Efficiency Market Hypothesis in 2008 - Essay Example

Discuss Efficiency Market Hypothesis in the context of the "crash of 2008," and/or the "Internet bubble" Introduction Efficient Market Hypothesis (EMH) holds that stocks or shares trade at their fair value thus preventing buyers and sellers from gaining unduly from market inefficiency. In other words since the market functions efficiently investors cannot buy undervalued shares or sell overvalued shares. Thus if any investor desires to earn higher returns he has to buy much riskier shares or bonds. When stocks rose by high percentages the analysts said that it was due to the efficacy of stock markets and therefore the positive rally reflected the true performance of the companies. Efficient markets do exist in theory. For example according to financial theory there are efficient stock markets that especially don't permit market manipulation by investors. However the practical scenario negates this proposition very often. For instance the rally of the stock could be attributed partially to the equity issue and not to the efficiency of the markets. The stock market crash of 2008 can be identified as a situation in which a stock market experiences a sudden and major decline in value of its underlying stocks. However crashes can occur mainly due to the rising stock prices and excessive economic optimism (Cuthbertson, 1996). Further it can be caused by the collapse of a speculative bubble, financial crisis or economic crisis. A substantial change in stock markets and price behavior can be caused by psychological influences that often lead to bubbles. Thus EMH is flawed to a certain extent because there is no such grantee that share prices would be solely determined by a pure interplay of market forces, i.e. demand and supply. In fact the crash in 2008 occurred due to structural deficiencies that in turn were characterized by a flurry of activity in which overvalued shares were traded hectically during the immediately preceding period before the crash. 2. Overall analysis Stock market influences on the investors' policy decision making process and corporate strategy have been discussed against backdrop of an evolving environment of change. This is because of the fact that business organizations are becoming more popular because their survival is directly proportional to the size of the market rather than the manageability (Elton, and Martin. 2003). Compact small business organizations have been described as economically unproductive in times of financial recessions because their excessive dependence on internal organizational capabilities leads to poor decisions. Therefore it's essential now to discuss the various theoretical underpinnings of the optimal capital structure in order to determine how efficiently the stock market would be able to function in the absence of the above mentioned shortcomings such as bankruptcy costs and information asymmetry. In addition, there are some highly influential theories. With the help of them it's possible to discuss how best an efficient stock market can be brought into existence (or not) thus rendering both capital structure and dividend policy of the firm irrelevant. However the extent to which those stock market imperfections can be overcome would determine the degree of perfection of the stock market in a given situation. On the other hand the success of big firms has been attributed to their ability to raise both debt and equity capital and the relative size of the market. In the first place financial recessions dependents on the firm's ability to raise capital. Since the market value of the firm is affected by the way in which the capital is structured, managers might prefer to raise debt instead of equity thus bringing down the value of the firm in the eyes of the investor (Copeland, and Fred, 1988). Subsequently shareholders might be compelled to sell their shares at lower prices. In such a scenario big corporate entities are able to survive on pre commitments made by institutional lenders who will not hesitate to buy debt instruments like corporate bonds and debentures in times of financial crash. The size of the market is sought to be preserved by big business organizations on the ground that any vacuum left behind by a declining company would be immediately filled by competitors. This is desirable from the viewpoint of the fact that market forces don't produce efficiencies as predicted by EMH. The main argument behind this environmental influence on the long run survival of the big business organization is centered on the fact that the firm has to sell a minimum portfolio of products in the long run to avoid being pushed out of the market. Thus share prices of firms are determined by speculative phenomenon to a greater extent. Small businesses have to devise their own strategies for survival in such a situation. The agency problem illustrates this better. For example when a principal hires an agent he does so with the intention that the latter would act in conformance with certain rules to bring about what the former wishes. However the motivating factor behind such performance is the monetary compensation such as a good salary to the manager. Therefore such behavior on the part of the manager would not be in his best interest. His tendency to deviate from