The Efficient market hypothesis can be considered as part of rational economics but it does not specify at all how individuals should or will act.
Therefore it might be a useful model of the functioning of the market as a whole but it does not explain the behaviors of investors as well as managers and other participants.
While the Efficient market hypothesis deals as a basis for understanding the normal working of the markets, from time to time it might happen that the market
as a whole or an individual stock may act irrationally.
Such behavior is well known and generally occurs when the market price of a share turns away from its intrinsic
value. The result is what commonly is called a bubble.
This term is often used but the reasons for the occurrence are quite unclear. In fact, at the same time as the
market as a whole has become more efficient, instances of irrationality have become more common or at least appear to be.
Therefore we try to discuss the question why capital markets, which are considered as efficient and perfect in theory, are volatile and imperfect in reality.
The paper responds to this question by discussing mainly the irrational behavior of people by turning into the field of psychology.
Furthermore it seeks for approaches of explanation conducted by different investment strategies containing among others an increased use of derivative instruments or single trades based on massive capacity which therefore influence prices.
Methodology and Structure of the paper
In general the paper can be divided in 3 parts, a theoretical as well as an analytical one and a final point the Conclusion (Part C) which sums up the basic findings of
the paper.
Whereas Part A can be regarded as delivering the theoretical
background, Part B contains the empirical analysis based on several case studies.
Chapter 1, 2 and 3 are providing the reader with the needed knowledge of the capital market, volatility and the efficient market hypothesis in order to assure the
understanding of the more complex prosecution of the paper
After discussing those fundamentals the paper soon takes a view on some instances of irrationality in Part B, but first of all delivers in Chapter 4, 5 and 6 some theories that attempt to explain such irrationalities.
Finally the paper is finished by linking those theories with the observed instances of irrationality
Table of Contents
INTRODUCTION
METHODOLOGY AND STRUCTURE OF THE PAPER
A: LITERATURE OF CAPITAL MARKETS
1. OVERVIEW OF THE CAPITAL MARKETS
1.1 The Role of the Financial System
1.2 Factors Affecting Performance of Financial System
1.3 Raising Long Term Finance
1.4 Overview to Securities Regulation
1.4.1 Need for Regulating Financial Markets
1.4.2 Objectives of a Financial Regulatory Framework
1.4.2.1 Promote robust supervision and regulation of financial firms:
1.4.2.2 Establish comprehensive supervision of financial markets:
1.4.2.3 Protect customers and investors from financial abuse:
1.5 The Emergence of World Capital Markets
1.5.1 Impact of the Globalization on the Capital Markets
1.5.2 Impact of Globalization on Domestic savings
2. THE VOLATILITY OF CAPITAL MARKETS
2.1 Defining volatility
2.2 Determinants of Volatility
2.3 How Volatility is measured
3. EFFICIENT MARKETS
3.1 Efficient-Market Hypothesis
3.1.1 Weak form
3.1.2 Semi-strong form
3.1.3 Strong form
3.2 Efficiency in Capital Markets and The “random walk” Approach
3.2.1 Diffusion / Flow and aggregation of information
3.2.2 Volume of information due to volatility and sensitivity of capital markets
3.3 Predictability in Capital Markets and The “non-random walk” Approach
3.3.1 Predictable patterns based on valuation parameters
3.3.1.1 Future returns from initial dividend yields
3.3.1.2 Market returns from initial price-earnings multiples
3.3.2 Cross-sectional predictable patterns based on firm characteristics
3.3.2.1 The size effect
3.3.2.2 The stocks value
3.3.2.3 The “puzzle” of equity risk premium
3.4 Arguments and Opponent Ideas regarding Efficiency in the Capital Markets
3.4.1 Mispricing
3.4.2 Excess volatility
4. MANAGEMENT DECISIONS LEADING TO MARKET IMPERFECTIONS
4.1 Fundamental Factors leading to market imperfections
4.2 Institutional Factors leading to market imperfections
5. MARKET IMPERFECTIONS AND IRRATIONAL EXUBERANCE
5.1 Media and the spread of information
5.2 Psychological Factors
5.2.1 Basic Theories on the behavior of individuals
5.2.1.1 The rational man theory
5.2.1.2 The Prospect Theory
5.2.1.3 The Chaos Theory
5.2.1.4 The Theory of Groupthink
5.2.2 Advanced Theories on the Behavior of Individuals
5.2.2.1 The Theory of quantitative checkpoints for investors
5.2.2.2 The Theory of Moral checkpoints for investors
5.2.3 Keynes & Minsky
5.2.3.1 Keynes “biggest fool” theory
5.2.3.2 Minsky’s Financial Instability Hypothesis
6. IMPACTS AND INFLUENCES IN THE CAPITAL MARKETS
6.1 Trading strategies influences: hedging, speculation
6.2 Liquidity and Structured Finance Products impact
B: EMPIRICAL EVIDENCE BASED ON CASE STUDIES
Case 1: Example of 1987 stock market crash
Case 2: New Economy Bubble – Deutsche Telekom AG
Case 3: EADS Insider Trading
Case 4: Irrational Development of Volkswagen stock price due to Porsche’s takeover plans
C: CONCLUSION
D: REFERENCES
Objectives and Research Themes
The primary objective of this work is to explore the disconnect between the theoretical perfection and efficiency of capital markets and their observed volatility and imperfection in reality. By integrating concepts from economics and the field of psychology, the paper investigates how irrational human behavior and specific market mechanisms create bubbles, crises, and market anomalies.
