Why are theoretically perfect and efficient capital markets so imperfect and volatile in practice?

Research Paper (undergraduate) , 2010 , 73 Pages , Grade: 1,3

Business economics - General

The Efficient market hypothesis can be considered as part of rational economics but it does not specify at all how individuals should or will act.
Therefore it might be a useful model of the functioning of the market as a whole but it does not explain the behaviors of investors as well as managers and other participants.
While the Efficient market hypothesis deals as a basis for understanding the normal working of the markets, from time to time it might happen that the market
as a whole or an individual stock may act irrationally.
Such behavior is well known and generally occurs when the market price of a share turns away from its intrinsic
value. The result is what commonly is called a bubble.
This term is often used but the reasons for the occurrence are quite unclear. In fact, at the same time as the
market as a whole has become more efficient, instances of irrationality have become more common or at least appear to be.
Therefore we try to discuss the question why capital markets, which are considered as efficient and perfect in theory, are volatile and imperfect in reality.

The paper responds to this question by discussing mainly the irrational behavior of people by turning into the field of psychology.

Furthermore it seeks for approaches of explanation conducted by different investment strategies containing among others an increased use of derivative instruments or single trades based on massive capacity which therefore influence prices.

Methodology and Structure of the paper
In general the paper can be divided in 3 parts, a theoretical as well as an analytical one and a final point the Conclusion (Part C) which sums up the basic findings of
the paper.
Whereas Part A can be regarded as delivering the theoretical
background, Part B contains the empirical analysis based on several case studies.
Chapter 1, 2 and 3 are providing the reader with the needed knowledge of the capital market, volatility and the efficient market hypothesis in order to assure the
understanding of the more complex prosecution of the paper

After discussing those fundamentals the paper soon takes a view on some instances of irrationality in Part B, but first of all delivers in Chapter 4, 5 and 6 some theories that attempt to explain such irrationalities.
Finally the paper is finished by linking those theories with the observed instances of irrationality

Inhaltsverzeichnis (Table of Contents)

• INTRODUCTION
• METHODOLOGY AND STRUCTURE OF THE PAPER
• A: LITERATURE OF CAPITAL MARKETS
  • 1. OVERVIEW OF THE CAPITAL MARKETS
    • 1.1 The Role of the Financial System
    • 1.2 Factors Affecting Performance of Financial System
    • 1.3 Raising Long Term Finance
    • 1.4 Overview to Securities Regulation
      • 1.4.1 Need for Regulating Financial Markets
      • 1.4.2 Objectives of a Financial Regulatory Framework
        • 1.4.2.1 Promote robust supervision and regulation of financial firms:
        • 1.4.2.2 Establish comprehensive supervision of financial markets:
        • 1.4.2.3 Protect customers and investors from financial abuse:
      • 1.5 The Emergence of World Capital Markets
        • 1.5.1 Impact of the Globalization on the Capital Markets
        • 1.5.2 Impact of Globalization on Domestic savings
    • 2. THE VOLATILITY OF CAPITAL MARKETS
      • 2.1 Defining volatility
      • 2.2 Determinants of Volatility
      • 2.3 How Volatility is measured
    • 3. EFFICIENT MARKETS
      • 3.1 Efficient-Market Hypothesis
        • 3.1.1 Weak form
        • 3.1.2 Semi-strong form
        • 3.1.3 Strong form
      • 3.2 Efficiency in Capital Markets and The “random walk” Approach
        • 3.2.1 Diffusion / Flow and aggregation of information
        • 3.2.2 Volume of information due to volatility and sensitivity of capital markets
      • 3.3 Predictability in Capital Markets and The \"non-random walk\" Approach
        • 3.3.1 Predictable patterns based on valuation parameters
          • 3.3.1.1 Future returns from initial dividend yields
          • 3.3.1.2 Market returns from initial price-earnings multiples
        • 3.3.2 Cross-sectional predictable patterns based on firm characteristics
          • 3.3.2.1 The size effect
          • 3.3.2.2 The stocks value
          • 3.3.2.3 The \"puzzle\" of equity risk premium
        • 3.4 Arguments and Opponent Ideas regarding Efficiency in the Capital Markets
          • 3.4.1 Mispricing
          • 3.4.2 Excess volatility
      • 4. MANAGEMENT DECISIONS LEADING TO MARKET IMPERFECTIONS
        • 4.1 Fundamental Factors leading to market imperfections
        • 4.2 Institutional Factors leading to market imperfections
      • 5. MARKET IMPERFECTIONS AND IRRATIONAL EXUBERANCE
        • 5.1 Media and the spread of information
        • 5.2 Psychological Factors
          • 5.2.1 Basic Theories on the behavior of individuals
            • 5.2.1.1 The rational man theory
            • 5.2.1.2 The Prospect Theory
            • 5.2.1.3 The Chaos Theory
            • 5.2.1.4 The Theory of Groupthink
          • 5.2.2 Advanced Theories on the Behavior of Individuals
            • 5.2.2.1 The Theory of quantitative checkpoints for investors
            • 5.2.2.2 The Theory of Moral checkpoints for investors
          • 5.2.3 Keynes & Minsky
            • 5.2.3.1 Keynes \"biggest fool\" theory
            • 5.2.3.2 Minsky's Financial Instability Hypothesis
        • 6. IMPACTS AND INFLUENCES IN THE CAPITAL MARKETS
          • 6.1 Trading strategies influences: hedging, speculation
          • 6.2 Liquidity and Structured Finance Products impact
      • B: EMPIRICAL EVIDENCE BASED ON CASE STUDIES
        • Case 1: Example of 1987 stock market crash
        • Case 2: New Economy Bubble - Deutsche Telekom AG
        • Case 3: EADS Insider Trading
        • Case 4: Irrational Development of Volkswagen stock price due to Porsche's takeover plans
      • C: CONCLUSION
      • D: REFERENCES

