Academic journal article Journal of Corporation Law

Market Indeterminacy

Academic journal article Journal of Corporation Law

Market Indeterminacy

Article excerpt


"Market indeterminacy" is the inability to determine whether asset prices are efficient or inefficient, that is, whether or not asset prices fully and immediately reflect available information, such that no investor can earn abnormal expected returns by trading on available information at current prices. Market indeterminacy pervades asset markets because we lack reasonably precise models of "correct" prices, sometimes called models of "fundamental value," against which we can compare observed asset prices to detect efficiency and inefficiency. Arbitrageurs face market indeterminacy as well, so there is little reason to think that professional arbitrage will inevitably drive prices to fundamental values. Market indeterminacy casts doubt on the usefulness of the market efficiency concept in law and policy. For example, contrary to current practice, there is insufficient scientific basis to characterize some markets as efficient, and others as inefficient for purposes of the fraud-on-the-market theory of securities law. Market indeterminacy also undermines the reliability of event studies in some litigation and policy applications, and makes it hard to regulate financial markets.


Ronald Gilson and Reinier Kraakman wrote The Mechanisms of Market Efficiency at the end of an optimistic time for market efficiency proponents. ' For academic lawyers able to wade through the financial economics literature in the early 1980's, the field offered theoretical and empirical achievements with numerous apparent implications for corporate and securities law.2 In the midst of this intellectual gold rush, Gilson and Kraakman showed commendable prudence, stopping to ask a basic but important question: "What makes the market efficient when it appears to be so?"3 Without an answer to that elementary question, various proposed legal reforms supported by the supposed "fact" of market efficiency might accidentally interfere with the processes that presumably caused prices to be efficient in the first place.4

With the benefit of twenty years of hindsight, Gilson and Kraakman's inquisitiveness remains impressive, but the focus of their concern-How do we explain the "fact" of market efficiency?-seems less vital.5 As the 1980's progressed, much empirical evidence began to undermine the efficient markets paradigm. The "certain anomalies" that Gilson and Kraakman dismissed in 1984 soon became a torrent.6 The U.S. stock market crash of 1987 and the quick rebound that followed caused many to be unsure whether prices were "efficient" at most points in time, even prices of the largest and most liquid stocks. The rise and fall of the Japanese stock market generated more skepticism about market efficiency.7 In the early 1990's, academic economists began to develop theoretical models that asked the almost heretical question whether arbitrage was actually powerful enough to keep prices efficient.8 The empirical death of the widely accepted Capital Asset Pricing Model (and its ubiquitous "market beta" measure of risk) followed by 1992.9 The stock market's high valuation of internet and technology stocks in the late 1990's contributed greatly to skepticism of efficient markets theory. The same market's decline in 2000-2002 put a large dent in the financial security of many stock market investors (including foreign investors) taught to believe that market prices were efficient and reliable signals of investment value.10 Considering developments since 1984, the "fact" of market efficiency may hardly seem factual at all.

At the same time, no paradigm as encompassing as market efficiency has taken its place. Economists working in the emerging field of behavioral finance argue that market inefficiency pervades asset markets. Their research has advanced the decline of market efficiency as the only accepted academic description of financial markets, and fostered an active and ongoing debate in financial economics. …

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