Sometimes the same word can have different meanings in
different languages. One example is
'diversion'. In English it means typically a
different way. However, in Spanish
'diversion' means having fun. I guess
that when you take a different way, it can be fun.
Once upon a time, I spent time assessing the efficiency
of UK equity markets. The key idea was
that if markets are efficient and there is no manipulation (e.g. information
leakage), then we should be able to use the logic of event studies and test
that there are no abnormal equity price movements before a corporate
announcement. I moved on, and the
initial work was eventually carried out.
It was published by the FSA (here) and as far as I can recall, it made it as far as the
front page of the Financial Times!
I thought that it would be a good diversion from my
current activities to read something about capital markets. I came across an interesting paper on market
efficiency published in Institutional Investor (here). The paper was written in the wake of the
award of the 2013 Nobel Prize in Economics to three economists, including Eugene
F. Fama and Robert J. Shiller. What made
the award interesting is that it recognises the challenges of assessing
efficient markets; Fama pioneered the notion of efficient capital markets and
Shiller has challenged it. (The third
Nobel laureate was Lars Peter Hansen who, as I understand it, deserves it for
his work on the maths of finance.)
The paper is an interesting tour of many years of
research by the authors – applied and academic.
It explains in simple language the ‘joint hypotheses’, i.e. the need to
test jointly the assumption of efficient capital markets with an equilibrium
pricing model, usually capital asset pricing model (CAPM), and the potential
implications, e.g. the market may be efficient but assets may not be priced
according to the CAPM
The paper also provides a clear articulation of the
challenges to the efficient market hypotheses. One of the responses is to test alternatives
to the CAPM model, e.g. momentum strategies.
One of them is that there are behavioural biases, e.g. investors overreact
to both good news and bad news, and capital markets are not efficient. Overall, the authors come out in favour of
efficient markets, ‘at least as the base case’, without committing to a view
that markets are ‘perfectly efficient’.
One of the implications of less than perfect efficiency of capital
markets is that market arrangements, including regulation, matter to some
degree.
In my view, the best point made in the article is the
consideration of the link between belief in market efficiency – ‘market
fundamentalism’ – and the recent (or ongoing) financial crisis. As the authors put it, financial crises are not
created by someone buying something that he thinks is a fair deal in an
efficient market. Financial crises are
created by people that think that markets are inefficient, i.e. an impossibly
good deal is available and will continue to be available.
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