Appling the EMH evaluate the role that government played in economic recovery using recent real-life examples - Essay Example

? Appling the EMH evaluate the role that government played in economic recovery using recent real-life examples Table of Contents Introduction 3 Aim and objectives of the study 3 Efficient market hypothesis 3 Types of market efficiency 4 The significance of government intervention on the efficient market 5 The price adjustments test 6 Random Walk Theory 6 Case 1: Financial market of United States: Role of government in market efficiency during global financial crisis 7 Case 2: European sovereign debt crisis – Government intervention catalyzes market efficiency 10 Conclusion 12 References 13 Introduction The concept of efficiency is at the epicentre on the finance concepts. The efficiency in the market is a term that is used to describe the market of financial assets as well as securities. The information prevailing in the market has the central role to play in this type of market structure. The prices of financial assets are often influenced by the intervention from the part of the government as the economic situation of a state is often under the policies parameters of the government. The decision making of the investors revolve around the information pertaining in the market. However the market variations can be correct predicted in some cases by the managers and they can ignore themselves from the financial gimmicks. Aim and objectives of the study The theme around which the discussion will tend to revolve is of efficient market hypothesis under the intervention of the government. The hit of the financial crisis has left many countries under the scanner and so the usefulness of the study cannot be underestimated. Enormous scope of the study is waiting in the background as it is extremely important to understand or analyze the intervention of the government in detailed manner in this volatile scenario. The study will take into consideration or will try to consider the various policies of the government which will determine the scope of legislation on efficiencies of the market in the near future. The present times has witnessed gradual instability in the market due to the imposition of the different market policies of the government and would provide an opportunity of learning in the current scenario. Efficient market hypothesis The efficient market hypothesis implies that if any new form of information is available in the market the share price of the company will move accordingly and the movement of the price will be rational according to the information available in the market. In this type of market no trader will have an opportunity to earn profits which is above the normal level on the return from a share greater than the fair return from the associated risk. The chance of absence of normal profits arises as the past or the future information is reflected in the current prices of the shares. The availability of new information in the market has the ability to affect the prices of the shares (Palan, 2007, p. 3). The hypothesis is concerned in analysing the conditions under which an investor can earn abnormal profits from investing in a stock. It claims that the relevant information is reflected in the stock price. It states that abnormal returns cannot be availed with only public information. People are of the opinion that efficiency means that it is not possible to outperform the market at a certain point of time. It can be expected that under certain points of time the prices will deviate from the fair value as it majorly depends on the unpredictable future. It does not mean that an investor will not be able to beat the market scenario at any time. In the market which is efficient one half of the purchased shares subsequently outperform as the process tend to deviate randomly (Harder, 2010, p.7). Adoption of particular investment strategy in the long run can contribute to beat the market situation. It may be possible to find few investors who have beaten up the market scenario in a completely efficient market with price deviating from the true value. The laws of probability have the central role to play in the efficient market conditions. There are investors who actually went against the flow and succeeded but it is not possible to analyse whether they achieved it through luck or by technique. Types of market efficiency Different theories have been put forward by economists on the basis of available information and the reflection of the information on the prices (Ogilvie, 2008, p. 71). There are three levels of market efficiency which are discussed below: Weak form of efficiency: the weak form of efficiency states that shares prices fully reflects the information on the historical prices and so the investors cannot beat the market in spite of analysing the movements of the past prices of the concerned shares. Semi-strong form of efficiency: the semi strong form of efficiency states that the public information is calculated on the price of the stock but technical or fundamental analysis lacks the capability to beat the market. The semi strong efficiency states that the prices of stocks should contain all the relevant information and should have important significances on the industry as well as upon the decision of the policy makers. Strong form of hypothesis: the strong form of hypothesis states that all types of information whether public or private are incorporated in the prices of shares and in this form even the insiders lacks the capability to earn abnormal gains. The significance of government intervention on the efficient market The professionals have supported the efficient market hypothesis for mainly two reasons. The efficient market hypothesis offers a logical as well as theoretical background on the performance of the market and the theory provides some empirical evidence to support it. However since the last decade and a half many economists have ignored the hypothesis stating it as the model to analyse the performance in the market as well as behaviour of the investors. The supporters of behavioural finance reject the market efficiency and interpret it in a different fashion as they are of the opinion that the believers of the efficient market hypothesis are biased. They opine that the stocks markets are too volatile for the prices to get dependant on the rational valuations. The investors tend to overreact or under react under different circumstances. This will enable the investors to buy the low priced shares and sell them at higher prices in another market what is arbitrage by the