Chapter Five

Financial Markets in the Financial System

5.1. Introduction
Investors exchange financial instruments in a financial market. The more popular term used for the
exchanging of financial instruments is that they are “traded.” Financial markets provide the
following three major economic functions: (1) price discovery, (2) liquidity, and (3) reduced
transaction costs. Despite the important role of financial markets, their role in allowing the efficient
allocation for those who have funds to invest and those who need funds may not always work as
described earlier. As a result, financial systems have found the need for a special type of financial
entity, a financial intermediary, when there are conditions that make it difficult for lenders or
investors of funds to deal directly with borrowers of funds in financial markets. Financial markets
can be classified depending on different factors and discussed in this chapter.
5.2. Money Markets
Money market purpose and structure
The purpose of money markets is facilitate the transfer of short-term funds from agents with
excess funds (corporations, financial institutions, individuals, government) to those market
participants who lack funds for short-term needs.

They play central role in the country’s financial system, by influencing it through the country’s
monetary authority.

For financial institutions and to some extent to other non-financial company’s money
markets allow for executing such functions as:
 Fund raising;
 Cash management;
 Risk management;
 Speculation or position financing;
 Signaling;
 Providing access to information on prices.
The money-market instruments are often grouped in the following way:

 Treasury bills and other short-term government securities (up to one year);
 interbank loans, deposits and other bank liabilities;
 Repurchase agreements and similar collateralized short-term loans;
 Commercial papers, issued by non-deposit entities (non-finance companies, finance
companies, local government, etc. ;
 Certificates of deposit;
All these instruments have slightly different characteristics, fulfilling the demand of investors
and borrowers for diversification in terms of risk, rate of return, maturity and liquidity, and also
diversification in terms of sources of financing and means of payment. Many investors regard
individual money market instruments as close substitutes, thus changes in all money market
interest rates are highly correlated.

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 Major characteristics of money market instruments are:
 Short-term nature;
 Low risk;
 High liquidity (in general);
 Close to money.
In terms of risk two specific money-market segments are:
unsecured debt instruments markets (e.g. deposits with various maturities, ranging from
overnight to one year);
Secured debt instruments markets (e.g. REPOs) with maturities also ranging from
overnight to one year.
Differences in amount of risk are characteristic to the secured and the unsecured
segments of the money markets. Credit risk is minimized by limiting access to high-quality
counter-parties. When providing unsecured interbank deposits, a bank transfers funds to another
bank for a specified period of time during which it assumes full counterparty credit risk. In the
secured REPO markets, this counterparty credit risk is mitigated as the bank that provides
liquidity receives collateral (e.g., bonds) in return.
Money market participants
Money market participants include mainly credit institutions and other financial
intermediaries, governments, as well as individuals (households).

Ultimate lenders in the money markets are households and companies with a financial surplus
which they want to lend, while ultimate borrowers are companies and government with a
financial deficit which need to borrow. Ultimate lenders and borrowers usually do not participate
directly in the markets. As a rule they deal through an intermediary, who performs functions of
broker, dealer or investment banker.
Important role is played by government, which issue money market securities and use the
proceeds to finance state budget deficits. The government debt is often refinanced by issuing
new securities to pay off old debt, which matures. Thus it manages to finance long- term needs
through money market securities with short-term maturities.

