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2. Semi-Strong Form Efficiency: In this form of market efficiency, no investor can earn excess returns from using trading rules based on any
publicly available information.
3. Strong Form Efficiency: In this form of efficiency, no investor can earn excess returns using any information whether publicly available or not.
As every casual follower of financial news knows, stock prices rise and fall in response to earnings and revenues Yee, 2001. Positive information regarding
expected Earnings per Share EPS will boost the stock price and vice versa.
C. Stock Rate of Return
Capital Market Theory explains the behavior of investor in making an investment decision. Investor will consider two most important factors when
making an investment decision; risk and return. A stock‟s rate of return is gained
from the dividend paid annually or capital gain or margin from the purchase-sell activity.
Chris Brooks 2002 p.154 in his book, Introductory of Econometrics for Finance explain two methods in calculating return gained from capital gain margin; simple
return and continuously compounded returns. The formula of each method is as follows:
Simple returns: �
2.1
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Continuously compounded return
2.2
Where, R
t
= Simple returns on t period r
t
= Continuously compounded returns on t period P
t
= Stock Price on t period P
t-1
= Stock Price on t-1 period Investor will make an investment decision to buy a particular stock if a stock‟s
rate of return forecasted to be increased in the future. In this condition, investor will gained more return than they‟re required rate of return. When a stock‟s return
is predicted to up, it will increase the demand from investor to that particular stock and automatically increase the stock price. On the other hand, when a stock‟s
return is predicted to decrease, it will also decrease the demand from investor to that particular stock and resulted in the decrease of stock price as well. Investor
will tend to sell the stocks which not meet their required rate of return. Here we can see a linear correlation between a stock‟s rate of return and stock‟s price.
D. Risks
Despite considering a stock‟s return, investor who wishes to invest their money on capital market must also define the risk of the stock. In one definition,
risks are simply future issues that can be avoided or mitigated, rather than
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present problems that must be immediately addressed Hubbard, 2009. While others said that risk is the uncertainty about rate of return in the future Bodie et
al: 2007. Risks that faced by investors are strongly related to the fluctuation of stock price. According to Yan Yee Chong 2006, p. 75 in his books Investment
Risk Management , risks are classified into several types:
a. Business Risk Business risk is the potential for loss of value through competition,
mismanagement, and financial insolvency. There are a number of industries that are predisposed to higher levels of business risk airlines,
railroads, steel, etc. b. Credit and Country Risk
Credit risk is the risk that firm unable to deal with its obligations, and therefore the asset will become unprofitable. Country risk refers to the risk
that a country will change the rules under which its financial system operates in some way that affects that country‟s native financial instrument
and assets; country risk is also known as political risk. c. Interest
The raise of interest rate will decrease the demand of stocks investment because people will prefer to invest in the form of deposits. This resulted
in the decreasing of stock price. d. Market Risk
Market risk is risk associated with daily fluctuations in stock price. Market risk is also referred to as volatility; assets with high volatility market risk
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are likely to fluctuate greatly in stock price, whereas assets with low volatility are more immune to fast, large price changes. Volatility is
important in the stock world for a variety of reasons. The more volatile a stock, the more potential for profit there may exist which is why some
investors focus on identifying growth stocks, which have the capability for explosive growth, but at the same time, there is also the possibility of
dramatic loss. The less volatile the investment, the less on average the return will be to that investment.
e. Liquidity Risk The final type of risk associated with stock market transactions is liquidity
risk. Liquidity risk refers to risk that the stock will not be able to be traded fast enough to avoid or loss or capitalize on a potential profit. Liquidity
risk can be avoided by making sure the daily volume of share trading is above a certain level.
Generally, risk is calculated by the deviation of the actual return from the required rate of return expected return as a result of successfailure of an investment. Risk
of a stock can be measured by its variance or standard deviation. With the risk of uncertainty, investors not only need to calculate the return of a stock but also the
risks associated with it. There are two types of risks that commonly faced by the investor when investing
their money; systematic and unsystematic risk. Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and
cannot be avoided through diversification. While unsystematic risk is company or
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industry specific risk that is inherent in each investment. Systematic risk can be mitigated only by being hedged, while the amount of unsystematic risk can be
reduced through appropriate diversification.
E. Inflation
