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Financial Markets

Question 1
Asymmetric information
Asymmetric information is a situation where there is imperfect knowledge. In particular it
occurs where one party has different information to another. A good example is when selling a
car, the owner is likely to have full knowledge about its service history and likelihood to break
down. The potential buyer, by contrast, will be in the dark and he may not be able to trust the car
Asymmetric information is a problem in financial markets such as borrowing and lending. In
these markets the borrower has much better information about his financial state than the lender.
The lender has difficulty knowing whether it is likely the borrower will default. To some extent
the lender will try to overcome this by looking at past credit history and evidence of his salary.
However, this only gives limited information. The consequence is that lenders will charge higher
rates to compensate for the risk. If there was perfect information, banks wouldn't need to charge
this risk premium.
Moral hazard

Moral hazard is the idea that, under certain circumstances, individuals will alter their
behaviour and take more risks. Moral hazard can occur if there is information asymmetry or a
contract affects the behaviour of two different agents. Krugman (2009) defines Moral hazard as
the risk that a person has the incentive to take greater risks before the completion of the contract,
any situation in which one person makes the decision about how much risk taking, while
someone else bears the cost if things go badly. One example of bank bailouts and moral hazard is
presented as following. If a manufacturing company goes bankrupt, the government will not
intervene. Therefore, they have an incentive to avoid taking unnecessary risks. However,
generally governments feel they have to bailout banks to prevent a collapse in confidence in the
banking industry. Therefore, banks may change their behaviour and take more risks. Sometimes
people argue we shouldnt bailout banks because this creates future moral hazard. If we always
bail them out, they will repeat the risky mistakes later.
Financial regulation
One main cause for the tighter regulations has been the continual problem of asymmetrical
information or the lack of proper data to make sound and accurate decisions by individuals or
firms. Consumers are forever under the prey of moral hazards, which for example could be the
improper or risky-ness of fund usage without the fund suppliers consent. The above would
cause or lead to further economic problems later. For instance during the 1990s with the
liberalization of the financial sector of many Asian nations, Thailand, South Korea, Malaysia,
their banks began to lend out tremendous amounts of money for real estate development or other
ventures. Without proper expertise and lack of sufficient data about their borrowers pasts, many
loans turned out badly. Many banks or financial companies suffered great losses as a result. This
increased the uncertainty in the financial markets, which led to substantial declines in their
securities markets. With asymmetrical information, and the blurred line between a financially
sound bank and a debt-reddened one, consumers assumed the worst and started a mass
withdrawal. A bank run ensued. Many banks folded and the governments started to have to bail
out them out, and with governments lacking enough funds, devaluations might have been
considered by them. This added to currency speculations by financial moguls, eventually led to
the ruins of many economies.

It is therefore necessary for governments to provide the legislation and facilities for proper
financial regulations. For instance, banks should be required by law to disclose their activities.
Bank balance sheets checked regularly and prevented from undertaking risky ventures in real
estate or junk bonds. A minimum reserve requirement or ration must set up to ensure consumer
protection and pacify their fears of banking systems.
Question 2
There are two different types of currency exchange rates. Spot exchange rates are the rates
that are applicable for purchase and sale of foreign exchange on spot delivery basis or immediate
delivery basis. Although, the term spot denotes immediate happening and closing of transaction,
practically it takes two business days for a spot exchange transaction to get settled. So, we can
say that the Spot rate is the rate of exchange of the day on which the transaction has occurred and
of the days the execution of the transaction is taking place. Forward exchange rates, in contrast,
are the rates that are applicable for the delivery of foreign exchange at a certain specified future
date. This is a way by which uncertainty and risk could be avoided in dealing with foreign
exchange transactions. Forward rates may be greater than the current spot rate or less than the
current spot rate. The forward exchange rate of a currency will be slightly different from the spot
exchange rate at the present date due to uncertainties and future expectations.
The foreign spot rate is determined by supply and demand. Banks all over the world are
buying and selling different currencies to accommodate their customers' requirements for trade
or to exchange one currency into another. For example, an American bank receives a deposit
from a German bank on behalf of their client who wants to buy something from a company in
America. The German client has to pay the American supplier in dollars. The German client has
euros and these euros need to be exchanged then for dollars. The German buyer will instruct his
bank to exchange the euros to dollars and transfer the money to the U.S. supplier. If the bank
doesn't have a supply of dollars, it will buy the dollars from another bank and sell euros. The
sum total of all banks selling dollars and all banks buying dollars creates a supply and demand
for U.S. Dollars. If the demand for dollars increases then the dollar will appreciate against other
currencies. If the demand drops then the dollar depreciates against the other currencies. The rates

are set by all the participating banks bidding and offering currencies all day long amongst each
other. This is the interbank system and is the way currencies are traded and the way exchange
rates are determined.
The forward exchange rate is determined by a parity relationship among the spot exchange
rate and differences in interest rates between two countries, which reflects an economic
equilibrium in the foreign exchange market under which arbitrage opportunities are eliminated.
When in equilibrium, and when interest rates vary across two countries, the parity condition
implies that the forward rate includes a premium or discount reflecting the interest rate
differential. Forward exchange rates have important theoretical implications for forecasting
future spot exchange rates. In fact, forward rates can be calculated from spot rates and interest
rates using the formula:

Where S is the spot rate and F the forward rate, and r
and r
are foreign currency interest rates
and domestic currency interest rates respectively.
Question 3:
Forms of market efficiency
Weak form of market efficiency is when past information related to prices is fully reflected in
the current market prices and hence it cannot be used to earn excess return. Weak form of market
efficiency is the weakest form of efficient market hypothesis (EMH). Semi-strong form of
market efficiency and strong form of market efficiency are the two other forms of efficient
market hypothesis. Weak form of market efficiency implies that technical analysis cannot be
used to predict future price movements. Technical analysis is the use of past price movements to
predict future price fluctuations. However, in the weak form of market efficiency, fundamental
analysis and non-public information can be used to earn excess return. Analysts and economists
believe that most of the markets are at least weak-form efficient. The example of weak form
market efficiency is presented as follow: Prashant is a broker working at the Punjab Stock
Exchange. He has developed a recent interest in investments and has no prior experience. He
observed that the price of Mohali Sports Equipment drops on Monday and rises on Friday. On 7

January 2013, he purchased 100 shares of MSE's stock for 11 INR per share. He was quite
saddened to see that the price was 10.5 INR per share on Friday, 11 January 2013. The market
seems to be weak-form efficient, because it is not letting Prashant earn excess return by just
picking stocks based on some past price pattern.
Semi-strong form of market efficiency is when prices already reflect all publically available
information and it is not possible to earn excess return by fundamental analysis. Semi-strong
form of market efficiency lies between the two other forms of market efficiency, namely the
weak form of market efficiency and strong forms of efficient market efficiency. When a market
is semi-strong form efficient, neither technical analysis nor fundamental analysis can help predict
future price movements. However, non-public information can be used to earn above average
return. Many markets exhibit characteristics of semi-strong form of market efficiency. The
example of weak form market efficiency is presented as follow: Alex held 100 shares of Cure
Inc. which he had purchased on 1 January 2013 for $25 per share. Cure Inc. is a company
engaged in research and development of new antibiotics against resistant microbes. Alex is not
an active investor so he does not checks the stock performance daily. On 14 January 2012
(Sunday), he came across an article shared by his friend on Facebook. The article was published
on 11 January 2012 (Friday). According to the article, Cure Inc. has failed in a project worth a
net present value of $20 million. Total outstanding shares of Cure Inc. are 5 million. Alex sold
off his holding for $2,050 (at $20.5 per share) in the opening hours of 15 January 2012
(monday). He was glad that he minimized his loss but towards the end of 15 January 2012, the
company's stock price had even climbed to $21. He is wondering what happened. The market
seems to be semi-strong form efficient. The market had adjusted itself to the public information
on Friday (11 January 2012) as soon as the market came to know about it. Alex should not have
used this public information to project a decline on Monday. The drop in price is almost equal to
the net present value per share no longer available ($20 million divided by 5 million).
Efficiency of the London Stock Exchange
The London Stock Exchange (LSE), founded in 1801, is the fourth largest stock exchange in
the world and the largest in Europe (2011 figures). As one of the most international stock
exchanges in the world, with approximately 3,000 companies from over 70 countries listed, it is

a prime location for companies and investors to consider when looking for new opportunities.
However, prior to listing or investing, the efficiency of the market should be determined. To do
this we must first ask, what is a stock exchange?
A stock exchange, also known as a stock market, is an organised market in which industrial
and financial securities can be sold and purchase. They provide a convenient place for trading
securities in a systematic manner, and are indispensable for the smooth and orderly functioning
of the corporate sector within a free market economy.
It is argued in the efficient market hypothesis (EMH) that an efficient market is one in which
prices fully reflect all available information relating to a particular stock or market. Therefore, no
investor would have a competitive advantage over another and there would be no instances in
which a return on a stock price can be predicted, as no individual would have access to
information that others did not. But is this true of the LSE?
If the EMH is correct then the price of a share on the market should only change when
information is made publicly available. To test this theory, let's consider the share price for
Tesco in the few weeks prior to, and after, the announcement on 15th January 2013 that horse
meat was discovered in beef burgers on sale in Tesco stores.
As could be expected, Tesco's share price fell to it's lowest (347.1) for the period the day after
the announcement was made (16th January 2013). However, what is interesting is the decline in
share price from 10th January 2013. Between Tesco's announcement on 10th January that
Christmas sales were the best they had seen in three years, and the announcement of the horse
meat discovery, no other announcements were made which should have caused the decline. This
suggests the possibility that the information may have been made aware to some investors, prior
to the public announcement, therefore causing a premature decrease. This case isn't the only one
which disproves that the LSE does not follow the EMH. HMV's share price fell significantly,
prior to the announcement that they were going into administration, again suggesting that some
investors knew of the news before the actual announcement was made. So, if the LSE is not
efficient according to the EMH, to what extent is it efficient?
It is suggested there are three forms of efficiency within a stock exchange; weak, semi-strong
and strong. Within weak form efficient markets, future share prices cannot be predicted by

analysing past previous. Share prices are believed to follow a 'random walk', meaning there are
no patterns or trends and that future price movements are solely based upon information not
contained within the price series. Therefore, within this type of economy an individual investing
with no prior research will receive the same level of return as those purchased based upon a
recommendation from an analyst who has studied historical data. A semi-strong efficient market
reflect all relevant publicly available information, including past price movements and
information relating to changes in management, the issues of dividends and profit levels.
Therefore, within these types of market there is no need for an analyst to consider historical
information as they have already been absorbed into the market price. Strong-form efficiency
reflects all public and privately available information. This market allows for insider-trading to
occur, and can leave external investors feeling cheated.
Although, in the cases discussed, there is some suggestions of a possibility of insider trading
there is no evidence to prove this. The majority of movements on the market do follow publicly
made announcements with other increases/decreases reflecting previous trends regarding similar
issues. Therefore, I believe that the LSE is a semi-strong efficient market. However, I do feel that
a shift to strong-form efficient market could be possible if regulations are not effectively

This document is provided by:
VU Thuy Dung (Ms.)

Center for Online Writing Resources

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