CHAPTER 1 INTRODUCTION

Section 1 Introduction to Investment Planning and Management

Section 2 Major Classes of Investments
Section 3 Organization and Functioning of Security Markets
Section 4 Efficiency Capital Market

1.1 INTRODUCTION TO INVESTMENT PLANNING AND MANAGEMENT

1.0 INTRODUCTION

Investment planning and management is concerned with how investment objectives are
determined, the types of investment products in which investors can allocate funds,
how investments are valued, the types of strategies that can be employed by investors
to realise specific investment objectives, the best way to construct portfolio given an
investment strategy, and the techniques of evaluating the performance of an investor
(Fabbozi & Markowitz, 2003).

1.1.1 OBJECTIVES
After studying this Section, the learner should be able to:

 Define the terms “investment”, “investment planning”, “investment management”.

 Describe the motivation for “investment”.
 Describe the importance of “investment”.
 Describe the investment planning and management process.
 Explain the relationship between investment return and risk.

1.1.2 MAIN CONTENT

1.1.2.1 Investment Defined

The term investment refers to “the current commitment of funds for a period of time in
order to derive future payments that will compensate the investor for (1) the time the
funds are committed, (2) the expected rate of inflation, and (3) the uncertainty of the
future payments (Reilly & Brown, 2002)”.

On the other hand, investment activity involves the use of funds or savings for further
creation of assets or acquisition of existing assets. Those who invest are termed as
investors and are categories into individual investors and institutional investors.
Institutional investors include pension funds, depository institutions (commercial
banks, savings and credit cooperative societies, etc.), insurance companies, investment
companies (mutual funds), local government authorities, government agencies, etc.
The term investment, as used in this manual, covers both financial assets and real
assets. Financial assets are paper (or electronic) claims on some issuer, such as the
government or company. Marketable securities are financial assets that are easily and
cheaply tradable in organised markets. On the other hand, Real assets are tangible
assets such as gold, silver, diamond, art, and real estate.

1.1.2.2 Investment Planning Defined

Investment planning is the process of planning the allocation of portfolio across broad
asset classes such as bonds, stocks, cash and real estate considering the legal and policy
constraints facing the entity or individual investor (Tokat et al., 2000). It involves the a
commitment of funds to one or more assets that will be held over a specific period

Investment planning constitutes an important activity for successful investment.

Evidence show asset allocation is the most important factor in determining investment
performance (Culp et al., 1997).

1.1.2.3 Investment Management Defined

Investment management refers to the process of defining investment objectives,

adopting and executing strategies to optimise results considering the risks involved,
and evaluating performance periodically (Mejorada, 2003).

In other words, Investment management can be defined as the process of managing

financial assets, such as stocks and bonds, and real assets, such as real estate, to meet
the objectives of the owner/investor.

1.1.2.4 Investment Motivation

Generally, investors invest for the purpose of preservation and growth of wealth.
Investors also invest in order to manage their wealth effectively, obtaining the most
from it while protecting from inflation, taxes, and other factors.

The study of investment planning and management is therefore aimed at equipping

learners with the skills of investing in order to earn better returns in relation to the risk
assumed when investing. The module is aimed at providing a clear understanding of
what to be reasonably expected from an investment and help the learner avoid pitfalls
awaiting him/her as an investor, such as scams and frauds.
1.1.2.5 Investment Planning and Management Process

Typically, the investment planning and management process involves the following
five steps: (a) setting investment objectives, (b) establishing investment policy, (c)
selecting a portfolio strategy, (d) selecting assets, and (e) measuring and evaluating
performance (Fabozzi et al., 2007).

(a) Setting investment objectives

The first step in investment planning and management is setting investment objectives.
Investment objective refers to the results desired by an investor and depends on specific
need of the investor. Investment objectives of institutional investors are often more
formal and restrictive than those of individual investors.

Example. The long-term objective of total return of ABC Ltd. shall be the rate of change
of the CPI plus 5.0%. The objectives of an individual investor may be to accumulate
funds to purchase a house or to have sufficient funds to pay for school fees of children.

Investment objectives provide a benchmark for evaluation the performance of the

investment manager, and evaluate alternative investment strategies to assess the
potential for realising the specified investment objective.

(b) Establishing an investment policy

The second step in investment planning and management is establishing policy

guidelines for meeting the investment objectives. An investment policy involves asset
allocation decision so as to decide how the funds of should be distributed among the
major classes of investments such as cash equivalents, equities, fixed-income securities,
real estate, and foreign securities).

(c) Selecting a portfolio strategy

The third step involves selecting a portfolio strategy that is consistent with the
investment objectives and investment policy guidelines of the investor. The three types
of portfolio strategies are (i) active strategies and (ii) passive strategies and (ii)
structured portfolio strategies.

