The Four Cornerstone Theories of the Financial Markets Term Paper Essay:
Table of Contents
The Modigliani-Miller (MM) Theory of Capital Structure…………………………………3
Markowitz-Sharpe-Linter Capital Asset Pricing Model (CAPM)…………………………5
Black-Scholes Option pricing theory………………………………………………………7
Jensen-Meckling Agency Theory……………………………………………………………8
There has been an evolution of academic finance from the overreliance on behavioral finance to the application of other numerous theories of financial markets. Financial markets are governed by four major theories namely Modigliani-Miller theory of capital structure, Markowitz –Sharpe-Linter Capital Asset Pricing Model (CAPM), Black-Scholes option pricing model and Jensen-Meckling agency theory. The relevance of these theories in the financial markets cannot be overemphasized. An analysis into the four theories reveals diverse aspects of the financial markets that require critical consideration by the stakeholders involved before undertaking any form of decision related to investment, purchase or sale of financial commodities in the market. From the four theories, important factors of the financial markets and commodities are addressed providing a basis through which investors and other stakeholders in the financial markets can make decisions.
The Modigliani-Miller (MM) Theory of Capital Structure
The Modigliani-Miller (MM) theory of capital structure is regarded as one of the cornerstone theories of financial markets. The MM theory has made an attempt to give an account of the circumstances under which some decisions undertaken by a firm have no bearing on its value. According to MM, “with well-functioning markets (and neutral taxes) and rational investors, who can ‘undo’ the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm – debt plus equity – depends only on the income stream generated by its assets. if follows, in particular, that the value of the firms should not be affected by the share of debt in its financial structure or by what will be done with the returns – paid out as dividends or re-invested (profitably)” (Modigliani, 1980, p. xiii). The present MM theorem is understood in terms of four main components all obtained from the series of publications made by MM from 1958 to 1963. The four publications had a different perspective and argument. Nevertheless, the combined four publications by MM brought about the theory of capital structure in financial markets.
The first component of MM theorem brought about the argument that there are certain conditions whereby the debt-equity ratio of a firm has no influence on its value (Pagano, 2005). The second MM theorem also argues that leverage undertaken by a firm does not affect its weighted average cost of capital. This argument is supported by the fact that the cost of equity capital is a linear function of the debt-equity ratio. Additionally, MM theorem argues that the dividend policy of a firm has no relationship with its market value. Finally, the MM theorem argues that the financial policy of a firm make equity holders indifferent. In a close view and analysis of the MM theory of capital structure, it is true to say that when a firm increases debt, there is an erosion of the value of the available equity. This means that when the firm decides to sell-off the safe cash flows to debt holders only makes the firm to remain with a lowly valued equity and actually does not change the total value of the firm. Therefore, the attempts by the firm to enjoy gains obtained through seemingly cheaper financing through debt are eventually offset by the increased risk. It is then be deduced from MM theorem that it is irrelevant to allocate a given amount of capital between debt and equity as the weighted average cost of capital remains unchanged irrespective of the combinations of debt and equity.
The MM theorem has very fundamental importance in the modern financial markets. The theorem has two major critical contributions towards the understanding of the modern theory of financial markets. To start with, the MM theorem highly impacts on the theory of modern finance by formally arguing against the use of arbitrage. The MM theorem brings out the fundamental reasons leading to the failure of irrelevance based on the assumptions of neutral taxes, access to credit markets in symmetric manner, absence of capital fractions, and absence of information revelation through the financial policy of the firm. In their assumptions, MM believed that each firm was in a certain class of risk. However, the assumptions on relevance are regarded essential in that it is through these assumptions that arbitrage conditions are set (Glickman, 1996). The effective conditions set for arbitrage based on the assumptions of MM theorem enable investors to replicate financial actions of the firm. When the assumptions of MM theorem are systematically assessed, it is possible to expand frontiers of finance and economics. The MM theorem opened up a series of literature on the importance of debt and equity in firm’s capital structure decisions. Indeed, it is evident from numerous literatures that capital structure decisions arise as a means of responding to diverse market frictions (Eisfeldt & Rampini, 2005). The MM theorem therefore puts all agents at the same level. Through the theorem it has been possible to address problems in monetary economics, international economics, and public finance. The relevance of MM theorem in modern finance is therefore evident in the fact that investment decisions do not depend on finance.
Markowitz-Sharpe-Linter Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM) developed by William Sharpe (1964) and John Linter (1965) opened the beginning of a theory to price assets. Prior to the introduction of CAPM, there was no clear model for pricing financial assets on the basis of investment opportunities and nature of tastes as well as with clarity of testable predictions of return and risk. The relevance of CAPM in modern financial markets is seen in the estimation of cost of equity and the evaluation of portfolio performance. CAPM is an important theory taught to MBA students pertaining to investment courses to this day. Indeed, CAPM has such a simple and straight forward logic allowing interesting intuitive predictions on measurement of risk as well as assessment of risk and return relationship.
CAPM is built on Harry Markowitz’s (1959) model of mean-variance portfolio. According to the model developed my Markowitz, an investor will select a portfolio with a random return at a given time. It assumes that investors are risk averse and only put mean and variance into consideration when making choices among portfolios. Markowitz’s model derives from the assumptions that investors make choices that are mean-variance efficient meaning that given an expected return, investors minimize portfolio variance and also that given a certain level of variance; investors seek to maximize expected portfolio return. The combination of assets in producing efficient portfolios gives the basis through which expected risk and return can be related in CAPM.
