Personal website of R.Kannan

Personal Website of R.Kannan
Students Corner - Project on Indian
Financial Market

Project on Indian Financial Market - Module: 5
Financial Sector Effeciency
[Source: RBI Report on Currency and Finance 1999-2000 dated January 29, 2001]

Efficiency of Financial Markets in India

There is some evidence that on the stock market and the foreign exchange market in India are becoming informationally more efficient than before. The concept of market efficiency, however, has often been differently interpreted and alternative empirical tests have been applied to assess the efficiency of a market (Box VII.2).

Box VII.2
Market Efficiency

Three commonly discussed forms of market efficiency are found in the literature. Weak form efficient market hypothesis suggests that current price of any asset reflects all information embodied in the past history of the asset price itself. Semi-strong form efficient market hypothesis states that all publicly available information such as financial statements, strategy and past history, etc. is fully reflected in the current price of the asset. Strong form efficient market hypothesis advocates that all public and private information is fully reflected in the price and, therefore, even the agents with inside information cannot constantly beat the market. The underlying assumptions of efficient markets in fact make it difficult to test their empirical relevance. The assumptions include:

large number of rational, profit maximising investors who actively participate in the markets based on informed analysis and valuation,
flow of information is symmetric, random and unrelated over time, and
market agents react quickly and accurately to any new information, causing the prices to instantly reflect any new information.

Empirical tests of weak form efficiency are generally done through the autocorrelation and variance ratio tests. Non-parametric runs-tests are also used. Event studies help in empirical analyses of semi-strong form of efficiency. Comparative analyses of the performance of different class of market participants help in evaluating the relevance of strong form efficiency. The most common test of weak form efficiency is the random walk hypothesis which states that successive price or return changes are independent over time and that the actual price hovers around a fundamental value. Campbell, Lo and Mackinlay (1997) define three types of random walk (RW) models: RW1 assumes identically and independently distributed (i.i.d.) increments, RW2 assumes independently and not identically distributed increments (i.n.i.d.), and RW3 assumes uncorrelated increments. Given that emerging market returns on assets generally exhibit non-normality and heterosecdasticity, RW3 tests using autocorrelation and variance ratio tests are commonly applied. RW1 also assumes that the increments are uncorrelated but such increments need not be independent because squared increments may be correlated. In practice, market efficiency test is essentially a test of a joint hypothesis. According to Fama (1965), market efficiency and asset pricing represent an inseparable joint hypothesis and, therefore, any inefficiency observed on the basis of empirical tests may actually be the result of wrong models used for pricing of assets and determination of returns. For example, besides the widely known Capital Asset Pricing Model (CAPM), P/E ratio, market capitalisation, book to market, small versus large, credit ratings etc. have been used to explain equity returns. However, if stock returns can be predicted on the basis of these factors, then the market cannot be characterised as informationally efficient.

Efficiency of the foreign exchange markets is contingent upon forward premia serving as an unbiased predictor of future spot rate changes. Excess returns prevail if that is not the case. The existence of excess returns in the foreign exchange markets has been one of the most intractable puzzles in the international finance literature. With the exchange rate getting primarily getting determined in the market, the issue of foreign exchange market efficiency has assumed importance for India in recent years. The trading in the forward segment has picked up since 1994 making the alignment of the term structure of forward premia an important issue.

Evidence for recent years suggests that unlike in the case of the most developed countries, informational efficiency is not observed in the Indian foreign exchange markets. However, there is some evidence of such efficiency at the short-end of the market. Joshi and Saggar (1998) using monthly data, covering both pre and post-liberalisation period, note that Indian forex markets are not efficient, that forward premia are persistent and that volatility of expected depreciation is larger than implied excess returns.

