11,12,13

At the end of this lecture you should be able to:
• discuss the concept of market efficiency
• explain the factors affecting a market’s efficiency
• distinguish between market value and intrinsic value
• explain the difference between the week form, semi-strong form and strong-form
market efficiency
• discuss implications of market efficiency
• understand the concept of the behavioural finance view of investor behaviour
© Irina Mateus 2023

Concept of Capital Market Efficiency
The efficient-market hypothesis (EMH) asserts that financial markets are
“informationally efficient. ”
Efficient market is one where the market price is an unbiased estimate of the true
value of the investment.
prices instantaneously and unbiasedly reflect all available, relevant
information
•An instantaneous price reaction

• Any unexpected “news” is fully reflected in the price by the time of the next
trade
• Unexpected news arrives randomly and can be “good” or “bad”

3
In an efficient market, stock prices are unbiased estimates of the true intrinsic value.
Interpretation: the current stock price is the best guess possible about the value of
the stock, given the available information.
Market efficiency does not require that the market price be equal to the true value at
every point in time
Errors in the market price are unbiased, deviations are random
There is an equal chance that stocks are under or overvalued at any point in time
It implies that no group of investors should be able to consistently find under or

overvalued stocks using any investment strategy
•
4
Market Efficiency - Main Assumptions
A large number of profit-maximizing participants are analyzing and valuing
securities independently of each other
New information comes to the market in a random manner and the timing of news
announcements is independent of each other
Competition is the source of efficiency, and price changes should be independent

and random.
Market participants adjust their estimates of security prices rapidly to reflect their
interpretation of the new information received
Does not mean that market participants correctly adjust prices
Some participants may over-adjust and others may under-adjust, but overall their
price adjustments will be unbiased

5
Market Value versus Intrinsic Value
Intrinsic value is the true, actual value of an asset. It is what the asset is really
worth.
Market value is the price of an asset. It is what buyers are willing to pay for the
asset.
In an efficient market, the two values should be very close or the same.
Following EMH at any point in time the actual price of a security will be a good
estimate of its intrinsic value.
Nevertheless market value and intrinsic value may differ over time, the discrepancy
will get corrected as new information arrives.
In an inefficient market, the two values may differ significantly.

6
In an efficient market, the expected returns implicit in the current price of the
security should reflect its risk.
Investors buying the security should receive a return that is consistent with the
perceived risk of the security.
One cannot consistently achieve returns in excess of average market returns on a

risk-adjusted basis, given the information available at the time the investment is
made.
Unlikely that markets are efficient to all investors (average investor).
Some markets are efficient while others are not, market is efficient with respect to
some investors and not to others. (tax rates and transactions costs, advantages on
some investors relative to others)

7
Factors that contribute to and impede the degree of efficiency
•The number of market participants.
•Information availability and financial disclosure.
•Limits to trading.
If mispricing exists investors will act so that these mispricing disappear quickly.
A lack of trading activity can cause market imperfections that impede market
efficiency.

8
Types of Capital Market Efficiency
Efficient Market Hypothesis initially proposed by Fama (1970)
Book “Efficient Capital Markets: A Review of Theory and Empirical Work.”
– Weak form
– Semi-strong form
– Strong form
Fama (1976) An efficient capital market is a market that is efficient in processing

information.

9
Weak Form of Market Efficiency
Information on past prices is fully reflected in current prices.
Past prices cannot help investors earn returns in excess of what other investors are
earning on similar risk securities.
Investors cannot predict future price changes by extrapolating prices or patterns of
prices from the past.
This approach is commonly associated with technical analysis

Technical analysts (chartists) believe weak form inefficiency
It’s possible to “beat the market” trading on past price movements and trends

10
Weak Form of Market Efficiency
Technical Analysis involves the analysis of historical trading information (primarily
pricing and volume data) in an attempt to identify recurring patterns in the trading
data that can be used to guide investment decisions. Trade on predictions
from the past behaviour
Evidence: investors cannot consistently earn abnormal profit using past prices or
other technical analyst strategies in developed markets.
Some evidence suggests that there are opportunities to profit on technical analysis
in countries with developing markets
Evidence includes China, Hungary, Bangladesh and Turkey.
Academics such as Eugene Fama say the evidence for technical analysis is sparse
and is refuted by the efficient market hypothesis
11
Semi-Strong Form of Market Efficiency
All publicly available information is fully and instantaneously reflected in current
market prices
Examples: Announcements of earnings and dividends, share buybacks, stock

splits, mergers, takeovers, etc
Implication: Past and currently available information is fully reflected in current

market prices
Investors cannot use any publicly available information to “beat the market”
Note: A market cannot be semi-strong form efficient if it is weak form inefficient

12
Fundamental Analysis is a method of assessing the intrinsic value of a security by
analysing various macroeconomic and microeconomic factors.
Fundamental analysis uses information about the economy, industry and company
as the basis for investment decisions (i.e. unemployment rate, GDP growth,
industry growth, quality of and growth in company earnings).
Fundamental analysis requires the ability to read financial statements, an

understanding of macroeconomic factors, and knowledge of valuation techniques
Calculate intrinsic value compare to market value decision
Fundamental analysts believe in weak form efficiency

13
The Event Study Approach
In a semi-strong form of an efficient
market, the cumulative abnormal returns
should:
- have no discernible movement away

from zero prior to the event
- jump at the event date
- have no discernible trend after the event

date

14
Different Types of Market Reaction

15
Different Types of Market Reaction
What type of market
reactions are these
consistent with?

16
Semi-Strong Form of Market Efficiency
Analysing earnings announcements to identify under-priced and overpriced
securities is pointless.
Trading on the basis of the announcement-that is, once the announcement is
made - would not, on average, yield abnormal returns.
Contradiction: If there is no possibility of beating the market in an efficient market
then why it assumes that profit-maximizing investors constantly seek out ways of
beating the market and thus making it efficient.
investors would stop looking for inefficiencies lead to market

inefficiencies.
Evidence: the developed securities markets might be semi-strong efficient.

The markets in developing countries may not be semi-strong efficient.

