomly.
Why Economists Criticize the Theory:
1. Empirical Evidence: Empirical sstudies show that prices do not completely follow random walks. Low serial
correlations exist in the short term, and slightly stronger correlations over the longer term. Their correlations and
the strength depend on a variety of factors.
2. Seasonal and Temporal Patterns: Researchers have found that some of the biggest price deviations from
random walks result from seasonal and temporal patterns. In particular, returns in January significantly exceed
other months (January effect) and on Mondays stock prices go down. These effects have persisted across markets
for decades, but without giving a completely satisfactory explanation for their persistence.
3. Technical vs. Fundamental Views: Technical analysts use these anomalies to predict future price movements
from historical data. Eugene Fama argue argue that most of these patterns occur accidentally, rather than as a
result of irrational behavior of investors.
4. Behavioral Finance Perspective: This school of thought blames cognitive and emotional biases for deviations
from randomness. This school argues that investors are not always rational, which causes non-random behavior.
5. Price- earnings dividends relationship: Over the long run, the share price is directly related to the earnings
and dividends. Over short periods the relationship between share price and dividends can be quite unmatched.
Conclusion: While the Random Walk Theory provides a useful framework, most economists believe it
oversimplifies market dynamics. Real-world data shows patterns, trends, that cannot be explained by randomness.

06. What are the causes of Stock Price Change?

Stock prices change every day as a result of market forces. Share prices change because of supply and demand.
If more people want to buy a stock (demand) than sell it (supply), then the price moves up. Conversely, if more
people wanted to sell a stock than buy it, there would be greater supply than demand, and the price would fall.
What is difficult to understand is “what makes people like a particular stock and dislike another stock.” There
are many answers to this problem and every investor has their own ideas and strategies. This is because of positive
news and negative news about the company from investors perspective.
The principal theory is that the price movement of a stock indicates what investors feel a company is worth.
Don't equate a company's value with the stock price. The value of a company is its market capitalization, which
is the stock price multiplied by the number of shares outstanding.
For example, a company that trades $100 per share and has 1 million shares outstanding has a lesser value than
a company that trades $50 that has 5 million shares outstanding ($100 x 1 million = $100 million while $50 x 5
million = $250 million).

07. Market Capitalization: It is a measure of the value of a company, calculated by multiplying the number of
outstanding shares by the current price per share. For example, a company with 100 million shares of stock
outstanding and a current market value of $25 a share has a market capitalization of $2.5 billion.

08. How do stock prices work?

Stock prices are driven primarily by human psychology and company fundamentals. Stock prices appear to
behave randomly to many people who view price behavior on a stock chart. When you view a price chart, what
you are really looking at is supply and demand in action. Investors tend to behave like a school of fish. As fish
move in unison, so do investors. As they respond to forces that create either supply or demand for stocks.
1. Supply and Demand: The law of demand states that as a stock price falls, demand for that stock rises. When
demand becomes strong enough, the price will stop falling and begin rising. Likewise, the law of supply states
that when the stock price rises, more people are willing to sell it. When enough sellers are willing to sell, the price
will stop rising and eventually begin to fall lower.
2. Earnings: One of the biggest factors that creates supply and demand are company earnings. As a company’s
investor expectations, they will sell, creating supply.
3. Emotion: Investors are people and people are emotional beings. As such, the emotions of fear and greed can
have a big impact on price supply and demand. When investors, behaving like a school of fish, become greedy,
stock prices will rise. Falling prices can cause investors to become fearful, causing them to sell lower and lower.
4. The Economy and Other Factors: Economic outlook can impact company earnings, so the economy will
impact stock prices. Other factors include analyst outlooks, major events in the world (such as terrorist attacks),
oil prices, inflation and many others.

09. What are the six lessons of market efficiency?

Lesson 1: Markets have no memory (don't wait for recent price changes to be reversed; they probably will not )
Lesson 2: Trust market prices (more than your own hunches)
Lesson 3: Look at market prices in detail to predict the future (term structure; market's unfavorable assessment
of Viacom's takeover of Paramount; for the market price implicitly weights a lot of people's serious assessments)
Lesson 4: Do not believe in financial illusions (dividends and stock splits; stock prices run up before a split)
Lesson 5: Value is lost when the company does something that a shareholder can do on his own for smaller
transaction costs
Lesson 6: Demands for stocks should be highly, highly elastic.

