Efficient Market Hypothesis in Explaining the Overall Functioning of the Financial Markets - Essay Example

Introduction The recent financial crises are considered as one of the leading crises of the world with relatively no example in the history of mankind. The resulting failure of many financial institutions as well as other manufacturing concerns and gradual decline in the economic activity in most of the developed indicate the overall sensitivity of the crises. The response was emanated from the different governments rather than from the market itself as many governments including US and UK governments injected money into the system to safeguard it from complete collapse. What is however important to note that these crises were largely unanticipated as they emerged due to the subprime mortgages which form a very little percentage of the overall activity that take place in the financial markets. This therefore raises the question of how many investors actually mispriced the risk that has to be included into the pricing of the securities given the fact that market participants always form rational expectations about the future equilibrium prices. Rational Expectations theory forms the basis of some of the most important macroeconomic models in recent times. The formation of the efficient market hypothesis is also one of the macroeconomic models which utilizes the rational expectations theory and assert that market participants always form rational expectations about the future equilibrium prices. Thus it is useless in predicting the future financial crises as the market participants already discount such future information into their risk calculations.(Hui & Lui, 2002). However, despite such theoretical assumptions, the current global financial crises were more of a shock for most of the participants as they emerged out of blue and affected almost every market on the earth. This paper will attempt to discuss the question of predicting the future financial crises in the light of efficient market hypothesis and rational expectations and will attempt to answer the question by considering the current global financial crises. Current Global Financial Crises The current financial crises has slowed down the pact of economic growth in many countries including US and UK and many governments have to inject money in order to save their financial systems from complete collapse. These financial crises apparently emerged due to the imprudent banking practices and resulting lending into the subprime mortgage sector. Over the period of time, the competition for banks became stronger and banks, thanks to de-regulation, were allowed to engage themselves into practices which were relatively more speculative in nature. Subprime lending is also an example of earning high returns at the cost of high risk. However, as a result of the securitization process and subsequent default of the subprime borrowers, banks started to face credit crunch and this whole episode culminated into much bigger crises that are at hand now.1 The impact of the current global financial crises have been sever as many important institutions such as Lehman Brothers, American Insurance etc have filed for the bankruptcies whereas banks like RBS were saved when British Government injected public money into RBS and other institutions to save them from complete collapse. Efficient Market Hypothesis The basic theme behind the efficient market hypothesis is the assumption that markets are basically informationally efficient. This also means that the prices of the assets traded on the market already discount the future information and as such there is no benefit for employing different analysis techniques such as fundamental and technical analysis to find out the fair prices of the assets. Thus accordingly, it is relatively more impossible to outperform the market on consistent basis due to the implicit tendency of the market to already incorporate the future information or news. This hypothesis defines news as something which can affect the prices of the assets in markets.(Dobbins & Witt, 1979). According to this hypothesis, there are basically three forms of market efficiency i.e. weak form of efficiency, semi-strong form of efficiency and strong form of efficiency. According to weak form of efficiency, the prediction of asset prices may not be possible by just analyzing the historical price trends therefore technical analysis may not be able to provide investors consistent excessive returns over the period of time. Similarly, under semi-strong form of efficiency, it is stated that the asset prices readily incorporate the publically available information in most unbiased manner and as such there is very little benefit in performing the fundamental analysis as it may not provide the excessive returns on the consistent basis to the investors. Finally, the strong form of efficiency share prices seems to incorporate all the publically as well as privately held information and hardly anyone can earn excessive or abnormal profits in a market depicting strong form of efficiency. (Sil & Tsoukalas,1999). The rational expectations assumption is also implicit in the efficient market hypothesis as it assumes that the different economic agents basically held expectations about the future economic events and identify such expectations as the best guess for the future outcome of different economic events. The rational expectation theory is therefore considered as the basis of the efficient market hypothesis based on the assumptions that if the prices of the assets does not reflect the past, present or even future information than there remains a possibility of earning higher profits because there is than unexploited profit which shrewd investors can spot and enjoy. Accordingly, the buying and selling activity that take place as a result of this will drive the prices towards equilibrium and the opportunity to earn the unexploited profits will vanish over the period of time. The neoclassical models of economics view economy and markets as a network of fully connected markets. One of the assumptions behind this model lies in the fact that it assumes that almost all the market participants are homogenous in nature and as such prices under this model are largely determined by the market forces which continue to evaluate the excess demand and supply and adjust the prices accordingly. Thus apparently, markets are always in equilibrium until they are not being disturbed by some external forces that can disrupt the equilibrium by force. This sort of model therefore works mostly like the force field idea defined in physics and comply with the assumptions made under the efficient market hypothesis as it is assumed that the prices are normally distributed thus implicitly it assumes that the deviations from mean whether negative or positive are therefore not possible under the equilibrium conditions. This assumption therefore provided the necessary space for the policy makers to basically underestimate the impacts of the large negative price movements on the overall economic outcomes. What is also significant to note that the general equilibrium conditions under the neoclassical theory assumes that the promises made between different economic agents are always met and as such there always exist an equilibrium therefore the financial crisis in such economic setting may be only a distant reality.