Capital Market Efficiency Hypotheses: Observations in Croatia - Essay Example

Capital Market Efficiency Hypotheses - observations in Croatia ID 19714 Order No. 300305 [University Name] [Course Name] [Supervisor] [Any other details] 15 May 2009 Table of Contents: Introduction In this short essay, the author presents an analysis of the stock market efficiency hypotheses and applied the same as per experiences in Croatia. The author first presents a general understanding about Capital Market Efficiency Hypotheses and then applies the understanding from Croatian perspective that corporations cannot fool the markets using creative accounting. Capital Market Efficiency Hypotheses Jordan (1983. pp1325-1327) presented that if the efficient market hypotheses (EMH) is viewed from an ideal perspective, then the asset prices published in the markets should be fully reflecting all the available information (including internal information of the listed companies) that shall be useful to the investors to foster their investment decisions in the stocks of corporations. The internal information being revealed to the stock markets is termed as "dimensions of signal space" whereby empirical researches suggest that a smaller relative signal space for large number of assets result in fully revealing equilibrium prices. However, Jordon (1983. pp1325-1327) proved that efficient market hypotheses cannot be viewed from the ideal perspective whereby the signals (of internal information) and the corresponding return on assets need not be normal if the dimension of signal space is larger for smaller number of assets. In such cases, the researcher argued that the market equilibrium is generally inconsistent with the efficient market hypotheses. If investors are risk neutral, the equilibrium price of each asset can be equal to its expected returns. However, investors do have risk aversion - in the form of relative risk aversion and constant risk aversion. Each signal, when known to the investors adds to the risk perception thus affecting the return from the asset - positively or negatively - depending upon how the signal has been perceived. Beaver (1981. pp23-26) described the phenomenon of "incomplete markets" whereby the expectations are formed on future prices based on informal signals and the equilibrium is characterized as dependent upon these expectations that have formed from the informal signals. In growth times (bull markets) or during uncertainty (bear markets) the polarity of the signals automatically change as a result of relative risk aversion of the investors. Hence, during bull markets, even the companies not rated high may still enjoy a rally and during bear markets, even the best performing companies may suffer crash of security prices. Beaver (1981. pp23-26) suggest that during uncertainty, the mapping from the endowments, and individual preferences & belief in the prices drive the capital market equilibrium. Hence, it can be viewed from the discussions by these authors that the efficiency of the market reduces with the deviations of the security prices from its intrinsic value. The market driven by higher speculations, thus can be considered as highly inefficient. Beaver (1981. pp23-26) suggests that the intrinsic value of securities can be considered as the one that would be the result of identical endowments, beliefs and preferences of all individuals. However, in real world stock markets the individual assessments and beliefs vary considerably thus resulting in security price differing substantially from the intrinsic value of the stock. Thus more or less, stock markets are inefficient. Some individuals cause drastic impacts on the beliefs of the masses as they possess the reputation of financial experts and are allowed to give their viewpoints through television channels, news papers, magazines, etc. Some of these individuals may possess superior information of the signals, some may possess subset of that information and some may possess entirely different information. These speculations do confuse the markets and at times are used for the benefit of the corporations. Hence, corporations do use these high impacting speculators to practice creative accounting and are successfully able to time their securities in the markets. If this was not possible, the spurt of scams that we witness across the globe wouldn't have happened. The irony is that corporations are successful in doing this now & again whenever the bull markets are prevalent. There are no tangible controls from the government governing bodies in the flow of these "on the spot" signals although at the bigger picture level, fair value accounting is being enforced globally under the GAAP. From the perspective of corporations, the market timing that is in their favor is to issue the shares at high prices and repurchase them at lower prices (Baker and Wurgler. 2002. pp1). This phenomenon occurs almost every year - as function of the boost of bull markets and sudden conversions into bear markets. The Asian markets like Hang Seng, Nikkei, Sensex, etc. boost by the hundreds of points on a particular day and crash by another hundreds of points in the very next day. Is it possible that such high dynamism is witnessed due to the intrinsic values of shares It is just that the flow of signals are largely controlled by the market speculators and the corporations that enjoy their benefits out of such fluctuations. The markets in US, UK and Europe, however, are more efficient compared to Asian markets and hence the fluctuations are not of such magnitudes unless there is a large crisis - like the sub-prime crisis that we have witnessed. Efficiency Hypotheses as applied to stock markets in Croatia The Croatian market is much more matured compared to the Asian markets. The signals do flow to the investors through market analysts and news channels but the information is much more realistic and detailed as they are largely linked with the databases of LSE, FTSE and NASDAQ. The market efficiency is definitely better than the Asian markets although the system doesn't fully comply with the efficient market hypotheses. Rather, the Jordan (1983. pp1325-1327) theory of signal space versus no. of assets does apply to the Croatian markets. The signal space is too small in Croatia and hence the equilibrium doesn't get disturbed as drastically as can be seen in the stock markets of Asia. The market did crash in 2008 but it was a result of the global crisis that impacted everyone across the world. It doesn't mean that market efficiency was disturbed due to loads of speculative beliefs by investors. Conclusion: In this short essay, the author presented the theory of Efficient Market Hypotheses of Capital markets with the help of few empirical literatures. The author applied the hypotheses to the stock market of Croatia thus concluding that the market efficiency of Croatian stock markets is much better than Asian markets as such. Reference List: Beaver, William H. (1981). Market Efficiency. The Accounting Review, Vol. 56, No. 1. pp23-26. American Accounting Association. Retrieved on May 15, 2009. Available at http://www.jstor.org/stable/246460. Baker, Malcolm and Wurgler, Jeffrey. (2002). Market Timing and Capital Structure. The Journal of Finance, Vol. 57, No. 1. pp1. Blackwell Publishing for the American Finance Association. Retrieved on May 15, 2009. Available at http://www.jstor.org/stable/2697832. Jordan, J.S. (1983). On the Efficient Markets Hypothesis. Econometrica, Vol. 51, No. 5. pp1325-1327. The Econometric Society. Retrieved on May 15, 2009. Available at http://www.jstor.org/stable/1912277. End of Document Read More