17
Strong Form of Market Efficiency
All information, public and private, is fully reflected in prices
The market does not neglect any relevant information
Implication: Since all information is impounded in prices fully and instantaneously

it is useless try to predict future prices (and returns)
No investors will be able to consistently find undervalued stocks.
Implications of strong form inefficiency: Company insiders with inside information

may exploit their private information to earn “excess” or “abnormal” returns/profits
Note 1: A market can be semi-strong form efficient but not necessarily strong
form efficient
Note 2: Stock exchanges typically actively monitor and prevent insider trading

18
Strong Form Market Efficiency
Trades by corporate insiders (US market)
•Abnormal returns mainly in the 1960s and 1970s, not anymore
• Preliminary Australian evidence (since 1995) indicates that insider
purchasers outperform the market
Analysts’ recommendations such as in the “Heard on the Street” column of the

Wall Street Journal have a significant effect on stock prices on the day they
appear
• Analysts “sell” recommendations contain more information
Evidence suggests that securities markets are not strong-form efficient: abnormal
profits can be earned when nonpublic information is used.
Insider trading is strongly prohibited, under securities law
Exceptions: https://www.youtube.com/watch?v=q0fAJagnPwg

19
Current view of efficient markets
For an intra-marginal investor, there may be gains to be had from gathering and
acting on information
Intra-marginal investor is someone who can trade on information before the price
has fully reflected it.
How long until prices reflect information?

Varies by type of information and stocks’ characteristics (thinly traded stocks,
widely followed stocks, sector)
Busse and Green (Journal of Financial Economics, 2002)

Found that trading based on the information can make a profit if done within 15
seconds
Spillover of asset price volatility from the US to European markets does exist
(Mateus.et.al., 2017). The greatest spike is in the first minute, and is absorbed in
the first 5 min after the volatility increase.
20
Market Analysis and Market Efficiency
Most empirical evidence indicates neither type of analysis has been effective in
earning abnormal returns consistently, after transactions costs
Continuous market analysis is what makes financial markets efficient!
The odds of finding an undervalued stock should be random (50/50).
At best, the benefits from information collection and equity research would cover
the costs of doing the research.
A strategy of randomly diversifying across stocks or indexing to the market is

superior (little or no information cost and minimal execution costs).
A strategy of minimizing trading is superior to a strategy that required frequent

trading.

21
Implications of Market Efficiency
EM is a self-correcting mechanism, where inefficiencies appear at regular
intervals but disappear almost instantaneously as investors find them and trade
on them.
EMH does not imply that stock prices cannot deviate from true value (large
deviations possible but random).
It does not imply that no investor will 'beat' the market in any time period (beat
prior to transactions costs)
It does not imply that investors cannot beat the market in the long term (by luck,
not because of the selected investment strategy)
The expected returns are consistent with the risk over the long term (deviations in
the short term).
Not necessarily that all market participants are perfectly rational

22
Market efficiency - important topic for investment analysis and portfolio
managers.
The extent to which a market is efficient affects how many profitable trading
opportunities exist.
In the efficient market consistent superior risk-adjusted returns are not
achievable.
In the efficient market a passive investment strategy (i.e. buying and holding a
broad market portfolio)) that does not seek superior risk-adjusted returns is
preferred to an active investment strategy because of lower costs (i.e. transaction
and information-seeking costs).
If markets are inefficient - an active investment strategy may outperform a
passive investment strategy on a risk-adjusted basis.

23
Behavioural Finance
Behavioral finance is the study of the influence of psychology on the behavior of
investors or financial analysts + the subsequent effects on the markets.
It focuses on the fact that investors are not always rational, have limits to their
self-control, and are influenced by their own biases.
Traits of behavioural finance are:

•Investors are treated as “normal” not “rational”
•They actually have limits to their self-control
•Investors are influenced by their own biases
•Investors make cognitive errors that can lead to wrong decisions
Behavioural biases – irrational beliefs or behaviours that can unconsciously

influence an investor’s decision-making process.

25
Behavioural Finance
From every activity, product, and service, including financial ones people want
three types of benefits:
• utilitarian,
• expressive
• emotional
Utilitarian benefits answer the question,

What does something do for me and my wallet?
Expressive benefits answer the question,

What does something say about me to others and to myself?
Emotional benefits answer the question,

How does something make me feel?
The second generation of behavioural finance describes investors, and people as
“normal”—neither “rational” nor “irrational (normal-knowledgeable and normal-
smart but sometimes normal-ignorant or normal-foolish). Some decisions
are driven by cognitive and emotional errors.
© Irina Mateus 2023 26
The Behaviour of Individual investors
Evidence shows that many investors do not appear to hold a diversified portfolio.
US studies show that 90% of investors held fewer than ten different stocks, which
are typically concentrated in the industry and geographical location.
The studies of retirement saving accounts in the US show that 1/3 of the assets
of employees are invested in their employer’s own stock.
Reason:
- familiarity bias.
- relative wealth concerns – “keep up with the Jones” – matching portfolios

27
Systematic Trading Biases
Emotional Biases
Disposition effect – relates to emotional bias (Loss aversion)

Investors dislike losses more than they like comparable gains.
Loss aversion makes investors hold their loss-making investment to avoid
recognizing losses and instead, sell stocks that have gone up slightly in price just
to realize a gain of any amount (even when fundamental analysis indicates a larger
potential profit later).
It may also reflect the reluctance to “admit a mistake” by taking the loss.
Believe that the stock will “bounce back”. Evidence: the losing stocks that investors
tend to hold underperform the winners that they sell (by 3.4%).