 An active portfolio strategy is a strategy that uses available information and

forecasting techniques to seek a better performance than a portfolio that is simply
diversified broadly.
A passive portfolio strategy involves minimal expectational input, and instead relies on
diversification to match the performance of some market index. A passive strategy
assumes that the marketplace will reflect all
 Available information in the price paid for securities, and therefore, does not
attempt to find mispriced securities.
 A structured portfolio strategy is one in which a portfolio is designed to match or
exceed the performance of some specific liabilities that will need to be paid out in
the future.

Thus, given the choice among active, structured or passive portfolio management
strategies, the selection of appropriate strategy depends on two factors: (i) the investor’s
or fund manager’s view of the pricing efficiency of the market, and (ii) the nature of the
liabilities to be satisfied.

(d) Selecting the specific assets

After the portfolio strategy is specified, the fourth step involves selecting the specific
assets to be included in the portfolio in an attempt to construct an efficient portfolio. This
involves evaluation of individual securities. An efficient portfolio is one that provides
the greatest expected return for a give level of risk, or equivalently, the lowest level of
risk for a given expected return.

(e) Measuring and evaluating investment performance

The measuring and evaluating investment performance is the last step and it involves
measuring the performance of the portfolio and then evaluating the performance
relative to some benchmark such as popular equity indexes like S&P 500 or some bond
indexes. The selected benchmark for evaluating performance of the portfolio is called a
benchmark or normal portfolio.

1.1.2.6 Overview of Investment Risk and Return

Investors base their decisions on their expectations concerning the future. Often,
investment involves uncertainty of payments from an investment which is referred to as
investment risk. Risk is present when there is a possibility that actual results may be
different from expectations. Formally, risk in investment refers to the uncertainty about
the actual return that will be earned on an investment. Investment involves risk when
investors cannot know the rate of return their investments will yield in the future.

The expected rate of return on an investment represents the mean of a probability

distribution of possible future returns on the investment. Realised return is the actual
return over some past period. Risk reflects the chance that the actual return on an
investment may be different than the expected return. One way to measure risk is to
calculate the variance and standard deviation of the distribution of returns.

It is very important to understand the concepts of risk and return since, investors seek
to maximize their returns from investing subject to the risk
they are willing to incur. If future payment from an investment involves risk, the
investor will demand a return that exceeds the pure time value of money plus the
inflation rate. The additional return added is called a risk premium.

Most, if not all, investors are risk averse, therefore, to get investors to take more risk,
requires offering higher expected returns. Conversely, if investors want higher expected
returns, they have to be willing to take more risk. Traditional risk and return models
tend to measure risk in terms of volatility or standard deviation. It should be noted
that, although in theoretical models, the expected returns and variances are in terms of
future returns, in practice, the expected returns and variances are calculated using
historical data and are used as proxies for future returns.

1.2 MAJOR CLASSESS OF INVESTMENTS

1.2.1 INTRODUCTION
This section explains the most important investment alternatives available to investors.
The emphasis is on the basic features of the financial and non-financial assets available
in the money market, capital market and real estate market. It is expected that,
knowledge of the investment alternatives covered in this section will help the learner to
understand new investment opportunities as they appear.

1.2.2 OBJECTIVES
After studying this section, you should be able to:

 Describe the major forms of direct investment securities.

 Describe major forms of indirect investment securities.
 Describe real estate investment.

1.2.3 MAIN CONTENT

1.2.3.1 Securities Investment - Direct Investing

In financial markets, direct investment involves the purchase of a security where the
investor controls to the purchase and sale of each security in a portfolio. Investors can
invest directly in: (a) non-marketable securities, (b) money market securities, (c) capital
markets and, (d) derivative securities.

(a) Nonmarketable Securities

Non marketable securities refer to any security that is difficult to buy or a sell because it
does not trade on a normal market or exchange. Common investment vehicles include:
(i) saving deposit, (ii) nonnegotiable certificates of deposit and (iii) money market
deposit accounts.

(i) Saving deposit refers to funds held at a commercial bank or thrift institutions such as
SACCOS. Saving account in insured institutions offer a high degree of safety on both
the principal and return on principal. Most savings account offer ultimate in liquidity.
Liquidity and safety feature of savings deposit accounts substantially for the popularity
of savings account.

(ii) Nonnegotiable certificates of deposits are investment securities issued by banks.

Certificates of deposit (CDs) pay a fixed rate of interest for keeping funds in the account
for a fixed period of time. CDs enforce penalties for early withdrawal. Securities and
products that are considered non-negotiable cannot be transferred from one party to the
next and thus are typically illiquid.
Money market accounts (MMDAs) or money market deposit account (MMDA) is a
deposit account offered by a bank, which invests in government and corporate
securities and pays the depositor interest based on the level of money market interest
rates.

