Efficient Market Hypothesis under Government Intervention - Essay Example

? Applying the EMH evaluate the role that government played in economic recovery using recent real-life examples Contents Contents 2 Introduction 3 Objectives and rational of the Study 3 Efficient Market Hypothesis (EMH) Theory 4 Types of market efficiency 5 Effect of government intervention: The behavioural finance critique of market efficiency 6 Tests for rapid price adjustment 6 Random Walk Theory 7 Case 1: US financial market - Government intervention influencing efficient market hypothesis during the financial crisis 8 Case 2: European debt crisis – Government policies and intervention influencing efficient market hypothesis 10 Conclusion 12 Reference 14 Introduction The central core of finance depends on the concept of efficiency. The term is used to describe the market of financial assets and securities. The term depends on the relevant information prevailing in the market. Government intervention is one type of information which influences the price of the financial assets because the government intervention controls the economic situation of a country. So, it has been seen that this information also influences the investors’ decision making. However, people in a democratic environment believe that you cannot fool everyone all the time. Hence, there might be some managers who will be able to analyse and predict information correctly and will not be fooled or mislead by creative accounting or financial gimmicks. Objectives and rational of the Study The topic under review is of efficient market hypothesis under government intervention. This is a very important topic at the current juncture wherein most of the countries are under the scanner of financial crisis. There is not just enormous scope in the study of the given topic but also the need to understand the government intervention and management of the portfolios in a detailed manner in this volatile scenario as seen in the recent past in the global economy and share markets. The detailed study as this would definitely help the cause in understanding the requirements of different sectors and the government policies which determines the scope of the different government legislation on market efficiency in the near future. In the recent years, there has been a gradual instability because of the market volatility due to the different government policy and the detailed study would tend to give a great learning opportunity about this adverse scenario. Efficient Market Hypothesis (EMH) Theory Efficient market hypothesis implies that, if any new information about a company is revealed it will be immediately incorporated into the share price rationally and rapidly, with respect to the direction of the share price movement and its size. In an efficient market except by chance, no trader will get an opportunity to earn abnormal return on a share or a return which is greater than the fair return for the risk associated to that share. The possibility of absence of abnormal profits arises because the past and current information is immediately reflected in the current share prices. The prices are affected only by the new information. EMH is concerned with under what conditions an investor can gain abnormal profits or excess returns in a stock. EMH claims that all the information available readily reflects in the price of the stock. According to EMH abnormal positive returns are not possible by any trader using the information available to public. Many people think that market efficiency means that it is impossible to outperform the market at any given point of time which is incorrect. Efficiency does not mean that prices will not apart from true value: At any point of time it is expected that prices will deviate from their true value, majorly because value depends on the future and future is unpredictable. Efficiency does not mean that no investor will be able to beat the market in any single time period. In an efficient market approximately one half of the shares purchased subsequently outperform not because of the skill but due to the fact that prices of the shares deviate randomly. Investor may beat the market by following a particular investment strategy in the long term: In a completely efficient market with price deviating from their true value, you can find few investors who have beaten the market for many years. This might happen because of the laws of the probability. There are millions of investors and it is likely that few will beat the market, however, it is difficult to analyse whether it is luck or a technique. One of those investors is Warren Buffett who has outperformed the market consistently over forty years (Harder, 2010, p.5). Types of market efficiency Economists have suggested different levels of market efficiency based on the type of information which is reflected in the prices. Fama came up with three levels of market efficiency which are mentioned below: Weak form efficiency: This type of efficiency claims that share prices fully reflect all information contained in past history of share prices. It means that nobody can beat the market by analysing past price movements. Semi strong efficiency: This form of EMH implies that all public information is calculated into a stock’s current share price, neither the fundamental nor the technical analysis can be used to beat the market or achieve superior gains. It states that stock priced should contain all relevant information available to public and that is has an important implication for stock broking industry and policy makers. Strong efficiency: It is the strongest version which implies that all relevant information whether public or private is incorporated in the share price. In a strong form efficient market even the insiders are unable to make superior gains. Effect of government intervention: The behavioural finance critique of market efficiency EMH has been supported by many financial professionals because of two main reasons; it offers a logical and consistent theoretical model of how markets perform and secondly it has empirical evidence supporting the same. However, since last fifteen years many respected economists have rejected EMH as a model of market performance and investor behaviour. Since these economist comment based on psychological research, they are termed as behaviourist and their findings are termed as behavioural finance. The behavioural finance rejects the market efficiency and behaviourists interpret efficient market hypothesis in a