The Existence of Efficient Market Hypothesis (EMH) in the International Financial Markets


Seminar Paper, 2018
8 Pages, Grade: 1

Excerpt

The Existence of Efficient Market Hypothesis (EMH) in the International Financial Markets

The Efficient Market Hypothesis (EMH) theory commonly referred to as the Random Walk Theory is one of the most debated topics in finance studies over the years because of the growing concerns that investors can trade on the available information so as to make abnormal profits in the market (Fama, 1970, p.383). EMH states that the price of a security (current stock prices) in the market reflects all the available information on its fundamental value at all times, hence investors cannot make any abnormal profits above the market prices using this information. EMH explains why changes in security prices occur and how those changes happen, hence very crucial to investors as they make their investment decisions in the security market (Fama, 1970, p.387). Many investors both domestic and global invest on securities that are undervalued as they expect their value to increase in the future. Other investors including investment managers also stress that they are able to choose those securities that can outperform the market prices with the core objective of gaining more profits. EMH argues that none of these assumptions is effective because the advantage gained is less than the transaction costs incurred such as research costs on the information hence not in a position to outperform the market price of these securities (Fama, 1970, p.389).

EMH argues that investors are unlikely to benefit from predicting price movements in the market. The only change that results into the change of the stock prices is the arrival of new information in the market. For international financial markets to be efficient prices respond quickly to information without bias (Fama, 1970, p.392). On that note, the prices of the securities reflect the available information in the market. Market efficiency, therefore, exists in international financial markets because of the strong competition among investors who want to maximize their profits from any new information they receive in the market. Investors are able to identify over-and-under priced stocks while others spend a considerable amount of time in detecting mis-priced stocks so as to take advantage of the changes in price (Baker & Nofsinger, 2010, p.179). EHM is built on a slogan of trust market prices whereby no investors can trade on the available information so as to beat the market price. In financial markets, all investments are fairly priced according to the capital market theory whereby the price of a stock reflects the present value of the expected future cash flows. Many economists have criticized the EMH on the efficiency of financial markets based on the recent global financial crisis that started in the US and the Euro zone crisis which was as a result of the global financial crisis (Klein, 2009, p.90).

Recent financial crisis in international financial markets including the Euro zone crisis shows that there is a link between EMH and the international financial markets. Earlier literature focused on capital market liberalization with macroeconomic conditions is seen as beneficial in the formation of global markets for financial services (Eakins & Mishkin, 2012, p.128). Recent booms in the credit market have triggered overvaluation of assets and overconfidence among investors neglecting tremendous costs and risks thus resulting into negative consequences at international markets. During the recent global financial crisis that started in the US, the derivative security prices moved beyond the arbitrage bounds, going against the law of one price that states that different portfolios with identical cash flows usually trade at different prices. This situation violated the corporate bond CDS basis (Ang & Chen 2010, p.119). During the financial crisis, economists argue that the 30 year swap spread was negative even at the time of writing. This scenario explains why most of the arbitrage deviations occur in financial markets across the globe thus affecting the price of the asset. On that note, the arbitrage deviations from the law of one price mostly occur during turmoil periods hence violating the market efficiency theory. The declining of asset prices during the recent financial crisis in the US shows that markets are not always efficient as argued by the EMH (Eakins & Mishkin, 2012, p.131).

Economists argue that the Euro Zone crisis is a metamorphosis of the 2007 global financial crisis which resulted into sovereign debt crisis because public funds were used to bailout huge banks thus reducing revenue growth in the country. European countries were able to manage the financial crisis through export led recovery as witnessed in countries such as Scandinavia and Germany. The situation in European zone became worse attributed to interest rates spreads resulting into insolvency crisis and later a collapse of the currency (De Grauwe, 2013, p.87). The theory of economic time shows some of the difficulties associated with unifying currencies across states with irregular monetary systems. It is difficult, therefore, to have central banks independent from political governments in using the irregular currency systems. This implies that countries adopting the single currency must have identical political systems under the irregular currency systems (Karanikolos, 2013, p.1329). In 2004, Euro was termed as an exemplary currency. Further, the euro crisis confirms the idea derived from the theory of economic time that argues that not all economies are mandated to use a currency which is of the same quality. The theory of economic time has, therefore, being used to explain some of the causes and consequences of financial crisis including the euro currency crisis (currency-financial crisis) (Blanchard & Francesco, 2002, p.198).