Standard random walk based tests of efficiency indicate that the Indian equity market may not be efficient. The stock returns series is non-stationary and exhibits persistence. However, there is growing evidence that the Indian stock market is showing improvement in efficiency. The stock market has become more liquid. With the establishment of National Stock Exchange (NSE) and various other reform measures, the institutional mechanism has undergone significant changes to minimise the possibility of manipulations. With the emergence of portfolio management activities by banks, mutual funds and other non-bank financial institutions, the information content of these securities has improved. With electronic order matching, the transaction cost in stock exchanges has come down considerably.

The foreign exchange market has also become relatively more efficient. Efficiency tests using daily spot and forward exchange rates for the recent period indicate that at the short end of the market, particularly for one month, the Indian forex market exhibits parametric efficiency. Improvements in informational efficiency of the markets may, however, be constrained by the presence of noise traders in both the stock and the forex markets (Box VII.3).

Box VII.3
Noise Trader Risk and Professional Arbitrage

One of the reasons why financial markets may not be efficient is the presence of noise traders. The case for efficient market hypothesis (EMH) exists on three suppositions. First, financial market participants are assumed to be rational in setting their price expectations. However, it is not generally realised that the EMH does not depend on this supposition for its survival. Realistically, not all agents in any financial markets can be expected to be rational. Second, to the extent some investors do not behave rationally, their trades cancel each other out. Third, irrational trades do not off-set each other, but the asset prices still get efficiently determined as the impact of these irrational trades are wiped out by gains by the professional arbitrageurs. Arbitrageurs by making simultaneous purchase and sale of the same, or similar, security in two different markets to book profits from the price differential in the two markets play a vital role in ensuring market efficiency. For instance, by buying underpriced security and selling short another similar security they are able to hedge risks, in the process correcting the underpricing in a fairly short-run.

Arbitrage is a common practice in financial markets and yet, empirical support for EMH is limited. As Black (1986) points out, a large segment of traders are unsophisticated and trade on noise rather than information on fundamentals. These noise traders sell winning stocks or hold losing stocks and fail to diversify risks because they react to irrelevant information. Odean (1998) examines the proven irrationality of investors not to sell stocks at losses, specially after slump. However, otherwise, short of correct information on fundamentals, noise traders do not choose to adopt passive trading opportunities. They may take trading positions that are very different from those that may be rationally set under the Neuman-Morgenstern framework (Kahneman and Riepe, 1998). They may systematically take positions that are inexplicable in terms of Bayesian probability theory. They may not fully factor in all information based on past prices and returns and instead take a short history in setting their trade quotes. The short history may have a high element of chance and may not fit the true model for the financial markets. It is because of this short-history that investors hold more bonds and less of equities in several countries (Benartzi and Thaler, 1995). This could be a possible explanation for Mehra-Prescott equity premium puzzle.

Psychological factors reflected in investor sentiments and heuristic beliefs are important elements in noise trading, specially so in stock and forex markets. Biases, rumours, following the errors in beliefs that some time take the shape of herd mentality are more common in the market place than what the pure theorists accept. It is only recently that economists as part of behavioural finance are studying these aspects. While at least some arbitrageurs can be expected to be rational, their impact in financial markets can be constrained by limited and risky arbitrage opportunities in the absence of sufficiently good substitute securities. Also, when investor sentiments rule the roost, professional arbitrageurs' ability to lean against them becomes limited. In several such cases, the rational arbitrager chooses to trail the noise traders. He finds arbitrage risky on account of uncertainty attached to investor sentiments that makes future prices unpredictable. Agency costs involved in arbitrage further reduce arbitragers' abilities to lean against the market trend. Incentive contracts for fund managers typically penalises losses with a rather limited profit sharing, except that in cases of hedge funds.

The operational efficiency of a financial system hinges critically on minimising transaction costs through the institution of a well-functioning payment system. The Reserve Bank has, in recent years, initiated payment system reforms. It has facilitated orderly development of modern payment and settlement systems, focusing on commercially important centres which account for 65 per cent of the banking business in terms of value. The Reserve Bank's initiatives place emphasis on three broad inter-related heads, viz., (i) development of an institutional framework to oversee payment system, (ii) operationalisation of information technology applications, thereby improving functionality of financial system, and (iii) institution of satellite-based and terrestrial-based communications infrastructure and providing for adequate bandwidth.

