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
- 1.5 The Emergence of World Capital Markets
- 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
- 3.2 Efficiency in Capital Markets and The “random walk” Approach
- 3.3 Predictability in Capital Markets and The "non-random walk" Approach
- 3.4 Arguments and Opponent Ideas regarding Efficiency in the Capital Markets
- 4. MANAGEMENT DECISIONS LEADING TO MARKET IMPERFECTIONS
- 5. MARKET IMPERFECTIONS AND IRRATIONAL EXUBERANCE
- 6. IMPACTS AND INFLUENCES IN THE CAPITAL MARKETS
- 1. OVERVIEW OF THE CAPITAL MARKETS
- B: EMPIRICAL EVIDENCE BASED ON CASE STUDIES
Objectives and Key Themes
This paper aims to explore the discrepancy between the theoretical model of perfect and efficient capital markets and their observed volatility and imperfections in practice. It investigates why, despite advancements in market efficiency, instances of irrationality persist and significantly impact market behavior.
- The Efficient Market Hypothesis and its limitations.
- Determinants of volatility in capital markets.
- The role of irrational behavior and psychological factors in market fluctuations.
- Influence of management decisions and institutional factors on market imperfections.
- Impact of various trading strategies and financial instruments on market dynamics.
Chapter Summaries
INTRODUCTION: The introduction establishes the central question: why are theoretically perfect and efficient capital markets so imperfect and volatile in practice? It highlights the contrast between the efficient market hypothesis, a cornerstone of rational economics, and the frequent occurrences of market irrationality, often manifesting as "bubbles." The paper proposes to address this question by exploring psychological factors and the influence of investment strategies, including the use of derivatives.
METHODOLOGY AND STRUCTURE OF THE PAPER: This section outlines the paper's structure, dividing it into three parts: a theoretical part (Part A), an empirical analysis based on case studies (Part B), and a conclusion (Part C). Part A lays the theoretical groundwork, covering capital markets, volatility, and the efficient market hypothesis. Part B examines instances of market irrationality, using case studies to illustrate real-world examples. The conclusion synthesizes the findings.
1. OVERVIEW OF THE CAPITAL MARKETS: This chapter provides a foundational overview of capital markets, defining them as markets for long-term financial instruments (bonds, mortgages, stocks, and derivatives). It discusses the key participants (individual and institutional investors) and their varying roles and objectives within these markets. The chapter emphasizes the importance of understanding different market types for effective trading, focusing specifically on capital markets.1,2,3
2. THE VOLATILITY OF CAPITAL MARKETS: This chapter delves into the concept of volatility in capital markets, defining it, exploring its determinants, and outlining methods for its measurement. The discussion lays the groundwork for understanding the dynamic and often unpredictable nature of capital markets, which is crucial for comprehending the subsequent analysis of market imperfections.
3. EFFICIENT MARKETS: This chapter examines the Efficient Market Hypothesis (EMH), outlining its weak, semi-strong, and strong forms. It contrasts the EMH's assumptions of rationality and efficient information processing with observed market anomalies. The chapter explores the "random walk" and "non-random walk" approaches to understanding market behavior, considering predictability based on valuation parameters and firm characteristics, and acknowledges arguments challenging the EMH's completeness, such as instances of mispricing and excess volatility.
4. MANAGEMENT DECISIONS LEADING TO MARKET IMPERFECTIONS: This chapter investigates how management decisions contribute to market imperfections. It analyzes both fundamental and institutional factors that can lead to market inefficiencies and deviations from the theoretical ideal of perfect markets. The discussion likely explores aspects such as corporate governance, accounting practices, and regulatory frameworks.
5. MARKET IMPERFECTIONS AND IRRATIONAL EXUBERANCE: This chapter delves into the psychological underpinnings of market imperfections, exploring the role of irrational exuberance and examining the impact of media influence on the spread of information. It likely explores various psychological theories (rational man theory, prospect theory, chaos theory, groupthink) and their implications for investor behavior and market outcomes. Key theories, such as Keynes' "biggest fool" theory and Minsky's Financial Instability Hypothesis, are likely discussed.