what is expected of him is common among all managers. In order to reduce such negative behavior the manager must be adequately compensated. However the principal does not know what the agent would do to ensure that his own interest prevails. This behavior on the part of the manager leads to market uncertainties. Even though the manager is concerned about profit and higher share price there is very little that he can do avoid a collapse when the strategy is exposed to risk. (a). Asset substitution problem As and when debt to equity ratio increases managers tend to substitute new assets through new investment thus relatively increasing debt in place of equity. Assuming that projects are riskier, there is still a fairer chance of success against failure thus obliging both debt-holders and share holders to condone such risky investment decisions on the part of managers. Successful investment projects lead to cumulative share holder benefits while unsuccessful ones lead to cumulative debt-holder woes (Hull, 2004). (b). Underinvestment problem Managers would not hesitate to reject projects with positive Net Present Value (NPV) because they would not be bothered to increase the value of the firm any more than to allow the accrual of benefits associated with riskier debt to debt-holders themselves rather than to share holders. (c). Free cash flow problem Finally there is the problem of free cash flow. In the absence of free cash flow benefits accruing to investors, the manager has a tendency to reduce the value of the firm through prodigal behavior, such as granting bonuses and higher salaries. Therefore higher levels of leverage would act as a preventive factor of such behavior and ensure discipline. Since this theory focuses on agency costs and financial distress of firms, there is some theoretically valid argument attached to its outcomes though. Agency costs apart financial distress arises due to the firm's failure to meet demands from debtors. If debt holders find out that the firm is unable to meet its obligations, then they would force the firm to declare bankruptcy and go for liquidation (Merton, 2008). In the first instance there is the direct cost entailed by insolvency. Thus subsequent liquidation process would compel the management to sell assets at distress prices. All this is associated with a particular outcome, viz. value of the firm. Thus the inverse relationship between distress costs and value of the firm could be used as a measure of capital structure but nevertheless capital structure is not determined by the value of the firm. Hence the argument that financial distress like agency costs would not be taken as a conclusive measure to arrive at firm's value determination decisions is valid enough not to warrant a second look at the irrelevance of capital structure in determining value. On the other hand the current global economic downturn has quite a lot of implications for the firm's decision making process. Highly leveraged firms tend to take greater risks by focusing on debt financing of its capital stock as against those less-leveraged high equity firms which prefer to be safe-players. Debt capital as against equity capital of the firm if correctly managed brings in fortunes by way of higher returns. This is probably the best alternative in times of an economic downturn. Strategic finance policy shifts in the corporate sector against the backdrop of the current financial crash have been marked by more debt to pay existing debt. This kind of leveraging practice has a very far reaching impact on the overall capital structure of the firm as well. Issuing more debt in order to settle existing debt is a strategic financial initiative adopted by firms thus obviating the need for issuing equity (Islam, 2004). However the strategic financial policy on leveraging in the corporate sector has acquired a new dimension, i.e. while exiting debt might accumulate indefinitely due to interest payment obligations there is very little freedom available to the manager to manipulate the overall capital structure despite the sustained efforts to raise more debt to pay exiting debt. The authors suggest a more cautious approach to leverage decisions. The existing theoretical constructs including those governing the determination of firm's capital structure have been over-utilized to construct theoretical and conceptual contingency models that have very little relevance and appropriateness to the context. Conceptual framework building efforts have been of very little success against the backdrop of financial crash. This is particularly so since firms don't always behave predictably in times of crises. These authors reiterate the importance of strategic innovation in the face of difficult financial decisions due to market uncertainty. While many researchers have examined the causal factors of raising more debt to pay off existing debt in companies which are highly leveraged, there is very little research carried out into the associated links between such leverage decisions and impending global economic crises. The author places emphasis on cost management in leveraging though some incisive insights have been developed in connection with strategic financing options in critical contexts. Some researchers have invariably focused attention on causal factors ranging from