analysts. The following sections will replicate the behavioural finance as a critique to market efficiency. The theoretical underpinnings will follow while the last section will tend to focus upon the advantages of market efficiency as well as behavioural finance. The price adjustments test This test mainly focuses on the adjustment of prices or to be more specific the rapidity with which prices begins to adjust. The objective of the test is to determine the effect of government policies on the price adjustment mechanisms on the market efficiency. One of the eminent researchers once put forward the first event where prices adjusted to the availability of new information in the markets. Let the new information be stock split. If these type of information are available in the market the companies will initiate to issue new shares for the already existing shareholders which will pave the path for fall in individual share price but the overall value of shares will remain more or less the same. The aim of the test was to line up the organizations according to event time. The method was one of the popular methods among the researchers who wished to analyse the reactions of the market in response to new information or the introduction of corporate events like mergers and acquisitions. The studies reflect the market efficiencies as the prices respond quickly is response to information, however there are exceptions to that. Random Walk Theory Many researchers followed the above test in order to analyse the randomness of the movements in the prices of stocks with the aim to demonstrate the efficiency in the capital market. The market efficiencies are influenced by the excessive burden of tax, the level of inflation within an economy, the price ceilings and the consumer surplus. The following studies depicted the inefficiency by identifying permanent variations in the returns on the stock market. The studies relating to market efficiency observed that the movements of the price stocks tend to follow a random walk (Spitzer, 2001, p. 21). The investors who believe in the random walk theory state prediction of future prices of the stocks as a waste of time. The share prices of the different corporation reflects the intervention from the part of the government in the field on restructuring the tax legislation, the control of the economy from financial turmoil as well as inflation. The followers of the theory trusts that it is practically impossible to predict the future movements of the prices of shares and therefore one should accept the efficiency market hypothesis. Case 1: Financial market of United States: Role of government in market efficiency during global financial crisis During last two decades of nineteenth century, real estate and properties market in United States had seen major increase of demand as well as price in the housing market. This scenario influences the majority of people in the country to buy more properties for high wealth in future. Most of the people started buying properties even in overvalued price from the financial help i.e. loan from major banks in the country. But, after few years down the line, this market suddenly melted down and demand of the properties especially house buildings went down dramatically and reached the price level far below than the purchase price. Therefore, the property owners could not able to pay back the amount of loan they had taken from the banks. Thus, major banks falls into huge debt and few of these bankrupted. Property purchase at fair value always increases wealth in much higher percentage than other popular investment plan. Therefore, investing in housing market was always been most lucrative wealth creation alternatives to the people of United States. They invested huge amount in land and real estate aiming to sustainable increase in price in future. However, tech bubble of 2002 also resulted financial crisis in US economy and this also blew out of proportion in 2007 and stimulated the key causes of global financial crisis. Thus Financial Crisis of 2007-09 not only took the whole US economy into the plunge but spread across the world economy with the ripple effect of recession. The buyers of housing and property market in US became bound to come down to fair value of the assets. On the other side, the sellers of those properties had built those properties on the fair market value over the time. At the same time, the buyer had to have steady disposable income or good credit rating to support their purchase by financial help from banks to support their purchase. Thus, whole housing market came into critical situations in terms of valuation of the properties by the sellers and financial help seeking from major banks by the buyers for these overvalued transactions. In the meanwhile, the Federal government of United States intervened in the property market by applying mandatory policies. The government used to two agencies like Freddie Mac and Fannie Mea for ensuring property ownership to all the peoples. US government implemented Community Reinvestment Act to ensure loans should be granted from the nationalised banks to the people in the country who were still not able to afford the purchase of properties. Unfortunately, loans were granted by the government authorities to the people above their credit worthiness and credit limits. Many private banks also involved in financing for purchase of properties. The main motive behind this was that the there was no urgent payback period of the purchaser as all were aware about the fact that value of properties especially house buildings rise gradually and the purchaser can easily pay the loan amount with interest in future. The buyer also took this way to increase their credit worthiness and credit limits along with wealth creation. In this way there was huge was formed in the economy as the buyers and sellers and major banks were highly involved in it. This caused a destructive bubble to build up very rapidly. In 2007, the value bad loans or bad debts of the banks increased out o proportion because the value of the mortgages decreased in disproportionate rates. Many private banks that hold huge properties as mortgage of their most of the loans, incurred huge loss due to devaluation of their mortgage. Overall, the whole financial market sank into a huge debt trap and this scenario put all the investors of these financial institutions into frenzy. As a result stock price of most of the corporate houses started declining vary rapidly and thus the investors incurred huge loss on their investments. One of leading financial institution i.e. Lehman Bother