Money market instruments

1. Treasury bills (popularly referred to as T-bills) are short-term securities issued by the U.S.
government; they have original maturities of four weeks, three months, or six months. T-bills carry
no stated interest rate. Instead, the government sells these securities on a discounted basis. This
means that the holder of a T-bill realizes a return by buying these securities for less than the maturity
value and then receiving the maturity value at maturity.
2. Commercial paper is a promissory note—a written promise to pay—issued by a large,
creditworthy corporation or a municipality. This financial instrument has an original maturity that
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typically ranges from one day to 270 days. The issuers of most commercial paper back up the paper
with bank lines of credit, which means that a bank is standing by ready to pay the obligation if the
issuer is unable to. Commercial paper may be either interest bearing or sold on a discounted basis.
3. Certificates of deposit (CDs) are written promises by a bank to pay a depositor. Investors can
buy and sell negotiable certificates of deposit, which are CDs issued by large commercial banks.
Negotiable CDs typically have original maturities between one month and one year and have
denominations of $100,000 or more. Investors pay face value for negotiable CDs, and receive a fixed
rate of interest on the CD. On the maturity date, the issuer repays the principal, plus interest.
4. Another form of short-term borrowing is the repurchase agreement. To understand a
repurchase agreement, we will briefly describe why companies use this instrument. There are
participants in the financial system that use leverage in implementing trading strategies in the bond
market. That is, the strategy involves buying bonds with borrowed funds. Rather than borrowing
from a bank, a market participant can use the bonds it has acquired as collateral for a loan.
Specifically, the lender will loan a certain amount of funds to an entity in need of funds using the
bonds as collateral. We refer to this common lending agreement as a repurchase agreement or repo
because it specifies that the borrower sells the bonds to the lender in exchange for proceeds and at
some specified future date the borrower repurchases the bonds from the lender at a specified price.
The specified price, called the repurchase price, is higher than the price at which the bonds are sold
because it embodies the interest cost that the lender is charging the borrower.
The interest rate in a repo is the repo rate. Thus, a repo is nothing more than a collateralized loan;
that is, a loan backed by a specific asset. We classify it as a money market instrument because the
term of a repo is typically less than one year.
5. Bankers’ acceptances are short-term loans, usually to importers and exporters, made by banks to
finance specific transactions. An acceptance is created when a draft (a promise to pay) is written by a
bank’s customer and the bank “accepts” it, promising to pay. The bank’s acceptance of the draft is a
promise to pay the face amount of the draft to whoever presents it for payment. The bank’s customer
then uses the draft to finance a transaction,
giving this draft to the supplier in exchange for goods. Because acceptances arise from specific
transactions, they are available in a wide variety of principal amounts. Typically, bankers’
acceptances have maturities of less than 180 days. Bankers’ acceptances are sold at a discount from
their face value, and the face value is paid at maturity. The likelihood of default on bankers’
acceptances is very small because acceptances are backed by both the issuing bank and the purchaser
of goods.

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5.3. The Capital Market
The capital market is the sector of the financial market where long-term financial instruments issued
by corporations and governments trade. Here “long-term” refers to a financial instrument with an
original maturity greater than one year and perpetual securities (those with no maturity). There are
two types of capital market securities: those that represent shares of ownership interest, also called
equity, issued by corporations, and those that represent indebtedness, issued by corporations and by
the U.S., state, and local governments. Earlier we described the distinction between equity and debt
instruments. Equity includes common stock and preferred stock. Because common stock represents
ownership of the corporation, and because the corporation has a perpetual life, common stock is a
perpetual security; it has no maturity. Preferred stock also represents ownership interest in a
corporation and can either have a redemption date or be perpetual.
A capital market debt obligation is a financial instrument whereby the borrower promises to repay
the maturity value at a specified period of time beyond one year. We can break down these debt
obligations into two categories: bank loans and debt securities. While at one time, bank loans were
not considered capital market instruments, today there is a market for the trading of these debt
obligations. One form of such a bank loan is a syndicated bank loan. This is a loan in which a group
(or syndicate) of banks provides funds to the borrower. The need for a group of banks arises because
the exposure in terms of the credit risk and the amount sought by a borrower may be too large for
any one bank.
Debt securities include (1) bonds, (2) notes, (3) medium-term notes, and (4) asset-backed securities.
The distinction between a bond and a note has to do with the number of years until the obligation
matures when the issuer originally issued the security. Historically, a note is a debt security with a
maturity at issuance of 10 years or less; a bond is a debt security with a maturity greater than 10
years. The distinction between a note and a medium-term note has nothing to do with the maturity,
but rather the method of issuing the security.
5.4. The Primary Market
When an issuer first issues a financial instrument, it is sold in the primary market. Companies sell
new issues and thus raise new capital in this market. Therefore, it is the market whose sales generate
proceeds for the issuer of the financial instrument. Issuance of securities must comply with the U.S.
securities laws.
The primary market consists of both a public market and a Private placement market. The public
market offering of new issues typically involves the use of an investment bank. The process of
investment banks bringing these securities to the public markets is underwriting. Another method of
offering new issues is through an auction process. Bonds by certain entities such as municipal
governments and some regulated entities are issued in this way.