(b) Money Market Instruments

Money market is a segment of the financial market in which financial instruments with
high liquidity and very short maturities are traded. Money market instruments are
issued by governments, financial institutions and companies. Some of these instruments
are negotiable, some are not. Money market instruments are typically in large
denominations and involve low transaction costs. The major money market instruments
include: (i) Treasury bills, (ii) Negotiable certificates of deposit, (iii) Commercial paper,
(iv) Repurchase agreements and (v) Bankers’ acceptance.

(ii) Treasury bills (T-bills): a short term money market instrument sold at discount by the
government. The Treasury bill is risk free on nominal basis (not accounting for
inflation). It is often used as a benchmark asset. Maturities up to one year - 91, 182, 364
days. Treasury bills are redeemed at face value. T-bill rates are less than the rates
available eon other money market securities because of their risk-free nature.

T-bills price is estimated using the following formula:

Y = (F-P)/P * 365/N * 100

Where Y = desired yield

F = Face value = 100
P = Price quoted, out of 100
N = maturity of the T-bills, e.g., 91 days

Example: Suppose the investor requires a return/yield of 15% on a 91days T-bills.

Compute bid price.

P = 96.4 per 100 TZS.

(ii) Negotiable certificate of deposits (CDs) are negotiable, meaning that they can be sold in
the open market before maturity.

(iii) Commercial paper refers to a short-term, unsecured promisory note often issued by
large, well-known, and financially strong company. Commercial papers are usually
sold at discount either directly by the issuer or indirectly through a dealer. Commercial
paper is rated by rating services as to quality relative probability of default by the
issuer.

(iv) A securities repurchase agreement (repo) is an arrangement involving the sale of

securities at a specified price with a commitment to repurchase the same or similar
securities at a fixed price on a specified future date. A repo viewed from the point of
view of the cash provider is called a reverse repo, i.e., security purchased under
agreement to resell at given price in future.
(v) A banker’s acceptance (BAs) is a short-term, non-interest-bearing notes, drawn on and
accepted by commercial banks, sold at a discount and redeemed at maturity for full face
value. BAs are primarily used to finance foreign trade.

(c) Capital Market Securities

Capital market securities encompass fixed-income and equity securities with maturities
greater than 1 year and those with no maturity at all. Fixed-income securities promise to
pay specific amount at specified dates. Risk in the capital markets is often higher than in
the money market because of the time to maturity. The capital market includes both
debt and equity securities. Common investment vehicles include: (i) bonds, (ii) Asset-
backed securities, (iii) equity securities, and (iv) derivative securities.

(i) Bonds can be described as long-term debt instrument representing the issuer’s
contractual obligation, or IOU. The bond issuer agrees to pay interest on this loan and
repay the principal at a stated maturity date. Bonds are fixed-income securities because
the interest payments (for coupon bonds) and the principal repayment for a typical
bond are specified at the time the bond is issued and fixed for the life of the bond. Zero
coupon bonds are sold with no coupons at a discount and redeemed for face value at
maturity.

(ii) Asset-backed Securities (ABS) refers to securities issued agMainst some type of
asset-linked debts bundled together, such as credit card receivables or mortgages.

(iii) Equity securities equity securities represent an ownership interest in a company.

Equity securities provide a residual claim on the income and assets of a company.

(d) Derivative Securities

Derivative securities (also known as contingent claims) are securities that derive their
value in whole or in part by having a claim on some underlying security or basket of
securities. The most common derivative securities are options and futures. An option on a
security gives the holder the right to buy (a call option) or sell (a put option) a particular
asset or set of assets at a future date or within a specified period at a specified price. A
future is an obligation to buy a particular asset or bundle of assets at a currently
determined market. Price. Future and options represent side bets on the performance of
particular securities. In trading futures, the profit or loss to seller is exactly equal to the
loss or profit of the buyer.

1.2.3.2 Securities Investment - Indirect Investing

Indirect investing in securities refers to the buying and selling of shares of investment
companies (mutual funds) that, in turn, hold portfolios of securities, relieving the
individual investor from making decisions about the portfolio. Investment company
shareholders pay the costs of having money management professionals manage a
mutual fund or similar portfolio, and share the benefits or losses derived from portfolio
of securities being managed. Mutual funds are of two major types: (i) open-end fund
and (ii) closed-end fund.