The crisis started in the United States and spread to other countries across the globe hence showing the inefficiency of the EMH as many economists believed that liberalization of financial markets as argued in the EMH theory generates efficient allocation of savings to all investments by investors across the globe (Coval & Shumway, 2015, p.30). The market realism theory is one of the significant theories on EMH as it argues that market information in financial markets is very crucial because it enhances the efficiency of these markets. In effect, the theory argues that market prices seize all available valuable information on the future. Most investors are forced to exploit mispricing so as to realize the abnormal profits above the market price but this result into additional costs in their investments for instance, research costs (Eakins & Mishkin, 2012, p.128). Financing risk is high in international markets whereby security prices diverge from their economic value. The 1998 highly leveraged hedge fund collapse linked with the convergence of the United States and European bond yields after the Asian crisis. The main implication of EMH is that some of the players in international markets (agents) do not value assets based on rational asset pricing but rather driven by emotion. With such emotion or sentiment, the diffusion of valuable information into security prices becomes slow (Ang & Chen 2010, p.111).

The overreaction and undereaction by investors is another concern of the EMH. The theory argues that investors in international financial markets do not always react to any new information in the market whereby in some occasions, investors do overreact to performance by buying securities with gains received previously and selling securities that have witnessed recent losses. In such a situation, the price of these securities is pushed beyond the fair market price (Ang, Bali & Cakici, 2010, p.172). The core implication of this scenario is price reversals whereby losers are purchased while winners are sold. However, the main critique on this occasion is that risks are not accounted for hence the need for risk adjusting in line with the EMH (AgarwaL et al, 2010, p.186).

The EMH exists in international financial markets such as securities markets which are said to be efficient with respect to valuable information in the market. In capital securities markets, the price of stocks is driven towards efficiency which can only be achieved through active trading by all investors in the market. Investment managers are able to get economic benefits only by trading on the available information in the market (Ang & Bekaert, 2007, p.654). The main implication of EMH is that all investors in the market must achieve the highest returns from the sell of their stocks. The investment strategies used by some investors to beat the market price fail as predicted because of the efficiency of the market which has being created by adjustment of prices to new information (Bates, 2008, p.2297).

References

AgarwaL, V., W. Fung, Y. C. Loon & Naik, N. Y. 2010. Risk and Return in Convertible Arbitrage: Evidence from the Convertible Bond Market, Journal of Empirical Finance 18, 175-194.

Ang, A. & Chen, J. 2010. Yield Curve Predictors of Foreign Exchange Returns, Working Paper, Columbia University.

Ang, A., BALI, G. & Cakici, N. 2010. The Joint Cross Section of Stocks and Options, Working Paper, Columbia Business School.

Ang, A., & Bekaert, G. 2007. Stock Return Predictability: Is it There? Review of Financial Studies 20, 651-707.

Baker, H. K.,& Nofsinger, J. R, 2010, Behavioral Finance: Investors, Corporations and Markets. New Jersey: John Wiley & Sons

Bates, D. S., 2008. The Market for Crash Risk, Journal of Economic Dynamics and Control 32, 2291-2321.

Blanchard, O, & Francesco, G, 2002, Current Account Deficits in the Euro Area: The End of the Feldstein-Horioka Puzzle ?, Brookings Papers on Economic Activity.

Coval, J. D.,& Shumway, T, 2015, Do behavioral biases affect prices, The Journal of Finance, Vol. 60, issue. 1, p. 1–33.

De Grauwe, P, 2013, Design Failures in the Eurozone: Can They Be Fixed? London School of Economics, Europe in Question’ Discussion Paper Series57.

Eakins, G., & Mishkin, 2012, Financial Markets and Institutions, Boston: Prentice Hall.

Fama, E, 1970, Efficient capital markets: a review of theory and empirical work, Journal of Finance, Vol. 25, issue. 2, p. 383–417.

Karanikolos, M, 2013, Financial Crisis, Austerity and Health in Europe, The Lancet 381 (9874), pp. 1323-31.

Klein, N, 2009, The Shock Doctrine, Toronto: Knopf Canada.

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Title
The Existence of Efficient Market Hypothesis (EMH) in the International Financial Markets
Grade
1
Author
Year
2018
Pages
8
Catalog Number
V424591
ISBN (eBook)
9783668699922
File size
506 KB
Language
English
Tags
existence, efficient, market, hypothesis, international, financial, markets
Quote paper
Caroline Mutuku (Author), 2018, The Existence of Efficient Market Hypothesis (EMH) in the International Financial Markets, Munich, GRIN Verlag, https://www.grin.com/document/424591

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