Efficient-markets hypothesis

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"...transactions in securities as commonly conducted upon securities exchanges and over-the-counter markets are affected with a national public interest which makes it necessary to provide for regulation and control of such transactions and of practices and matters related thereto, including transactions by officers, directors, and principal security holders, to require appropriate reports, to remove impediments to and perfect the mechanisms of a national market system for securities and a national system for the clearance and settlement of securities transactions and the safeguarding of securities and funds related thereto, and to impose requirements necessary to make such regulation and control reasonably complete and effective, in order to protect interstate commerce, the national credit, the Federal taxing power, to protect and make more effective the national banking system and Federal Reserve System, and to insure the maintenance of fair and honest markets in such transactions..." Securities Act of 1934, Section 2



In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", or that prices on traded assets (e.g., stocks, bonds, or property) already reflect all known information, and instantly change to reflect new information.

Therefore it is impossible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.

The hypothesis has been attacked lately by critics who blame belief in rational markets for much of the current financial crisis,[1] with noted financial journalist Roger Lowenstein recently declaring "The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis."[2]

EMH as a cause of the crisis

"...On such ideas, and on the complex mathematics that described them, was founded the Wall Street profession of financial engineering. The engineers designed derivatives and securitisations, from simple interest-rate options to ever more intricate credit-default swaps and collateralised debt obligations. All the while, confident in the theoretical underpinnings of their inventions, they reassured any doubters that all this activity was not just making bankers rich. It was making the financial system safer and the economy healthier.

That is why many people view the financial crisis that began in 2007 as a devastating blow to the credibility not only of banks but also of the entire academic discipline of financial economics. That verdict is too simple. Granted, financial economists helped to start the bankers’ party, and some joined in with gusto. But even when the EMH still seemed fresh, economists were picking holes in it. A strand of sceptical thought, behavioural economics, has been booming. There are even signs of a synthesis between the EMH and the sceptics. Academia thus moved on, even if Wall Street did not. Nonetheless, the extent to which politicians and regulators trying to reform finance can trust financial economists is an open question.

The EMH, to be sure, has loyal defenders. “There are models, and there are those who use the models,” says Myron Scholes, who in 1997 won the Nobel prize in economics for his part in creating the most widely used model in the finance industry—the Black-Scholes formula for pricing options. Mr Scholes thinks much of the blame for the recent woe should be pinned not on economists’ theories and models but on those on Wall Street and in the City who pushed them too far in practice.

Financial firms plugged in data that reflected a “view of the world that was far more benign than it was reasonable to take, emphasising recent inputs over more historic numbers,” says Mr Scholes. “Apparently, a lot of the models used for structured products were pretty good, but the inputs were awful.” Indeed, the vast majority of derivative contracts and securitisations have performed exactly as their models said they would. It was the exceptions that proved disastrous.

Mr Scholes knows whereof he speaks. Long-Term Capital Management (LTCM), a hedge fund he founded with, among others, Robert Merton, a fellow Nobel laureate, skidded off the road in 1998. Since then, he has been pointing out dangers ignored or underestimated in the finance industry, such as the risk that liquid markets can dry up far faster than is typically assumed. (That did not stop Platinum Grove, the latest hedge fund in which he is involved, taking a big hit during the recent meltdown.)"

Public disclosure, risk, and performance

This paper examines the relationship between the amount of information disclosed by bank holding companies (BHCs) and their subsequent risk profile and performance.

Using data from the annual reports of BHCs with large trading operations, we construct an index of publicly disclosed information about the BHCs’ forward-looking estimates of market risk exposure in their trading and market-making activities.

The paper then examines the relationship between this index and the subsequent risk and return in both the BHCs’ trading activities and the firm overall, as proxied by equity market returns.

The key findings are that more disclosure is associated with lower risk, especially idiosyncratic risk, and in turn with higher risk-adjusted returns.

These findings suggest that greater disclosure is associated with more efficient risk taking and thus improved risk-return trade-offs, although the direction of causation is unclear.