(i) An open-end fund is an investment company whose capitalisation constantly changes

as new shares are sold and outstanding shares are redeemed. A close example of an
open-end fund in Tanzania is the Umoja Fund Unit Trust Scheme managed by the Unit
Trust of Tanzania. The scheme’s objective is to achieve a diversified portfolio that
would provide capital growth and regular income to investors.

(ii) A closed-end is an investment company with a fixed capitalisation whose shares trade
on exchanges.

1.2.3.3 Investing in Real Estate

Real estate differs from security investments in that it involves ownership of a tangible
asset or real property rather than a financial claim. Real Estate investments may be
classified into two broad categories: (a) Income Properties and (b) Speculative
Properties.

(a) Income Properties refers to the residential and commercial properties that are leased
out and expected to provide returns primarily from period of rental income.

For most individuals, a residential house is the most important asset. Estimation of total
return from residential property involves estimation of rental savings plus capital
appreciation. Further, ownership of a residential property provides psychological
satisfaction for individual investors. Residential property investments often require
availability of large outlay which is often difficult to be raised by an individual in the
short run. Indeed, difficulty in obtaining loans for residential property investment is
often blamed for underdeveloped of residential property investment in Tanzania.

Commercial properties include office buildings, shopping centres, warehouses, factories

and so on. Investors are interesting in investing in commercial property due to mainly
in the form of regular rental income which can be revised upward periodically.

(b) Speculative Properties include raw land and investment properties that are expected
to provide returns primarily from appreciation in value due to location, scarcity and so
on.

1.2.4 Conclusion
In this chapter we have discussed a number of important issues in connection with
investment planning and management as a field of study and major classes of
investment. Investment planning involves decision on the allocation of portfolio across
alternative asset classes considering the legal and policy constraints facing the investor.
Investment management involves determination investment objectives, adopting and
executing strategies to optimise results considering the risks involved, and evaluating
performance periodically.

1.3. ORGANIZATION AND FUNCTIONING OF SECURITIES MARKETS

1.3.1. Introduction
The main purpose of this section is to explain how and where securities are traded, and
introduces much of the terminology of security trading. It shows the difference between
primary and secondary markets, the mechanism for short sales, the difference between
dealer marker and an exchange market, types of orders and the difference arrangements
with investment bankers that can be made when issuing new securities.

1.3.2. Meaning of security and security market

A security is a financial instrument that represents an ownership position in a publicly-
traded corporation (stock), a creditor relationship with governmental body or a
corporation (bond), or rights to ownership as represented by an option. A security is a
fungible, negotiable financial instrument that represents some type of financial value.
The company or entity that issues the security is known as the issuer.

Securities market is a component of the wider financial market where securities can be
bought and sold between subjects of the economy, on the basis of demand and supply.
Primary markets, where new securities are issued and secondary markets where
existing securities can be bought and sold.

1.3.3. Characteristics of a well-functioning securities market

A well-functioning securities market will offer the following characteristics:
 Timely and accurate information on the price and volume of past
transactions and on current supply and demand conditions.
 Liquidity (the ability to buy or sell quickly at a known price), which
requires marketability (the ability to sell the security quickly) and price
continuity (prices don’t change much from one transaction to the next in
the absence of news).
 Internal efficiency refers to low transaction cost.
 Informational (external) efficiency, which means that prices adjust
rapidly to new information so the prevailing market price reflects all
available information regarding the value of the assets.

1.3.4. Distinction between primary market and secondary capital markets

Primary capital market refers to the sale of new issues of securities. Most issues are
distributed with the aid of an underwriter. The underwriter provides three services to
the issuer:
i. Origination, which involves the design, planning and registration of the
issue.
ii. Risk bearing, which means the underwriter insures or guarantees the price
by purchasing the securities.
iii. Distribution, which is the sale of the issue.

New equity issues involve either:

 New shares issued by firms whose shares are already trading in the
marketplace. These issues are called seasoned or secondary issues
  First time issues by firms whose shares are not currently trading in the
marketplace. These are called initial public offerings (IPOs).

Secondary financial markets are where securities trade after their initial
offerings. Secondary markets are important because they provide liquidity.
The greater liquidity the securities have, the more willing investors are to
buy the securities. Liquid secondary markets also provide investors with
continuous information about the market price of their securities. The better
the secondary market, the easier it is for firms to raise external capital in the
primary market.

