Broadly speaking, the financial sector has four, clearly interrelated, functions: provide liquidity, allocate credit and hence resources, price assets and exercise corporate control. For quite a long time, “mainstream” economic theory accepted the Modigliani – Miller proposition which stated that there is no relationship between corporate capital structure and the real performance of firms. The last two decades, it has been increasingly disputed as the importance of the financial sector on economic growth and efficiency is gradually recognised.
Probably few would disagree that financial markets have succeeded in providing a relatively high degree of liquidity, especially after the recent developments which have led to more active, competitive and complete markets. Indeed, it has been argued that the primary function of capital markets is the provision of liquidity given the surprisingly small percentage of company finance provided by them.
Some argue that, in fact, most of this apparent liquidity is illusionary because when it will be most needed it will not be available It has also been argued by such people as Stiglitz and Black that liquidity -and by extension the very existence of capital markets- inevitably leads to inefficiency. These issues are related to the question of the efficiency of the financial markets which we will now examine.
Of course we should bear in mind that the distinction between efficiency and liquidity is somewhat arbitrary since the existence of liquidity generally makes the economy more efficient by allowing people to substitute in and out of assets quickly and with little cost. According to the Efficient Markets Hypothesis (EMH), financial markets are efficient with respect to their information set so that it is not possible to make (systematic) economic profits by trading using this information. Prices will only change if new information becomes available.
The theory assumes perfectly competitive securities markets and all individuals being risk-averse, expected utility maximisers. It should be noted that the theory does not require frictionless capital markets or perfect product markets. For any practical purposes, the notion of EMH depends on the precise definition of the available information. Fama has identified 3 different types of efficiency based on exactly what type of information structure is relevant: The Weak form of the EMH asserts that prices fully reflect the information contained in the historical sequence of prices.
Thus, investors cannot devise a trading strategy to yield abnormal profits on the basis of past price patterns (technical analysis). This form of efficiency is associated with the idea of a random walk, though the returns may not be independent of each other if there are costs of gathering information. The semi-strong form of the EMH states that current stock prices reflect not only historical price information but also all publicly available information relevant to a company’s securities.
Again here prices reflect information to the point where the marginal benefits of acting on information do not exceed the marginal costs. The strong form of the EMH asserts that private information that is known to at least one market participant about a company is fully reflected in market prices. Hence, even insiders cannot have privileged information which they could use to secure superior investment results. A major criticism of the EMH is that the market appears to exhibit much more volatility than can be justified by rationally formed expectations or at the rates at which they are discounted.
This implies that prices do not reflect all available information so that there exist unexploited opportunities for profit. A possible explanation for that include that it takes time to fully process new information and to learn to price new instruments so that time-arbitrage opportunities arise. Others, however, have argued that inefficiency not only is an inherent feature of the system but also serves a purpose.