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Characteristics of a good capital market

by Lesotho Times
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A WELL functioning stock market exchange facilitates the mobilisation of domestic resources and foreign portfolio flows and efficiently allocates these resources to promising opportunities and businesses, and to withdraw capital from less promising ones. On arrival of new information a good capital market quickly adjust the odds to reflect new information so that all bets bullish, bearish, or passive are fair.

One enters a market to buy or sell a good or service quickly at a price justified by the prevailing supply and demand. To determine the appropriate price, participants must have timely and accurate information on the volume and prices of past transactions and on all currently outstanding bids and offers. Therefore, one attribute of a good market is timely and accurate information.

A fair and efficient capital market is one in which security prices adjust rapidly to the arrival of new information and, therefore, the current prices of securities reflect all information about the security (informationally efficient market).

“Fair and efficient” means that markets quickly and accurately reflect new information not that they are always correct. But studies (and theory) have shown that the market consensus is more correct, on average over time, than any individual or group. Accordingly, market prices are the best available estimates of value. The fact that the vast majority of professional investors underperform the market is testimony to this form of market efficiency.

An initial and important premise of an efficient market requires that a large number of profit maximising participants analyse and value securities, each independently of the others. A second assumption is that new information regarding securities comes to the market in a random fashion, and the timing of one announcement is generally independent of others. The third assumption is especially crucial: profit-maximising investors adjust security prices rapidly to reflect the effect of new information. Although the price adjustment may be imperfect, it is unbiased. This means that sometimes the market will over adjust and other times it will under adjust, but you cannot predict which will occur at any given time.

Security prices adjust rapidly because of the many profit-maximising investors competing against one another. The combined effect of: information coming in a random, independent, unpredictable fashion and numerous competing investors adjusting stock prices rapidly to reflect this new information means that one would expect price changes to be independent and random.

It is clear that the adjustment process requires a large number of investors following the movements of the security, analysing the impact of new information on its value, and buying or selling the security until its price adjusts to reflect the new information. This scenario implies that informationally efficient markets require some minimum amount of trading and that more trading by numerous competing investors should cause a faster price adjustment, making the market more efficient.

Markets work best, however, when investors have diverse and diffuse information with uncorrelated biases. Bubbles can occur when investors develop correlated biases — for example, that housing prices only go up or that all Internet companies will succeed. With correlated biases, price discovery can sometimes go awry.

Since security prices adjust to all new information, these security prices should reflect all information that is publicly available at any point in time. Therefore, the security prices that prevail at any time should be an unbiased reflection of all currently available information, including the risk involved in owning the security. Therefore, in an efficient market, the expected returns implicit in the current price of the security should reflect its risk, which means that investors who buy at these informationally efficient prices should receive a rate of return that is consistent with the perceived risk of the stock.

A company’s true value is never certain. Some investors are constantly making trades based on small scraps of information that may not yet be reflected in prices. They are called speculators. In their activities, speculators uncover new information, bringing prices ever closer to fair value (i.e., reflecting all information). This is called price discovery. Efficient price discovery means that all investors — from the individual investor to the largest pension funds can invest with confidence, knowing that prices are generally a fair reflection of available information.

Markets are complex adaptive systems that pursue the will of the people and the wisdom of crowds. In fact, one of the key features of complex adaptive systems (such as markets) is that they quickly learn, adapt to new information, and move forward.

Another prime characteristic is liquidity, the ability to buy or sell an asset quickly and at a known price — that is, a price not substantially different from the prices for prior transactions, assuming no new information is available. An asset’s likelihood of being sold quickly, sometimes referred to as its marketability, is a necessary, but not a sufficient, condition for liquidity. The expected price should also be fairly certain, based on the recent history of transaction prices and current bid-ask quotes.

A component of liquidity is price continuity, which means that prices do not change much from one transaction to the next unless substantial new information becomes available. Suppose no new information is forthcoming and the last transaction was at a price of M20; if the next trade were at M25, the market would be considered reasonably continuous.  A continuous market without large price changes between trades is a characteristic of a liquid market. A market with price continuity requires depth, which means that numerous potential buyers and sellers must be willing to trade at prices above and below the current market price. These buyers and sellers enter the market in response to changes in supply and demand or both and thereby prevent drastic price changes. In summary, liquidity requires marketability and price continuity, which, in turn, requires depth.

Another factor contributing to a good market is the transaction cost. Lower costs (as a percent of the value of the trade) make for a more efficient market. An individual comparing the cost of a transaction between markets would choose a market that charges 2 percent of the value of the trade compared with one that charges 5 percent. Most microeconomic textbooks define an efficient market as one in which the cost of the transaction is minimal. This attribute is referred to as internal efficiency.

Finally, a buyer or seller wants the prevailing market price to adequately reflect all the information available regarding supply and demand factors in the market. If such conditions change as a result of new information, the price should change accordingly. Therefore, participants want prices to adjust quickly to new information regarding supply or demand, which means that prices reflect all available information about the asset. This attribute is referred to as external efficiency or informational efficiency.

Capital markets are information driven, for this reason the regulator requires the disclosure of material information to be made public to all interested parties at the same time. The intent is to level the playing field by ensuring that professional investors do not have a competitive advantage over nonprofessional investors.

NB: Currently there are no listed securities on the Maseru Securities Market (MSM), however there are ongoing discussions which could result in listings.

Katleho Securities, (Members of Maseru Securities Market).

For more information on Capital Markets Contact

+266 27002418, 53230700, 68730055

lnyambuya@katleho.co.ls, securities@katleho.co.ls, www.katleho.co.ls

Plot Number 12292-972 Mabelebele Street, Katlehong, Maseru, Lesotho


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