bankrupted in this critical economic scenario as this bank hold highest amount of mortgage of overvalued properties. The stock markets were highly affected as share price of constituents i.e. stocks were suddenly declined dramatically. One of the most important theories of behavioural finance i.e. efficient market hypothesis theory can be applied in the situation of financial crisis of 2007-09. According to this theory, stock price reflects the past, present and expected future events related economic and business environment of a specific country. So, the US investors had to make their investment decisions based o the past and present scenario of the economy in order to reduce their risk by hedging i.e. investing diversified financial instruments. Share price of major stocks of two stock exchanges also reflected future information about the market and this allowed the investors to anticipate the performance of their invested stocks in near future. Apart from this, motives behind intervention by the US government in the capital market are to tighten some the corporate governance policies for the businesses. The government implemented few Acts and made those mandatory in all the listed companies in the country. One of the important corporate governance Act was Sarbanes Oxley Act which was implemented to ensure detailed and reliable financial disclosure by the businesses for their investors. This relay stimulated the confidence of the investors regarding their investments in the equity market. Change in federal government aiming to contingent relief from the destructive economic slowdown showed some extent of resilience in the share prices. Rising price of the shares also reflected hope of the investors regarding faster comeback from recession. The new government developed and implemented some policies for the corporate houses to revitalize the whole stock market and stabilize the US economy. The government injected trillions of dollars in the market from the Federal Reserve as an aid to the financial crisis. Interest rate came down to lowest rate so that the borrowers and property owners repay their loans as affordable rate. The government also took steps to nationalize the two agencies Fannie Mea and Freddie Mac to bail out these two agencies from debt crisis. Government also intervened by developing Home Affordable Refinance program. Government supported the re-payers through this program. These types of government interventions restored the functionality of stock market and major mark indexes like S&P 200, S&P 500 etc. Main reason behind higher extent of government intervention in the debt crisis was to restore the confidence of the potential investors. Therefore, intervention of US government in different modes helped to stabilize the stock market as well as whole economic condition of the country. Investors’ confidence level also gained regarding holding their investments in stocks as well as new investment plan. This reflected the stock price as price started increasing again. The investors, market professionals, and financial research organizations started forecasting of the stock prices in the near future and predicted that it would take around two to three years for the capital market as well as whole US economy to be stabilized and restored. Thus efficient market hypothesis theory is satisfied in the relation of government intervention with stock price. Therefore, this case is a perfect example of government intervention lead to market efficiency. Case 2: European sovereign debt crisis – Government intervention catalyzes market efficiency Euro-zone debt crisis comprises of debt crisis in the countries of European Union. This economic slowdown can be attributed to global financial crisis of 2007-2009, crisis in housing and property market in US and most importantly government policies and wrong intervention to a specific country of Euro zone, Greece. The economy of Euro zone is interconnected with all the countries in EU and therefore, debt is facilitated by each of the countries. Therefore, financial loss or economic slowdown in a borrower country directly affects the economy of the creditor countries. One of the main reasons behind sovereign debt crisis in Europe was higher savings from the fixed income by individuals from their investment in the securities. Household savings increased from $36 trillion to $70 trillion from 2000 to 2007. The Euro zone government allowed using this huge fund in the global financial market especially in the developed economies with an aim to receive higher return. Then the government started overlooking in monitoring of this fund due to lucrative return and thus a bubble formed. Gradually the bubble increased and burst at the time when the amount of bad debt became huge by disproportionate increasing rate. This resulted European sovereign debt crisis. This scenario of the economy reflected in the earning disclosures of the companies and the stock prices started declining very fast. Therefore, stock price followed the efficient market hypothesis (Bruetsch, 2009, p.3). There is also higher extent of government intervention in this situation of the economy similar as role of US government in GFC. None of the member countries were given permission to print notes as all these are financially controlled by the European Central Bank. Central Bank revised the monetary policies in 2012 to encourage he open market transactions through buying back more number of government bonds and securities from the market. The central bank also bought back securities from the member countries to inject huge amount of liquidity in each countries of the union. Conclusion From the above analysis of the two cases, it can be conclude that government intervention plays a great role in reform of economic crisis as well as market efficiency. Both the recession in US and debt crisis in Euro zone had negative impact on the stock price. Therefore, efficient market hypothesis is satisfied in both of the cases. Government intervention through major change and implementation of monetary policies restored the confidence of the investors and financial interests of them were protected. References Bruetsch, M. 2009. From Capital Market Efficiency to Behavioural Finance. GRIN Verlag; Germany. Harder, S. 2010. The Efficient Market Hypothesis and Its Application to Stock Markets. GRIN Verlag; Germany. Spitzer, F. 2001. Principles of random walk. Springer: US. Palan, S. 2007. The Efficient Market Hypothesis and Its Validity in Today's Markets. GRIN Verlag: US. Ogilvie, J. 2008. Management Accounting: Financial Strategy. Elsevier. UK. Read More