Capital Market Efficiency - Essay Example

? Capital market efficiency Capital market efficiency 0 Introduction The performance of markets under different economic and political conditions has been highly explored in the literature. One of the most important challenges that modern markets have to face seems to be the following one: the information related to events that can influence the price of securities and other financial products are often incorrect. On the other hand, it has been proved that information can highly affect the market performance. In fact, it has been revealed that informational efficiency is one of the three core aspects of market efficiency. The characteristics and the forms of market efficiency are analyzed in this paper. In addition, reference is made to market ethics, at the level that ethics can secure, at least up to a level, market efficiency, being related to all three aspects of market efficiency, i.e. information, institutions and transactions. The literature developed in this field proves that existing research in regard to market risks and potentials focuses on the potentials of markets to become efficient but also on the ability of certain financial systems to promote market efficiency. This is the case of the Islamic finance system which is highly differentiated from the conventional finance system at the following point: in Islamic finance emphasis is given on the intervention of ethics in economic transactions. Because of this reason the reference to the Islamic finance system has been considered as quite necessary for evaluating the issues explored in this paper. It has been proved that it is not quite difficult for a market to be efficient, especially since efficient markets are not considered as perfect markets. Still, it can be rather difficult for those managing financial products to promote ethics in all financial transactions. Indeed, certain aspects of each market are not aligned with the rules of market efficiency, as analyzed below. The alteration of existing finance systems in the global market can be characterized as emergent since it is only in this way that market efficiency could be secured worldwide. 2.0 Market efficiency. The concept of market efficiency has been related to certain facts; the quality of economic activities developed in each market can be an indicative example of market efficiency, as described by theorists who have studied the particular subject (Palan 2007). It should be noted that market efficiency is also described as capital market efficiency (Kevin 2006). The two terms reflect almost the same phenomenon: the development of a high range of economic activities with no delays or other failures within an environment that it is highly influenced by ethics (Kevin 2006). The only difference between the above two terms is the following one: capital market efficiency refers to the potential of specific financial products to respond to the expectations of their investors while market efficiency refers to the expectations of all people living locally, i.e. within the territory in which the market involved is based, to take a return from their deposits or other investments (Palan 2007). The characteristics and the role of market efficiency have been highly explored in the literature. Different approaches have been used though for describing the particular concept (Mama 2010). In any case, it seems that the content of market efficiency is not standardized, depending on the market conditions and economic activities that the particular term has to reflect (Mama 2010). Reference can be made, in particular to the following forms of efficiency, as appeared in the modern market: a) transactional efficiency; this term is used in order to show the ‘costs and speed of reliably transferring funds between market participants’ (Mama 2010, p.10); b) from a different perspective, informational efficiency is a term used in order to show the efficiency in regard to information (Mama 2010, p.11), meaning not only the information gathered in regard to the performance of a particular market but also the information exchanged in the context of negotiations and transactions developed within a particular market (Mama 2010, p.11); c) of particular importance seems to be the institutional efficiency of the market. In general, institutional efficiency is used for describing the characteristics of a particular market in terms of regulation and trade rules. The results from the measurement of the efficiency of Indian capital market for the period 2007 up to 2009 are presented below, in Graph 1. It is made clear that using the market efficiency theory can lead to contradicting results in regard to the performance of the various parts of a specific capital market. Graph 1 – Measurement of the efficiency of Indian capital market for the period 2007-2009 (Source: Mishra et al. 56) Through the above Graph, differences seem to exist in the performance of the two indices of the Indian capital market for the same period, i.e. from 2007 up to 2009. The market efficiency theory in the above case would be used in combination with other theoretical frameworks so that the exact performance of the market under examination is identified. In the study of Broyles (2007) a clear definition of efficient markets is provided. According to the above researcher, a market is characterized as efficient when ‘transaction prices fully reflect in an unbiased way all available price sensitive