Taxonomy of Finance Theories

Taxonomy of Finance Theories 1

Running Head: Taxonomy of Finance Theories

Taxonomy of Finance Theories Dr. Vernon T. Cox January 30, 2012

Taxonomy of Finance Theories 2

TABLE OF CONTENTS Introduction ................................................. 3  Taxonomy of Financial Theories................................. 4  The Purchasing-Power–Parity Theory ........................... 4  The Expectations Theory of Exchange Rates .................... 5  The Interest-Rate–Parity Theory .............................. 6  Efficient Market Theory ...................................... 6  New Equity Theory ............................................ 6  Agency Costs Theory .......................................... 7  Theory of Proprietary Governance and Community ............... 7  Product Cycle Theory ......................................... 8  The Theory of Portfolio Selection ............................ 8  Modigliani-Miller Theory ..................................... 9  Conclusion..................................................... 9  Table 1....................................................... 11  Financial Theories .......................................... 11  References.................................................... 16 

Taxonomy of Finance Theories 3

Introduction “Capital is a collective product, and only by the united action of many members, nay, in the last resort, only by the united action of all members of society, can it be set in motion.” (Marx & Engels, 1847, p. 14) Although the origin of this statement is based on communism, a system that is not readily acceptable in the United States, the details have some roots within our financial methods and the financial theories that we utilize to engage our economy. Capitalism, though not perfect, has a long history of incremental gains and its flagship, the United States, is an icon for a functional financial system. Many countries around the world are moving toward a financial scheme similar to the structure of the U.S.; even while the U.S. is evaluating and rejuvenating capitalistic processes. Chew (2001) states, “Marxist politicians understand that the sociological model is the foundation for the centralization of power.” (Chew, 2001, p. 13) Chew (2001) goes on to say, “Ironically, as many formerly socialist Eastern European and Asian countries are moving toward capitalism, the U.S. is moving toward more socialistic regulatory and political policies.” (Chew, 2001, p. 13) The financial system in the U.S. is constantly under pressure to evolve and outperform itself. As we look at many financial theories, in this paper, the differences

Taxonomy of Finance Theories 4 will illustrate the vast cradle of ideas the give life to the financial industries that employ those assumptions. Taxonomy of Financial Theories The Purchasing-Power–Parity Theory According to the authors of the text Corporate Finance 5th Edition, this theory is focused on the financial relationship between countries. The purchasing-power–parity theorem states that $1 should have the same purchasing power in each country. One version of the purchasing-power–parity theorem states that the change in exchange rates between the currencies of two countries is connected to the inflation rates in the countries’ commodity prices. (Ross, Westerfield, & Jaffe, 2001, p. 1133) This theory has many detailed segments that require information that is available in Ian Giddy’s (1976) article, An Integrated Theory of Exchange Rate Equilibrium. An excerpt from the article illustrates many of these aspects. This brief paper will show that (a) a theoretical equilibrium state of the world exists in the absence of capital controls and trade barriers when prices for the same goods in different markets are equal, after translation at the spot exchange rate; (b) differences in rates of aggregate price change in different markets eventually cause offsetting exchange rate changes which

Taxonomy of Finance Theories 5 restore condition; (c) returns on equivalent securities denominated in different currencies but covered in the forward market are almost instantaneously equalized; (d) the market's expected rate of change of the exchange rate equals, to a close approximation, the control-free interest rate differential between the two currencies; (e) in the absence of predictable exchange market intervention by central banks, the interest rate differential is the best possible forecaster of the future spot rate; and (f) the forward rate also provides the best forecast of the future spot rate. (Giddy, 1976, p. 883) The Expectations Theory of Exchange Rates If all the necessary information about the rates that are associated with the relative countries is equally available, this theory declares that the individuals that work in the exchange industry will equally have the data necessary to make market decisions. Ross, Westerfield, and Jaffe also identify the background of The Expectations Theory of Exchange Rates. “The expectations theory of exchange rates states that the forward rate of exchange is equal to the expected spot rate.” (Ross et al., 2001, p. 1134) Giddy (1976) says, “The notion that the foreign exchange market is highly efficient, in the sense that information is disseminated quickly and acted on immediately,