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5.5. The Secondary Market
A secondary market is one in which financial instruments are resold among investors. Issuers do not
raise new capital in the secondary market and, therefore, the issuer of the security does not receive
proceeds from the sale. Trading takes place among investors. Investors who buy and sell securities
on the secondary markets may obtain the services of stockbrokers, entities who buy or sell securities
for their clients. We categorize secondary markets based on the way in which they trade, referred to
as market structure. There are two overall market structures for trading financial instruments: order
driven and quote driven. Market structure is the mechanism by which buyers and sellers interact
to determine price and quantity. In an order-driven market structure, buyers and sellers submit their
bids through their broker, who relays these bids to a centralized location for bid-matching, and
transaction execution. We also refer to an order-driven market as an auction market.
In a quote-driven market structure, intermediaries (market makers or dealers) quote the prices at
which the public participants trade. Market makers provide a bid quote (to buy) and an offer quote
(to sell), and realize revenues from the spread between these two quotes. Thus, market makers
Derive a profit from the spread and the turnover of their inventory of a security. There are hybrid
market structures that have elements of both a quote-driven and order-driven market structure.
We can also classify secondary markets in terms of organized exchanges and over-the-counter
markets. Exchanges are central trading locations where financial instruments trade. The financial
instruments must be those listed by the organized exchange. By listed, we mean the financial
Instrument has been accepted for trading on the exchange. To be listed, the issuer must satisfy
requirements set forth by the exchange. In the case of common stock, the major organized exchange
is the New York Stock Exchange (NYSE). For the common stock of a corporation to list on the
NYSE, for example, it must meet minimum requirements for pretax earnings, net tangible assets,
market capitalization, and number and distribution of shares publicly held. In the United States, the
SEC must approve the market to qualify it as an exchange. In contrast, an over-the-counter market
(OTC market) is generally where unlisted financial instruments trade. For common stock, there are
Listed and unlisted stocks. Although there are listed bonds, bonds are typically unlisted and therefore
trade over-the-counter. The same is true of loans. The foreign exchange market is an OTC market.
There are listed and unlisted derivative instruments.
5.6. Debt Markets

Debt markets are used by both firms and governments to raise funds for long-term purposes, though
most investment by firms is financed by retained profits. Bonds are long-term borrowing instruments
for the issuer. Major issuers of bonds are governments (Treasury bonds in US, gilts in the UK,
Bunds in Germany) and firms, which issue corporate bonds Corporate as well as government bonds
vary very considerably in terms of their risk. Some corporate bonds are secured against assets of the
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company that issued them, whereas other bonds are unsecured. Bonds secured on the assets of the
issuing company are known as debentures. Bonds that are not secured are referred to as loan stock.
Banks are major issuers of loan stock. The fact that unsecured bonds do not provide their holders
with a claim on the assets of the issuing firm in the event of default is normally compensated for
by means of a higher rate of coupon payment. Important characteristics of bonds involve:
The conventional or straight bond has the following characteristics: Residual maturity (or
redemption date). As time passes, the residual maturity of any bond shortens. Bonds are classified
into ‘short-term’ (with lives up to five years); ‘medium-term’ (from five to fifteen years) ; ‘long-
term’(over fifteen years). Bonds pay a fixed rate of interest, called coupon. It is normally made in
two installments, at six-monthly intervals, each equal to half the rate specified in the Bond’s coupon.
The coupon divided by the par value of the bond (100 Euro) gives the coupon rate on the bond.
The par or redemption value of bonds is commonly 100 Euro (or other currency). This is also the
price at which bonds are first issued. However, since the preparations for issue take time, market
conditions may change in such a way as to make the bonds unattractive at their existing coupon at
the time they are offered for sale. They will then have to be sold at a discount to 100 Euro, in order
to make the coupon rate approximate the market rate of interest. If, vise versa, the market interest
rates fall, the coupon may make the bond attractive at a price above 100 Euro. In these cases the
issuers are making a last-minute adjustment to the price which they hope will make the bonds
acceptable to the market.
Bond prices fluctuate inversely with market interest rates. If market rates rise, people prefer to
hold the new, higher-yielding issues than existing bonds. Existing bonds will be sold and their price
will fall. Eventually, existing bonds with various coupons will be willingly held, but only when their
price has fallen to the point where the coupon expressed as a percentage of the current price
approximates the new market rate.
5.7. Equity Markets
Equity market is one of the key sectors of financial markets where long-term financial instruments
are traded. The purpose of equity instruments issued by corporations is to raise funds for the firms.
The provider of the funds is granted a residual claim on the company’s income, and becomes one of
the owners of the firm. For market participants equity securities mean holding wealth as well as a
source of new finance, and are of great significance for savings and investment process in a market
economy.
The purpose of equity is the following:

 A new issue of equity shares is an important source of external corporate financing;

 Equity shares perform a financing role from internally generated funds (retained earnings);
 Equity shares perform an institutional role as a means of ownership.
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Within the savings-investment process magnitude of retained earnings exceeds that of the new stock
issues and constitutes the main source of funds for the firms. Equity instruments can be traded
publicly and privately.
External financing through equity instruments is determined by the following financial factors:
 The degree of availability of internal financing within total financing needs of the firm;
 The cost of available alternative financing sources;
 Current market price of the firm’s equity shares, which determines the return of equity
investments.
Internal equity financing of companies is provided through retained earnings. When internally
generated financing is scarce due to low levels of profitability and retained earnings, and also due to
low depreciation, but the need for long-term investments is high, companies turn to look for external
financing sources. Firms may raise funds by issuing equity that grants the investor a residual claim
on the company’s income. Low interest rates provide incentives for use of debt instruments, thus
lowering demand for new equity issues. High equity issuance costs force companies to look for other
sources of financing as well. However, during the period of stock market growth high market prices
of equity shares encourage companies to issue new equity, providing with the possibility to attract
larger magnitude of funds from the market players.
Equity instruments
1. Common shares
Common (ordinary) shares represent partial ownership of the company and provide their holders
claims to future streams of income, paid out of company profits and commonly referred to as
dividends. Common shareholders are residual claimants, i.e. they are entitled to a share only in those
profits which remain after bondholders and preference shareholders have been paid. If the company
is liquidated, shareholders have a claim on any remaining assets only after prior claimants have been
paid. Therefore common shareholders face larger risks than other stakeholders of the company (e.g.
bondholders and owners of preferred shares. On the other hand, if the value of the company
increases, the shareholders are entitled to larger potential benefits, which may well exceed the
guaranteed interest of bondholders. Common or ordinary share (stock) – an equity share that does
not have a fixed dividend yield.
2. Preferred shares
Preferred shares is a financial instrument, which represents an equity interest in a firm and which
usually does not allow for voting rights of its owners. Typically the investor into it is only entitled to
receive a fixed contractual amount of dividends and this make this instrument similar to debt.
However, it is similar to an equity instrument because the payment is only made after payments to
the investors in the firm’s debt instruments are satisfied. Therefore it is call a hybrid instrument.

