Financial crisis 2007-2012 - Essay Example

 Financial crisis 2007-2012 Introduction: financial crisis 2007-2012 and criticism of the efficient markets theory The financial crisis of 2007-2012 has led to severe criticism of the Efficient Market Hypothesis Theory. The Efficient Market Theory states that the information on the market events that occurred in the past, present and those expected in future flows to the investors on the basis of which investment decisions are taken. The financial crisis of US in 2007-2012 occurred as a result of enormous heavy investments in real estate markets without looking at the investment risk (Allen, 1999, p.33). Also the investments were done assuming that the available market information on the housing markets are correct. The banks granted loans assuming that markets were efficient while overlooking the underlying risk. This led to increase in the number of defaulters that eventually resulted in the financial crisis and the global economic meltdown of 2007-2012. Evaluation of argument: financial crisis means redundancy of the efficient market theory as an explanation of financial decisions The financial crisis of 2007-2012 highlighted the redundancy of efficient market theory as an explanation of the financial decisions. This statement has been evaluated with the help of the following course of events that took place in the economy of US and in the global economic scenario. The investments in the mortgage market in US were very lucrative as it offered high returns in short interval of time. More and more numbers of people considered the investments in US mortgage market as an instrument of short term gains. According to efficient market theory, the information flow from the market was such that it influenced not only the borrowers but also the lenders for purchase of housing properties (Harder, 2010, p.59). The policies of the US government also contributed to the flow of market information to the investors suggesting that the investments in the real estate and housing markets of US is likely to produce easy profits in a short span of time. The US government also made the ownership of houses for US citizens as a fundamental right. All these information flow from the markets influenced the investment decisions in the housing markets. Thus investments in the mortgage markets increased with instances of bank lending with open hands. On one hand when the market information influenced the financial decisions, the underlying bubble of crisis was not noticed. Due to assumptions of the efficient market theory, the valuation of the underlying mortgages got overvalued. The banks provided finances for housing loans without adequate check on the credit parameters which led to the entry of huge borrowers who were not creditworthy (Carey and Stulz, 2007, p.44). The weight of bad loans started to increase when the borrowers defaulted in repayment of loans. The valuation of the mortgages fell which were accepted as underlying securities at the time of financing the loans. This led to erosion of value of the company and the shareholders which eventually led to financial crisis of 2007-2012. The underlying causes of financial crisis were not reflected in the information flow to the investors that led to bad investments (Palan, 2007, p.25). This establishes the redundancy of efficient markets in explaining the financial decisions. Financial theories and models This part of the study will evaluate several aspects of Efficient Market Hypothesis and Random market Hypothesis. Efficient Market Hypothesis Efficient Market hypothesis is also known as joint hypothesis problem. It declares that the financial market is efficient. According to this hypothesis, an individual cannot achieve consistent returns in the excessive average market return on the basis of risk adjustment (Laopodis, 2012, p.280). There are three key versions of this efficient market hypothesis such as strong hypothesis, semi strong hypothesis and weak hypothesis. The weak-form hypothesis states that the prices are based on several traded assets such as bonds, properties and stocks. This weak-form hypothesis reflects all kinds of past available information. In addition the semi strong hypothesis states that the prices of these traded assets reflect all the publicly available information. The strong version hypothesis states that the prices of these traded assets directly reflect all the insider or hidden information (Palan, 2007, p.26). Several critics stated that the market efficiency cannot provide certainty about the future. Market efficiency is the general overview and simplification of the world. It cannot be always true or predictable. Random Walk Hypothesis The random walk hypothesis is an important financial theory. This theory states that the market prices of stocks develop according to the random walk. According to this theory, the stock market prices cannot be predicted. The concept of random walk hypothesis can be outlined to Jules Regnault who was the French broker (Evans, 2003, p.19). The hypothesis states that the stock prices have no value in the future forecasting prices as past, present and future prices just reflect the market responses to the information that generally comes in the market randomly. Generally, the price movements are not predictable. Random Walk hypothesis is a controversial hypothesis. This controversial theory implies that the technical analysis has no importance in its specific attempts to forecast future stock market price movements in the market. Conclusion It is clear from the above discussion that Random Walk Hypothesis and Efficient Market Hypothesis are closely related to each other. The financial crisis of 2008 has led to criticism and renewed scrutiny of the Efficient Market Hypothesis. Efficient Market Hypothesis has three major versions such as strong, semi strong and weak version. It is known all that the real estate bubble is one of the major reasons behind the financial crisis in United States. Before the real estate bubble, the leading investments banks were trying to make investment in the real estate sector. Lehman Brothers was one of the leading investment banks. Due to huge market loan, the investment bank collapsed in the year 2008. The Random Walk Hypothesis states that the stock market prices may not have any value in the future forecasting prices comparing to the past, present and future prices. It can only reflect the market responses to the available information that usually comes in the market randomly. References Allen, R. E. 1999. Financial Crises and Recession in the Global Economy. UK: Edward Elgar Publishing. Carey, M. and Stulz, R. M. 2007. The Risks of Financial Institutions. USA: University of Chicago Press. Evans, L., 2003. Why the Bubble Burst. UK: Routledge. Harder, S. 2010. The Efficient Market Hypothesis and Its Application to Stock Markets. Germany: GRIN Verlag. Laopodis, N., 2012. Understanding Investments. UK: Routledge. Palan, S. 2007. The Efficient Market Hypothesis and Its Validity in Today's Markets. Germany: GRIN Verlag. Palan, S., 2007. The Effective market Hypothesis and its validity in Today’s Markets. USA: Cengage Learning. Read More