Theories of asset pricing

“This is the second article in a series of articles that examine the practical applications of economic thought. Its focus is on the most fundamental aspects of finance theory, namely asset pricing. We discuss the major pricing models developed during the past 5 decades and critically examine their practical applications.

Sadly, the results are not very encouraging. As with other academic economic disciplines, the gap between what is taught and what actually takes place in the markets is quite large, a gap that is in no way mitigated by the behavioralist arm of the subject.

The seminal works of Sharpe and Lintner have provided us with a sound foundation upon which to build realistic pricing models, but sadly the unwavering acceptance of these models has resulted in research that becomes even more ingrained in academic thought than a viable examination of how pricing models could be adapted to match the practical world.”

Is there enough and timely information?

From a conceptual viewpoint, our regulatory approach has various roots but owes much to the Efficient Market Hypothesis. The current crisis has put under discussion those theories but in particular this one.

A simple formulation of Fama’s Efficient Market Hypothesis could be the following: provided that there is enough and timely information, traders will not miss the opportunity to make a gain if they are allowed to.

Let’s get slightly into two details.

The first detail is “provided that there is enough and timely information”. We securities regulators are permanently looking after more transparency. We believe information is necessary for markets to work properly. But, what do we mean by enough information? Is it “enough information” the one contained in prospectuses of hundreds of pages? Is it enough the output of extremely complex models? Is it enough the innumerable quantity of notes to financial statements under IFRS? This crisis suggests that eventually not. We now know that most of that information nobody read it and eventually only few people could understand. In practice despite hundreds of Gigabytes of information, investors did not take into account all relevant information.

The second condition has to do with the former hero, “the trader”. We think of the trader as the one rational agent that using all relevant information would take “optimal decisions”. There is too much evidence that this was not the case.

Olivier Blanchard, Chief Economist of the IMF, said that investors replicated the price pattern of the last couple of years to forecast the behaviour of real estate prices for the next couple of years. (IMF, 2009)

Ben Bernanke, Chairman of the Federal Reserve, testifying before Congress on September 23, 2008 said that “The troubles at Lehman had been well known for some time, and investors clearly recognized- as evidenced by the high cost of insuring Lehman’s debt in the market for CDS- that the failure of the firm was a significant possibility. Thus we judged that investors and counterparties had had time to take precautionary measures” (Caballero and Kurlat, 2009)

Rationality will be more properly understood after this crisis and regulation should learn from this. How bounded or limited is the economic agent’s rationality?

We know recognize that:

  • successful traders have an exaggerated good opinion of themselves such that they believe they can beat the market, a belief that in itself contradicts the Efficient Market Hypothesis
  • people tend to stick to prior beliefs, even if new information contradicts it
  • independent directors may be subservient,
  • etc...

I suggest that beyond the rationality argument, there are two other elements we must consider:

  1. Corporate governance. Most “traders” are not individuals but legal entities, firms that have a strategy and structures of control and surveillance. We have discussed about compensation, but for the subject is far more complex. How do boards work? Which incentives they face? Why don’t they want to hear bad news and prepare for facing risks? Does it help to have a strong majority shareholder?
  2. Competition. We need to take a closer look at how competition takes place in financial markets. Competition induces innovation, but innovation quickly spreads across the financial sector. So we end up in a situation with significant herd behaviour. The outcome of this is the following: behaving well, namely being prudent in terms of risk taking may not be a dominant strategy when all other participants play risky bets. This vicious circle must be handled through regulatory action.

The "idea that liquidity is the new God"

"...But to Mr. Turner, the point has been less about his proposal — a pragmatist, he realizes that there is little chance such a tax would win international support — than the reaction to it. The uproar shows that the “quasi-religious” dogma of finance — that the markets are always right and that governments should let money flow freely around the world — is as ingrained as ever, he said. But now more than ever, given the events of the past year, regulators must challenge such notions, he said.

“We have begun to accept this idea that liquidity is the new God,” Mr. Turner said in an interview earlier this month.

“The ideology of efficient markets became deeply embedded within the regulatory community,” he continued. “And if you are of the belief that we have to challenge this, then you can’t help not to make speeches about it.”