1.3.5. Types of orders

There are four types of orders namely market orders, limit orders, short sale
orders and stop loss orders.
i. Market orders are orders to buy or sell at the best price available.

ii. Limit orders are orders to buy or sell that specify a maximum or minimum
price. A limit buy typically has a limit below the current price. A limit sell
order typically has a limit above the current price. Limit orders have a
time limit, such as instantaneous, one day, one week, one month etc. A sell
order with a limit of Tshs.500 will execute only if a buyer will pay
Tshs.500 or more. A buy order with a limit of Tshs.500 will be executed
only at a price of Tshs.500 or less.

iii. Short sale orders are orders where a trader borrows stock, sells it and then
purchases the stock later to return the stock back to the original owner.

iv. Stop loss orders are used to prevent losses or to protect profits. Suppose you
own a stock currently selling at Tshs.400. You are afraid that it may drop
in price, and if it does, you want your broker to sell it, thereby limiting
your losses. You would place a stop loss sell order at a specific price (e.g.
Tshs.350), if the stock price drops to this level, your broker will place a sell
market order. A stop loss buy order is usually combined with a short sale
to limit losses. If the stock price rises to the “stop” price, the brokers enters
a market order to buy the stock.
Process of selling a shock short
Short sales are orders to sell securities that the seller does not own. For a short
sale, the short seller should to the following:-
i. Simultaneously borrows and sells securities through a broker.
ii. Must return the securities at the request of the lender or when the short
sale is closed out.
 iii. Must keep a portion of the proceeds of the short sale on deposit with the
broker.
Why would anyone ever want to sell securities short?
The seller thinks the current price is too high and that it will fall in the future, so
the seller hopes to sell high and then buy low. If the short sale is made at
Tshs.300 per share and then the price falls to Tshs.200 per share, the short seller
can buy shares at Tshs.200 to replace the shares borrowed and keep Tshs.100 per
share as profit.

Three rules apply to short selling:-

i. The uptick rule states that stocks can only be shorted in an up market.
Thus, a short sale can only trade at a price higher than the previous trade.
Zero ticks, where there is no price change, keep the sign change of the
previous order.
ii. The short seller must pay all dividends due to the lender of the security.
iii. The short seller must deposit collateral to guarantee the eventual
repurchase of the security.
1.3.6. Process of buying stock on margin
Margin transactions involve buying securities with borrowed money. Brokerage firms
can lend their customers money and keep the securities as collateral. The required
equity position is called Margin requirement.

A Margin Requirement is the percentage of marginable securities that an investor must

pay for with his/her own cash. It can be further broken down into Initial Margin
Requirement and Maintenance Margin Requirement. According to Regulation T of the
Federal Reserve Board, the Initial Margin requirement for stocks is 50%, and the
Maintenance Margin Requirement is 25%, while higher requirements for both might
apply for certain securities.

Initial Margin Requirements is the percentage of the purchase price of securities (that
can be purchased on margin) that the investor must pay for with his own cash or
marginable securities.
Maintenance Margin Requirement is the minimum amount of equity that must be
maintained in margin account.
Example: Return on margin trade
Assume that an investor purchases 100 shares of stock for Tshs.75 per share (Total cost
of Tshs.7,500). Compute the investor’s return if the stock is sold for Tshs.150 per share
(Total value of Tshs.15,000) and the transaction was:-
a) 100% cash
b) A margin purchase with an initial margin requirement of 60%
Answer:
a) As a 100% cash (equity) transactions, the investor would have a return equal to:
= (Tshs.15,000/Tshs.7,500 – 1 ) x 100
= 100%

b) With an initial margin of 60%, the cost of investment (equity in the position) would be
only Tshs.4,500 = 0.6 x (Tshs.75 x 100). The other Tshs.3,000 of the purchase will be
borrowed from the brokerage firm. If the shares where then sold at Tshs.150 per share,
the position would be worth Tshs.12,000 (Tshs.15,000 – Tshs.3,000). In this situation, the
investor would have a return equal to:
=[(Tshs.12,000 – Tshs.4,500) – 1] x 100 = 167%

Note: the calculated return in this example is artificially high because they ignored
commission and interest paid on the margin loan

Margin Call
A margin call is a broker’s demand on an investor using margin to deposit additional
money or securities so that the margin account is brought up to the minimum
maintenance margin. Margin calls occur when the account value depresses to the value
calculated by the broker’s particular formula.

An investor receives margin call from a broker if one or more of the securities he had
bought with borrowed money decreases value past a certain point. The investor must
either deposit more money in the account or sell off some of his assets.

Example;
Consider an investor who buys Tshs.1,000,000 of stock by using Tshs.500,000 of his own
funds and borrowing the remaining Tshs.500,000. The investor’s broker has a
maintenance of 25% with which the investor must comply.

At the time of purchase, the investor’s equity is Tshs.500,000 (the market value of
securities of Tshs.1,000,000 minus the broker’s loan of Tshs.500,000) and the equity as a
percent of the total market value of the securities is 50% ( the equity of Tshs.500,000
divided by the total market value of securities of 1,000,000), which is above the
maintenance margin of 25%.