- The divergence between Efficient Market Hypothesis and real-world market imperfections.
- Psychological drivers of investor behavior, including theories of irrationality.
- The role of media, information asymmetry, and noise in influencing stock prices.
- Management decisions, institutional factors, and speculative trading strategies.
- Empirical analysis through case studies such as the 1987 crash, the dot-com bubble, EADS, and Volkswagen/Porsche.
Excerpt from the Book
5.2.1.1 The rational man theory
This theory follows the idea of rational self-interest and is described as the idea that individuals will make different choices because of their individual preferences and circumstances, along with the information that is available to them. The definition testifies that what constitutes rational behavior for one individual does not necessarily represent rational behavior for every individual. The theory further postulates the existence of an egocentric being, who strives to maximize his personal utility at all times.
Another advanced aspect of this theory concerns the information which is available to individuals. A fully rational behavior would lead to decision making based on all information available in order to secure optimal results. However In today’s complex world, individuals could not process or acquire all the information necessary to make a fully rational decision. Rather people tend to make decisions that are satisfactory and that represent reasonable or acceptable results.
Summary of Chapters
1. OVERVIEW OF THE CAPITAL MARKETS: Provides foundational knowledge on financial systems, securities regulation, and the historical development and globalization of capital markets.
2. THE VOLATILITY OF CAPITAL MARKETS: Examines the definition, determinants, and measurement techniques of market volatility as a critical risk indicator.
3. EFFICIENT MARKETS: Discusses the Efficient Market Hypothesis, its three forms, the "random walk" approach, and contrasting arguments regarding market anomalies and mispricing.
4. MANAGEMENT DECISIONS LEADING TO MARKET IMPERFECTIONS: Analyzes how fundamental and institutional factors, such as information asymmetry and agency problems, influence corporate investment decisions.
5. MARKET IMPERFECTIONS AND IRRATIONAL EXUBERANCE: Explores psychological theories, the impact of media, and economists' views like Keynes and Minsky to explain irrational market behavior.
6. IMPACTS AND INFLUENCES IN THE CAPITAL MARKETS: Evaluates how trading strategies, speculation, liquidity, and structured finance products contribute to market inefficiencies.
B: EMPIRICAL EVIDENCE BASED ON CASE STUDIES: Provides practical analysis through four specific cases: the 1987 crash, the Deutsche Telekom bubble, EADS insider trading, and the Volkswagen/Porsche takeover.
C: CONCLUSION: Summarizes the key findings, reinforcing the complexity of reconciling efficient market theory with observed market irrationality and volatility.
Keywords
Capital Markets, Efficient Market Hypothesis, Volatility, Market Imperfections, Irrational Exuberance, Information Asymmetry, Behavioral Finance, Speculation, Insider Trading, Financial Crises, Asset Pricing, Random Walk, Hedging, Corporate Governance, Institutional Investors
Frequently Asked Questions
What is the core focus of this research?
The paper examines the phenomenon of why capital markets, which are considered perfect and efficient according to classical economic theories, frequently appear volatile and imperfect in actual practice.
What are the central themes covered?
The central themes include the Efficient Market Hypothesis, psychological influences on investor behavior, the impact of media and noise, management decision-making, and the effects of speculative trading strategies.
What is the primary research question?
The primary research question addresses why capital markets exhibit volatility and imperfection in reality, despite the theoretical assertion that they are efficient and rational.
Which scientific methodology is applied?
The paper employs a mixed approach, combining a literature-based theoretical framework on market efficiency and behavioral economics with an empirical analysis of specific historical financial case studies.
What is covered in the main body of the work?
The main body covers the fundamentals of capital markets, the definition and measurement of volatility, the critique of market efficiency theories, the role of management in creating imperfections, and the psychological and external factors leading to market bubbles.
Which keywords best describe this study?
The work is characterized by terms such as market efficiency, behavioral finance, information asymmetry, financial volatility, and speculative trading.
How does the "biggest fool" theory contribute to market volatility?
Keynes' "biggest fool" theory explains that investors may purchase shares not based on intrinsic value, but on the expectation that other investors will also buy in, driving prices upward until the market eventually corrects itself.
What role did media play in the Deutsche Telekom bubble?
The media acted as a primary source of "noise" and narrative, helping to generate hype and attract retail investors through marketing campaigns, which contributed to the severe mispricing of the stock.
How did Minsky’s Financial Instability Hypothesis explain the 1987 crash?
Minsky’s theory highlights that periods of boom and euphoria lead to fragile financial systems; when negative news (like tax changes or trade deficits) hits, it triggers profit-taking and panic, leading to a market crash.
What conclusion does the author reach regarding market efficiency?
The author concludes that while markets function with some degree of efficiency, they are inherently susceptible to imperfections, anomalies, and irrational human behavior that often dominate in practice.
- Arbeit zitieren
- Michael Marquardt (Autor:in), 2010, Why are theoretically perfect and efficient capital markets so imperfect and volatile in practice?, München, GRIN Verlag, https://www.grin.com/document/145030