information’ (Broyles 2007, p.62). Through the above definition it is implied that in terms of its characteristics, an efficient market needs to be mostly informational; at the next level it can be transactional or institutional, in the context described above. As explained by Boyles (2007), an efficient market is not necessarily perfect. In fact, a market can be efficient even when transaction costs are at average level and when most of the investors, not necessarily all of them, are able to access information related to their investment (Boyles 2007). Another characteristic of the efficient market is the following one: in such market, different perceptions can be developed in regard to the expected performance of securities (Boyles 2007). It is the above fact that can lead to ‘unbiased prices’ (Boyles 2007, p.62), a characteristic of efficient market. At this point, reference should be made to the view of Fama in regard to efficient markets. According to the above theorist, a market can be efficient when the ‘expected profit of a security is equal with the average discount rate for the security’s expected cash flow’ (Boyles 2007, p.62). In other words, Fama has not emphasized on other characteristics of the efficient market apart from their ability to highlight the involvement of the market in securing the profits of securities of different value. It should be noted that the efficient market hypothesis, as part of the efficient market theory, can be developed using different models. An indicative model for developing the specific task is presented below (Graph 2). The model has been used for testing the market efficiency of the Romanian Stock market. The equation used and the explanation of the symbols are provided in order to show the potential differences in the methodology employed when the efficient market hypothesis needs to be used for measuring the performance of a particular market. Graph 2- Test of the efficient market hypothesis for the Romanian Stock Market (Source: Dima & Milo 2009, p.407) 3.0 Forms of pricing efficiency In order to understand the concept of pricing efficiency it would be necessary to refer primarily to the potential role of the Efficient Market Hypothesis in identifying the efficiency of a market. According to Moix (2001) the provision of information for developing a market so that it becomes efficient is critical. In fact, Moix (2001) notes that the particular model has been introduced for showing the use of information in market efficiency. Indeed, the Efficient Market Hypothesis is based on the fact that in ‘an efficient market prices are adjusted with no delay to the new information entering the market’ (Moix 2001, p.59). It is explained that the information is automatically incorporated in the prices so that the latter are changed based on the new events (Moix 2001, p.59). The automatic fixing of prices under the influence of information entering the market has been characterized as pricing efficiency. It should be noted that in order for the validity of the process to be secured, two requirements need to be met: ‘a) information need to enter the market randomly and b) information is incorporated in prices automatically’ (Moix 2001, p.59). It should be noted that three different modes of pricing efficiency exist: ‘a) weak form, b) semi-strong and c) strong’ (Kevin 2006, p.124). The first of the above forms deals with ‘the past information in regard to the prices of securities’ (Kevin 2006, p.124), b) the semi-strong deals with ‘private information that has been published, so that it is accessible by everyone’ (Kevin 2006, p.124) and c) the strong; referring to both the above categories, i.e. ‘both the past and the private/ public information) (Kevin 2006, p.124). 4.0 Investment and financing in efficient market Investing in the context of an efficient market can hide certain risks. At a first level, an efficient market can guarantee that the quality of information provided to the investors is high, a fact though that cannot secure the success of the particular investment (Mayo 2010). On the other hand, in an efficient market trust in regard to all transactions can be high, or at least it is kept at an average level (Mayo 2010). This means that within efficient markets the negotiations related to investments are credible (Mayo 2010). Reference should be also made to the institutional aspect of the efficient market. According to this aspect, investors in efficient markets can feel safe since in case of any failure or unexpected event they could seek for protection using the local laws and ethical rules. Another aspect of investment in the context of efficient markets is presented in the study of Mayo (2010). According to Mayo investing in efficient markets has the following implication: in these markets, ‘technical analysis is mostly used as a form of investment analysis’ (Mayo 2010, p.411). Technical analysis is based on the extensive use of graphs for representing the potential performance of an investment. However, the specific mode of representation of an investment’s performance can be inaccurate (Mayo 2010, p.411). In fact, under certain cases the level of success of investment portfolios based on technical analysis has been the same with that of portfolios that were bought randomly’ (Mayo 2010, p.411). Moreover, technical analysis has the following requirement: ‘selling and buying need to be continuous’ (Mayo 2010, p.411), a condition that may be difficult