Monday 31 August 2015

Capital Markets, Financial Crisis and ‘Diversions’

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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