The Relevance of Efficient Capital Markets

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Scholes, Myron. "The pricing of options and corporate liabilities." Journal of political Economy 81.3 (1973): 637-654.

Call options are the rights of buying the underlying assets at an agreed time and a specified time. There exist two different types of "call options," and they include the American, executed at all time until its expiry date and the European, only applied on specified future time. Investors can also see corporate liabilities as a combination of options, and this allows the method of analysis and the used valuation formula to apply for accounts such as corporate bonds, common stocks and warrants.

The relationship between the price and the call option is directly proportional, that is, the more the stock’s price, the exceptional the option value. However, a change in stock price at a constant maturity date also causes a tremendous variation in the benefit of options. Nonetheless, at equilibrium, the returns should be equal to that of a riskless asset.

Some of the primary advantages of dealing with options include having higher returns in a less risky situation as compared to other methods such as equity. Again, they help in providing cost efficiency due to a greater leveraging power, which can assist an investor to obtain an option position similar to that of stock, but at a considerable cost saving. Again, they offer different strategic alternatives as they are flexible in creating synthetics which an investor can utilize differently to achieve the investment objective. The relevance of this point is that understanding the analytic methods and options pricing shapes the trading plans, and can help investors to trade intelligently and carefully. The formula used to test these options usually differ from the real price at which the options are sold or bought, and they deviate depending on the systematic ways from the formula’s expected value.

Miles, James A., and John R. Ezzell. "The weighted average cost of capital, perfect capital markets, and project life: a clarification." Journal of financial and quantitative analysis15.3 (1980): 719-730.

In helping the financial management to make budgeting decisions of wealth-maximizing capital, a model is required to account for the effect of both investment and financing decisions and their interactions. The price of the levered cash flow streams of a project equates to the value at the market of unlevered stream plus the saving of the tax on the interest expense related to debts used in financing the project. Some of the valuation model used in this case includes the Modigliani And Miller's (MM) which analyzes the normative capital budgeting through the Adjusted Present Value Model (MM-APV). Another method is the textbook approach, utilized when the risk of the project is at the same level as the portfolio of the firm concerning the existing investment.

The importance of the wealth-maximizing capital budgeting decisions is that they provide adequate details of measuring the possible risks and potential returns from investment. A business can lose the trust of shareholders if it invests without determining the effectiveness of allocating the resources, as making poor decisions can significantly affect the entire company. The relevance of taking this decision is that they draw a clear path at which an investment shall follow. Capital budgeting decisions are entirely irreversible, and if the project fails to proceed, the only solution is to scar the assets at a considerable loss, and therefore, every investor should have a chance to understand the business, and this makes the paper more relevant.

The paper concludes by stating that MM-APV and textbook approach depends on the debt repayment schedule or the leverage ratio exogenous to the known market values. MM-APV is neutral to the financing policy of a firm, while the textbook allows a firm to value the debt tax benefits through discounting the unlevered cash flows.

Malkiel, Burton G., and Eugene F. Fama. "Efficient capital markets: A review of theory and empirical work." The journal of Finance 25.2 (1970): 383-417.

Efficient capital market

An ideal market is the one where the exchange can determine the production and investment conclusions and also allow stakeholders to select among the securities that describe the claim of activities of a given firm. The theory of efficient market concentrates more on whether charges “fully reflect” the obtainable information, and the approach has much empirical content that assumes that the equilibrium of the market conditions is stated based on the reported expected returns. The test divides the empirical information into strong, semi-strong and weak forms. Through the found statistical evidence for dependence on changes of price or returns, some of the achieved details seem consistent with the fair game model.

The importance of these efficient markets model is that they allow one to familiarize with how markets do not operate. Again, the dynamic pricing of returns and pricing is also critical as a prerequisite for participating in market environments and therefore investors have to understand this information.

The relevance of this point is that there exists positive dependence on daily price or return changes in the common market as well as dependence usable on the rules of marginally profitable trading. However, the evidence supporting the efficient markets model is widespread while the different proof is sparse and that means that much needs to be done here since the literature on efficient market models has become a significant contributing power in the current financial markets.

The paper concludes that specialists and cooperate insiders are the only group with documented monopolistic access to information. Moreover, there exists no evidence to suggest that deviations from the strong model fail the investment population, therefore, for the sake of investors, the efficient markets model seems reasonable as it is almost the reality.

January 19, 2024




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