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The London Stock Exchange

The existence of a secondary capital market is vital to businesses wishing to raise

long-term finance. Potential long-term investors will not generally be prepared to take

up issues of shares or loan notes unless the opportunity exists to liquidate their invest-

ment at any time. Since it is not practical for businesses themselves constantly to hold

cash in readiness to redeem the securities, it is necessary for there to be a secondary

capital market where security holders may sell their investments. The absence of sec-

ondary market facilities tends to make the raising of long-term finance impossible or,

at best, very expensive in terms of returns demanded by investors. It is thought by

some observers that underdeveloped countries are often restrained in their industrial

and commercial development by the lack of an established secondary capital market

and therefore by the lack of long-term investment finance.

Price efficiency

Potential investors will not only require the existence of the opportunity to liquidate

their securities as and when they wish; they will also be interested in whether their

investment is efficientlypriced. Efficiency in the context of pricing implies that, at all

times, all available information about a business’s prospects is fully and rationally

reflected in that business’s security prices. That is to say, the market price of a particu-

lar security is the present (discounted) value of the future economic benefits that the

security will bestow on its owner. This will interest investors as they would generally

prefer that the price at any particular moment be set rationally and not be a matter of

sheer chance. Perhaps more important is the fact that, as the capital market is the inter-

face between managers and investors, efficiency means that financial decisions made

by managers will reflect in the business’s security prices and so have a direct effect on

shareholders’ wealth. As maximisation of shareholders’ wealth is generally accepted

as the principal criterion for management decisions, this reflection of management

action is a significant matter, with several implications.

In this chapter we shall look briefly at the mechanisms of the London Stock

Exchange (LSE) in its secondary role before going on to see that it seems to be efficient

to a large extent. Lastly we shall consider the implications for investors and for finan-

cial managers of the efficiency (or otherwise) of the LSE.

9.2 The London Stock Exchange

As with all capital markets in their secondary role, the LSE is basically a marketplace

where securities of private businesses and public bodies may be bought and sold.

LSE members

Whereas in many types of markets members of the public may directly buy and sell

on their own behalf, in the LSE they are barred from entry. Only members of the LSE

have direct access to buy and sell securities. When members of the public wish to buy

or sell securities through the LSE, they can do so only by using a member as an agent.

The rules governing the conduct of the members are laid down and enforced by a

Council elected by the membership. One of the functions of the Council is to authorise

specific securities as suitable to be dealt in on the LSE. Authorised (listed) securities

are those that satisfy a number of criteria established by the Council. The object of