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 that markets are too volatile to be efficient. This evidence is suggesting that the reaction is the crucial factor, rather than the actual information. Generally, market participants react differently to negative and positive market shocks, hinting at asymmetrical effects. This research aims to analyse the impact of the asymmetrical effect on the efficiency of the financial market during the recent crises. We test the efficiency of the financial market using the daily prices of the US and German sovereign debts between January 2002 and March 2013. This allowed us to test the efficiency during the pre-crisis, financial crisis and sovereign debt crisis periods. We used a GJR-GARCH based variance bound test based on the test derived by Fakhry & Richter (2015). Our tests produced mixed results, pointing at the markets being too volatile to be efficient. Interestingly the addition of the asymmetrical effect led to a reduction in EMH test statistics based on the results from Fakhry & Richter (2015) and hence may have had an impact on the efficiency of the market. Conversely, the results are more appropriate speak of bounded rationality than irrationality. The key contribution is the extension of the variance bound test to include the asymmetrical effect. This allowed us to discuss the reaction to negative and positive shocks from the crises on the efficiency of the German and US markets. A key conclusion of the paper is that it does hint at the use of a switching GARCH model as an alternative to the GJR-GARCH model. Therefore, a prospective future research could be the use of a switching GARCH model to analyse the different impact of high and low volatility regimes on the efficiency of the market. Another prospective is the use of sovereign debt indices instead of the issued sovereign debts as the observed data. This would allow us to overcome a number of issues highlighted in the conclusion.
Highlights
The efficient market hypothesis has been the cornerstone of asset pricing since the early 1960s, developed through prominence articles such as Malkiel (1962) and Fama (1965, 1970)
In order to analyze the efficiency of the sovereign debt market under different global market conditions, we subdivide our observed markets into the following periods: pre-crisis period, financial crisis of the late 2000s and sovereign debt crisis of the 2010s
Hindsight is a lovely tool to have but during any crisis, human nature dictates that market participant react to events rather than the fundamentals of the asset, which was the case during the financial crisis and to a certain extent the sovereign debt crisis
Summary
The efficient market hypothesis has been the cornerstone of asset pricing since the early 1960s, developed through prominence articles such as Malkiel (1962) and Fama (1965, 1970). As hinted by Black (1976), a key observation made primarily in stock markets is that there is a negative correlation between returns and volatility, meaning that a negative movement has a greater impact than a positive movement of similar magnitude on the volatility. It suggests that market participants react differently to negative and positive shocks. Fakhry and Richter (2015) hint at a different effect on the efficiency of the market due to the environment. The use of these indices in any research would require approval of the issuing firm and we did not have access to the indices during the research
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