different way from the supporters of EMH as they think that the supporters are true believers and biased. Behaviourists say that financial and stock markets are simply too volatile for prices to be based on rational valuations. They also say that investors are emotional people who think of the financial information in biased ways which leads them to overreact and under react many times. This will ensure chances for investors to purchase low priced shares in one market and sell them overpriced or profitable in other market; this process is called arbitrage. Further we will discuss the behavioural finance as critique of market efficiency in the following three sections. The first one will offer empirical evidence supporting the behavioural finance as critique of market efficiency. The second will talk about theoretical underpinnings of behavioural finance and biasness and finally the third will discuss the relative advantages of market efficiency and behavioural finance. Tests for rapid price adjustment The second type of Fama’s test for market efficiency checks how rapidly prices adjust. The primary objective of this test is to the reaction of price adjustment policy of the government policy on the market efficiency. In one of the empirical articles in financial economics Fama introduced the first event study which identified how stock market responds to new information like stock split. In a stock split, companies issue new shares to existing shareholders which causes a decline in the price of individual share however it hardly makes any difference in overall value of the shares. The reason for this study was to line up companies in event time rather than calendar time. Every company was assigned with the day “0” which refers to the day of stock split, “-1” a day before and “+1” afterwards and so on. This allowed them to calculate average returns each event day by adding up all the sample returns and dividing them by number of observation. This method became one of the key studies for researchers to analyse how the market reacts to new information or corporate events like mergers and security issues. With a few important exceptions, event studies support market efficiency as prices respond rapidly and completely to information or announcements. Random Walk Theory It was first mentioned by the mathematician Louis Bachelier (1900) and later Burton Malkeil presented the modern interpretation. Many researchers, following Fama’s work, investigated the randomness of stock price movements to demonstrate efficiency of capital market. The different government intervention like excessive tax burden, rate of inflation, consumer surplus, price ceiling influences the stock price movement which influence the market efficiencies. Later on studies also demonstrated market inefficiency by identifying permanent and systematic variations or anomalies in stock market returns. Market efficiency has been tested over a long period of time and it has been observed that movement of the stock prices follow a random walk. The random walk theory states that an investor can have a good chance of beating the market if they throw darts on New York Times stock listing pages. Investors who adhere to the random walk theory believe that searching for undervalued shares or predicting the future stock price is just a waste of time. Any new developments of government like restructuring the tax legislation, controlling the financial crisis and the inflation etc reflect in share prices of the different corporation. Followers of random walk theory believe that is impossible to predict future events and they are left with no other choice but to accept the efficient market hypothesis. Case 1: US financial market - Government intervention influencing efficient market hypothesis during the financial crisis During the decades of 1980 and 1990, the properties and real estates in US had seen a sharp and sustainable rise in prices. This resulted in increase of ownership of property to a major part of the population. The recession that started in the US financial market and finally melted down globally was due to the sudden fall in the prices of the US properties or the housing market. Buying a house has always been a lucrative investment for the US people as investment in land or real estate resulted in a sustainable and steady increase in the prices over the fair value of the properties. The purchase of properties at fair value and subsequent increase of the asset value was a good option not only for them but also for their heirs. However, a bubble of crisis which had peeped once in 2002 blew out of proportion in 2007 and took the whole US economy into a plunge along with the spreading the ripple effect of recession throughout the world. The seller and the purchaser of the US properties came to fair market value for transaction on those properties. The seller on one hand had built on the fair market value of the property over time and the buyer had to have a steady income level supported by a good credit rating to finance the purchase. In the mean while, the US federal government intervened through its agencies Fannie Mea and Freddie Mac to ensure that all sections of the population may it be poor or rich should have access to ownership of US properties. Community reinvestment act was implemented to ensure that loans were granted to sections of the population who had not been able to afford it so far. Suddenly loans were granted to people irrespective of their credit scores and also without looking at their income levels. The underlying mystery was that there was no urgency on the part of the purchaser as the value of the properties in which they would be invested were supposed to increase sharply over the fair values which they could sell in future for more capital gains. Thus a destructive bubble in the US economy started to build up. By 2007, the weight of bad loans increased to disproportionate figures which resulted in the financial crisis that blew out of proportion. The financial institutions that held those properties as mortgages were severely affected due to devaluation of those underlying properties or assets. This resulted in heavy losses in the financial markets that put the investors into frenzy. As a result of huge losses in the financial markets, the major corporate houses saw a sharp decline in their share prices and even went bankrupt. According to the efficient market hypothesis, due to the past and present information on the financial performance of the US economy, the investors