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Business Finance

Essay by   •  January 26, 2011  •  1,430 Words (6 Pages)  •  1,145 Views

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1. Introduction

The primary role of the capital market is allocation of ownership of the economy’s capital stock (Fama 1970). �When a business is started it may run for some time as a private organization. It might be a partnership, a proprietorship, or even incorporated. Sometimes the founders and owners of these organizations want to raise capital for expansion of their businesses’ (Richard Field 2002). Therefore a share market exists as a platform for founders and owners, who have not enough capital, to raise capital for their business expansion and for investors, who have capital but no business, to invest in the existing business. When potential investors were trying to make investment decision, they would usually first seek for information helping them to make the decision.

1.1 Efficient Market Hypothesis

The efficient market hypothesis is that the price of a security accurately reflects the information available (Peirson et al. 2003, p. 531). When the potential investors successfully found the available information about a specific company, they might decide to invest (or not invest) in the company’s security. Therefore, the security prices would reflect the available information. The prices of stocks fully incorporate all relevant information and hence stock returns will display unpredictable behaviour are called efficient market (Worthington, 2006).

1.2 Definitions of Efficient Market

In 1970, there were three categories of capital market efficiency used by Fama: Weak form efficient, the information set includes only the history of prices; semi-strong form efficient, prices efficiently adjust to other information that is obviously publicly available, such as announcements of annual earnings stock splits, etc; strong form efficient, given investors or groups have monopolistic access to any information relevant for price formation are reviewed. However, in 1991, Fama had redefined these three categories, which were: tests for return predictability, event studies, and tests of private information. The tests for return predictability, the event studies, and the tests of private information could be tools to examine whether the market is weak form efficient, semi-strong form efficient, or strong form efficient.

1.3 Implication of Efficient Market

Because strong form efficiency is that an investor cannot earn abnormal returns from having inside information; if this were true, and everybody believed it to be true, then investors would have no incentive to seek information, as they could expect no rewards for their efforts (Peirson et al. 2003, p. 534). Therefore, strong form efficiency is only an ideal of share markets. Contrariously, if there were a weak form efficient share market, the new (even public or private) information would not affect the securities’ prices since the prices would be only affected by historical series of prices. If it were possible to find �the pattern’ of stock price movements, everybody would do it; the profit would be competed away (McGraw 2008, slide 12). Therefore, weak form efficiency would be less appeared in most of the share markets.

2. Australian Share Market Overview

The Australian Securities Exchange (ASX) as it is now known resulted from the merger of the Australian Stock Exchange and the Sydney Futures Exchange in December 2006 (wikipedia, ). It is also the primary stock exchange of Australia. For most of the share markets, they are also semi-strong form efficient instead of neither weak form efficient nor strong form efficient. Therefore, Australia might also one of the semi-strong form efficient markets. There is the �event studies’ developed by Fama (1991) testing whether Australian share market is semi-strong form efficient.

3. Event Studies

�Event studies’ is a method to examine the behaviour of firms’ stock prices around corporate events and it also serves an important purpose in capital market research, as a way of testing market efficiency (Khotari, 2006). Since Fama redefined the term of semi-strong form efficiency to be the �event studies’ and the content of semi-strong form efficiency kept unchanged, therefore the definition of event studies should also be the prices efficiently adjust to other information that is obviously publicly available particularly around the arrival of new information (Fama & McGraw, 1970 & 2008, slide 20). That means when a share market reflects the new public information, such as dividend increases or decreases, earnings announcements, mergers, capital spending and new issued of stocks (McGraw 2008, slide 23), it should be a semi-strong form efficient share market.

3.1 Implication of Event Studies on Australian Shares Market

3.1.1 Issue of Sub Prime Lending Crisis of US

To imply the event studies on the Australian share market, there is an example to explain. Firstly, it is the affection of the sub prime lending crisis of US. The sub prime lending crisis of US had been affecting all share markets over the world. Australian share market is also one the share markets that had been affected.

At the end of 2006, the US enterprises that engaged in sub prime lending had started to cut off the employees. However, since there was not much information regarding this problem, the Dow Jones Index was still raising (Appendix 1). In the beginning of 2007, the market showed that the bad debts of sub prime lending were increasing rapidly; however, the Dow Jones Index was not hence decreasing. At August of 2007, HSBC announced the estimation of the overall loans reserve would be increased 1.76 billion USD more. Therefore, the Dow Jones Index was dropped.

Since China is a major exporter of US and Australia exports raw materials, such as metals and cotton, to China; when the US stock market falls, which means the demand of goods from China would be hence decreased. Therefore, it would indirectly affect Australian stock market. Eventually, Australian share market was therefore dropped at August reflecting the available information (Appendix 2).

The Australian share market is semi-strong form efficient. When the problem of sub prime lending started appearing in US in 2006, the Australian share market did not reflect this private (or not public) information. Since the crisis of sub prime lending started to be more intense, it therefore reflected in the Australian share market. According to the theory of semi-strong form efficient:

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