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Technically preferred shareholders share ownership of the firm with common shareholders and are
compensated when company generates earnings. Therefore, if the company does not earn sufficient
net profit, from which to pay the preferred share dividends it may not pay dividends without the risk
of bankruptcy. Because preferred stockholders typically are entitled to a fixed contractual amount,
preferred stock is referred to as a fixed income instrument. Preferred share – an equity security,
which carries a predetermined constant dividend payment.
5.8. Derivative Market
We classify financial markets in terms of cash markets and derivative markets. The cash market, also
referred to as the spot market, is the market for the immediate purchase and sale of a financial
instrument. In contrast, some financial instruments are contracts that specify that the contract holder
has either the obligation or the choice to buy or sell something at or by some future date. The
“something” that is the subject of the contract is the underlying asset or simply the underlying. The
underlying can be a stock, a bond, a financial index, an interest rate, a currency, or a commodity.
Such contracts derive their value from the value of the underlying; hence, we refer to these contracts
as derivative instruments, or simply derivatives, and the market in which they trade is the derivatives
market. Derivatives instruments, or simply derivatives, include futures, forwards, options, swaps,
caps, and floors. We postpone a discussion of these important financial instruments, as well as their
applications in corporate finance and portfolio management, to later chapters. The primary role of
derivative instruments is to provide a transitionally efficient vehicle for protecting against various
types of risk encountered by investors and issuers. Admittedly, it is difficult to see at this early stage
how derivatives are useful for controlling risk in an efficient way since too often the popular press
focuses on how derivatives have been misused by corporate treasurers and portfolio managers.
4.1. Foreign Exchange Markets
U.S. borrowers and investors need not look solely to domestic financial markets to accomplish their
financial goals. Nor need foreign entities depend solely on their domestic markets. As a result,
payments for liabilities made by borrowers and cash payment received by investors may be
denominated in a foreign currency.
Foreign Exchange Rates
An exchange rate is defined as the amount of one currency that can be exchanged per unit of
another currency or the price of one currency in terms of another currency. For example, consider
the exchange rate between the U.S. dollar and the Swiss franc. The exchange rate could be quoted in
one of two ways:
1. The amount of U.S. dollars necessary to acquire one Swiss franc, or the dollar price of one
Swiss franc.

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 2. The amount of Swiss francs necessary to acquire one U.S. dollar, or the Swiss franc price of
one dollar.
Exchange rate quotations may be either direct or indirect. To understand the difference, it is
necessary to refer to one currency as a local currency and the other as a foreign currency. For
example, from the perspective of a U.S. participant, the local currency would be U.S. dollars, and
any other currency, such as Swiss franc, would be the foreign currency. From the perspective of a
Swiss participant, the local currency would be Swiss francs, and other currencies, such as U.S.
dollars, the foreign currency.
Direct quote is the number of units of a local currency exchangeable for one unit of a foreign
currency. An indirect quote is the number of units of a foreign currency that can be exchanged for
one unit of a local currency. Looking at this from a U.S. participant’s perspective, a quote indicating
the number of dollars exchangeable for one unit a foreign currency is a direct quote. An indirect
quote from the same participant’s perspective would be the number of units of the foreign currency
that can be exchanged for one U.S. dollar. Obviously, from the point of view of
a non-U.S. participant, the number of U.S. dollars exchangeable for one unit of a non-U.S. currency
is an indirect quote; the number of units of a non-U.S. currency exchangeable for a U.S. dollar is a
direct quote.
Given a direct quote, we can obtain an indirect quote (the reciprocal of the direct quote), and vice
versa. For example, suppose that a U.S. participant is given a direct quote of dollars for Swiss
francs of 0.7402 – that is, the price of a Swiss franc is $0.7402. The reciprocal of the direct quote is
1.3508, which would be the indirect quote for the U.S. participant; that is, one U.S. dollar can be
exchanged for 1.3508 Swiss francs, which is the Swiss franc price of dollar.
If the number of units of a foreign currency that can be obtained for one dollar – the price of a dollar
or indirect quotation – rises, the dollar is said to appreciate relative to the foreign currency, and the
foreign currency is said to depreciate. Thus appreciation means a decline in the direct quotation.

Foreign-Exchange Risk
From the perspective of a U.S. investor, the cash flows of assets denominated in a foreign currency
expose the investor to uncertainty as to the cash flow in U.S. dollars. The actual U.S. dollars that the
investor gets depend on the exchange rate between the U.S. dollar and the foreign currency at the
time the non-dollar cash flow is received and exchanged for U.S. dollars. If the foreign currency
depreciates (declines in value) relative to the U.S. dollar (i.e., the U.S. dollar appreciates), the dollar
value of the cash flows will be proportionately less. This risk is referred to as foreign-exchange
risk.

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 Any investor who purchases an asset denominated in a currency that is not the medium of
exchange of the investor’s country faces foreign-exchange risk. For example, a Greek investor who
acquires a yen-denominated Japanese bond is exposed to the risk that the Japanese yen will decline
in value relative to the Greek drachma.
Foreign- exchange risk is a consideration for issuers too. Suppose that IBM issues bonds
denominated in Japanese yen IBM’s foreign-exchange risk is that at the time the coupon interest
payments must be made and the principal repaid, the U.S. dollar will have depreciated relative to the
Japanese yen, requiring that IBM pay more dollars to satisfy its yen obligation.
Spot Market
The spot exchange rate market is the market for settlement within two business days. Since the early
1970s, exchange rates between major currencies have been free to float, with market forces
determining the relative value of a currency. Thus, each day a currency’s price relative to another
currency may stay the same, increase, or decrease.
While quotes can be either direct or indirect, the problem is defining from whose perspective the
quote is given. Foreign exchange conventions in fact standardize the ways quotes are given. Because
of the importance of the U.S. dollar in the international financial system, currency quotations are all
relative to the U.S. dollar. When dealers quote, they either give U.S. dollars per unit of foreign
currency (a direct quote from the U.S. perspective) or the number of units of the foreign currency per
U.S. dollar (an indirect quote from the U.S. perspective). Quoting in terms of U.S. dollars per unit of
foreign currency is called American terms, while quoting in terms of the number of units of the
foreign currency per U.S. dollar is called European terms.
A key factor affecting the expectation of changes in a country’s exchange rate is the relative
expected inflation rate. Spot exchange rates adjust to compensate for relative inflation rate between
two countries. This is the so called purchasing-power parity relationship. It says that the exchange
rate – the domestic price of the foreign currency – is proportional to the domestic inflation rate, and
inversely proportional to foreign inflation.
Cross Rates
Barring any government restrictions, riskless arbitrage will assure that the exchange rate between
two countries will be the same in both countries. The theoretical exchange rate between two
countries other than the U.S. can be inferred from their exchange rate with the U.S. dollar. Rates
computed in this way are referred to as theoretical cross rates. They would be computed as follows
for two countries, X and Y:
Quote in American terms of currency X
Quote in American terms of currency Y

