The Four Cornerstone Theories of Financial Markets - 1375 Words

The Four Cornerstone Theories of Financial Markets (Research Paper Sample) Content: The Four Cornerstone Theories of Financial MarketsNameInstitutionDateThe Four Cornerstone Theories of Financial MarketsThe bedrock of finance theory is the nature of the relationship between return on an investment, and the risk involved. It is imperative to note that risk is inversely related to the level of certainty about obtaining the return. In other words, the higher the degree of certainty, the lower the risk. Any investment made in a bank savings account entails some risk, particularly when the deposits are insured, whereas uncertain future prospects tend to make investing in a fledgling corporation a highly risky proposition (Grabbe, 1986). Despite the fact that investors aim at getting higher returns for assuming higher risk, the precise nature of the tradeoff has been the focal point of the inquiry in the field of finance. Four cornerstones theories of the financial markets have enhanced the comprehension of this tradeoff, and in the process transformed the role played by various participants like banks in the financial markets (Chew, 1999). This paper explains in detail the four cornerstone theories of the financial markets. These four cornerstone theories include: * The Markowitz-Sharpe-Linter capital asset pricing model (CAPM); * The Modigliani-Miller (MM) theory of capital structure; * The Jensen-Meckling agency theory; and * The Black-Scholes option theory (OPT). 1 The theory of capital structureMiller and Modigliani, analyzed the capital-structure theory, and developed the capital-structure irrelevance proposition. They theorized that in a perfect market, it does not matter what capital structure a company uses to finance its operations. According to their hypothesis, the market value of a company can be estimated by the risk of its underlying assets, and its earning power, and its value cannot be influenced by the way it chooses to distribute dividends or finance its investments (Mehta Fung, 2004). This theory is based on seve ral assumptions, which include: * No effect of debt on a companyà ¢Ã¢â€š ¬Ã‹Å"s earnings before interest and taxes * Equivalence in borrowing costs for both companies and investors * No taxes * Symmetry of market information, meaning companies and investors have same information * No bankruptcy costs * No transaction costsMM capital-structure irrelevance propositionMM capital-structure irrelevance proposition assumes no bankruptcy costs, and no taxes are incurred. In this proposition, the weighted average cost of capital remains constant despite the changes in the companyà ¢Ã¢â€š ¬s capital structure. For instance, it does not matter how a firm borrows, since there is no tax paid on the interest payment, and as a result, the weighted average cost of capital does no change. In addition, the fact that there are no benefits from increase in debt, the capital structure cannot affect the companyà ¢Ã¢â€š ¬s stock price. Therefore, the capital structure is thus considered impertinent t o the companyà ¢Ã¢â€š ¬s stock price. However, bankruptcy costs, and taxes influence the companyà ¢Ã¢â€š ¬s stock price (Mehta Fung, 2004).MM tradeoff theory of LeverageThe tradeoff theory takes into assumption that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. Tradeoff theory recognizes the tax benefit from interest payments, since the interest paid on debt is taxable. Effective issuing of bonds normally reduces companyà ¢Ã¢â€š ¬s tax liability. On the other hand, payment of dividends on equity does not reduce a companyà ¢Ã¢â€š ¬s tax liability.The only difference between the two theories arises from the tax benefit of the interest payments. In other words, the MM capital-structure irrelevance theory does not deduct taxes from interest payments, whereas the tradeoff theory of Leverage deducts taxes on interest payments (Chew, 1999). 2 Capital asset pricing model (CAPM)When an investor intends to invest in more than one asset, that is, if an investor has an intention to create a portfolio of investments, Markowitz theorized that the risk of the portfolio cannot be estimated by a simple sum of weighted risks of its components. In addition, a portfolio of related investments gives an investor an opportunity to reduce some risk of individual investments. If the trends in the returns are not closely correlated, the gains of some investments will cancel loses of others (Grabbe, 1986).The effect of portfolio risk is always less than the sum of the risk of individual investments. In addition, Sharpe and Linter, modified the concept of portfolio to the market portfolio, which consists of risky assets traded in the market. They also devised the CAPM framework. The exhibited that a risk for an individual asset/security in an informationally efficient market is estimated by its contribution to the risk of the market portfolio, and not by standard deviation of its returns (Mehta Fung, 2004).The total ris k of investment/asset can therefore be divided into two; systematic risk assumed by the investor and the unsystematic risk that will be diversified away in case the portfolio includes other assets. Because the MM theory and the CAPM theory share the common concept of efficient market, their compatibility implies that a change in the capital structure of a firm will induce a commensurate change in the systematic risk of its stock. 3 Option pricing theoryBlack and Scholes revealed through the option pricing theory that an individual investor can manage the risk by selling or buying derivatives that are based on securities. Therefore, it can be concluded that individuals do not have to hold all securities represented in market portfolio. There are two basic forms of derivatives. These are futures and options. Options are further divided into puts and calls. If a person sells a à ¢Ã¢â€š ¬Ã‹Å"put optionà ¢Ã¢â€š ¬, he/she assumes a bad risk, and receives appropriate compensation for tha t (Grabbe, 1986). In case individuals buy the à ¢Ã¢â€š ¬Ã‹Å"call optionà ¢Ã¢â€š ¬, they enjoy good returns without assuming bad risks. For the company, the OPT has the advantage of risk management, because it alters the companyà ¢Ã¢â€š ¬s risk profile without affecting its capital structure or assets.Organized markets dealing in derivatives have been struggling to satisfy customer needs for risk management products by offering innovative products. Despite the much struggle, these markets have not been able to meet their customer needs fully. Banks have been complimenting the situation by offering customized products that aid the customers in fine-tuning risk management. 4 Agency theoryAll the other three theories (MM, OPT, and the CAPM) are based on the assumption of an informationally efficient market, where arbitrage action is effective in instantaneously removing any distortions in the pricing of a security. Contrary to this, agency theory assumes the assumption that there is asymmetric information in the principal-agent relationship. Therefore, the principal who has delegated a duty to the agent does not have a perfect knowledge of the agentà ¢Ã¢â€š ¬s actions. As a result, the principal is compelled to monitor the agentà ¢Ã¢â€š ¬s actions to ensure that the agent does not go against his/her interests (Rich, 2010).Assuming a case where there is a highly risky project, which has a small systematic risk component, and good returns, the project may appear viable from the owner/principalà ¢Ã¢â€š ¬s perspective, but manager/agents may decide not to undertake it. This is because such an investment may fail and as a result, tarnish the management reputati...