agency costs to information asymmetry in leverage decisions (Hull, 2005). However their efforts have been less focused on the diverse and dynamic causes associated with financial crisis. The inevitability of poor leveraging decisions of business organizations having a negative impact on market related outcomes has to be underlined here. Thus EMP is seen as a mere assumption based on some uncorrelated endogenous and exogenous variables that very poorly add up to produce the predicted for efficiencies. Such mechanisms like the lack of transparency in the structured credit market, securitization, low interest rate levels and liquidity problems affected the stock market stability and also there was a significant failure in risk management which exposed large companies to structured credit market. While risk factors aren't so transparent enough for managers to take decisions with certainty and risk factors can be identified with some certainty due to good focus on major developments. Debt and equity in the capital structure of the firm is not necessarily determined by these causal factors alone. In the same vein associated outcomes have received much less attention except that there is a paradigm shift in analytical interpretations from endogenous variables to exogenous variable. Thus in this literature review determination of causes and outcomes would assume a multidimensional approach including corporate governance and sustainability issues. Firms have a tendency to keep the level of risk associated with debt to a minimum by adopting strategic capital restructuring measures that take into consideration the impact of interest rate and exchange rate movements. It's in fact an articulate strategic response to the external competitive environment and the volatility in financial markets. Thus firms have initiated not only theoretical and conceptual frameworks for dealing with risk so that tax exemptions are utilized but also other measures like the financial ratios to determine the real impact of interest and exchange rate movements across a broader spectrums of variables - e.g. debt repayment commitments and capital replacement costs. Firms responded to financial crash with circumspection by raising as much less debt as possible either to pay off existing debt or/and to expand operations. However, the borrowing requirements were determined by the balance sheet's position between assets and liabilities. Therefore the average company didn't borrow so much as to finance existing debt if the sales were down. While there is an equally important aspect of financing expansion through integration such as merger & acquisition (M&A) this is beyond the remit of this paper. In fact many firms have preferred to merge together so that scale related synergies could obviate any need for excessive borrowings. Small and medium scale (SMEs) firms have always adopted this strategy to overcome market uncertainties. Conclusion In conclusion it must be noted that technical and fundamental analysis of efficiency in share markets with reference to EMH might change the final outcomes such as trade returns to a greater extent. However from the viewpoint of the average firm even if the current forecasts were a little out of line, there would still be a steady cash flow return because an opportunity cost per annum ensures a considerable setting off of risk associated with such unforeseeable outcomes (Brealey, and Stewart, 2004). Despite financial market volatility investments and cash flow forecasts perform predictably well in accordance with agents' behaviour and sentiments. Thus there is a highly plausible scenario of positive financial outcomes. The decision to invest in shares based on EMH would have a positive impact on company finances depending on the cash flow variances. Continuous positive variances would enhance the company financial performance over the period under consideration, assuming other variables such as external debt remains constant over the period. However the stock market crash has proved the existence of imperfections that are primarily and immediately associated with the EMH. Finally, what are so strategically imperative are the policy choices and strategic outcomes thereof. This policy norm applies equally well to these market-based outcomes mentioned above. There is no gainsaying the fact that organizations, both public and private operate in a strategically intense environment of uncertainty and volatility. REFERENCES 1. Brealey, Richard, and Myers Stewart. Principles of Corporate Finance. New York: McGraw-Hill, 2004. 2. Copeland, Thomas, and Weston Fred. Financial Theory and Corporate Policy. Boston: AddisonWesley ,1988. 3. Cuthbertson, Keith. Quantitative Financial Economics: Stocks, Bonds and Foreign Exchange.NewJersey: Wiley,1996. 4. Elton, Edwin, and Gruber Martin. Modern Portfolio Theory and Investment Analysis, Wiley: New Jersey, 2003. 5. Hull, John. Options, Futures, and Other Derivatives. New Jersey: Prentice-Hall, 2004. 6. Hull, John. Fundamentals of Futures and Options Market. New Jersey: Prentice-Hal, 2005. 7. Islam, Sardar. Empirical Finance: Modelling and Analysis of Emerging Financial and Stock Markets (Contributions to Economics). New York: Physica-Verlag, 2004. 8. Merton, Robert. Financial Economics. New Jersey: Prentice Hall, 2008. Read More