28
Overconfidence and Excessive Trading
Overconfidence bias (the illusion of knowledge bias)
They believe they can pick winners and losers, in fact,
they cannot trade too much
Self-attribution bias (a subset of overconfidence bias) is the tendency to take

credit for successes and attribute the blame for failures to others (or chance).
Those who trade more won’t earn higher returns (higher transaction costs)
Consequences: Underestimating risks; Rejecting or ignoring contradictory

information; Overestimating expected returns; Excessive trading; Experience
below-market returns.
Confidence in investing is a weakness leads to an inability to practice good

risk management. Fear of Being Wrong is Helpful in Investing !!!
Evidence: trading activity increases with the number of speeding tickets an

individual receives
Could be explained by sensation seeking and desire for intense risk-taking
experience. © Irina Mateus 2023 29
Regret-aversion Bias (Herd Behaviour)
An investor whose negative experience with a past investment would prevent her
from making a similar investment – despite objective evidence that the new
investment offers the best opportunity exhibiting regret-aversion bias
Herd mentality bias refers to investors’ tendency to follow and copy what other
investors are doing. It’s driven by emotion and instinct causes price changes
without accompanying news.
Herding is clustered trading that may or
may not be based on information (social interaction).
Reasons:
1) believe others have superior information, try to take advantage by copying the
trades.
information cascade - investors may be ignoring their own preferences and
information hoping to profit from the information of others.
2) Relative wealth concerns (afraid of outperforming peers)
3) Reputational risk (based on significant relative underperformance)
Self-Control Bias
Self-control bias is a lack of self-discipline.
Many people are lacking self-control when it comes to money.
Investors favour short-term satisfaction over long-term goals
Consequences:
- potential asset-allocation imbalance
problem
- lost sight of basic financial principles
(time value of money, dollar cost
averaging, etc)
- insufficient savings to fund retirement
needs take excessive risk later in
their lives to try to compensate for
insufficient savings accumulation.

31
Status Quo Bias
Status quo bias is an emotional bias in which people
prefer to keep things as they are rather than make a
change, even when it is necessary.
(maintain the status quo)
Consequences:
- Investors may fail to investigate other investing opportunities.
- may unknowingly retain portfolios with inappropriate asset allocation
Endowment Bias
Endowment bias occurs when an individual sets a
higher asking price when selling an asset than she
would be willing to pay for an asset with the same
characteristics. (irrationally strong attachment to
assets or attached sense of loyalty)
Consequences:
- Failing to sell (and replace) certain assets; - Holding an inappropriate asset
allocation; - Failing to explore opportunities
Cognitive Errors
There are two categories of cognitive biases: 1) belief perseverance biases and
information-processing biases.
Belief perseverance biases arise when individuals are selective in how they deal
with new information that challenges their existing beliefs.
The types of selective behaviour:
- Selective exposure: (notice information that is of interest)
- Selective perception: (ignore or modify information that contradicts existing
beliefs
- Selective retention: (remember or emphasise only information that confirms
existing beliefs)

33
Types of Belief Perseverance Biases
Conservatism Bias
It is demonstrated by maintaining their previous beliefs and inadequately
incorporating (or “under-reacting to”) new information, even when this new
information is significant.
Example: analysts continue to issue negative earnings forecasts even after
companies have begun to report improved earnings (analysts lag reality)
Confirmation Bias
Confirmation bias occurs when individuals place too much
emphasis on information that confirms their existing
beliefs and underweight (or ignore) information that
challenges these beliefs.

34
Illusion of Control Bias
when individuals incorrectly believe that they can control or
influence outcomes, or for individuals to think that he have
more control over the situation than he actually do.
Illusion: the outcome is driven by the skill rather than luck.
Individuals may believe that they can influence the returns on their investments
(when reliant on complex models; employees belief)
Hindsight Bias ("I knew it all along“)

Investors assume having a talent in predicting an
outcome
Similar to the above it relates to self-deception bias –
limits the ability to learn
Hindsight bias is demonstrated by those who remember their forecasts that turned
out to be accurate and forget those that were inaccurate.
lead to excessive risk-taking due to an irrationally high assessment of one’s
ability to correctly predict outcomes.
Information-Processing Biases
Anchoring and Adjustment Bias
Anchoring bias occurs when people rely too much on

pre-existing information or the first information they
find when making decisions.
So when we think about currency values, which are intrinsically hard to value,
anchors often get involved. Anchors - don’t necessarily reflect intrinsic value. Don’t
focus on the anchor – use critical thinking instead.
Framing Bias
Framing bias occurs when people make a decision
based on the way the information is presented, as
opposed to just on the facts themselves.
Investors may react to a particular opportunity differently, depending on how it is
presented to them
The earnings report: In Q3, EPS $1.35 vs expected $1.37; or Q3, EPS $1.35 vs Q2, $1.31
Challenge the framing and avoid impulsive decisions !!!
Conclusion
Investors who are affected by primarily cognitive biases are likely to respond well
to education.
However, an education-based approach is not as useful when working with
investors who display primarily emotional biases.
“When advising emotionally biased investors, advisers should focus on explaining
how the investment program being created affects such issues as financial
security, retirement, or future generations rather than focusing on such quantitative
details as standard deviations and Sharpe ratios.
Source: IFT Notes: The Behavioral Biases of Individuals

37
Behavioral Efficient Markets
Both standard finance and behavioral finance provide evidence refuting the price-
equals-value efficient market hypothesis, but their evidence generally supports the
hard-to-beat efficient market hypothesis.
Behavioral finance also explains why so many investors believe that markets are
easy to beat when, in fact, they are hard to beat.
Behavioural Finance perspective: Hard-to-beat efficient markets are not

necessarily value-efficient markets. It might be that discrepancies between prices
and values exist, but discrepancies are hard to identify in time or difficult to exploit
for abnormal returns.
Some investors are able to beat the market, earning abnormal returns over time,
but most are unable to do so.
“Markets are crazy, but this does not make you a psychiatrist”.
Source: Meir Statman “Behavioral Finance” CFI Institute

38
At the end of this lecture you should be able:
Explain the meaning and main characteristics of multinational
corporations
Identify why firms decide to expand internationally following the main
theories discussed in class
Describe differences between international business methods
Understand MNC valuation model
Explain the concept of international risk exposure and types of risk
Describe the ways of operational risk mitigation and currency risk

mitigation
Explain the concept of Purchasing Power Parity and International Fisher

Effect
2
Multinational Corporation
Multinational corporations (MNCs) are defined as firms that engage in some
form of international business.
A multinational corporation (MNC) is a company that operates in its home

country, as well as in other countries around the world.
In addition, MNC must make a foreign direct investment in the foreign countries
they operate.
Initially: firms attempt to export products to a particular country or import

supplies from a foreign manufacturer.
Later: recognize additional foreign opportunities and establish subsidiaries in
foreign countries (i.e. IBM, Nike)
The commonly accepted goal of MNCs is to maximize shareholder wealth.
However, managers of a firm may take a decision that conflicts with the firm’s
goal to maximize shareholder wealth (i.e. desire to grow to receive higher
compensation) – agency problem.
International Business: Theories
why do firms become motivated to expand their business internationally?
Three theories:
1) Theory of comparative advantage
Some countries, such as Japan and the United States, have a technology
advantage, while other countries, such as Jamaica, Mexico, and South Korea,
have an advantage in the cost of basic labor.
Countries use their advantages to specialize in the production of goods that can
be produced with relative efficiency.
When a country specializes in some products, it may not produce other products,
so trade between countries is essential.
MNCs utilise comparative advantages across countries to increase production

efficiency, and as a result to provide a return in excess of that required.