Taxonomy of Finance Theories 6 suggests that the present spot exchange rate properly reflects all available information.” (Giddy, 1976, p. 887) The Interest-Rate–Parity Theory The interest-rate–parity theorem states that the interest rate differential between two countries will be equal to the difference between the forward-exchange rate and the spot-exchange rate. This equality must prevail to prevent arbitrageurs from devising get-richquick strategies. The equality requires the rate of return on risk-free investments in the United States to be the same as that in other countries. (Ross et al., 2001, p. 1134) In response to this theory, Giddy (1976) says, “ Recent empirical evidence, as well as, the adamant assertions of bankers and foreign exchange traders provide substantiation for the validity of this theory.” (Giddy, 1976, p. 887) Efficient Market Theory Based on Chew (2001) Eugene Fama introduced the theory of the efficient market. Chew says, “Thirty years have passed since Eugene Fama introduced the idea of an “efficient” stock market…” (Chew, 2001, p. 20) On the idea of a efficient market Chew further says, “Put simply, the idea is that investors compete so fiercely in using public information that they bid away its value for earning additional returns.” (Chew, 2001, p. 20) New Equity Theory

Taxonomy of Finance Theories 7 This theory has major implications to the firms’ leadership when an announcement is made to the public about an organizations intention to offer new equity. This single message has a significant effect on the value of the stock. Chew says, “This theory and evidence has a number of managerial implications….Investors recognize their vulnerability in this process… The result, in the average case, is that the new equity is purchased by investors at a discount from the pre-announcement price.” Agency Costs Theory Specifically, the agency cost theory is a critical factor in evaluating the financial condition of a firm. If this theory is ignored, this unawareness can have significant results. Chew (2001) says, “What the theory of “agency cost” accomplished was to call attention to the potential loss in value of public corporations caused by the divergence of interest between management and shareholders.” (Chew, 2001, p. xviii) Theory of Proprietary Governance and Community According to the Fred E. Foldvary “Spencer Heath (1876–1963) pioneered the theory of proprietary governance and community.” (Foldvary, 2004, p. 411) Foldvary says, “Heath’s vision was a society in which collective goods are produced and provided by entrepreneurs and financed from the site rentals they generate.” (Foldvary, 2004, p. 412) This type of business, according to Heath, would be a financial service to society. Heath adds, “the

Taxonomy of Finance Theories 8 balance of rent not required for these purposes will be the clear earnings of the proprietors who have administered and supervised the enterprise,” (Foldvary, 2004, p. 412) Although this concept is complex it is grounded in the current real estate transactions. Foldvary says, Tenants willingly pay rentals in exchange for having possessory rights to use a site and its improvements. The landlord takes the kernel, but evidently the shell is worth the full expense to the tenants. Indeed, in the Heathean proprietary communities, leaseholders would pay for just such rights. (Foldvary, 2004, p. 414) Product Cycle Theory According to Madura (2003) firms become Multi-National Corporations (MNC) when they have progressed through the theory of product cycle. Madura says, According to this theory, firms become established in the home market as a result of some perceived advantage over existing competitors, such as a need by the market for at least one more supplier of the product….As time passes, the firm may feel the only way to retain its advantage of competition in foreign countries is to produce the product in foreign markets, thereby reducing its transportation costs. (Madura, 2003, p. 9) The Theory of Portfolio Selection

Taxonomy of Finance Theories 9 The theory of portfolio selection, according to Millet (1999) is the foundation theory that clarified the risk and return. “Markowitz in this remarkable paper gave, for the first time, a precise definition of what had hitherto been just vague buzzwords: risk and return.” (Millet, 1999, para. 10) According to Millet (1999) “Markowitz saw investors as actually applying the model to pick their portfolios using a combination of past data and personal judgment to select the needed means, variances, and covariance’s.” (Millet, 1999, para. 15) By utilizing the algebraic equations that Markowitz defined, an investor could select a portfolio based on historical information. Modigliani-Miller Theory In the article authored by Millet (1999) the ModiglianiMiller theory (MM) of capital budgeting is also explained. “The theme of that paper, and indeed of the whole field of corporate finance at the time, is capital budgeting.” (Millet, 1999, para. 36) According to Levinsohn (2003) the MM theory is a explanation of what a investor should look for in a perfect world. Levinsohn says, “Still, Modigliani and Miller reasoned that if a company's financing policy at all influences its cost of capital, their theory at least defines the necessary conditions under which that will happen.” (Levinsohn, 2003, para. 3) Conclusion

Taxonomy of Finance Theories 10 “In his theory of proprietary communities, Heath did not therefore contradict Henry George, but took his thought in a new direction.” (Millet, 1999, p. 412) Although this statement concerns the Theory of Proprietary Communities, the meaning permeates through the financial industry. Each of the theories presented were somewhat revolutionary to the intermediaries that were utilizing the current techniques of the era. When the economist, financiers, bankers, and venture capitalist fully understood each premise they acted in the best fashion to make use of the idea. By exposing investors to these theories, the creative energy of the authors of each of these new financial processes were justified to go back to the drawing board for more inspiration.

