Academic journal article International Journal of Business

The Efficiency of the GIPS Sovereign Debt Markets during Crisis

Academic journal article International Journal of Business

The Efficiency of the GIPS Sovereign Debt Markets during Crisis

Article excerpt

ABSTRACT

The efficient market hypothesis has been around since 1962, the theory based on a simple rule that states the price of any asset must fully reflect all available information. Yet there is empirical evidence suggesting that markets are too volatile to be efficient. In essence, this evidence seems to suggest that the reaction of the market participants to the information or events is the crucial factor, rather than the actual information. This highlights the need to include the behavioural finance theory in the pricing of assets. Essentially, the research aims to analyse the efficiency of the GIPS (i.e. Greek, Italian, Portuguese and Spanish) sovereign debt markets during the crises, in essence the recent global financial and sovereign debt crises. We use a GARCH-based variance bound test to test the null hypothesis of the market being too volatile to be efficient. In general, our EMH tests resulted in mixed results, pointing at the acceptance of the null hypothesis of the market being too volatile to be efficient. However, interestingly a number of observations are pointing at the rejection of the null hypothesis of the market being too volatile to be efficient.

JEL Classifications: B13, B16, B21, B23, C12, C13, C58, G01, G02, G14, G15, H63

Keywords: efficient market hypothesis; volatility tests; GARCH; sovereign debt market; crises

I. INTRODUCTION

The efficient market hypothesis has been the cornerstone of asset pricing since the early to mid-1960s, developed through prominence articles such as Malkiel (1962) and Fama (1965, 1970). However as suggested by Fakhry and Richter (2015), the efficient market hypothesis relies on some untestable assumptions and models like perfectly competitive markets and rational risk averse profit maximising market participants. Hence as suggested by Ball (2009), there have been many criticisms from policy makers and academics, especially in the aftermath of the financial crisis. Conversely, the momentum in the 1990s of behavioural finance also highlighted the issues surrounding the efficient market hypothesis. Essentially the efficient market hypothesis is difficult to test, however as Fakhry and Richter (2015) suggest it is possible to test the efficiency of the market through the use of the Shiller volatility test as derived by Shiller (1981a)

The GIPS (in essence the Greek, Italian, Portuguese and Spanish) markets have deep-rooted structural and imbalance issues in their economies as highlighted by Landesmann (2013) and Gros (2012) among others. Conversely, the GIPS markets are also at the centre of the Eurozone sovereign debt crisis. For these reasons, it would be interesting to test the impact of the crises on the efficiency of the GIPS sovereign debt markets.

As we are testing the efficient market hypothesis, we start this paper with a short review of the tests and empirical evidence of market efficiency. The next section gives methodology of the empirical test. Section III presents the data and empirical results and Section IV concludes.

II. REVIEW OF THE TESTS OF THE EFFICIENT MARKET HYPOTHESIS

In testing the efficient market hypothesis, we need to test whether markets follow the random walk model and prices incorporate information immediately. The variance ratio tests of Lo and MacKinlay (1988) allow the testing of the random walk model, the influencing assumption in the weak form efficient market hypothesis. However, a key factor is as stated by Fama (1970); any test of the efficient market hypothesis involves a joint hypothesis of the equilibrium expected rates of returns and market rationality. Thus, there is a need to review the variance bound test of Shiller (1979) and LeRoy and Porter (1981) which states any excess volatility in the price of any asset is the result of inefficient markets as argued by Shiller (1992). This would mean that in a rational market, fundamental information is not the driving force of the price and inefficiency in the market drives the price away from the long-term equilibrium. …

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