4
Sources of comparative advantage:
- International differences in climate (seasons, geography)

- Differences in factor endowments (resource-rich: land, labour, capital, human
capital)
- Differences in technology (able to produce more output with a given input)
2) Imperfect Markets Theory
Markets for the various resources used in production are “imperfect” because
due to costs and restrictions: labour and other resources cannot easily flow
among countries (immobile)
Government interventions (tariffs, import quotas)
Thus, MNCs such as the Gap and Nike often capitalise on a foreign country’s
resources.
Imperfect markets provide an incentive for firms to seek out foreign

opportunities.
3) Product Cycle Theory
As a firm matures, it may recognize additional opportunities outside its home

country.
Product cycle
Firm creates Firm exports Firm establishes foreign

product to product to subsidiary to establish
accommodate local accommodate presence in foreign country
demand foreign demand and possibly to reduce costs
or
Firm differentiates product Firm’s foreign
from competitors and/or business declines as
expands product line in its competitive
foreign country advantages are
eliminated

Why companies want to become multinational corporations?
Reasons:
- Access to lower production costs (setting up production in developing

countries, outsourcing, advantages: e.g. inexpensive supply chains, and
advanced technological/R&D capacity)
- Increase revenue potential (opportunity to grow when opportunities at home
are exhausted)
- Gain a competitive advantage
- Proximity to target international markets (target consumer market.
Advantages: reduce transport costs, feedback, information)
- The advantage of international brand recognition (easier, lower costs for
marketing)
- Access to a larger talent pool
- Avoidance of tariffs
- Diversification of income (reduces exposure to market changes)
International Business Methods:
Firms use several methods to conduct international business.
The most common methods are:
• International trade
• Licensing
• Franchising
• Joint ventures
• Acquisitions of existing operations
• Establishing new foreign subsidiaries

International Trade:
Can be used by firms to penetrate markets (by exporting) or to obtain supplies
at a low cost (by importing).
Minimal risk. If the firm experiences a decline in its exporting or importing, it can
reduce or discontinue this part of its business at a low cost.
Licensing:
Licensing is defined as the granting of permission by the licenser to the
licensee to use intellectual property rights under defined conditions.
Obligates a firm to provide its technology (copyrights, patents, trademarks, or

trade names) in exchange for fees or some other specified benefits.
Firms can use their technology in foreign markets without a major investment in
foreign countries and without transportation costs (from exporting).
Disadvantage - difficult to ensure quality control in the foreign production

process. The lower costs – lower returns
Franchising:
obligates a firm to provide a specialized sales or service strategy, support
assistance, and possibly an initial investment in the franchise in exchange for
periodic fees (i.e. McDonald’s, Pizza Hut). Access to a firm’s successful business
model
Advantage: firms penetrate foreign markets without a major investment in foreign

countries.
Joint Ventures:
a venture that is jointly owned and operated by two or more firms.
This type of business deal is formed with a specific goal – to enter a new market,
create a new product or enhance a service. Each business retains its unique
identity and autonomy
A joint venture with firms that reside in foreign markets.

Benefit from applying their respective comparative advantages. 2 main types:
Personnel-Based Joined Venture and Equipment-Based Joint Venture.
Example: Xerox Corp. and Fuji Co. (of Japan); Fiat Chrysler and Google; Ford
and Toyota © Irina Mateus 2023 10
Acquisitions of Existing Operations:
Firms acquire other firms in foreign countries to penetrate foreign markets.
Acquisitions allow firms to have full control over their foreign businesses and to
quickly obtain a large portion of foreign market share.
Disadvantage: subject to the risk of large losses, as the large investment is

required
If the foreign operations perform poorly - difficult to sell at a reasonable price
Potential option is a partial international acquisition, can obtain a stake in

foreign operations
Advantage: Smaller investment – less risk

Disadvantage: no complete control over foreign operations
Example: Airbnb acquisitions in Europe (Accoleo and Crashpadder), copycats

Wimdu and 9flats © Irina Mateus 2023 11
Establishing New Foreign Subsidiaries:
Penetrate foreign markets by establishing new operations in foreign countries
with the aim to produce and sell products.
This method requires a large investment but it maybe smaller in comparison to

the acquisition of existing operations.
Advantage: Preferred to foreign acquisitions because the operations can be

tailored exactly to the firm’s needs.
Disadvantage: the firm will not gain any rewards from the investment until the
subsidiary is built and a customer base established.

MNC Valuation Model
The value (V) of a domestic company in the United States is commonly
measured as the present value of its expected cash flows, where the
discount rate used reflects the weighted average cost of capital and
represents the required rate of return by investors:
∞
𝐸(𝐶𝐹$,𝑡 )
𝑉=෍
(1 + 𝑘)𝑡
𝑡=1
where 𝐸(𝐶𝐹$,𝑡 ) − expected cash flows to be received at the end of

period t,
t - the number of periods into the future in which cash flows are
received,
k - the required rate of return; represents the cost of capital (including
both the cost of debt and the cost of equity) to the firm and is
essentially a weighted average of the cost of capital based on all of the
firm’s projects. © Irina Mateus 2023 13
MNC Valuation Model
Cash flows generated by a U.S.-based MNC’s coming from various countries
may be denominated in different foreign currencies.
To estimate the value of MNC, the foreign currency cash flows should be
converted into dollars.
The expected dollar cash flows to be received at the end of period t are equal
to the sum of cash flows denominated in each currency j times the expected
exchange rate at which currency j could be converted into dollars by the MNC
at the end of period t.
𝑚
𝐸(𝐶𝐹$,𝑡 ) = ෍[𝐸(𝐶𝐹𝑗,𝑡 ) x 𝐸(𝐸𝑅𝑗,𝑡 )]