(Allen & Snyder,2009). Current Financial Crisis However, despite such assumptions, many critics believe that the efficient market hypothesis as well as the rational expectations theory failed to predict the current global financial crisis. Many believe that one of the leading causes of the current global financial crisis is the efficient market hypothesis as it does not lead to the correct understanding of the dynamics of the market and how actually market function. New York Times, went on to declare that efficient market hypothesis has officially been declared as dead at the World Economic Forum at Davos as the overall policy implications of the efficient market hypothesis have been relatively more devastating for the economy against the general perception about the different policy implications of the efficient market hypothesis.2(Wighton,2009) The question of whether the efficient market hypothesis explicitly predict the financial crises or not shall therefore be viewed from the different perspectives as many empirical and behavioral studies clearly indicated that the efficient market hypothesis potentially do not define the overall functioning of the markets. For example, mass psychology of herd behavior can effectively influence the market outcomes. Similarly, the dot com bubble as well as the housing bubbles are some of the examples that efficient market hypothesis basically failed to anticipate due to its implicit assumptions about the efficient working of the market.( The recent financial crisis therefore also led to the renewed criticism of the efficient market hypothesis as it is believed that the efficient market hypothesis is basically responsible for underestimation of the impacts of the bubble bursting on the economy. This is also significant due to the fact that the impact of current financial crisis is considered as more severe as compared to the earlier crises which were relatively moderate in nature. The main criticism that has been emerging is also focused on the criticism of modeling the good behavior of the economic agents through the mathematical modeling rather than taking into account the irrational and irresponsible behavior of the various economic agents. Too much reliance on the market therefore not only created lose control but it also resulted into the de-regulation of the markets which basically allowed the culmination of irrational behavior by the economic agents which resulted into the greater impact on the economy in the form of current financial crisis.(Folsom,2009) One of the arguments, put forward by Jeremy J Siegel, do however, indicates that the efficient market hypothesis may not be entirely responsible for the current financial crisis. This analysis is based on the studies conducted on the prices of real estate for the past 61 years up to 2006 indicating that the overall variability in the prices of the real estate properties were only less than 3% which basically allowed credit rating agencies as well as finance managers to lower down the risk premium to be obtained on the subprime borrowers. Further, based on this assumption, the financial managers basically trusted more on the collateral as a back up in case of defaults to cover themselves against potential risks. What is however, important to note that the real estate properties started to fluctuate to a large extent during 2006 and afterwards however, media income levels witnessed relatively low increase? This mismatch or disparity between the asset prices as well as the income levels largely resulted into the current financial crisis and as such, according to Siegel, efficient market hypothesis may not be entirely blamed for the current financial crisis that are being witnessed by the developed world including US.(Seigel,2009). What is also argued that this hypothesis and implications were not completely understood and the current debate on whether the efficient market hypothesis is behind the current global financial crisis is rudimentary in the sense that the overall implications of this hypothesis are not well understood?(Ribstein,2009). Conclusion The efficient market hypothesis is one of the leading theoretical attempts made in the field of finance which describes the overall functioning of the financial markets. It identifies three basic forms of efficiency i.e. weak, semi-strong as well as strong form of efficiency and indicates the various implications of the information on the asset prices. It also assumes that the market participants often form rational expectations about the future and as such the present prices in the market are best guess of the future. However, despite these assumptions, the current financial crisis were largely unanticipated and many market participants including regulators failed to anticipate the overall impact of the financial crisis despite the fact that EMH predicted that the current state of the prices in the markets are often based on the best guess about the future. The systematic under pricing of the risk into the asset prices therefore failed to take into the future economic shocks that materialized in the form of current financial crisis. Many critics however, still believe that the EMH may not be directly responsible for the current financial crisis as there are some factors which started to behave abnormally only recently. Further it is also argued that there is also a general lack of understanding of the overall implications of the efficient market hypothesis and most of its critics failed to distinguish it from other theoretical assumptions such as random walk theory etc. References 1. Allen, R & Snyder, D (2009) New thinking on the financial crisis. critical perspectives on international business. 5 (1) 36-55 2. Dobbins, R & Witt, S (1979) Some Implications of the Efficient Market Hypothesis. Managerial Finance. 5 (1) 65-79 3. Folsom, R (2009) True “Villain” of the Financial Crisis? http://www.fxrepublic.com, Available: http://www.fxrepublic.com/2009/08/27/efficient-market-hypothesis-true-villain-of-the-financial-crisis/ Last accessed 16th December, 2009 4. Hui, E & Lui, T (2002) ational expectations and market fundamentals: Evidence from Hong Kong’s boom and bust cycles. Journal of Property Investment & Finance. 20 (1) 9 – 22 5. Ribstein, L (2009) Sorry, Folks: The Efficient Market Hypothesis Did Not Cause The Financial Crisis The Business Insider, Available: http://www.businessinsider.com/sorry-folks-the-efficient-market-hypothesis-did-not-cause-the-financial-crisis-2009-12 Last accessed 16th December, 2009 6. SIEGEL, J (2009) Efficient Market Theory and the Crisis The Wall Street Journal, Available: http://online.wsj.com/article/SB10001424052748703573604574491261905165886.html Last accessed 16th December, 2009 7. Tsoukalas, D & Sil, S (1999) The determinants of stock prices: evidence from the United Kingdom stock market. Management Research News. 22 (5) 1 – 14 8. Wighton, D (2009) Efficient market hypothesis is dead - for now Times Online, Available: http://business.timesonline.co.uk/tol/business/columnists/article5607960.ece Last accessed 16th December, 2009 Read More