Efficient Market Hypothesis

The concept of market efficiency was first developed in the finance literature and its full form was first explained by Engene Fama.  But now-a-days this concept is being used in other areas also.  Efficient market is defined as one where prices fully reflect all the available information.  By definition then there should not exist any unexplained opportunities for profit.

It states that it is impossible to beat the market because prices already incorporate and reflect all relevant information. This is also a highly controversial and often disputed theory.

The definition of efficient market is a little vague and its vagueness it seems, is intentional.  It can be shown that, under certain circumstances, it is not required all market operators to share exactly identical views on the future price.  Some investors may be better informed than others.

The implication of the concept of market efficiency in forex market is interesting.  Let us assume that both spot and forward markets of a currency are characterized by the following condition: (a) There are a large number of investors with ample funds available for arbitrage operations, and (b) There are not exchange controls and also no transaction costs.

In this situation suppose an American investors thinks that spot price of deutsche mark (DM) in terms of the dollar is going to be 15 per cent higher in twelve months than it is to day.  The investor may be able to profit by buying DM forward, and then selling DM spot at the end of 12 months.  If his judgment proves right, his profit will be 15 per cent less the premium paid for forward DM (transaction cost is nil as assumed).  As the market information is perfect, other investors will follow suit, and the forward DM will be bid up until the premium is high enough to prevent any further speculation.

One interesting question is: how long will the speculation continue in the market to have a share of the profit. This is not indefinite, as at some point investors will realize that, although the potential of profit from speculation is not zero, the probable reward is not great enough to compensate for the risk of being wrong.  Thus equilibrium will be reached and speculation will spot at the point where the gap between the forward rate and the expectation of the market of the future spot rate is just equal to the required risk premium charged, or in equation it becomes

F_t (t+1) = E_t(St+1) + r_t

Where LHS is the logarithm of forward price of DM at time t for delivery at period (t+1) and rt is the risk premium.  In the above equation the forward rate reflects both the publicly available information congealed in the rational expectation Et(St+1) and the attitude of the market towards risk revealed in the risk premium.  Thus the equation shows the equilibrium in the efficient market.  The interpretation of efficiency explained here corresponds to what E.  Fama called semi-strong form of efficiency (FAMA, 1970).  Strong form of efficiency applies when the market price reflects all information, whether publicly available or not.

It is quite possible to imagine a situation where the market price reflects only the restricted information set which can be used in the formation of weakly rational expectations.  Here the expected value in the equation would be conditioned on the past value of the time series, and not on the universe of publicly available information.  This helps in defining a weakly efficient market.

 

A weakly efficient market is one where the market price reflects the market information in its own past history.  It implies that there no longer exists any opportunity to profit by making use of past time series of prices alone.

One interesting aspect of weakly efficient market is that there will normally remain opportunities to make a profit by the exploitation of information additional to the past time series of prices.  Another implication of market efficiency is the unbiasedness of the market.

A forex market is said to be unbiased when the forward market is efficient and investors are risk neutral, so that the forward rate is equal to the mathematical expectation of the spot rate at the time of the maturation of the contract.

Efficient of inefficient players in the forex market are big and they are equipped with very powerful computers with dedicated software.  In spite of the fact that they have access to massive data set and powerful software, calculations go wrong and survey data repeatedly point out irrational movement of expectations.  May be this is another mystery of the market forces.

 

 

Reference: Fama E F, Efficient Capital Markets: A Review of Theory and Empirical Evidence, Journal of Finance, 25, 1970, 383-417

Theory of Profit

Prof. Hawley, an American economist in 1907, propounded the risk-bearing theory of profit. Prof. Hawley remarks, “The profit of an undertaking, or residue of the product after the claims of land, labour and capital are satisfied, is not the reward of management or coordination but of the risk and responsibilities that the undertaker subjects himself to“.

So, according to this theory, profit is the reward for risk-taking in business. Every business involves some risk or other. Since the entrepreneur undertakes the risk, he is entitled to receive profit. If he does the reward, he will not be prepared to undertake the risks. Hence, higher the risk, the greater is the possibility of profit. This profit of the entrepreneur exceeds the ordinary return on capital. If it were less than the ordinary return on capital, the entrepreneur would not be prepared to undertake the risk.