      Zielsetzung und Themenschwerpunkte (Objectives and Key Themes)

      This paper examines the apparent contradiction between the theoretical model of efficient and perfect capital markets and their observed volatility and imperfections in practice. It investigates the reasons for this discrepancy, focusing on the role of irrational behavior, psychological factors, and investment strategies in shaping market dynamics. Key themes explored in the paper include:
      • The Efficient Market Hypothesis and its limitations in explaining real-world market behavior
      • The impact of psychological factors and behavioral biases on investor decisions
      • The role of investment strategies, such as hedging and speculation, in influencing market volatility
      • The impact of institutional factors, such as media coverage and regulatory frameworks, on market dynamics
      • The analysis of specific case studies to illustrate the interplay of theoretical concepts and real-world market events

      Zusammenfassung der Kapitel (Chapter Summaries)

      • Introduction: This chapter introduces the central question of the paper, exploring the discrepancy between the theoretical model of efficient capital markets and their observed volatility and imperfections in practice. It highlights the role of irrational behavior and market bubbles in this context.
      • Methodology and Structure of the paper: This chapter outlines the structure and approach of the paper, dividing it into three main parts: theoretical background, empirical analysis, and conclusion. It also provides a brief overview of the content covered in each chapter.
      • Overview of the Capital Markets: This chapter provides a comprehensive overview of the financial system, including its role, factors affecting its performance, and the different types of financial markets. It also discusses the importance of securities regulation and the emergence of global capital markets.
      • The Volatility of Capital Markets: This chapter defines volatility and explores its determinants, including market factors, economic indicators, and investor sentiment. It also examines different methods for measuring volatility.
      • Efficient Markets: This chapter delves into the Efficient Market Hypothesis, outlining its different forms and its implications for market behavior. It explores the “random walk” approach, which assumes that market prices reflect all available information, as well as the “non-random walk” approach, which acknowledges the potential for predictability in market movements.
      • Management Decisions Leading to Market Imperfections: This chapter examines how managerial decisions can contribute to market imperfections. It explores both fundamental factors, such as corporate governance and information asymmetry, and institutional factors, such as regulatory frameworks and accounting practices.
      • Market Imperfections and Irrational Exuberance: This chapter delves into the psychological factors that drive irrational behavior in capital markets. It explores various theoretical frameworks, including the rational man theory, the prospect theory, and the chaos theory, to explain investor decision-making and the emergence of market bubbles.
      • Impacts and Influences in the Capital Markets: This chapter examines the impact of trading strategies, such as hedging and speculation, on market dynamics. It also discusses the role of liquidity and structured finance products in shaping market behavior.

      Schlüsselwörter (Keywords)

      This paper focuses on the interplay between theoretical models and real-world observations in the context of capital markets. It explores the limitations of the Efficient Market Hypothesis, the impact of psychological factors on investor behavior, and the role of investment strategies and institutional factors in shaping market dynamics. Key terms and concepts include: efficient market hypothesis, market volatility, irrational behavior, psychological biases, investment strategies, hedging, speculation, liquidity, structured finance, market imperfections, and case studies.

• College: University of Applied Sciences Northwestern Switzerland
• Grade: 1,3
• Author: Michael Marquardt (Author)
• Publication Year: 2010
• Pages: 73
• Catalog Number: V145030
• ISBN (eBook): 9783640565429
• ISBN (Book): 9783640565375
• Language: English
• Tags: Irational Behaviour, Capital Market, Kapital markt, Volatility, Volatilität, Perfect, Imperfect