in US had to rethink on their investment decision in order to hedge the risk of their stake ownership. The share prices of the US stocks also reflected information on the future that allowed the investors to anticipate the future performance of the stocks. In addition to these, the US government intervention in order to tighten the financial regulations to effectively meet the financial crisis resulted in short term adverse condition for the US corporate houses. This was, however, to restore good health of the US economy. The introduction of Sarbanes – Oxley Act and regulations in financial disclosures for the protection of investors restored some confidence in the investors. The change in federal government in a hope of contingent relief from the crisis in US economy showed some resilience in the share prices. Again the share prices reflected the market confidence and hope of a comeback from the financial crisis that started in US. The new US federal government in 2009 undertook some policies to re-stabilize the US economy and the stock prices. The federal government injected trillion of dollars into the economy from their federal reserve in order to keep their interest rates low so as to allow the borrowers and house owners to repay at affordable interest rates. Also the government took measure to nationalise the agencies Fannie Mea and Freddie Mac to bail them out of their debts. The government also intervened with the Home Affordable Refinance Program in which the government supported the re-payers who despite their credentials kept up their repayments. These government interventions restored the fluctuation of stock prices like FTSE 100, etc due to regain of investor’s confidence in the financial market. Thus the government intervention in the US was a major factor that helped to regain the investor’s confidence in the face of financial crisis that was reflected in the stock prices. Future anticipation of the financial markets predicts that it would take one or two more years for the US economy to return to a completely stable position by 2014. Thus the theory of efficient market hypothesis is maintained in terms of the movement in the US stock prices as a result of the economic crisis and the reaction of the stock market investors to government policies and intervention to stabilize the adverse effects of the financial crisis. Case 2: European debt crisis – Government policies and intervention influencing efficient market hypothesis The debt crisis in the Euro-zone comprising of countries in European Union can be attributed to the crisis in real-estate sector, worldwide global recession of 2007-2012, globalization of finance and also more importantly the policies of the governments in Euro-zone. The main blood stream of the economy of Euro-zone is the interconnection of debt facilities between the countries. As a result of this, financial losses leading to increase in debts or failure to service their debts would have an adverse impact on the creditor countries. The economy of the creditors would also incur a crisis due to its Euro-zone neighbour. One of the major causes of the European sovereign debt crisis was the increase in savings from fixed income securities from $36 trillion in 2000 to $70 trillion in 2007. This fund was used in the global financial market by the developed economies which offered tempting higher returns as compared to the US treasury investment bonds. Due to lucrative return, government regulations were also overlooked by the sellers and purchasers flowed in heavily thereby creating a bubble. The bubble burst when the amount of bad loans increased disproportionately resulting in the European debt crisis. This information on the economic crisis as a result of losses in the financial statements, balance of payments eroded investor confidence that led to the fall in stock markets (Bruetsch, 2009, p.5). Thus the fall in share prices follow the efficient market hypothesis. The borrowers in Italy owed $366bn to France in 2011. The proportion of default on the part of Italy affected France and in turn other Euro-zone countries that were interconnected through the economic chain. Also Greece hid its increasing debt proportions and fooled European Union members with derivatives. In order to contain the debt crisis, the individual member countries are not allowed to print notes but have to depend on the European Central Bank for their liquidity. The European Central Bank intervened with its revised policies in 2012 like encouraging open market operations by buying government securities and debts. Although the European Central Bank provided support to the member countries by buying government debts and securities, it also restricted inflation by absorbing the same amount of funds. Other policies like dollar swap with the support of Federal Reserve, revision of credit policies like accepting any Greek debt instrument as collateral helped in stabilizing the economies of Greece, France, Italy, etc. A bail out package for the Euro-zone countries from different sources is given below. These interventions by the regulatory bodies through their policies helped to restore the investor confidence which reflected in the prices of the stock index. Thus policy interventions played a crucial role in establishing market efficient as the share prices fluctuated according to the information flow on the market and economic conditions of past and present and the present share prices reflecting anticipation of the investors for future events. Conclusion It cannot be denied that the government interventions play a crucial role in stabilizing the economies that were overturned due to the financial crisis as result of devaluation of properties or inability to service the debt obligations. Due to the global crisis, the investor confidence eroded which had adverse impact on the stock prices. The fluctuation in the stock prices was also due to drift in the present market condition. As a result of revised regulations and containing policies by the government, the economies started to revive and the interest of the investors were protected. This resulted in the decrease in volatility of share prices which reflects belief of the investors from their anticipation of future events in the economy. This follows the efficient market hypothesis. Reference Harder, S. 2010. The Efficient Market Hypothesis and Its Application to Stock Markets. GRIN Verlag; Germany. Bruetsch, M. 2009. From Capital Market Efficiency to Behavioral Finance. GRIN Verlag; Germany. Read More