to be met, especially in modern market which is characterized by strong turbulences. Graph 2 - Graphical representation performance of Indian capital market, from 2007 to 2009 (Source: Mishra et al 2010, p.51) The potentials of efficient markets to secure the success of investments are analyzed in the study of Elton et al. (2009). In the above study, emphasis is given on a particular aspect of efficient market: the informational efficient market (Elton et al. 2009). It is explained that the incorporation of information in prices with no delay is a key advantage of the efficient markets (Elton et al. 2009). Still, it is not made clear whether this process need to be based on certain criteria (Elton et al. 2009). Also, no explanation is given in regard to the following issue: since speed in the incorporation of information in prices is vital in efficient markets (Elton et al. 2009), is there a mechanism in these markets that can guarantee the monitoring of the above process so that mistakes are avoided? The answer seems to be negative. The inability of efficient market to check the accuracy of information incorporated in prices is considered as this market’s major weakness being able to lead to false impressions in regard to the potential performance of an investment. 5.0 Lessons from efficient market theory. The efficient market theory is based on certain rules and criteria. This means that the particular theory cannot perform high in all markets but only in those that can respond to the requirements of the specific theory. At a first level, the efficient market theory has made clear that the success of business operations can be promoted only in markets where all three aspects of market efficiency can be supported (Palan 2007). For example, in a market where only transactional and institutional efficiency can exist, the market efficiency cannot be guaranteed at the level that the process and the exchange of information required for developing economic transactions would not be available (Palan 2007). A market that does not respect knowledge as the basis of successful entrepreneurial activities cannot become efficient, at least not in the long term (Arouri, Jawadi & Nguven 2010). Graph 3 – Comparison of Average Excess Return and Time in regard to the purchase of insiders on November 26, 2008 in NY Exchange Market (Source: Darrell & Bacon 2010, p.179) One of the most important lessons of the market efficient theory is the following one: the relationship between market performance and specific events is not standardized. Reference can be made, as an example, to the Graph 3, above, where the purchases of insiders in the New York Exchange Market are presented. According to the above Graph, the differences in the correlation between the Average Excess Return of purchases and Time are low over a particular, short, period of time. The period of Time used in the above Graph is one day, since the Graph is based on the purchases made in the particular Stock Market in the 26th of November 2008. On the other hand, it has been supported that ‘the efficient market theory is based on competitive general equilibrium market theory as applied in any competitive market’ (Sharpe 2004, p.221). The above view promotes the idea that efficient markets are highly competitive markets, a view though that cannot be considered as fully justified especially if taking into consideration the following fact: the level at which an efficient market is near to a perfect market cannot be predicted in advance (Arouri, Jawadi & Nguven 2010). Thus, an efficient market cannot, necessarily, guarantee the competitiveness of the firms operating within the particular market (Arouri, Jawadi & Nguven 2010). However, an efficient market where competition is highly protected it should be preferred, compared to efficient market of different characteristics, at the level that such market could guarantee equality and fairness in the support of business operations. A key lesson of the efficient market theory is the following one: the success of investments within markets may not be based on facts that are traditionally considered as important in most markets worldwide. 6.0 Market efficiency and ethics The characteristics of market efficiency have been already described above. The potential relationship of market efficiency and ethics should be explored because of the following reason: ethics can be a decisive factor in regard to market performance (Arouri, Jawadi & Nguven 2010). The particular view is based on a specific fact: all three aspects of market efficiency, i.e. the institutional, the informational and the transactional market efficiency are based on ethics. Indeed, in order for market efficiency to be secured it is necessary that the information provided to investors is accurate(Arouri, Jawadi & Nguven 2010). It is also required that the rules regulated the financial market involved are ethical. In addition, the transactions developed across a market need to be based on ethics; otherwise the particular market would not be characterized as efficient. At this point, the following issue appears: as already explained an efficient market is not necessarily a perfect market (Besley & Brigham 2008). This means that certain of its aspects will not be aligned with ethics. Up to which level the opposition of a market’s activities with ethics should be accepted? No specific answer can be given. It seems rather that it is sufficient for ethics to