𝑖=1
where 𝐸(𝐶𝐹𝑗,𝑡 ) − the amount of cash flow denominated in a particular foreign

currency j at the end of period t
𝐸(𝐸𝑅𝑗,𝑡 ) - the exchange rate at which the foreign currency (measured in dollars
per unit of the foreign currency) can be converted to dollars at the end of period
t. © Irina Mateus 2023 14
Exchange rates
Spot exchange rate - represents the number of units of one currency that can
be exchanged for another.
The currencies of the major countries are traded in active markets, where rates
are determined by the forces of supply and demand.
Quotations can be in terms of the domestic currency or in terms of the foreign

currency.
Example: If the US dollar is the domestic currency and the British pound the
foreign currency, a quotation might be 1 GBP = 1.30296 USD or 1 USD =
0.767484 GBP
The result is the same, for one is the reciprocal of the other (1/ 0.767484 =
1.30296, and 1/ 1.30296 = 0.767484).
Forward exchange rate - the rate today for exchanging one currency for
another at a specific future date.

MNC Valuation Model
Example: Carolina Co. has expected cash flows of $100,000 from local
business and 1 million Mexican pesos from business in Mexico at the end of
period t. Assuming that the peso’s value is expected to be $0.09, the expected
dollar cash flows are:
𝑚
𝐸(𝐶𝐹$,𝑡 ) = ෍[𝐸(𝐶𝐹𝑗,𝑡 ) x 𝐸(𝐸𝑅𝑗,𝑡 )] = [$100,000] + [1,000,000 𝑝𝑒𝑠𝑜𝑠 𝑋 ($0.09)]

𝑖=1
= 100,000 + $ 90,000 = $190,000
Thus, the value of an MNC can be estimated as:

∞
σ𝑚
𝑖=1[𝐸(𝐶𝐹𝑗,𝑡 ) x 𝐸(𝐸𝑅𝑗,𝑡 )]
𝑉=෍
(1 + 𝑘)𝒕
𝑡=1
MNC’s value is sensitive to the amount of cash flows in a particular currency

(CFj), the exchange rate at which that currency is converted into dollars
(𝐸(𝐸𝑅𝑗,𝑡 )), and the MNC’s weighted average cost of capital (k).
International Risk Exposure:
The MNC’s future cash flows (and therefore its valuation) are subject to
uncertainty because of its exposure to international economic conditions,
political conditions, and exchange rate risk
Exchange Rate Risk (operating exposure)

risk that a company's cash flow, foreign investments, and earnings may suffer
as a result of fluctuating foreign currency exchange rates.
If the foreign currencies to be received by a U.S.-based MNC suddenly weaken

against the dollar, the MNC will receive a lower amount of dollar cash flows
than was expected (reduction in MNC’s value).
A stronger foreign currency will make production more expensive, while profits
earned in foreign currencies will decrease.
If the local currency strengthens, local manufacturers will face more intense
competition from foreign manufacturers whose products will become cheaper.

Exposure to International Economic Conditions.
The amount of consumption in any country is influenced by the income earned
by consumers in that country.
Weak economic conditions low spending, decline in sales (a reduction in

the MNC’s cash flows, and a decrease in its value).
Political Risk exposure.

Political risk (also called country risk) arises due to potential actions of the host
government or the public that may affect MNC’s cash flows.
Example: A foreign government may increase taxes or impose barriers on the

MNC’s subsidiary.
The host government may decide to buy out a subsidiary whatever price it
decides is fair. Foreign firms maybe placed at a disadvantage.
Foreign Exchange Exposure resulting from accounting.
Transaction Exposure
is the risk of loss from a change in exchange rates during the course of a
business transaction
Changes in the value of outstanding financial obligations incurred prior to a

change in exchange rates but to be settled after the exchange rate changes
Concerned with future cash flows already contracted for
Translation exposure
arises because financial statements of foreign subsidiaries – which are stated in
foreign currency- must be restated in the parent’s reporting currency for the firm
to prepare consolidated financial statements .
Translation exposure, is the change in accounting income and balance sheet

statements caused by changes in exchange rates.
Mitigation of Operational Exposure
Operational strategy
is aiming to adjust or change the current company’s operations to prevent possible
risks associated with future currency fluctuations.
The operational mitigation strategy includes:

•Diversification of production facilities and markets of products:
•Sourcing flexibility:
•Diversification of financing:
Currency risk mitigation strategy

•Matching currency flows
•Currency risk-sharing agreements
•Currency swaps
Matching Currency Cash Flows
A company matches the foreign currency outflows with foreign currency inflows.
One way to offset an anticipated continuous long exposure to a particular currency
is to acquire debt denominated in that currency.
This policy results in a continuous receipt of payment and a continuous outflow in

the same currency (debt Financing as a Financial Hedge)

Currency risk-sharing agreements:
A company enters into a currency risk-sharing agreement with its
supplier/customer. According to this agreement, the sale/purchase contract is
executed at a predetermined price. Thus, both parties share the potential
currency risk.
Example: The Indian exporter and Wal-Mart agree that:

• If INRUSD rate varies within INR 43.50/USD to INR45/USD ( i.e, >= INR
43.50/USD to < INR45/USD), then Wal-Mart pays USD20 per unit of bed linen.
• If INR depreciates and remains within the range INR45/USD to

INR46.75/USD ( i.e, > =INR45/USD to < INR46.75/USD) , then the Indian
exporter receives USD 19 per bed linen.
• If INR appreciates and remains within a range of INR42/USD to INR43.50 (

i.e, > =INR42/USD to < INR43.50/USD), then Wal-Mart pays USD 22 per bed
linen.

Cross-Currency Swaps
A company can use currency swaps to obtain the required cash flows in foreign
currency at the desired exchange rate. The counterparties will exchange the
interest and principal in one currency for the same in another currency at fixed
dates until the maturity of the swap.

International Parity Conditions
The concept of arbitrage and the law of one price gives rise to the
following international parity conditions:
–Purchasing Power Parity (PPP)

–Fisher Effect (FE)
–International Fisher Effect (IFE)
–Interest Rate Parity (IRP)
–Forwards Rates as Unbiased Predictors of Future Spot Rates (UFR)
Macro Factors Governing Exchange-Rate Behaviour
In the long run, there are linkages between domestic and foreign inflation
and between interest rates and exchange rates.