Taxonomy of Finance Theories 11 Table 1 Financial Theories Theory

Key Points

Example

Purchasing-

(a) equilibrium state

The value of $1 in the

Power–Parity

of the world exists in

Fiji Islands should be the

Theory

the absence of capital

same as the value of $1

controls and trade

Papua New Guinea.

barriers (b) differences in rates of aggregate price change in different markets eventually cause offsetting exchange rate changes (c) returns on equivalent securities denominated in different currencies (d) the market's expected rate of change of the exchange rate equals, to a close approximation, the control-free interest rate differential

Taxonomy of Finance Theories 12 between the two currencies; (e)the interest rate differential is the best possible forecaster of the future spot rate; and (f) the forward rate also provides the best forecast of the future spot rate. Expectations

The expectations theory

Foreign exchange traders

Theory of

of exchange rates

in New Zealand should have

Exchange Rates

states that the forward

the same information as

rate of exchange is

those who trade in

equal to the expected

Australia

spot rate

Interest-Rate–

The interest rate

Funds invested in Canada

Parity Theory

differential between

on a product or service

two countries will be

will have the same rate of

equal to the difference

return as a product or

between the forward-

service in Cuba, all other

exchange rate and the

things being equal.

spot-exchange rate.

Taxonomy of Finance Theories 13 Efficient

Investors compete

Publicly available

Market

fiercely in using

information about an

public information.

equity offering G.E. is

Public information is

available for all

equally available to

investors and the stock

all investors.

quote is driven down within in minutes of opening.

New Equity

New equity offerings

The management at Intel

Theory

drives down the firms

offers 1 million

stock

additional shares of stock

Investors recognize

to generate cash to shore

their vulnerability in

up the cash flow due to a

this process when

costly public announcement

management offers more

concerning a flaw in their

stock

chip.

Separation of ownership

The CEO of the Hewlett-

and management or

Packard firm decides to

control creates

merge with Boeing aircraft

potential agency cost

company to create a huge

[negative effects for

organization worth 3 times

shareholders].(Brealey,

its current market cap.

Agency Costs

Myers, & Marcus, 2001, p. 637)

Taxonomy of Finance Theories 14 Theory of

Rental funds are used

A group of individuals

Proprietary

to finance the needs of

want to start a dry

Governance and

society.

cleaning business. To fund

Community

Businesses are created

the enterprise the group

with the excess funds

buys a hotel property and

available from renting

uses the excess cash to

property.

start the dry cleaning business.

Product Cycle

Firms become

A small company in the

Theory

established in the home

South Pacific sells

market

branded water on their

Due to the demand for

islands. The demand

the firms’ product the

increases and since the

company expands into

water is from the island

the international

no other local firm enters

arena.

the market. The firm engages a U.S. marketing firm to successfully enter the U.S. market.

The Theory of

Needed means,

A investor uses the Theory

Portfolio

variances, and

of Portfolio Selection to

Selection

covariance’s and other

automatically allow their

algebraic formulas are

computer to pick the

used to investigate

stocks with the last

historical data for

function before payment is

Taxonomy of Finance Theories 15 stock selection.

made, being a yes/no response required by the user.

Modigliani-

M&M measure of the cost

A Firms leadership chooses

Miller Theory

of capital for

to fund a capital project

aggregate investment.

with retained earnings

M&M propositions imply

instead of a debt or

that the choice of

equity financing after a

financing instrument is

MM consultant give

irrelevant.

guidance.

Taxonomy of Finance Theories 16 References Chew. D.H., (Ed.). (2001). The new corporate finance: Where theory meets practice. New York:

Irwin.

Foldvary, F. E. (2004). Heath: Estranged Georgist. American Journal of Economics & Sociology, 63(2) 411-432. Giddy, I. H. (1976). An Integrated Theory of Exchange Rate Equilibrium. Journal of Financial & Quantitative Analysis, 11(5) 883-893. Levinsohn, A. (2003). Modigliani and Miller Live On. Strategic Finance, 85(6) 1-3. Madura, J. (2003). International financial management (7th ed.). Mason, OH: South-Western. Marx, K. & Engels, F. (1847). Manifesto of the Communist Party. Marx/Engels Internet Archive Retrieved from http://www.marxists.org/ 26 April 04 Millet, M. H. (1999). The History of Finance. Journal of Portfolio Management, 25(4) 95-102. Ross, S. A., Westerfield, R. W., & Jaffe, J. (2001). Corporate Finance 5th Edition. Boston: McGraw-Hill Primis.