govern a market’s events at least at an average level, meaning that failures in regard to the promotion of ethics in markets worldwide can be tolerated but not at a level that trust across a market is severely harmed (Fell 2000). Market efficiency as related to ethics emphasizes on the potential of the market to promote ethics in regard to a particular sector or in regard to all its sectors (Fell 2000). In this context, ethics, as related to market efficiency can incorporate a high range of activities and frameworks, apart from information, institutions and transactions. More specifically, reference can be made to the terms of agreements, as related to various economic transactions, the mechanisms developed for securing safety of transactions, the participation of investors in all phases, if possible, of economic negotiations related to their agreement and the existence of an authority that handles the complaints related to the violation of market ethics and laws (Fell 2000). In addition, in regard to market efficiency ethics can be related to the empirical research developed for evaluating the performance of capital markets (Fell 2000). The above activity has to be carefully planned so that the following targets are achieved: a) findings are credible and have been gathered and tested using appropriate methods of data collection and analysis, b) participants are informed in regard to the development of the research, so that information is provided and consent is given, if necessary (Fell 2000). 7.0 Islamic market ethics When referring to Islamic market ethic the following issues should be highlighted: Islamic markets are highly based on ethics, at the level that ethics is considered as a core part of the Islamic finance system (Kevin 2006)). From this point of view, Islamic market ethic is mainly related to the following fact: are the rules of Islamic finance fully applied in markets worldwide? Because of the structure of the global economy, which is based on the model of conventional/ western finance, the Islamic finance system is fully developed only in countries based on the rules of Islamic law (Ho &Yi 2004). In other markets, the Islamic market ethics can also appear, but only partially, at the level that financial products based on Islamic finance are available. The financial products provided by Islamic banks based on countries that are not governed by the Islamic law, are often used as tools for promoting the Islamic market ethic, even if this effort has been proved quite challenging mostly because of the existing structure of the conventional finance system (Ho &Yi 2004). According to the issues discussed above, the Islamic market ethic can have two different forms: a) in its traditional form, available only in countries based on Islamic law, the Islamic market ethic reflects the respect of those participated in daily economic transactions, including investment activities, for the rules of the Islamic law (Fabozi 2003); the financial products provided by Islamic banks are appropriately customized for promoting the rules and the ethics of Islamic law; b) when referring to countries that are not based on Islamic law, the Islamic market ethic has a similar role: it promotes the rules of Islamic law, as these rules are incorporated in the financial products provided by the Islamic banks (Ho &Yi 2004). Still, ethics in Islamic finance should, necessarily, have certain differences compared to ethics developed in the conventional finance system: in the conventional finance system ethics influences daily operations but not directly (Das 1993). For example: in the agreements signed between conventional banks and their clients in regard to the financial products provided by the former, ethics is reflected to the terms placed at the end of each document (Das 1993). Through these terms the parties are informed on their ethical obligations. In the Islamic finance system a different approach is used. Ethics is not incorporated in the contract related to each agreement developed between the Islamic banks and their clients (Ogilvie 2009). Instead, the financial products of Islamic banks have been structured in such way so that they are fully aligned with ethics, as described in the Islamic finance system (Ho &Yi 2004). In other words, in the Islamic finance system the customer is not asked to respect ethics but he is asked to participate in an agreement based on ethics. 8.0 Efficiency in Islamic markets As explained earlier, market efficiency is related to certain characteristics. This means that there are certain terms which, when they are met, can secure the efficiency of the market. The theories presented above, in regard to market efficiency refer to all markets worldwide but at the level that these markets are related to conventional economic systems (Iqbal & Mirakhor 2011). This means that market efficiency theories and characteristics are primarily related to the Western finance system, which has been used as the basis for the development of the conventional banking system. From this point of view, Islamic finance would not be related to market efficiency (Iqbal & Mirakhor 2011). However, such view would not be accepted at the level that Islamic finance has been already expanded in many countries worldwide so that it would be difficult to claim that Islamic finance has not a key role in global market (Legrenzi & Momani 2011). At this point the following issue appears: since Islamic finance is already