The Efficiency of the GIPS Sovereign Debt Markets during Crisis

(ProQuest: . denotes formulae omitted.)I. INTRODUCTIONThe 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 HYPOTHESISIn 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.As stated by Bollerslev and Hodrick (1992) past empirical evidence suggests that there is a difference between short and long horizons with short horizons displaying only minor violations of the efficient market hypothesis while with long horizons, large proportions are more predictable based on the price variance being largely explainable by past prices alone. Of course, this does not mean that markets are inefficient. A possible explanation is that the price variations could be due to time varying risk premium. However, as Poterba and Summers (1988) argue the magnitude of the variability is too large, to be explained by the rational pricing theory. The evidence from the long horizon tests seem to point at an overlapping issue suggesting the statistics are better estimated with an alternative asymptotic distribution as derived by Richardson and Stock (1989), although, as Bollerslev and Hodrick (1992) state this problem could also be overcome by using the vector auto-regression method.The concept of the volatility tests is a comparison of the variability of prices with the variability of the future cash flows. The basic argument is that in an ideal world, future cash flows should determine the behaviour of prices today; therefore, as Shiller (1992) argues, any excess volatility is evidence of inefficient markets. …