Purchasing-Power Parity (PPP)
Idea: a basket of goods should sell for the same price in two countries, after
exchange rates are taken into account.
If two countries produce products that are substitutes for each other, the demand
for the products should adjust as inflation rates differ. The shifting in consumption
will continue until prices in both countries achieve new equilibrium due to currency
appreciation/depreciation.
Example: Assume U. S. and the UK trade extensively with each other and initially
have zero inflation. Then, US experiences a 9 percent inflation rate, while the UK
experiences a 5 percent inflation rate.
PPP theory suggests: £ should appreciate by approximately 4 percent, the

differential in inflation rates because the exchange rate should adjust to offset the
differential in the inflation rates of the two countries.
the prices of goods in the two countries should become similar

Purchasing-Power Parity (PPP)
Assume that 𝑃ℎ = 𝑃𝑓 (price indexes of the home and foreign countries)
If countries experience an inflation rate of 𝐼ℎ 𝑎𝑛𝑑 𝐼𝑓 the new price index of goods
become
𝑃ℎ (1 + 𝐼ℎ ) for home country; 𝑃𝑓 (1 + 𝐼𝑓 ) for foreign country

PPP states that If 𝐼ℎ > 𝐼𝑓 the exchange rate will adjust to maintain the parity in
purchasing power 𝑃𝑓 (1 + 𝐼𝑓 )(1 + 𝑒𝑓 )
Where 𝑒𝑓 - the percentage change in the value of the foreign currency.
PPP states that the percentage change in the value of the foreign currency should
change to maintain parity. Hence,
𝑃𝑓 (1 + 𝐼𝑓 ) 1 + 𝑒𝑓 = 𝑃ℎ (1 + 𝐼ℎ )
𝑃ℎ (1 + 𝐼ℎ ) (1 + 𝐼ℎ )
𝑒𝑓 = −1= − 1; simplified form 𝑒𝑓 ≅ 𝐼ℎ − 𝐼𝑓
𝑃𝑓 (1 + 𝐼𝑓 ) (1 + 𝐼𝑓 )

International Fisher Effect (IFE)
Closely related with PPP but uses interest rate rather than inflation rate differentials
to explain why exchange rates change over time
The IFE theory states that foreign currencies with relatively high interest rates will
depreciate because the high nominal interest rates reflect expected inflation.
Example: The nominal interest rate is 8 percent in the U.S.. Investors in the U. S.
expect a 6 percent rate of inflation, earn a real return of 2 percent over one
year. The nominal interest rate in Canada is 13 percent. Investors in Canada also
require a real return of 2 percent, the expected inflation rate in Canada must be 11
percent.
PPP theory states: the Canadian dollar is expected to depreciate by approximately
5 percent against the U.S. dollar (since the Canadian inflation rate is 5 percent
higher). U.S. investors would not benefit from investing in Canada because
the 5 percent interest rate differential would be offset by investing in a currency that
is expected to be worth 5 percent less by the end of the investment period. U.S.
investors would earn 8 percent on the Canadian investment, which is the same as
they could earn in the United States.
International Fisher Effect (IFE)
IFE suggests that the effective return on a foreign investment should, on average,
be equal to the effective return on a domestic investment
𝑟 = 𝑖ℎ
The actual return to investors from a foreign money market security depends on not
only the foreign interest rate (𝑖𝑓 ) but also the percentage change in the value of the
foreign currency (𝑒𝑓 ) denominating the security.
Thus the actual return on a foreign bank deposit (or any money market security) is
𝑟 = (1 + 𝑖𝑓 ) 1 + 𝑒𝑓 − 1
Since 𝑟 = 𝑖ℎ ; (1 + 𝑖𝑓 ) 1 + 𝑒𝑓 − 1 = 𝑖ℎ
(1 + 𝑖𝑓 ) 1 + 𝑒𝑓 = (1 + 𝑖ℎ )
(1 + 𝑖ℎ )
𝑒𝑓 = − 1; simplified form 𝑒𝑓 ≅ 𝑖ℎ − 𝑖𝑓
(1 + 𝑖𝑓 )
𝑖ℎ > 𝑖𝑓 the foreign currency will appreciate. This appreciation will improve
the foreign return to investors from the home country, making returns on foreign
securities similar to returns on home securities.
The International Fisher Effect states that the spot exchange rate should change to
adjust for differences in interest rates between two countries:
Example:
consider the relationship between the US dollar ($) and the British pound (£) both
now and 90 days in the future.
𝐹£ (1 + 𝑟£ )
=
𝑆£ (1 + 𝑟$ )
where 𝐹£ - current 90-day forward exchange rate in pounds per dollar
𝑆£ - current spot exchange rate in pounds per dollar
𝑟£ - nominal British interbank Euromarket interest rate, expressed in terms of the 90-day
return
𝑟$ - nominal US interbank Euromarket interest rate, expressed in terms of the 90-day return
If the nominal interest rate in Britain were 8 percent and the nominal US rate 6
percent, these annualized rates would translate into 90-day rates of 2 percent and
1.5 percent, respectively. If the current spot rate were 0.625 pounds per dollar, we
would have
(1 + 𝑟£ ) 1.020
𝐹£ = 𝑆£ 𝑥 = 0.625𝑥 = 𝟎. 𝟔𝟐𝟖𝟏 1USD = 0.6281GBP
(1 + 𝑟$ ) 1.015
Thus the implied forward rate is 0.6281 British pounds per US dollar.
The British-pound forward rate is at a discount from the spot rate of 0.625 pounds
to the dollar. That is, a pound is worth less in terms of dollars in the forward market,
1/0.6281 = $1.592, than it is in the spot market, 1/0.625 = $1.60. The discount is
(0.6281 − 0.625)/0.625 = 0.005 (0.5%).
If the interest rate in Britain were less than that in the United States, the implied
forward rate in our example would be less than the spot rate. In this case, the
British-pound forward rate is at a premium above the spot rate.
For example, if the US interest rate (annualized) were 8 percent and the British
interest rate 6 percent, the implied 90-day forward rate for British pounds would be
(1 + 𝑟£ ) 1.015
𝐹£ = 𝑆£ 𝑥 = 0.625𝑥 = 𝟎. 𝟔𝟐𝟐𝟎 1USD = 0.6220GBP
(1 + 𝑟$ ) 1.020
Therefore the forward rate (0.6220) is at a premium in the sense that it is worth
more in terms of dollars in the forward market than in the spot market.
If interest-rate parity did not occur, presumably arbitragers would be alert to the
opportunity for profit. © Irina Mateus 2023 30
Corporate Governance
Corporate Governance - is a system that guides the conduct of the people within
an organization, as well as the direction of the organization itself.
Different stakeholders have different interests leads to agency costs
Conflicts between bondholders and shareholders bondholders: who has debt and they get interest
for that
Conflicts between managers and investors.
The conflict of interest between a company's management and the company's