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 To illustrate how this is done, let’s calculate the theoretical cross rate between German marks and
Japanese yen using the exchange rates. The exchange rate for the two currencies in American terms
is $0.6234 per German marks and $0.009860 per Japanese yen. Then the number of Japanese yen
(Y) per unit of German marks (X) is:
$0.6234 = 63.23 yen/mark
$0.009860
Taking the reciprocal gives the number of German marks exchangeable for one Japanese yen. In
our example it is 0.01581.
New Issue Vs Stock Exchanges
New issue: a stock issued for the first time to raise new equity capital, this transaction is said to
occur in the primary market. Initial public offerings by privately held firms: the IPO market.
The act of selling stock to the public at large by closely held corporation or its principal
stockholders.
The Stock Exchanges
There are two basic types of stock markets: (1) organized exchanges, which include the New York
Stock Exchange (NYSE), the American Stock Exchange (AMEX), and several regional exchanges,
and (2) the less formal over-the=counter market.
The organized security exchanges are tangible physical entities. Each of the larger ones
occupies its own building, has a limited number of members, and has an elected governing body – its
board of governors. Members are said to have “seats” on the exchange, although everybody stands
up. These seats, which are bought and sold, give the holder the right to trade on the exchange. There
are more than 1,300 seats on the New York Stock Exchange, and recently
NYSE seats were selling for about $1.5 million.
Most of the larger investment banking houses operates brokerage departments, and they own
seats on the exchanges and designate one or more of their officers as members. The exchange are
open on all normal working days, with the members meeting in a large room equipped with
telephones and other electronic equipment that enable each member to communicate with his or her
firm’s offices throughout the country.
Like other markets, security exchanges facilitate communication between buyers and sellers. For
example, Merrill Lynch (the largest brokerage firm) might receive an order in its Atlanta office from
a customer who wants to buy 100 shares of AT&T stock. Simultaneously, Dean Witter’s Denver
office might receive an order from a customer wishing to sell 100 shares of AT&T. each broker
communicates by wire with the firm’s representative on the NYSE. Other brokers throughout the
country are also communicating with their own exchange members. The exchange members with

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sell orders offer the shares for sale, and they are bid for by the members with buy orders. Thus, the
exchanges operate as auction market.
The Efficient Markets Hypothesis
A body of theory called the Efficient Markets Hypothesis (EMH) holds (1) that stocks are always
in equilibrium and (2) that it is impossible for an investor to consistently “beat the market.”
Levels of Market Efficiency
If markets are efficient, stock prices will rapidly reflect all available information. This raises an
important question: what types of information are available and, therefore, incorporated into stock
prices? Financial theorists have discussed three forms, or levels, of market efficiency.
Weak-Form Efficiency. The weak-form of the EMH states that all information contained in past
price movements is fully reflected in current market prices. If this is true, then information about
recent trends in stock prices would be of no use in selecting stocks – the fact that a stock has risen
for the past three days, for example, would give us no useful clues as to what it will do today or
tomorrow. People who believe that weak-form efficiency exists also believe that “tape watchers” and
“chartists” are wasting their time. 1
For example, after studying the past history of the stock market, a chartist might “discover” the
following pattern: If a stock falls three consecutive days, its price typically rises 10 percent the
following day. The technician would conclude that investors could make money by purchasing a
stock whose price has fallen three consecutive days.
Semi Strong-Form Efficiency. The semi strong form of EMH states that current market prices
reflect all publicly available information. Therefore, if semi strong-form efficiency exists, it would
do no good to pore over annual reports or other published data because market prices would have
adjusted to any good or bad news contained in such reports back when the news came out. With semi
strong-form efficiency, investors should expect to earn the returns predicted by the SML, but they
should not expect to do any better unless they have good luck or information that is not publicly
available. However, insiders (for example, the presidents of companies) who have information which
is not publicly available can earn abnormal returns (returns higher than those predicted by the SML)
even under semi strong-form efficiency.
Another implication of semi strong-form efficiency is that whenever information is released to
the public, stock prices will respond only if the information is different from what had been
expected.
Strong-Form Efficiency. The strong form of EMH states that current market prices reflect all
pertinent information, whether publicly available or privately held. If this form holds, even insiders
would find it impossible to earn abnormal returns in the market.

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Many empirical studies have been conducted to test for the three forms of market efficiency. Most of
these studies suggest that the stock market is indeed highly efficient in the weak form and reasonably
efficient in the semi strong form, at least for the larger and more widely followed stocks. However,
the strong-form EMH does not hold, so abnormal profits can be made by those who possess inside
information.

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