expanded in most markets worldwide how the delays and failures in market efficiency have not been prevented? The above question could be answered as follows: indeed, Islamic finance has been expanded in most markets but its power in each market is limited, apart of course from the countries that are based on Islamic finance, such as the Arab countries (Legrenzi & Momani 2011). The specific phenomenon is explained as follows: countries based on conventional finance accept the entrance in their territories of financial institutions based on different finance systems, such as the Islamic finance system. However, in practice the potentials of these institutions to apply all rules of the foreign finance system, as for example of the Islamic finance, are quite limited. Reference can be made, as for example, to the Islamic Bank of Britain (Legrenzi & Momani 2011). The specific financial institution is not allowed to keep investment accounts, as structured in the context of the Islamic banking system, since such practice would come in opposition with the International Standards of Financial Reporting (Legrenzi & Momani 2011). The Islamic Bank of Britain had to respect the above rule. The above fact shows the limitation of power of finance systems that are independent from the western finance system. In this context, the Islamic finance system cannot intervene directly and promote rules that secure market efficiency. Still, this fact does not eliminate the value of the Islamic finance in helping the market to become efficient (Legrenzi & Momani 2011). For example, through the promotion of financial products that are interest-free and through the provision to investors of accurate information in regard to all aspects of their investment the Islamic finance contributes, even not directly, in market efficiency. In regard to the above certain points should be highlighted. The fact that the Islamic finance is highly differentiated from the conventional finance does not mean that the former cannot be involved in schemes developed by the latter (Ariff & Iqbal 2011). Neither means that Islamic finance cannot promote rules that are used in the context of the conventional finance. Instead, Islamic finance can adopt practices and rules developed in other finance systems under the terms that these practices and rules are not opposed to the rules of Islamic law (Ariff & Iqbal 2011). From this point of view, Islamic finance would be related to ethics as the specific concept is used in the conventional finance system (Ariff & Iqbal 2011). According to the issues discussed above, efficiency in Islamic market is related to the ability of this market to operate effectively and to promote ethics. Effective operation in the Islamic market, as also in the conventional markets, means the high quality of services provided to the client, the high quality of information provided to the client and the trust and safety in economic transactions (Ariff & Iqbal 2011). In addition, efficiency in Islamic market could be related to a series of additional practices and rules, as these practices and rules are derived from the Islamic law (Iqbal & Mirakhor 2011). In this context, in the Islamic market efficiency could reflect the lack of severe failures in managing risk and the availability of funds for covering emergent market needs (Iqbal & Mirakhor 2011). 9.0 Conclusion The needs of markets internationally are differentiated according to local culture and political systems but also according to the ethical rules on which each market is based. Indeed, the research developed for this paper has proved that ethics can highly influence market performance, promoting practices that are not opposed to public interest. In opposition, in markets where ethics are ignored, economic turbulences are quite common. As explained above, current paper focuses on market efficiency, meaning its characteristics and role. The potential influence of market efficiency by certain events, not only at the level of the economy, has been also reviewed aiming to identify the reasons for which market efficiency around the world is problematic, even in developed countries. At this point, the following fact should be highlighted: when referring to market efficiency, emphasis is given to certain market characteristics. This means that if these characteristics do not exist, then there is no case of market efficiency. Still, in practice, there are markets that are characterized as efficient without meeting the formal criteria of the market efficiency, as described in the literature. The above phenomenon cannot be, necessarily, characterized as negative. Indeed, as noted in the literature, efficient markets need not to be perfect (Broyles 2007). Still, a market has to meet specific criteria in order to be characterized as efficient. The problem is that it has not been made clear through existing literature whether all these criteria need to be met or whether certain of them are adequate for considering a market as efficient. These criteria, as analytically discussed above, lead to the following assumption: the ability of a market to secure a minimum quality standard of the services provided to investors can be a strong indication of this market’s efficiency. Of course, there are other issues that are also examined when referring to efficient markets: reference can be made in particular to market ethics but also to the openness of the market to new finance systems, especially