Forum 6 & 7

Posted: October 17th, 2013

Forum 6 & 7

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Forum 6 & 7

The efficient market hypothesis is interpreted in a weak form, a semi-strong form, and a strong form. How can we differentiate its various forms?

Weak form suggests that markets are efficient, and it is not possible to predict the future prices of stocks using the past information of market statistics such as stock prices and returns. The stock prices change at random, and they depend on the information available. Information concerning different assets arrives randomly, and this makes it difficult to determine prices using the past information. Anyone intending to predict the stock prices must base their information on other sources other than the past prices. This form of market efficiency is related to technical analysis. It questions this analysis because of the ability of the share prices to move randomly. Semi-strong form consists of all the information that is available publicly. The stock prices respond quickly, and almost immediately to any new public information about the asset. Fundamental analysis seeks to identify the identities that are overvalued or undervalued by studying the information that is available publicly. It is not possible to achieve excess returns in this form of market efficiency using fundamental analysis. Investors cannot depend on the public information that they receive. They cannot determine a way to benefit from this information because it travels fast and inconsistent. Stock prices using the strong form market efficiency incorporates any available information, including inside information. Any private or public information will affect the stock prices. Investors with insider information have some advantages over the others, because they can benefit from selling or holding the shares depending on the information that they have. However, doing taking such an action would constitute insider trading, a practice that is illegal in many countries (Ogilvie, 2008). In countries where insider trading or dealings are legal, the investors benefit a lot because they are able to know when to make a profit, or when to avoid making a loss.

Discuss the relationship between bond prices and interest rates. What impact do changing interest rates have on the price of long-term bonds versus short-term bonds?

Bonds and interest rates have an inverse relationship in that interest rates rise when the prices of outstanding bonds fall, and they fall when the bond prices increase. There is a difference between the rates of interest on long term and short-term bonds. Long-term bonds are more sensitive to changes in interest rates compared to short-term bonds. Interest rates have little or no effect on short-term bonds. There is minimal price volatility on the bonds since it takes the bonds a short time to mature. This is different for the bonds with a longer maturity rate. The bonds have more years to earn the interest. The interest rates will change and the prices will be more volatile during this time. Interest rates are higher on long-term bonds than on bonds that mature within a short period. This is because the longer the maturity, the longer it will take the insurer to pay off the bond. Purchasing short-term bonds will minimize the interest rate risk, but it will also lead to fewer profits for the investor. A long-term bond has a greater leverage effect in the change of the interest rates on its price. A rise in the interest rates of a long-term bond will lead to a greater decline in the bond prices compared to the same change of interest rates of a short-term bond. A decrease in the interest rates of a long-term bond will lead to a greater increase in the price of a long-term bond, than would have the price of a short-term bond (Boston Institute of Finance, 2005).

References

Boston Institute of Finance (2005). The Boston Institute of Finance mutual fund advisor course: Series 6 and series 63 test prep. Hoboken, NJ: John Wiley & Sons

Ogilvie, J. (2008). Management accounting: Financial strategy. United Kingdom: Elsevier