10. Some Lessons from Capital Market

Average Returns: The First Lesson
Lessons from capital market history
• There is a reward for bearing risk
• The greater the potential reward, the greater the risk, this is called the risk-return trade-off
Dollar Returns: Total dollar return = income from investment + capital gain (loss) due to change in price.
Example: You bought a bond for $950 one year ago. You have received two coupons of $30 each. You can sell
the bond for $975 today. What is your total dollar return?
Income = 30 + 30 = 60 Capital gain = 975 – 950 = 25 Total dollar return = 60 + 25 = $85
Percentage Returns: It is generally more intuitive to think in terms of percentages than in dollar returns.
◼ Dividend yield = income / beginning price.
◼ Capital gains yield = (ending price – beginning price) / beginning price.
◼ Total percentage return = dividend yield + capital gains yield.
Example: You bought a stock for $35 and you received dividends of $1.25. The stock is now selling for $40.
What is your dollar return? Dollar return = 1.25 + (40 – 35) = $6.25
What is your percentage return?
Dividend yield = 1.25/35 = 3.57% Capital gains yield = (40–35) / 35 = 14.29% Total percentage return = 17.86%

The Variability of Returns: The Second Lesson

Variance and standard deviation measure the instability of asset returns. The greater the volatility, the greater
the uncertainty.
• Historical variance = sum of squared deviations from the mean / (number of observations – 1)
• Standard deviation = square root of the variance

11. Risk Premiums: The “extra” return earned for taking on risk. The risk premium is the return over and above
the risk-free rate. Treasury bills are considered to be risk-free.

12. Efficient Market and Regulations

Regulations are an absolute necessity in the face of the growing importance of capital markets throughout the
world. The development of a market economy is dependent on the development of the capital market. The
regulation of a capital market involves the regulation of securities; these rules enable the capital market to
function more efficiently and impartially. A well regulated market has the potential to encourage additional
investors to partake, and contribute in, furthering the development of the economy.

13. What are the Capital Market Regulatory Authorities Worldwide?

1. U.S. Securities and Exchange Commission
2. Canadian Securities Administrators, Canada
3. Australian Securities and Investments Commission
4. Securities and Exchange Commission, Pakistan
5. Securities and Exchange Board of India
6. Bangladesh Securities and Exchange Commission (BSEC)
7. Securities and Exchange Surveillance Commission
8. Securities and Futures Commission, Hong Kong
9. Financial Supervision Authority, Finland
10. Financial Supervision Commission, Bulgaria
11. Financial Services Authority, UK
12. Comision Nacional del Mercado de Valores, Spain
13. Authority of Financial Markets

14. why security rating firms exist in capital market?

Security rating firms (credit rating agencies) play a vital role in the capital market by providing independent
assessments of the creditworthiness of issuers and securities. Main Reasons They Exist:
1. Reduce Information Asymmetry: Help investors understand issuer risk without doing analysis by themselves.
2. Facilitate Investment Decisions: Allow investors to screen investments based on risk tolerance or regulation.
3. Affect Borrowing Costs: Higher ratings reduce interest costs; lower ratings increase them.
4. Promote Market Transparency and Efficiency: Allow better comparisons between securities.
5. Act as a Risk Management Tool: Used in models and for regulatory compliance.

Moody’s, Standard & Poor’s (S&P), and Fitch Ratings are the top global agencies. Local agencies also rate
domestic securities. Rating agencies enhance trust, reduce uncertainty, and support efficient capital allocation,
despite their limitations.
Questions: Legend Ltd. experts return will be 5% but actually they earn 8%. what is their abnormal return?
Abnormal Return = Actual Return - Expected Return
Calculation: Abnormal Return = 8% - 5% = 3%
On 1st January 1st 2018 Abdul Rahim got 1000 shares @ tk 25 per share of Beximco Company Limited (book
value of which is TK 10) & received 10% cash dividend quarterly. on 30th December 2019 he sold all shares
at tk 35 per share. what is his total return.

Given Information:
- Purchase Date: January 1, 2018
- Number of Shares: 1,000
- Purchase Price per Share: Tk 25
- Book Value (Face Value) per Share: Tk 10
- Dividend: 10% cash dividend, quarterly (on face value)
- Sale Date: December 30, 2019
- Sale Price per Share: Tk 35

Step 1: Capital Gain

Purchase Price = 1,000 × 25 = Tk 25,000, Selling Price = 1,000 × 35 = Tk 35,000
Capital Gain = Tk 35,000 - Tk 25,000 = Tk 10,000

Step 2: Dividend Income

Quarterly dividend = 10% of Tk 10 = Tk 1 per quarter
Annual dividend per share = Tk 1 × 4 = Tk 4
Total for 2 years = Tk 4 × 2 = Tk 8 per share
Total Dividend Income = 1,000 × 8 = Tk 8,000

Total Return Calculation

Total Return = Capital Gain + Dividend Income = Tk 10,000 + Tk 8,000 = Tk 18,000

Return Percentage
Initial Investment = 1,000 × 25 = Tk 25,000
Return % = (18,000 / 25,000) × 100 = 72%

Final Answer:
Total Return: Tk 18,000, Return Percentage: 72%