those that promote ethics in regard to all aspects of each market. At the same time, the review of the relationship between ethics and market efficiency, as this relationship is analyzed in the literature presented above, has led to the following assumption: ethics are used as the basis for the development of the regulatory framework of all markets worldwide. However, in practice the use of ethics in daily economic transactions is limited. Reference is made to markets of different cultural and political characteristics. Still, there are certain economic systems that are differentiated from the conventional economic framework. These systems, such as the Islamic finance, can secure market efficiency. The Islamic finance, which is such finance system, has been traditionally considered as an effective tool for securing market efficiency worldwide. It is for this reason that the expansion of the particular system worldwide has been highly supported by economists. In practice, the establishment of the Islamic finance system in markets worldwide has been proved quite difficult not only because of the cultural difference appeared but mainly because of the opposing interests that govern most of the markets. From this point of view, the expansion of these systems globally could possible help to promote market efficiency, but such plan would have to face the following two challenges: a) The development of these systems globally cannot be equal to that of the conventional finance; this means that the potentials of these systems to press for an increased use of ethics in daily economic transactions are rather limited and b) market conditions tend to change globally; under these terms developing rules that can guarantee market efficiency can be quite difficult, almost impossible; c) through these systems people worldwide would become aware of the increased involvement of ethics in economic transactions. This means that through such system the efficiency of markets could be secured not only through the use of appropriate theoretical frameworks but rather through the transformation of existing terms of economic transactions both at personal and at corporate level. In any case, the information provided in regard to market efficiency reflects an import social and economic trend: in most markets worldwide emphasis is given on the standards and the quality of information on which markets are based. Of course this fact does not mean that markets around the world have become fully ethical; however, an effort is clear for the alteration of a high range of market practices so that market efficiency is guaranteed. 10.0 References Ang, A., Goetzmann, W. & Schaefer, S. (2011). The Efficient Market Theory and Evidence. Hanover: Now Publishers Inc Ariff, M. & Iqbal, M. (2011). The Foundations of Islamic Banking: Theory, Practice and Education. Cheltenham: Edward Elgar Publishing. Arouri, M., Jawadi, F. & Nguyen, D. (2010). The Dynamics of Emerging Stock Markets: Empirical Assessments and Implications. New York: Springer. Besley, S. & Brigham, E. (2008). Principles of Finance. 4th ed. Belmont: Cengage Learning. Broyles, J. (2007). Financial Management and Real Options. Hoboken: John Wiley & Sons, Darrell, A. & Bacon, F. (2010) INSIDER TRADING: A TEST OF MARKET EFFICIENCY. Proceedings of ASBBS. Volume 17 Number 1, 174-181 http://asbbs.org/files/2010/ASBBS2010v1/PDF/A/Asbell.pdf Das, D. (1993) International Finance: Contemporary Issues. London: Routledge. Dima, B. & Milo, L. (2009) TESTING THE EFFICIENCY MARKET HYPOTHESIS FOR THE ROMANIAN STOCK MARKET Annales Universitatis Apulensis Series Oeconomica, 11(1), 402-415 http://www.oeconomica.uab.ro/upload/lucrari/1120091/41.pdf Elton, E., Gruber, M., Brown, S. & Goetzmann, W. (2009) Modern Portfolio Theory and Investment Analysis. Hoboken: John Wiley & Sons. Fabozzi, F. (2003). The Handbook of Financial Instruments. Hoboken: John Wiley & Sons. Fell, L. (2000). An Introduction to Financial Products and Markets. Belmont: Cengage Learning EMEA. Ho, T. & Yi, S. (2004). The Oxford Guide to Financial Modeling: Applications for Capital Markets, Corporate Finance, Risk Management, and Financial Institutions. Oxford: Oxford University Press. Iqbal, Z. & Mirakhor, A. (2011). An Introduction to Islamic Finance: Theory and Practice. 2nd ed. Hoboken: John Wiley & Sons. Kazmer, D. & Konrad, M. (2004). Economic Lessons from the Transition: The Basic Theory Re-Examined. New York: M.E. Sharpe Kevin, S. (2006). Portfolio Management. 2nd ed. New Delhi: PHI Learning Pvt. Ltd. Legrenzi, M. & Momani, B. (2011). Shifting Geo-Economic Power of the Gulf: Oil, Finance and Institutions. Farnham: Ashgate Publishing, Ltd. Mama, H. (2010). Information Dissemination, Market Efficiency and the Joint Test Issue. Stoughton: BoD – Books on Demand. Mayo, H. (2010). Investments: An Introduction. Belmont: Cengage Learning Mishra, P., Malla, M., Mishra, S. & Pradhan, B. (2010) Performance of Indian Capital Market – An Empirical Analysis. European Journal of Economics, Finance and Administrative Sciences, Issue 23, 49-57 http://www.eurojournals.com/ejefas_23_04.pdf Moix, P. (2001) The Measurement of Market Risk: Modelling of Risk Factors, Asset Pricing, and Approximation of Portfolio Distributions. New York: Springer Ogilvie, J. (2009). Financial Strategy: F3 - Strategic Level. 6th ed. Oxford: Elsevier. Palan, S. (2007). The Efficient Market Hypothesis and Its Validity in Today's Markets. Norderstedt: GRIN Verlag. Read More