Financial market is that people and entities can trade financial securities, commodities, and other fungible items, which has a central place in the theories and models of finance. According the topic, uncertainty and risks must be distinguished in financial mark, which concepts that talk about expectations in future. In general, all activities in business carry some risk, but some are inherently more risky than others. However, uncertainty is a word that connotes actions or events over which one has no control and may occur in future. Risk and Uncertainty are concepts that talk about expectations in future, but whereas financial managers can minimize risk to face an uncertain future, they cannot remove uncertainty from financial market altogether (Irem, 2011). In this essay, the DCF Pricing Models and Efficient Market Hypothesis (EMH) will be used to analyze the different between risks and uncertainty in different market, such as Sovereign Debt Markets, Public Debt Markets, and Banking and Financial Markets. Finally, it will show the theories to be right or wrong of the real financial market in the respect.
2.0 Analyzing Risks and Uncertainty in different Models and theories
When the risk and uncertainty will be distinguished, the DCF Pricing Models and Efficient Markets Hypothesis can be used. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. The DCF Pricing Models is the standard theories to calculate the true or intrinsic value, which also a valuation method used to estimate the attractiveness of an investment opportunity (Oppenheimer, 2002). It also reflects the risks of the cash flows, which includes Time value of money (risk-free rate) and Risk premium (lecture week 2&3 sides). According to DCF Pricing Models, yield of government debt that is risk-free rate of return, when increasing the risk free rate will reduce the value of assets and vice versa. “Comparing with other debt securities, yield on risk-free government debt should be the lowest (QUT, Lecture Week 4). ” In this model, uncertainty is indicated as risk premium, which is an additional yield for risk debt securities. The governments avoid the risks in debt security to obtain the risk-free interest in financial market, but uncertainty still exists. When the risk-free government debt is fixed in one period of time, the yield (rt) will increase or decrease by the uncertainty factors to change the risk premium. Hence, in DCF Pricing Models, the risks and uncertainty can be distinguished clearly and the yield can be calculated by the risk-free rate plus Risk premium.
Another significant theory of financial markets is Efficient Markets Hypothesis (EMH). There are three major forms in the standard theory, which are weak form, semi-strong form, and strong form. In consequence of this, it cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made (Kiston, 2013). The risk and uncertainty are distinct in public debt markets, so the EMH should be used to analyze. “There is explicitly risk debt in this market, which can consider as price depend on risk and time value of money. It is the main reason why investors would like to allocate and monitoring of risk to a third party (QUT, Lecture week 5).” The semi-strong-form EMH claims both that prices reflect all publicly available information and that price instantly change to reflect new public information (Fox, 2009). Supporters believe that capital markets are efficient, such as semi-strong form, because the expected investment price volatility smaller lead to more effective market. The investors should monitor the change of price to adjust the financial instrument aim to reduce risks (Jarrt, 2010). However, the efficient market hypothesis is a…