Knight identifies entrepreneurship as:

• Recipient of pure profit
• Pure profit is bearing the cost of uncertainty
• For which self-confidence is important

Criticisms of this theory

1. No Direct relationship between Risk and Profit
2. Reward for Risk avoidance
3. Unforeseeable Risk

Prof. Knight asserted that the essential functions of an entrepreneur are to bear non insurable risks or uncertainties; he propounded what has come to be known as uncertainty bearing theory of profit.

Importance of Business Plan

A business plan is not just a document; it is a white paper on your business. Every new business you one needs to start must begin with a business plan. If you look at most of the successful businesses today all had a very good business plan in place at the inception. One can say that business owners that develop and follow a business plan are more likely to succeed than business owners who do not have a business plan.

There are several reasons why Business Plan is important, some of them are:

Secure Financing for your business

So often it is observed that those people who have business ideas do not have enough capital to start their own business. They need to obtain financing from various financial institutions. Any financial institution would not lend money just because you have an idea; you need to present to them a business plan. A well-written business plan shows lenders and investors that you are serious about your business idea and have spent sufficient time in the planning process.

To plan for uncertain future

Planning is vital at any stage of the organization in any business. If you pen down your business plans you understand your business better and also specific courses of action can be taken to improve it. You can list down all the alternative solutions and ideas, in future these can be used in case of any eventuality.

Plan and Think about all aspect of Business

As mentioned earlier once you sit to draft a business plan, you start to think about each and every aspect of the business. This will help you think of business strategy, recognize limits and identify the problems that you might face.

Communicate Ideas of Others

When you sit to write your business plan you would have already thought what business you want to venture into. Once you begin to start to write toy will begin to believe that your business would succeed. Once you have entered your ideas and plan on paper it will also help you convince the readers. Once your ideas are communicated to the readers they will also gain confidence in your business plan and this can help you get quick financing and also winning the confidence of suppliers.

Tool for Managing the Business

Once the business is up and running you can use the plan to supplement your decision making and planning your future decisions. It can also be used to track whether your business is developing according to plan

Business Plan: Meaning and Purpose

A business plan is a written document that describes all the steps that you need to open and operate a successful business.

Writing a business plan is one of the most important and difficult task that each and every successful entrepreneur has to do. One you know what business you are going to start and have planned all the details, you need to pen these down. This will not only help you sell your idea to convince your investors but also help you visualize all the aspects of the business.

A good business plan must:

• Describes what your business will produce, how you will produce it, and who will buy your product or service.
• Explains who will run your business and who will supply it with goods
• States how your business will win over customers from competitors and what your business will do to keep customers
• Provides detailed financial information that shows how your business will succeed in earning a profit

The business plan serves three important purposes.

1. A business plan explains the idea behind your business and spells out how your product or service will be produced or sold. To convince investors that your business idea is solid, you will need a completely new product or service or one that is better or less expensive than products or services that already exist. You will need to identify who your target customer is and show how your company will be able to obtain and keep customers.

2. A business plan sets specific objectives and describes how your business expects to achieve them. A good business plan includes sales projections for the short term (the first year), the medium term (two to five years after startup), and the long term (five years in the future). It describes what products and services will be introduced over the next five years and sets forth future business plans, such as expansion of the business.

3. A business plan describes the backgrounds and experience of the people who will be running the business. Banks and other lenders make financing decisions based on how well they think a company can meet its objectives. If you provide information on the background and experience of the people who will be running your company, the bank or investor will be more likely to invest money in your business.

The Invisible Hand

Economy is a tricky thing to control and governments are always trying to figure out how to do it. Back in 1776 economists Adam Smith shocked everyone by saying government should back out and leave people alone to buy and sell amongst themselves. He suggested that if they just leave self-interested traders to compete with one an another markets are guided by positive outcome as if by an invisible hand. If someone charges less than you customers will buy from him instead, you will have to lower the price or offer him something better. Whenever, enough people demand something there will be supply in the market like spoilt children, only in this case everyone is happy

Adam Smith, the father of modern economics believed that there existed an “invisible hand” which ruled over the economic system. According to him the economic system, left to it, is self-regulating. The basic driving force in such a system is trying to enhance its own economic well-being. But the actions of each unit, acting according to its own self-interest, are also in the interests of the economy as a whole.

Producers are led by the profit motive to produce those goods and services which the consumers want. They try to do this at the minimum possible cost in order to maximize their profits. Moreover, if there is competition among a number of producers, they will each try to keep the price of their product low in order to attract the consumers. The goods produced are made available in the market by traders. They also act in their own self-interest. However, in a self-regulating economy, there is rarely any shortage of goods and services.

Decisions to save and invest are also taken by the individual economic units. For example, households save some of their income and deposit part of it in the banks, or invest it in shares and debentures and so on. The producers borrow from the banking system and also issue shares and debentures to finance their investments. In turn, they reinvest a part of their profits.

All the economic functions have been carried out by individuals acting in isolation. There is no government or centralized authority to determine who should produce what and in what quantity, and where it should be made available. Yet in a self-regulating economy there is seldom a shortage of goods and services. Practically everything you want to buy is available in the market. Thus according to Adam Smith, the economic system is guided by the “invisible hand”. In a more technical way we can say that the basic economic problems in a society are solved by the operation of market forces.

Types of Research Design

Researches can be classified according to Purpose or Stage in the Decision-Making Process; it is claimed that the research purpose or stage in the decision-making process, determines the characteristics desired in the research design (Silverman, 2005)

Research Design is broadly classified into three broad categories:

The choice of the most appropriate research design depends largely on the objective of the research and how much is known about the problems and these objectives.

Almost all marketing research projects include exploratory and descriptive research. How much of each is necessary depends mostly on how much managers already know about the issue to be studied. When a decision problem has arisen from unplanned changes in the environment, there is usually a need for exploratory research to better understand what is happening and why it is happening. Sometimes, however, managers know a lot about the situation—they understand the key issues and know what questions need  to be asked—and the focus quickly shifts to descriptive research that is geared more toward providing answers than generating initial insights.

Relationship between the three researches

SLEPT Analysis

SLEPT analysis is a tool used to analyse a business environment. It is based on a PEST analysis with one additional dimension. SLEPT stands for Social, Legal, Economic, Political and Technological factors.

Social – Social factors relate to the habits of the consumer, as well as the status of the general public (for example, the average age and income of people in a certain area).

Legal – Legal factors refer to government legislation that places constraints or obligations upon a business; businesses must adapt to changes in the law quickly in order to avoid prosecution.

Economic – Economic factors are affected by social changes, for example through booms and slumps in the economy; in a boom most businesses benefit, whereas in a slump most businesses feel a negative effect. Other economic factors are tied in with legal issues, for example a change in the minimum wage.

Political – Political factors are similar to legal changes, except that this relates to changes in government influence in general; for example, businesses situated within the European Union have been affected by legislation passed by the EU and then implemented into the law of their own country.

Technological – Technological factors play a particularly significant role in modern business, and businesses must be aware of new technology in order to keep up with the rapid changes that are occurring in this field.

SLEPT Analysis

Before creating business plans or when evaluating existing ones it is important to ‘scan’ the external environment. This takes the form of a SLEPT analysis, i.e. an investigation of the Social, Legal, Economic, Political, and Technological influences on a business. In addition it is also important to be aware of the actions of your competitors. These forces are continually in a state of change.

Social

Factors relate to pattern of behaviour, tastes, and lifestyles. A major component of this is a change in consumer behaviour resulting from changes in fashions and styles. The age structure of the population also alters over time (currently we have an ageing population). An understanding of social change gives business a better feel for the future market situation.

Economic

Changes are closely related to social ones. The economy goes through a series of fluctuations associated with general booms and slumps in economic activity. In a boom nearly all businesses benefit and in a slump most lose out. Other economic changes that affect business include changes in the interest rate, wage rates, and the rate of inflation (i.e. general level of increase in prices). Businesses will be more encouraged to expand and take risks when economic conditions are right, e.g. low interest rates and rising demand.

Political

Changes relate to changes in government influence. In recent years these changes have been particularly significant because as members of the European Union we have to adopt directives and regulations created by the EU which then become part of UK law. Political changes are closely tied up with legal changes.

Technology

Changes in technology have also become particularly significant in the post-millennium world. This is particularly true in terms of modern communication technologies. The creation of databases and electronic communications have enabled vast quantities of information to be shared and quickly distributed in a modern company enabling vast cost reductions, and often improvements in service. Organizations need to be aware of the latest relevant technologies for their business and to surf the wave of change.