THEORIES RELATED TO RISK MANAGEMENT WITHIN FINANCIAL MARKETS.

  1. GENERAL MARKET EQUILIBRIUM

              This theory dates back to 1870s which was the work of a French economist Leon walras in his work on Elements of Pure Economics. It attempts to explain the behavior of supply, demand and prices in Economy with several interacting markets. It proves that interaction of demand and supply will result in a general equilibrium. This theory was initially classified under macroeconomics where analysis begins with larger aggregates, but the modern macroeconomics has emphasized microeconomics foundations which have resulted in two models;

  1. General Equilibrium Macroeconomics model –Have a simple structure that incorporates a few markets.
  2. General Equilibrium Microeconomics model-It involves a large number of different markets for goods(Tobin,1967).
  1. Efficient Market Hypothesis

This hypothesis states that a price of an asset fully reflects all the available information.

This was a development of Professor Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase or sell stocks of inflated prices. A market is said to be efficient if the security of prices remain unaffected even after revealing certain information to all participants. The main reason for the existence of a competitive market is the intense competition that exists among investors to profit from any new information. As more and more analysts compete against each other in their effort to take advantage of over –and under-valued securities ,the likelihood of being able to find and exploit such mis-priced securities becomes smaller and smaller. In equilibrium a few analysts will be able to profit from the detection of mis-priced securities while for the majority, the information analysis   payoff will likely not outweigh the transaction costs.

There are three variants of this hypothesis depending on available information;

  1. Weak variant-this is where by all the past publicly available information reflect the prices on traded commodities. After taking into account transaction costs of analyzing and of trading securities it is difficult to make money on publicly available information.
  2. Semi-strong variant- claims that prices reflect all publicly available information and that prices instantly change to reflect new public information. Public information includes; past prices, data reported in a company’s financial statement, earnings and dividend announcements.It also requires existence of analysts who are not only financial economists but also macroeconomists.
  3. Strong variant –claims that prices instantly reflect even hidden information. In this form nobody should be able to systematically generate profits even if trading of information is not publicly known at the time.

The most crucial implication of this hypothesis is that there is no room for fooling investors, thus all investments are fairly priced (on average, investors get exactly what they pay for)(Banz,1981).

  1. Rational Expectation Theory

This theory is based on the idea that people in the economy make choices based on their rational outlook, available information and past experience. It suggests that the current expectations in the economy are equivalent to what the future state of the economy will be. This theory assumes that outcomes that are being forecast do not differ systematically from the market results and also that people do not make systematic errors when predicting the future and deviations from perfect foresight are only random. This theory assumes that the actual price will only deviate from the expected if there is an information shock (caused by unforeseeable information at the time the expectations were formed. This hypothesis of rational expectations addresses critic by assuming individuals take all available information into account in forming expectations. At times the expectations may turn out incorrect, but it will not deviate systematically from the realized values. This theory has been used to support some strong conclusions about economic policymaking. The strongest version of this theory is where all profit opportunities have been exploited and all prices in financial market are correct and reflect market fundamentals.

 

REFERENCES

Ball, R. (1978). Anomalies in relationships between securities yield and yield-surrogates. Journal of Financial Economics.6 (2-3), page (103-126)

Banz, R. (1981). The relationship between return and market value of common stocks. Journal of Financial Economics.9 (1), page (3-18)

Cowles, A. (1993). Can stock market forecasters forecast? Econometrica.1 (3), page (309-324)

Fama, E. (1965). The behavior of stock market prices. Journal of Bussiness.38 (1), page (34-105)

Tobin.R (1967). Notes on optimal momentary growth. Journal of political Economy.3 (6), page (34-45).