And that is exactly what Mr. Turner has done, almost from the day that he took over as chairman of the Financial Services Authority during the very week that Lehman Brothers collapsed..."

Regulation versus "free markets"

Alan Greenspan, former Federal Reserve chairman, continues to argue that even financial products that led to the economic crisis should not be banned, affirming his belief that markets should be the final arbiter over which tools work.

Mr Greenspan, who has faced criticism for making decisions that allowed the economic crisis, maintains that the market should judge these products. He disagrees with those, such as George Soros, who has called for an outright ban on tools that may have led to the crisis, and Dominique Strauss-Kahn, director of the International Monetary Fund, who has called for tougher regulation.

“I think you have to allow the market to make those judgments,” Mr Greenspan said at last week’s Yalta European Conference, explaining that many practices would naturally find themselves “off the table”.

In spite of his pro-market mantra, Mr Greenspan said he thought capital requirements for financial institutions needed to be increased, regulators needed to crack down harder against fraud and that the problem of companies being too big to fail needed to be addressed.

Mr Greenspan’s remarks came almost a year after he acknowledged at a Congressional hearing that he had ”found a flaw” in his thinking and that he was wrong to assume that banks would protect themselves from financial market chaos.

Mr Strauss-Kahn, at the same conference, disputed the notion that the market was a sufficient remedy and argued that better enforcement of regulations was necessary to prevent future crises, which in low income countries can be “a question of life or death”. Relying completely on the market, he said, came with a “huge human cost” in terms of lost economic output and unemployment.

“I don’t think that it’s possible to ban, totally, some kind of financial innovation,” Mr Strauss-Kahn said. “On the other hand, I don’t think that we can totally rely on market forces to do that.”

The comments came as regulators fight to keep the economic recovery on track and central bankers review global financial regulation. A key question will be how to design an exit strategy to unwind from bold stimulus measures without rattling the markets.

On Thursday, Ben Bernanke, the current Fed chairman, proposed an oversight council that would monitor emerging risks to the financial system and called for a “holistic” approach to supervision. Meanwhile, the IMF said that the world economy was growing again, but that the recovery would be sluggish unless countries with large trade surpluses drive demand.

In the US, Mr Greenspan warned that the Federal Reserve must be free to tighten its monetary policy in spite of political pressures to keep interest rates low. Although there would be downward pressure on prices through next year, “serious inflation problems” loom in the longer-term.

Institute for New Economic Thinking

Leading Economists and Policymakers Including Nobel Laureates George Akerlof, Sir James Mirrlees, A. Michael Spence and Joseph Stiglitz Join to Foster New Thinking

George Soros Backs New Institute With $50 million Pledge

New York/Budapest -- In response to the policy challenges presented by the economic crisis and the need to develop fresh approaches to economic theory, a group of top academics, policy-makers, and private sector leaders today announced the creation of the Institute for New Economic Thinking (INET). www.iNETeconomics.org

INET’s founding Advisory Board members include Nobel laureates George Akerlof, Sir James Mirrlees, A. Michael Spence and Joseph E Stiglitz, Willem Buiter, Markus K. Brunnermeier, Robert Dugger, Duncan Foley, Thomas Ferguson, Roman Frydman, Ian Goldin, Charles Goodhart, Anatole Kaletsky, John Kay, Axel Leijonhufvud, Perry Mehrling, Y.V Reddy, Ken Rogoff, Jeffrey Sachs, John Shattuck, William R. White and Yu Yongding. www.iNETeconomics.org/advisory-board

The Institute was established with a pledge of $5 million per year for 10 years from Open Society Institute Chairman George Soros, a long-time critic of classical economic theory, who will fund the effort through the Central European University (CEU).

The Institute will make research grants, convene symposia, and establish a journal. A first conference will be at King's College, Cambridge on April 9-11. Scholars will explore the implications of the financial crisis for regulatory policy. The first round of research grants will be made before the end of the year to cutting-edge scholars working with leading universities around the world. INET’s Executive Director will be Robert Johnson, an economist with long experience in government, academia, and the private sector.

In an essay written on the creation of INET, Professor Stiglitz noted, “The financial crisis has caused a moment of deep reflection in the economics profession, for it has put many long-standing ideas to the test. If science is defined by its ability to forecast the future, the failure of much of the economics profession to see the crisis coming should be a cause of great concern.”

Speaking in Budapest at the CEU, through which INET will be funded and which will be a hub of the INET network, Soros said, “The entire edifice of global financial markets has been erected on the false premise that markets can be left to their own devices, we must find a new paradigm and rebuild from the ground up. I decided to sponsor INET to facilitate the process. I hope others will join me.” Because he is both an INET benefactor and proponent of a particular theory, Reflexivity, Soros will recuse himself from the grant-making process. “While I hope reflexivity will be one of the concepts examined, there are numerous alternatives to the prevailing dogma that must be explored.” Soros added.

Great Mortification: Economists’ Responses to the Crisis of 2007–(and counting)

Lesson 2: Economists Lost Control of the Discussion of the Crisis Early On

Exhibit #1 demonstrating that the economics profession was caught unawares by the meltdown in 2008 is the fact that they rapidly lost any control over how the crisis was discussed in public that year. From the failure of Bear Stearns forward, journalists scrambled to understand how it could be that problems in one sector would ramify and amplify into other sectors, such that the entire financial system seemed poised on the brink of utter failure. There had been bankruptcies and dodgy financial deals before: what was so different this time around? Reporters started out by interviewing the usual suspects (Greenspan, Bernanke—himself prophet of the Great Moderation of 2004) and economists from gold-plated schools (Martin Feldstein, Gregory Mankiw, Matthew Slaughter, Glen Hubbard, Larry Summers, Allan Meltzer), but you could tell that the tendering of lame reassurances was not holding up against the tsunami of bad news. Of course, the keening public just wanted simple answers, but the economists didn’t seem to have any answers whatsoever. So the journalists, with a little help from the chattering classes, came up with the metaphors that ultimately rose to dominate initial discussions of the crisis.

Upon reflection, it is perhaps not a shock that the concepts which came to dominate “explanation” in the generalist press were a mélange of biological and religious metaphors: Nature and God usually trump the Market in America. Although the actual array of metaphors used poses all sorts of interesting questions from a rhetorical point of view, the main lesson we shall draw here is that none of them had anything whatsoever to do with economic theory.

The first and most persistent explanation of the nature of the crisis involved repeated reference to “toxic assets.” A quick content search reveals the term first surfacing in the Wall Street Journal in January 2004. What started out as a mere figure of speech suddenly blossomed in 2008 to constitute Finance for Dummies in the heat of the crisis—and even seems to have influenced the shape of the original three-page Troubled Asset Relief Program (TARP) sent to Congress. People liked it because it embodied both a notion of the problem and the cure—if you “ingest/invest” too many “toxic assets” you die, but the way to get rid of poison is to flush it out of your system. Hence the entire crisis was not so different from an outbreak of E. coli in your spinach: dangerous, to be sure, but not a system pathology. All we had to do was detox, and everything would return to health. The beauty of the metaphor was it elided all the hard work of explaining ABSs, CDOs, CDSs, SIVs, and nearly everything else that actually caused the crisis. The assets were toxic; we didn’t need to know how or why. We didn’t stop to think that the financial system intentionally produced them and therefore the entire metaphor was wonky at base. (It would be as if a snake naturally produced venom, only to kill itself.)

But more to the point, the metaphor had no basis whatsoever in the orthodox theory of finance. In that theory, efficient markets are arbitrage-free, and any contingent claim can be reduced to any other contingent claim through some stochastic wizardry. Hence risk itself can always be commodified and traded away—that is the service the financial sector supposedly performs for the rest of the economy. The system as a whole simply cannot fail to price and allocate risks; hence there are no such things as virulently “toxic” assets. Crappy assets, junk bonds, dogs with fleas, yes, but inherently “toxic,” never.


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