Suppose that on the second trading day, the value of the purchased securities falls to
Tshs.600,000. This results in the investor’s equity of Tshs.100,000 (the market value of
Tshs.600,000 minus the borrowed funds of Tshs.500,000). However, the investor must
maintain at least Tshs.150,000 of equity (the market value of securities of Tshs.600,000
times the 25% maintenance margin) in his account to eligible for margin, resulting in a
Tshs.50,000 deficiency.
The broker makes a margin call, requiring the investor to deposit at least Tshs.50,000 in
a timely manner, his broker can liquidate securities for the value sufficient to bring his
account in compliance with maintenance margin rule.

Alternatively, the following formula may be used to indicate the stock price at which
the margin account is just at the maintenance margin.

Trigger price = P0 (1- Initial Margin/1 – Maintenance margin)

Where;
P0 = Initial purchase price

Example on marginal call price

Assume you bought a stock Tshs.400 per share. If the initial margin requirements is 50%
and the maintenance margin requirement is 25%, at what price will you get a margin
call?
Answer
Tshs.400 (1-0.5)/ (1-0.25)
= Tshs.266.67
The margin call is triggered at a price below Tshs.266.67

1.4. EFFICIENT CAPITAL MARKETS

1.4.1. Introduction
Market efficiency is a key concept, it has been tested extensively and has important
implications for investment strategy. You must know the three forms of market
efficiency and what the evidence from the tests of the three forms has been. Know the
types of tests for the various forms of the market efficiency. Finally, you must
understand the implications of the various forms of market efficiency for technical
analysis, fundamental analysis, and the role of portfolio managers in the investment
process.

1.4.2. Efficient Capital Market

An efficient capital market is one in which the current price of a security fully reflects all
the information currently available about that security, including risk. An
informationally efficient capital market is one in which security price adjust rapidly and
completely to new information. Market efficiency is based on the following set of
assumptions:
 A large number of profit maximizing participants are analyzing and valuing
securities independent of each other.
 New information comes to the market in a random fashion and news
announcement are independent of each other in regard to timing.
 Investors adjust their estimates of security prices rapidly to reflect their
interpretation of the new information received. Market efficiency does not
assume that market participants correctly adjust prices, just that their price
adjustments are unbiased. Some prices will over-adjust, and will under-adjust.
 Expected returns implicitly include risk in the price of the security.
Under these assumptions, the competitive behavior of this large group of market
participants should cause rapid price adjustments in response to any newly realized
information. The new price will reflect investors’ new estimates of the investment’s
value and riskiness.

1.4.3. The Three Forms of the Efficient Market Hypothesis (EMS)

In an influential academic paper, Eugen Fama divided the efficient market hypothesis
(EMH) into three categories.
1. Weak-form efficient markets. The weak form of the EMH states that current stock
price fully reflect all currently available security market information. Thus, past
price and volume information will have no predictive power about the future
direction of security prices. The conclusion is that an investor cannot achieve
excess returns using technical analysis.

2. Semistrong-form efficient markets. The semistrong form of the EMH holds that
security prices rapidly adjust to the arrival of all new public information. As
such, current security prices fully reflect all public available information. The
semistrong form says security prices include all security market and nonmarket
information available to the public. The conclusion is that an investor cannot
achieve abnormal returns using fundamental analysis.

3. Strong-form efficient markets. The strong form of the EMH states that the stock
prices fully reflect all information from public and private sources. The strong
form includes all types of information: market, nonmarket public and private
 (inside) information. This means that no group of investors has monopolistic
access to information relevant to the formation of prices, and none should be able
to consistently achieve abnormal returns.
Remember;
As a base level knowledge of the EMH, you should know that weak form addresses
security market information, the semistrong form addresses security market
information and nonmarket public information and the strong form addresses security
market, nonmarket, and inside or private information.

1.4.4. The tests used to examine each of the three forms of the EMH
Since the efficient market hypothesis has a major implications as to the value of security
analysis, there have likely been more academic studies in finance on the topic of market
efficiency than any other single area.

Weak-Form Tests of the EMH

There have been two types of tests of the weak form of the EMH, statistical tests and
trading rule tests.

Statistical tests for independence. The weak form contends that, over time, security
returns are independent of each other Statistical tests have been conducted to test for
this independence.
 Autocorrelation tests indicate that security returns are not significantly
correlated over time.
 Runs tests also indicate that stock price changes (upticks and downticks) are
independent over time.
Trading rule tests. A lot of EMH studies have been conducted to see if investors can
earn abnormal returns following mechanical trading rules (filter rules) based on price
data.
 Tests of filter rules show that investors cannot earn abnormal returns accounting
for the impact of transactions costs. (Filter rules entail trading stocks when prices
move up or down certain amount)
 Researchers have tested other trading rules and generally found that such
activity does not outperform a buy-and-hold policy on a risk adjusted basis after
taking accounts for commissions.

