An Analysis of Financial Market Efficiency in the Asia Pacific Region

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Raisa Sherif's picture

The Efficient Market Hypothesis, as put forward by Eugene Fama, states that financial markets are efficient and the security prices fully reflect all available information in the market (Fama, 1965). This efficiency could be of three types: (i) Weak form of efficiency, (ii) Semi-strong form of efficiency and (iii) Strong form of efficiency. Of the three, Fama emphasizes the weak form of efficiency, which implies that all past publicly available information will be reflected in the price of a security.  One of the most celebrated theories in financial economics, the efficient market hypothesis also advocates that market prices follow a random walk, indicating that it is impossible to deduce the current price movements of a security by analysing  past price changes. Thus it would be quite impossible to beat the market and on average, active trading need not fetch any returns in excess of passive trading (Fama, 1995).

The fundamental idea of the Efficient Market Hypothesis is that even if individual investors make mistakes in estimating the price of a security, collectively the market estimate matches its true value. Any avenue for generating excess profit cannot last long as the rational agents of the market will immediately exploit the prospect, leaving the opportunity non-existent. This theory fits with the Neo-classical philosophy that the price system acts as a mechanism to transmit information in any market (Hayek, 1945). Several empirical studies look into the efficiency of financial markets and many in the developed countries have been considered as exhibiting weak form efficiency.

However, the increasing volatility of the stock prices and the seemingly inexplicable investor behavior leading to large gains and losses in the markets prompted numerous studies on financial market efficiency. The advocates of efficient markets argue that any predictability is self-destructive as it then becomes evident to all the agents in the market and once everyone tries to capitalize on it, no one makes a profit from it. The findings of some of the empirical studies failed to provide evidence for what was considered as a cornerstone of financial economics. Studies by the likes of Shiller (1980) and Lo & MacKinlay (1988) find instances of predictability in the stock prices. Recurring patterns in the market like that of January effect (Haugen & Lakonishok, 1987) and Monday effect (French, 1980) were also discovered. These results cast a considerable doubt on the credibility of the Efficient Market Hypothesis. The contrasts in the studies make a compelling case to examine the characteristic differences between markets that exhibit these results and probe for its causes.

Keeping these studies in mind, this essay takes a closer look at the markets in the Asia Pacific region and analyses some of the empirical evidences for market efficiency. Due to the heterogeneity in the size, market environment and the type of agents involved, it is difficult to identify features that are uniform across the different financial markets of the region. The spectrum is varied from fully developed markets like that of Tokyo and Hong Kong to the numerous, small and emerging markets dotting the financial scene. Analysis of the stock market prices in developed markets like that of Hong Kong provides evidence for weak form of efficiency (Cheung & Coutts, 2010). However, a close examination of the emerging markets of the Asia Pacific region reveals interesting results. Not all of these emerging markets are sophisticated and most fail to satisfy the prerequisites for markets to be efficient like that of near perfect competition, homogenous agents, minimal transaction costs etc. The emerging nature of the markets in itself presents an opportunity to obtain profits. The presence of unnatural returns in emerging markets is established by several studies. Evidence is found in India (Harper & Jin, 2012; Arora, 2013) and Thailand (Watanapalachaikul & Islam, 2006). In Dhaka, it took almost a month for the market to reflect the information in the prices (Ahmed, 2002). This absence of market efficiency is not unique to the emerging economies of Asia Pacific region alone but is consistent with other emerging economies across the globe. Evidence from several developing eastern European countries also brings out the underlying predictability of the stock prices (Jagric, Podobnik, & Kolanovic, 2005). The emerging markets are far from being highly competitive, weakening the chances of efficiency. If the underlying condition is not met, it is futile to expect the markets to miraculously turn out to be efficient.

In addition to this, there are several other causes that lead to lack of market efficiency. The risk portfolio of the investors is one such factor. Prices become predictable when the market is prominent with risk-averse agents as is the case with most Asian markets (Barucci, 2003). Unequal access to information and insider trading also contribute to market inefficiency. However, any information possessed by an agent will be reflected in the market behavior and thus embedded in the price. Thus the inefficiency is not long term. Sophisticated analysis brings information to the public domain and moves markets close to being efficient. Sometimes information is costly to acquire, like hiring an expert as is the case with markets that are far from ideal. Thus financial markets in countries lacking stringent regulatory framework governing information disclosure (e.g. Dhaka), are far from being efficient. Noise trading, while providing liquidity to the market, disrupts the estimation of true value of assets in the short-run. This creates profit opportunities, but too many noise traders would make it difficult to exploit these opportunities. Business cycles affect the financial markets as well. For example, an economic downturn brings out the pessimistic sentiment in the market as was seen in Asian markets during the recession of 2008. 

Another instance of market inefficiency and financial crisis was experienced by the Asian economies during the 1990s culminating in the widely known Asian financial crisis of the 1997-98.  Markets like that of Japanese financial market, that were previously considered efficient, experienced one of the worst slumps shattering investor beliefs and severely shaking the credibility of efficient markets. In the aftermath of the recession, there has been an increase in integration of the markets of the Asia Pacific region among themselves and to the other financial markets. As a result there has been observed volatility spill-overs and correlation between the price movements in various markets indicating a form of predictability. The minibond crisis in Hong Kong indicates such a scenario. Any form of predictability of the market price movements stimulates opportunity for unnatural returns, indicating lack of market efficiency. Earlier evidence for interdependencies can be found in studies like that of Aggarwal and Rivoli where, the Monday effect in the U.S markets is reflected as a Tuesday effect in Hong Kong, Singapore, Malaysia and Philippines (1989). Volatility in the Japanese stock markets started in 1986 with inflated asset prices, not just limited to stock prices. Thus examining financial markets in isolation does not present the full picture.

These instances of markets lacking efficiency fuelled alternative justifications to explain the market behavior. The heuristics of stock pricing were redefined by studying the underlying psychological and behavioral factors. Emergence of Behavioral Finance questioned the assumptions of rational agents and efficient markets. More importantly, it offered a plausible style of reasoning to explain the seemingly inexplicable behavior of the agents in the market. Over or under-reaction to new information and psychological effects like that of band-wagon affect the individual financial decisions. Thus it states that the stock prices can be predicted by observing the historical price movements and studying the behavioural responses of agents, thus offering an alternative school of thought. However, these are microeconomic in their approach of looking at individual behaviour. In the macro level, the investor behaviour is observable and the psychological factors are embedded in it. The behavior is a reflection of the information available to agents and the efficient market hypothesis already takes that into account. The emerging theory of Adaptive Market Hypothesis tries to assimilate Efficient Market Hypothesis into the behavioural finance realm, borrowing heavily on the laws of evolution of competition, adaption and natural selection. However, the lack of conclusive evidence is the major drawback of these alternative explanations.

The presence of studies pointing to the lack of equilibrium raises questions on the credibility of the efficient market hypothesis. However, it is a hypothesis, a theoretical feature of an equilibrium that follows when the set of assumptions is satisfied. By providing the Neo-classical assumptions of perfect competition, complete information and rationality of agents, the hypothesis sheds light into the behaviour of market at equilibrium. From this as the starting point, it is easier to analyse the market behaviour when any of the assumptions are relaxed. Moreover, the fact that there are variations found in the levels of efficiency in different financial markets warrants the need to analyse each of them. Thus the Efficient Market Hypothesis is still a powerful tool to understand the market behaviour. And as is pointed out by the abovementioned studies, once a financial market moves closer to the theoretical assumptions, market efficiency characteristically follows.

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