stockholders comes from the separation of ownership and control in a
corporation.
Examples: Managers can take a decision to merge with another firm. It might not
be in the best interest of shareholders….
Reasons: desire to manage a larger firm, prestige, greater pay.
Other reasons: excessive perquisites Example: corporate jets, memberships
The seriousness of this conflict of interest depends on how closely aligned the
interests of the managers and shareholders are.
Corporate governance—the system of controls, regulations, and incentives
designed to prevent fraud
Aligning their interests comes at a cost – it increases the risk exposure of the
managers
The role of corporate governance system is to mitigate the conflict of interest that
results from the separation of ownership and control without unduly burdening
managers with the risk of the firm.
The interests are aimed to be aligned through:

- the right action (stock-based compensation; compensation sensitive to
performance)
- punishment (manager can be fired, shareholders and raiders launch control
contest)
Not easy
Poor corporate governance a company may fail to achieve goals, and, at

worst collapse of the company financial losses for shareholders.
3
The Role of the Board of Directors
Monitoring of managers is costly: no shareholders want to bear it
Shareholders elect the Board of Directors to monitor managers.

The Board of directors sets an appropriate governance structure in place.
It hires the executive team, sets its compensation, approves major investments
and acquisitions, and dismisses executives if needed.
US: clear fiduciary duty to protect interests of shareholders

Other countries: i.e. Germany - interests of shareholders and employees (2-tier)
Types of directors (categorised by research)
- Inside directors (employees, former employees, family members of

employees)
- Gray directors (not directly connected but have business relationships with the
firm)
- Outside (independent) directors (all other directors)
Independent directors are the most likely to make decisions solely in the
interests of the shareholders.
Research: Firms with independent boards make fewer value-destroying

acquisitions, more likely to fire CEO
No evidence on the connection between board structure and firm performance

very difficult to detect.
One of the reasons: the nature of the role of the independent director
On a board composed of insider, gray, and independent directors, the role of the
independent director is that of a watchdog.
Independent directors’ personal wealth is often less sensitive to performance

less incentive to closely monitor the firm.
Hence, a trend - more equity-based pay for outside directors.
Many independent directors sit on multiple boards.

5
A board is said to be captured when its monitoring duties have been
compromised by connections or perceived loyalties to management.
Evidence: the longer CEO has served, especially when that person is also
chairman of the board, the more likely the board is to become captured.
Even though independent directors have no business ties to the firm they are still
likely to be friends or acquaintances of the CEO.
When the CEO is also chairman of the board, the nominating letter offering a
seat to a new director comes from him/her.
This reinforces the sense that the outside directors owe their positions to the
CEO and work for the CEO rather than for the shareholders.
Researchers have found that smaller boards are associated with greater firm
value and performance.
Major U.S. exchanges (NYSE and Nasdaq) nowdays have listing requirements
demand companies to have a majority of independent directors on their
boards. Problem: typically those are not experts in the firm’s business
The structure of corporate governance
Equity Markets
The market place (external) Analysts and other market
agents
The corporation (internal)
Board of Directors
Chairman of the board and Debt Markets
members are accountable Rating agencies and other
for the organization analysts
Management
Chief executive officer
(CEO) and team run the
company Auditors
Corporate governance represents the Regulators

SEC, the NYSE, or other
relationship among stakeholders that is used to regulatory bodies by
determine and control the strategic direction and country
performance of the organization
7
The structure of corporate governance (internal forces)
The Board of Directors

The legal body which is accountable for the governance of the corporation. The
board’s “prime directive” is to be always seeking the best interests of
shareholders. The board of directors hires and oversees the executives who
comprise the team that manages the day-to-day operations of a company.
(shareholders have a direct say in how a company is run.
Officers and Management

The senior officers of the corporation-the chief executive officer (CEO), the chief
financial officer (CFO), and the chief operating officer (COO) – responsible for
firm’s strategic and operational direction.
They are motivated by salary, bonuses and stock options (positively) and the risk
of losing their jobs (negatively). They may have biases of self-enrichment or
personal agendas. In more than 80% of the companies in the Fortune 500, the
CEO is also the chairman of the board (conflict of interest).

The structure of corporate governance (external
forces/monitors)
Equity markets
Analysts and other market agents evaluate the performance of the firm on a daily
basis.
Securities analysts produce independent valuation of the firms they cover so that
they can make buy and sell recommendations to clients.
Debt markets
Ratings agencies and other analysts review the ability of the firm to service debt.
Lenders also carefully monitor firms to which they are exposed as creditors.
Auditors
Responsible for providing an external professional opinion as to the fairness and
accuracy of corporate financial statements. They check whether the firm’s financial
records and practices follow GAAP/IFRS accounting standards. Auditors are hired
by the firm they are auditing (conflict of interest)
Regulators
In the U.S. the Securities Exchange Commission (SEC) is a watchdog of the publicly
traded equity markets
- controls the behaviour of the companies themselves in those markets
- the behaviour of the various investors participating in those markets.
Main task – protect the investing public against fraud and stock price manipulation.
The SEC and other similar authorities outside the U.S. require regular and orderly
disclosure of certain types of business and financial data in order that all investors
may evaluate the company’s investment value with adequate, accurate and fairly
distributed information.
A publicly traded firm in the U.S. is also subject to the rules and regulations of the
exchange on which they are traded.

Managing Agency Conflict
Direct Action by Shareholders
Shareholder Voice
Any shareholder can submit a resolution that is put to a vote at the annual
meeting. Rarely receive majority support, but if large shareholders back
them, they can be embarrassing for the board (positive market response if
adopted).
Shareholders can organise “no” votes. When shareholders are dissatisfied with a
board, they may refuse to vote to approve the slate of nominees for the board.
(Example: the Walt Disney Company in 2004, CEO and Chairman Michael
Eisner)
Shareholder Approval
Shareholders must approve many major actions taken by the board (i.e merger
agreements). Listing requirements on the NYSE demand that shareholders
approve any large issue of new shares
A movement during the 2008 financial crisis – to let shareholders have a “say on
pay” vote. if company has poor performance so the shareholders
may apply for getting litle compensation.
Firms that narrowly passed shareholder resolutions subsequently saw their stock
prices increase in response.
In 2010 the Dodd-Frank Act required advisory votes of shareholders on executive

pay for all large U.S. corporations. Firm with poor performance or unusually high
executive pay are likely to see the compensation proposals rejected by
shareholders.
Proxy Contests
Shareholders can introduce a rival slate of directors for election to the board.
Hence, shareholders get a choice between the nominees put forth by management
and the current board and slate of nominees put forth by shareholders.
Evidence: stock price increases after announcements of proxy contests

(independently of the outcome of reelections). Microsoft – Yahoo!

Activist Funds
Activities have grown in recent years.
Identify what they believe undervalued stocks, buy significant stakes.
Aim to change the direction/strategy of management.
Positive response to the announcement. The average abnormal return of 7% (The

New York Times – Ochs-Sulzberger family).
when mgt team is so protective toward to the company if it performs bad.
when there is a risk of takeover then gt takes a good care for not getting
Management entrenchment fail.
Managers can use different tools to entrench themselves (i.e. anti-takeover
protections, staggered boards, poison pills, restrictions on the ability of shareholders
to call special meetings themselves).
Evidence: Firms with more restrictions on shareholder power performed worse vs.
firms with fewer restrictions.
Connections between the degree of entrenchment and the compensation to
power of the board.
managers.
The threat of Takeover
When internal governance systems fail (board oversight, compensation,

shareholder activism), the one remaining way to remove poorly performing
managers is a hostile takeover.
Some countries have much more active takeover markets than others (hostile
takeovers are very common in the U.S.).
An active takeover market complements a board’s own vigilance in dismissing

incompetent managers.

Corporate Governance around the world
In Europe, many corporations are run by families that own controlling

blocks of shares. Blocks of shares in excess of 20% controlling (if no
one else has any large concentration of shares)
If other 80% is dispersed, the major shareholder has considerable say in

the operation of the firm others have to coordinate to outvote
Hence, there is little conflict of interest between the controlling family and
the manager. The major conflict arises between the minority shareholders
and the controlling shareholders.
Controlling shareholder can make decisions that benefit them

disproportionally relative to the minority shareholders

Dual class shares and the value of control
A scenario in which companies have more than one class of shares and
one class has superior voting rights over the other class.
Example: Mark Zackerberg controls more than 50% of the voting power of
Facebook because he controls the majority of Facebook’s class B shares.
(class B shares have 10 votes for every 1 vote of a class A share).
Controlling shareholders (families) will hold all or most of the shares with
superior voting rights and issue the inferior voting class to the public.
Hence, they can raise capital without diluting their control.
Dual class shares are common in Denmark, Finland, Germany, Sweden,

Switzerland, Norway, Italy, Canada, Brazil, Korea, Mexico.

11,12,13

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

11,12,13

Uploaded by

Copyright:

Available Formats

At the end of this lecture you should be able to:

• discuss the concept of market efficiency

• explain the factors affecting a market’s efficiency

• distinguish between market value and intrinsic value

• discuss implications of market efficiency

• understand the concept of the behavioural finance view of investor behaviour

© Irina Mateus 2023

•An instantaneous price reaction

© Irina Mateus 2023

Errors in the market price are unbiased, deviations are random

It implies that no group of investors should be able to consistently find under or

Competition is the source of efficiency, and price changes should be independent

Does not mean that market participants correctly adjust prices

© Irina Mateus 2023

In an inefficient market, the two values may differ significantly.

© Irina Mateus 2023

One cannot consistently achieve returns in excess of average market returns on a

Unlikely that markets are efficient to all investors (average investor).

© Irina Mateus 2023

•Information availability and financial disclosure.

© Irina Mateus 2023

Book “Efficient Capital Markets: A Review of Theory and Empirical Work.”

Fama (1976) An efficient capital market is a market that is efficient in processing

© Irina Mateus 2023

This approach is commonly associated with technical analysis

© Irina Mateus 2023

Evidence includes China, Hungary, Bangladesh and Turkey.

Examples: Announcements of earnings and dividends, share buybacks, stock

Implication: Past and currently available information is fully reflected in current

Note: A market cannot be semi-strong form efficient if it is weak form inefficient

© Irina Mateus 2023

Fundamental analysis requires the ability to read financial statements, an

Calculate intrinsic value compare to market value decision

Fundamental analysts believe in weak form efficiency

© Irina Mateus 2023

- have no discernible movement away

- jump at the event date

- have no discernible trend after the event

© Irina Mateus 2023

© Irina Mateus 2023

© Irina Mateus 2023

investors would stop looking for inefficiencies lead to market

Evidence: the developed securities markets might be semi-strong efficient.

© Irina Mateus 2023

The market does not neglect any relevant information

Implication: Since all information is impounded in prices fully and instantaneously

No investors will be able to consistently find undervalued stocks.

Implications of strong form inefficiency: Company insiders with inside information

© Irina Mateus 2023

Analysts’ recommendations such as in the “Heard on the Street” column of the

Insider trading is strongly prohibited, under securities law

© Irina Mateus 2023

How long until prices reflect information?

Busse and Green (Journal of Financial Economics, 2002)

Continuous market analysis is what makes financial markets efficient!

The odds of finding an undervalued stock should be random (50/50).

A strategy of randomly diversifying across stocks or indexing to the market is

A strategy of minimizing trading is superior to a strategy that required frequent

© Irina Mateus 2023

Not necessarily that all market participants are perfectly rational

© Irina Mateus 2023

© Irina Mateus 2023

Traits of behavioural finance are:

Behavioural biases – irrational beliefs or behaviours that can unconsciously