Semistrong-Form Tests of the EMH

Semistrong-form tests require that security returns be adjusted to reflect market returns
and risk.
Early tests looked at a security’s performance in excess of the market return. Abnormal
returns were measured as the stock’s actual return less the market’s actual return.

Abnormal return = R(Actual) – R(Mkt)

Later tests looked at the security at the security’s performance in excess of market
returns adjusted for the security’s volatility (beta risk). Abnormal returns are measured
as the stock’s actual return less the stock’s expected return based on its beta risk.

Abnormal return = R(Actual) – E (R )

= R (Actual) – [RFR + β[E{Rmkt) – RFR}]

Example of Abnormal returns

A stock has a 10% return when the market return is 5% and the risk-free rate (RFR) is
2%. The stock beta is 1.2. Compute the unadjusted and adjusted abnormal return for
this security.

Answer:
a) The stock’s non-risk adjusted abnormal return is 10% - 5% = 5%
b) The stock’s risk adjusted abnormal return is 10% - {2% + 1.2(5% - 2%)} = 4.4%
Returns prediction studies to test the semistrong form of the EMH include time-series
tests and event studies.
Time-series tests are based on the assumption that, in efficient markets, the best
estimate of future returns is the long-run historical rate of return. So if markets are
semistrong-form efficient, an investor should not be able to improve upon these
estimates in the short or long term.

Event studies examine abnormal returns before and after the release of information
about a significant firm-related event. The hypothesis is that investors should not be
able to earn positive abnormal returns on average by buying or selling based on types
of firm events.

Cross-sectional tests of the semistrong-form of the EMH are based on the assumption
that markets are efficient when all securities’ returns lie along the security market line.
That is, a security’s rate of return should be directly related to its level of market risk
(i.e., beta). So after adjusting returns for risk, all securities returns should be equivalent
or comparable.
The hypothesis is that firm characteristics such as size, analyst coverage or book value
to market value ratios should not be useful in predicting abnormal returns.
Note that the results of these tests depend on the effectiveness of the asset pricing
model employed.

Strong-Form Tests of the EMH

In addition to informational efficiency, the strong-form EMH implies that no group of
investors has access to private information that would allow the group to consistently
experience above-average profits. (This implies perfect markets in addition to efficient
markets.).

Academic tests of the strong form look at the legal use of private information and
excluded illegal insider trading. The reported tests identify and study four groups of
investors who are expected to be able to outperform the market, or who claim to be able
to do so because of their access to private information.

Insider trading. Tests of Security Exchange Commission (SEC) insider trading filings
indicate that inside purchasers have made above average profits. Other tests show that
public traders tracking the purchases of insiders via SEC filings were able to earn excess
returns. However, studies conducted in 1976 indicate that this inefficiency seems to
have been eliminated.

Exchange specialist. Stock exchange specialist, by the very nature of their membership
on the exchange, have access to information in the limit order book that is only
available to them. Tests show that specialists derive above-average returns from this
information.

Security analyst. Some strong-form tests have addressed the question on whether
analyst and their advice can provide excess returns. These tests are based on the
assumption that analysts may have information that the rest of the market does not
have.
 The Value Line (VL) enigma. Studies indicate that VL rankings of 1 and 5 contain
significant information (Stocks rated 1 are the most attractive). Changes in the
rankings from 2 to 1 also appear to be significant. Recent studies, however, show
that any information in the VL reports is already reflected in price by the second
day after publication.
 Analyst recommendations. Studies of the “Heard on the Street” column in the Wall
Street Journal show that stocks have a significant price change on the day they
appear in the column.
Professional money managers. Tests indicate that mutual funds, bank trust department,
pension plans, and the endowment funds are not match the performance of a simple
buy-and-hold policy.

Overall Conclusions about the EMH

Most, but not all, evidence generated by testing the weak form of the EMH indicates
indicate that, after incorporating trading costs, simple trading rules cannot generate a
positive abnormal returns on average. Hence the result support the weak-form of the
EMH.
The results are mixed for the semistrong form of the EMH. Event studies strongly
support the EMH, while time series and cross-sectional tests give evidence that markets
are not always semistrong-form efficient.

Aside from the results on corporate insiders and specialists, the tests support the strong
form of the EMH. It appears that corporate insiders and exchange specialist have
monopolist access to highly valuable information.