In their analysis of risk and return, Sharpe and Linter made an addition to the two main assumptions of Markowitz in an attempt to identify an efficient portfolio in a clear market (Fama & French, 2004). Firstly, they completely agreed with Markowitz that based on a given clearing price at a point in time, there is an agreement for joint distribution of asset returns by investors to the present time. Secondly, Sharpe and Linter brought the assumption of lending and borrowing at risk-free rate. This rate is similar for all investors irrespective of the amount lent or borrowed. Therefore, risk-free rate of lending and borrowing creates the efficient set. The relevance of CAPM is undisputable in the sense that it analyses the relationship between return and risk based on market equilibrium conditions. The modern markets are characterized with agents seeking to optimize their portfolios. Thus their interaction result to market price equilibrium and eventually agreeing on distribution of returns on assets jointly.
Black-Scholes Option pricing theory
Based on the rapid increase in the relevance of finance in modern corporate world, there has been a growing complexity of modern instruments of finance. Consequently, the relevance of mathematical models in modern finance cannot be overemphasized. These models have become very vital in the analysis of financial models in order to price and implement them. This has been a shift in the control of corporate finance from business students to computer scientists and mathematicians. Myron Scholes and Fisher Black (1973) presented a major breakthrough in the 1970s with their introduction of a formula through which complex financial instruments could be priced. The formula is popularly known as Black-Scholes model. Through the Black-Scholes model, mathematical finance and financial engineering were born.
Valuation of contingent claims mainly through the BS model is an important breakthrough of modern finance. The BS model has been relevant both as a practical investment too and a theoretical framework in modern finance. Indeed, the model has become a universally accepted benchmark for comparing alternative models of pricing options. Models of pricing derivatives are based on the assumption that there is an elimination of profitable arbitrage at equilibrium (Black, 1972). Similarly, option prices need to follow a given known constraints like put-call parity. In case the prevailing prices do not conform to the constraints, it is possible for a static position to be set up during the present time in order to lock in excess return when the option reaches expiration. In the modern financial markets, the BS model determines the fair value of an option by assuming market conditions ruling out all possible profitable arbitrage opportunities. Thus assumptions of perfect market should be present.
The modern world has been completely revolutionized by Black-Scholes model. Investors, traders, and hedgers now have a standard method through which they can effectively value options. Furthermore, the importance of financial engineering has grown tremendously in the modern corporate finance. It is now possible for mathematicians and computer scientists to construct complex models for maximizing returns from portfolios while at the same time minimizing associated risks.
Jensen-Meckling Agency Theory
Ever since the release of the astounding work of Jensen and Meckling (1976) suggesting of an existence of conflicting interests among diverse parties in a firm, immense research has gone into this area. Indeed, the development of finance theory has been facilitated by both empirical and theoretical investigation. Finance theory has been widely applied in investigating the problems brought about by divergent interests among various stakeholders of the firm. Managers and shareholders have inherently has conflicts of interest in various firms. According to Jensen and Meckling (1976), agency relationship is a contract through which the principal engages the agent to undertake specified services on their behalf.
The origin of agency problems is explained by the impossibility of having a perfect contract for every action undertaken by the agent as their actions also affect them in terms of welfare alongside that of the principal. It therefore becomes important for the principal to undertake measures to induce the agent to make decisions to the best interest of the principal. Consequently, managers end up bearing the whole cost of not pursuing their goals in exchange for some benefits created for them by the shareholders. According to Jensen and Meckling, there is a reduction in inefficiency as managers undertake decisions aimed at value maximization. Agency costs are also reflected in the financial markets just like other types of costs incurred by a firm. These costs directly impact on the market price of the firm’s share (McColgan, 2001). The costs actually reflect loss of value to shareholders owing to the conflicting interests between agents and principals. These costs come in the form of residual loss, bonding costs and monitoring costs.
The modern corporate financial markets reflect agency costs in numerous ways. These conflicts are actually limitless in the modern corporate world (Ingersoll, 1986). Researchers have stressed on the importance of the contracting environment of a firm (Jensen, 1896; Himmelberg et al., 1999). The modern corporation has continued to witness widespread agency conflicts in spite of the diffused ownership of shares. The modern corporate world has witnessed numerous conflicts from outside investors and managers. Indeed, firms tend to substitute diverse mechanisms according to the unobservable characteristics in the environment.
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Eisfeldt, A. & Rampini, A. (2005). Leasing, Ability to Repossess and Debt Capacity. Kellogg School of Management, Northwestern University.
Fama, E.F. & French, K.R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25-46.
Glickman, M. (1996). Modigliani and Miller on Capital Structure: A post Keynesian Critique. UEL Department of Economics Working Paper, No. 8.
Himmelberg, C. Hubbard, R. & Palia, D. (1999). Understanding the Determinants of Ownership and the link between Ownership and Performance. Journal of Financial Economics, 53, 353-384.
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McColgan, P. (2001). Agency Theory and Corporate Governance: A Review of the Literature from a UK Perspective. Department of Accounting & Finance, University of Strathclyde.
Miller, M. & Modigliani, F. (1966). Some Estimates of the Cost of Capital to the Electric Utility Industry, 1954-57. American Economic Review, 48 (June), 261-443.
Modigliani, F. (1980). Introduction. In Abel, A. (ed). The Collected Papers of Franco Modigliani, 3, xi-xix. Cambridge, Massachusetts: MIT Press.
Pagano, M. (2005). Modigliani-Miller Theorems: A Cornerstone of Finance. Centre for Studies in Economics and Finance, Working Paper No. 139.
Sharpe, W.F. (1964). Capital Asset Prices: A theory of Market Equilibrium under Conditions of Risk. Journal of Finance. XIX (September), 425-442.
The Four Cornerstone Theories of the Financial Markets Term Paper Essay: