I would like to start by quoting Mr. Warren Buffet: "I'd be a bum on the street with a tin cup if the markets were always efficient. (...)Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn't do any good to look at the cards."
The efficient markets hypothesis (EMH) has been the central theory of finance over nearly 40 years now. Eugene Fama while stating this investment theory defined an efficient financial market as “a market where there are large numbers of rational profit maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants”. It rules out the possibility of trading systems based only on currently available information that have expected profits or returns in excess of equilibrium expected ‘profit or return’. Laconically speaking, if the EMH holds, the market knows the best and any investor –an individual or a fund cannot consistently beat the market. I would like to express my view on this using an old joke, which is widely told among economists, about an economist strolling down the street with a companion. They come upon a $100 bill lying on the ground, and as the companion reaches down to pick it up, the economist says, ‘Don’t bother – if it were a genuine $100 bill, someone would have already picked it up’. This example of economic logic going bizarre is a fairly accurate rendition of the efficient markets hypothesis (EMH). If this theory were true, bubbles should not exist in markets because everyone can see all the data and so no one would bid up an asset to unreasonable levels.
The theoretical foundation for EMH rests on three arguments which rely on progressively weaker assumptions. First, investors are assumed to be rational and hence are supposed to value a security rationally. Second, the trades of irrational investors are random and therefore cancel out each other without affecting prices. Third, to the extent the irrational investors are similar; they meet in the market with rational arbitrageurs who wipe out their influence on prices. These assumptions for an efficient market are difficult to exist in the real world and so they are narrowed to three versions of EMH which may be more realistically applied; these can be called the degrees of efficiency and are as follows:
1. Strong efficiency – is quite fanciful to believe and states all information in a market, whether public or private, is accounted for in a stock price. Not even insider information could give an investor the advantage. It implies that profits exceeding normal returns cannot be made, regardless of the amount of research or information investors have access to.
2. Semi-strong efficiency -This form of EMH implies that all public information is calculated into a stock's current share price and it is not possible to earn excess return by fundamental analysis.
3. Weak efficiency – This hypothesis assumes that the rates of return on the market should be independent; past rates of return have no effect on future rates. Technical analysis cannot be used to predict and beat a market. The assertion of weak form of efficiency is very much consistent with the findings of researches on random walk hypothesis; that is, the price changes from one time to another are independent
When market efficiency is desirable, there are three limitations in achieving it: the cost of information, the cost of trading and the cost of arbitrage. We can very easily say that markets are not informationally efficient. If that had been the case, then no investor or news participant would have the incentive to report new information because the value of that is zero. That is, when a company announces its earnings, no one wastes time trying to analyse it because the price already reflects it. But if no one has any incentive to react to new information, then it is impossible to reflect new information in prices. Market participants, arbitrageurs and speculators should be compensated in some way for making the market more efficient hence the price can adjust to new information only with a time lag. Similarly, traders incur costs while trading and when trading costs are high, the asset prices are bound to remain mispriced for a longer time than when these prices are low. Apart from this, if short selling is more difficult than buying long then prices are likely to be biased upward.
Given the present situation in North America and Europe, global economic recovery and the resumption of previous levels of growth will hinge on the continued rapid development of emerging markets in coming years, particularly in Asia-Pacific, where savings are abundant. However, the underdevelopment of the region’s financial markets, unless addressed, was posing a serious constraint to the future growth of Asia and, consequently, to regional and global economic growth as well. In most of Asia, financial market infrastructure remained inadequate to effectively support the region’s next stage of growth and in particular, to meet the enormous challenges of financing the region’s growing urban infrastructure. Asia-Pacific region has recently been witnessing a series of financial market developments and the current global economic situation underscores the compelling rationale for the development of sound and integrated financial markets. Asia’s financial markets have grown significantly over the past decade. But the capital markets, especially for bonds and securitised debts, remain small in relation to Asia’s GDP . Further, the region’s financial markets are still relatively small and fragmented. Two themes that will influence the development of Asia’s financial markets are: Firstly, the changes in the OTC derivatives markets as a result of global reforms; and secondly, the harnessing of technology to transform the financial infrastructure.
More standardised products, robust market infrastructure: central counterparties for clearing, trade repositories are shaping up in OTC derivatives market as a result of the reform process which is now shifting from rulemaking to implementation. The new market infrastructures are expected to provide greater transparency and allow risks to be managed more effectively among market participants. However, we are also seeing a proliferation of Central Counterparties (CCPs) which will provide choice to Asian market participants; it may also increase risk and lead to higher costs. Market participants will also face additional costs if CCPs and trade repositories lack economies of scale and hence the cost of trading goes high which might lead to mispricing of securities to a higher level.
Besides risk management, technology can be useful in developing liquidity in Asian markets. It can bring greater pricing efficiency and transparency, as we are seeing in the US and EU financial markets, as trading move to electronic platforms. In Asia-Pacific, there is still space for e-trading, notwithstanding smaller markets. To illustrate, an estimated 80% of trades are executed in electronic platforms in developed country FX markets, whereas 85% of FX trades in Asia-pacific region are still executed by voice. A reduction in transaction costs can promote greater liquidity for Asian asset classes, and broaden participation from investors including retail traders. Decreasing transaction costs would again promote markets to get efficient. It is important to make sure that market infrastructure is supportive of dynamic structures and evolving needs in the Asia-Pacific. A closer regional collaboration among public and private sectors, regulations and practices needed to support sound and efficient markets would be crucial in facilitating the continued growth of the region’s economies. The region would greatly benefit by a framework for enhanced regional public-private collaboration that can effectively complement various ongoing regional initiatives to help the region develop sound, efficient and integrated financial markets.
To conclude I would like to say that with all these key developments taking place in the Asia-Pacific region to boost the financial market infrastructure and technology will help in reducing the cost of trading and would help markets to be more efficient. But the bottom line is, expecting a strong form of market efficiency would be quite naive. The markets may turn out to be efficient in the long run due to competitive selection behaviour and arbitrage opportunities, but in the short run for an average investor believing in market efficiency would be nothing short of a blunder. We can pragmatically accept a possibility of semi strong form of efficiency to exist in the financial markets, but to hope a strong form or a weak form to be credible would definitely be a mistake.
1. Warren Buffet's speech in 1984 at Columbia Business School
2. "Market Rationality: Efficient Market Hypothesis versus Market Anomalies " by Kadir Can- European Journal of Economic & Political studies
3. Inefficient markets: An introduction to Behavioral Finance- by Andrei Shleifer
4. Mr Tharman Shanmugaratnam, Chairman of the Monetary Authority of Singapore, at the 52nd World Congress, Singapore, 15 March 2013
5. 2013 Shanghai Forum, Helene Rey Speech on Financial developments in Asia
6. BIS Quarterly Review December 2013 International banking and financial market developments
- "Are Asian stock markets efficient? Evidence from new multiple variance ratio tests" by Jae Kim and Abul Shamshudin, Journal of Empirical Finance 15 (2008) 518–532
- Asifma White paper on "Asia's Capital markets: Strategies for sustained growth", November 2013
- Voice of the Symposium, 2013 Asia-Pacific Financial market development organised by the Australian government
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