6. IMPACTS AND INFLUENCES IN THE CAPITAL MARKETS: This chapter investigates the impacts and influences shaping capital markets. The analysis likely focuses on the effects of trading strategies (hedging and speculation), the role of liquidity, and the impact of structured finance products on market behavior and stability. This chapter likely bridges the theoretical discussions with the practical implications for market function.
Keywords
Capital markets, Efficient Market Hypothesis, Volatility, Market imperfections, Irrational exuberance, Psychological factors, Investment strategies, Financial regulation, Market bubbles, Case studies, Risk, Return.
Frequently Asked Questions: Comprehensive Language Preview
What is the main topic of this paper?
This paper explores the discrepancy between the theoretical model of perfect and efficient capital markets and their observed volatility and imperfections in practice. It investigates why instances of irrationality persist and significantly impact market behavior, despite advancements in market efficiency.
What are the key themes explored in the paper?
Key themes include the Efficient Market Hypothesis and its limitations, determinants of volatility in capital markets, the role of irrational behavior and psychological factors in market fluctuations, the influence of management decisions and institutional factors on market imperfections, and the impact of various trading strategies and financial instruments on market dynamics.
What is the structure of the paper?
The paper is structured into three parts: Part A (theoretical overview of capital markets, volatility, and the efficient market hypothesis), Part B (empirical analysis based on case studies illustrating market irrationality), and Part C (conclusion).
What are the main topics covered in Part A: Literature of Capital Markets?
Part A provides a comprehensive overview of capital markets, including the role of the financial system, factors affecting its performance, raising long-term finance, securities regulation, the emergence of world capital markets, volatility in capital markets (definition, determinants, and measurement), and a detailed examination of the Efficient Market Hypothesis (EMH), including its different forms, its assumptions, and criticisms.
What specific aspects of the Efficient Market Hypothesis (EMH) are discussed?
The paper discusses the weak, semi-strong, and strong forms of the EMH. It contrasts the EMH's assumptions of rationality and efficient information processing with observed market anomalies. The "random walk" and "non-random walk" approaches to understanding market behavior are explored, along with arguments challenging the EMH's completeness, such as instances of mispricing and excess volatility.
What role do management decisions play in market imperfections?
The paper investigates how management decisions, both fundamental and institutional factors (corporate governance, accounting practices, and regulatory frameworks), contribute to market inefficiencies and deviations from the theoretical ideal of perfect markets.
How does the paper address irrational exuberance and psychological factors?
The paper delves into the psychological underpinnings of market imperfections, exploring the role of irrational exuberance and the impact of media influence on the spread of information. It examines various psychological theories (e.g., rational man theory, prospect theory, chaos theory, groupthink) and their implications for investor behavior and market outcomes, potentially including Keynes' "biggest fool" theory and Minsky's Financial Instability Hypothesis.
What are the impacts and influences discussed in relation to capital markets?
The paper analyzes the impacts and influences shaping capital markets, focusing on the effects of trading strategies (hedging and speculation), the role of liquidity, and the impact of structured finance products on market behavior and stability.
What kind of empirical evidence is used in the paper?
Part B of the paper uses empirical evidence based on case studies to illustrate real-world examples of market irrationality.
What are the keywords associated with this paper?
Keywords include: Capital markets, Efficient Market Hypothesis, Volatility, Market imperfections, Irrational exuberance, Psychological factors, Investment strategies, Financial regulation, Market bubbles, Case studies, Risk, Return.
- Quote paper
- Michael Marquardt (Author), 2010, Why are theoretically perfect and efficient capital markets so imperfect and volatile in practice?, Munich, GRIN Verlag, https://www.grin.com/document/145030