1.4.5. Various Market Anomalies and Their Implication for the EMH
An anomaly is something that deviates from the common rule. The common rule here is
the efficient market hypothesis. Tests for the EMH are frequently called “anomaly
studies” so in the efficient market literature, an anomaly is something that helps to
disprove the efficient market hypothesis.

The following are documented market anomalies

1. Earnings surprises to predict returns. Studies of quarterly reports indicate that the
markets have not adjusted stock prices to reflect the release of quarterly earnings
surprises as fast as would be expected based on the semistrong EMH. As a results, it
appears that earnings surprises can be used to identify individual stocks that will
produce abnormal returns.

2. Calendar studies. The “January anomaly” shows that, due to tax-induced trading
at year-end, an investor can profit by buying stock in December and selling them
during the first week in January. The “Weekend effect” show that the average
return for weekdays is positive but that a negative return is associated with the
Friday close to the Monday open. Also, the prices tend to rise on the last trade of
the day.

3. Price - earnings ratio (P/E) tests indicate that low P/E ratio stocks experienced
superior results relative to market, while high P/E ratio stocks have significantly
inferior results.

4. Small firm effect. Small firms consistently experienced significantly larger risk-
adjusted returns than larger firms. This is called small firm effect. Many
academics claim these results reflect the inability of the assets pricing model to
provide a complete measures of risk for small-firm stocks.

5. The neglected firm effect is a result of tests of the small firm effect. Small firm tests
also found that firms that have only a small number of analysts following them
have abnormally high returns. These excess returns appear to be caused by the
lack of institutional interest in the firms. The neglected firm effect applies to all
sizes of firms.
 6. Book value/market value ratios have been associated with abnormal returns. It has
been found that the greater the ratio of book value/market value, the greater the
risk adjusted rate of return, regardless of the firm size.

1.4.6. The implications of stock market efficiency for technical and fundamental
analysis
If weak-form market efficiency holds, technical analysis (based on past price and
volume information) has no value, and it cannot be used to earn positive abnormal
returns on average.

If semistrong-form efficiency and strong efficiency hold, neither technical nor

fundamental analysis has any value because both are based on public information.
Remember, semistrong-form efficiency is based on market information and other
available information, so it includes weak-form efficiency.

1.4.7. Implication of efficient market on the portfolio management process and the
role of the portfolio manager
Portfolio management. In an efficiency market, portfolio managers must create and
maintain the appropriate mix of assets to meet their clients’ needs. In other words,
portfolio management should be centered on client objectives and constraints and the
construction of the appropriate portfolio through effective assets allocation decisions.

Portfolio managers should help:

 Quantify their clients’ risk tolerance and return needs within the bounds of the clients’
liquidity, income, time horizon, and legal and regulatory constraints.
 Verbalize their clients’ portfolio policies and strategies needed to meet the clients’ needs,
then construct an optimal portfolio by allocating funds between financial and real assets.
This is referred to as assets allocation.
 Diversify their clients’ portfolio (on global basis) to eliminate unsystematic risk.
 Monitor and evaluate changing capital market expectations as they affect the
risk/returns expectations of the assets in the clients’ portfolio.
 Monitor their clients’ needs and circumstances.
 Rebalance their clients’ portfolio when changes are necessary.

1.4.8. Limitations to achieving fully efficient market

There are three primary limitations on the market’s ability to produce informationally
efficient prices.
1. Processing new information has costs and time consuming. If market prices are
efficient, there are no returns to the time and efforts spent on fundamental
analysis. But, if no time and efforts spent on fundamental analysis, there is no
process for making market price efficient. We can resolve this apparent
conundrum by looking to the time lag between the release of new value-relevant
information and the adjustment of market prices to their new efficient levels.
 There must be an adequate return to fundamental analysis and trading based on
new information to compensate analysts and traders for their time and efforts.
Those who acts rapidly and intelligently to the release of information will be
rewarded. If the stock prices adjust to their new efficient levels within minutes or
hours of the release of information, we can consider markets to be efficient. If this
price – adjustment process takes days or weeks, stock prices are not efficient. In
this period we expects that more activity by analyst, traders and arbitrageurs will
tend to reduce the adjustment period over time.

2. Market prices that are not precisely efficient can persist if the gains to be made
by information trading are less than the transaction costs such trading would
entail. In general, for securities with larger transactions costs, the deviation from
informationally efficient prices should be greater. For example, the difficulties
associated with short sale can be viewed as relatively high transaction costs.

3. There are limits on the ability of the process of arbitrage to bring about
efficient market. Information-based arbitrage strategies are not riskless and
there is no guarantee that prices will move to more rational levels over the near
term or that such strategies will consistently perform well. Arbitrageurs have
limited capital and so pursue only the most attractive opportunities, and have
constraints imposed on them by the suppliers of investment capital.