The Reserve Bank constituted a Payment System Group (PSG) in 1998 dedicated to various aspects of the payment system to oversee the institution of appropriate information technologies that draw on cross-country experiences and are consistent with our objectives of financial policies. The National Payments Council - NPC (Chairman: Shri S.P. Talwar) was also constituted as the apex body to co-ordinate reforms in payment and settlement in May 1999, along with five permanent task forces. These are-

monetary policy and related issues,
oversight of payment and settlement systems,
legal issues,
technology related issues and
issues relating to systems and procedures, supervises policy initiatives and guidelines for strengthening the payment and settlement system, including a time bound implementation of the Real Time Gross Settlement (RTGS) system. The Reserve Bank's Committee on Technology Upgradation in the Banking Sector (Chairman: Dr. A.Vasudevan) has laid out an agenda for future reforms in the technological environment for banking in India. Among others, the Indian Financial Network (INFINET) User Group acts as a bridge of understanding between the Reserve Bank and commercial banks.

The sharp increase in paper-based financial transactions is evident from the fact that the cheque clearance as a proportion to GDP is estimated to have reached over 403 per cent in 1999-2000 as against 350 per cent in 1998-99. This is partly reflective of Magnetic Ink Character Recognition (MICR) cheque clearing process, introduced in the 'mid-eighties and operating in 12 cities in 1999-2000. Other initiatives include introduction of electronic funds transfers through the inter-city RBI Electronic Fund Transfer (EFT) scheme (extended to 29 scheduled commercial banks, including the 27 public sector banks in 1999-2000, with monthly transactions amounting to Rs.5 lakh in 1998-99) and the intra-city Electronic Clearing Service (ECS) (extended to 8.4 lakh transactions valued at Rs.301.87 crore for debits in 1999-2000). In addition, initiatives such as inter-bank electronic payments system, clearing bank for extension of Delivery versus Payment (DvP) mode of trading in government securities, spread of automated teller machines by almost all major banks and putting in place shared payments network system termed as SWADHAN in Mumbai have also been undertaken. The Reserve Bank has also taken initiatives to introduce smart card technology.

The Reserve Bank introduced the INFINET in June 1999, jointly with public sector banks and the Institute for Development and Research in Banking Technology (IDRBT) at Hyderabad. It is a wide area based satellite communication and terrestrial lines network using VSAT technology, and is a critical precursor to an efficient telecommunication backbone for the banking and financial sector. The INFINET connectivity would be extended from the present 439 VSATs to 5,000 VSATs in the long-run, with augmented transponder capacity. As the INFINET depends critically on the messaging systems in place, the Reserve Bank set up a Working Group on Design of Message Formats, which submitted its report in October 1999, on issues relating to designing message formats relating to government transactions, currency chest transactions and open market operations. The state-of-the-art year 2000 compliant IBM S/390 mainframe systems with imaging capability (or faculty) were operationalised at the National Clearing Cells in four metropolitan cities in July-October 1999 to replace the existing MICR cheque processing system. In non-MICR centres, magnetic media based clearing was introduced during 1999-2000.

The payment system reforms crucially hinge on the institution of a full-fledged RTGS, in line with international best practices (Table 7.6). Apart from providing a real time fund settlement system domestically and internationally, the RTGS provides an effective risk control strategy for preempting domino effects of individual defaults. The Working Group on Operational and Technology Issues constituted by the Indian Banks Association in 1998 made several recommendations in this regard. The requisite infrastructure, in terms of the communication backbone, is being put in place along with the development of the Payment System Generic Architecture Model for both domestic and cross-border payments. Pending the institution of a full-fledged RTGS system, the Reserve Bank is implementing a Centralised Funds Management System (CFMS), as an intermediate service facility, which would be implemented in phases to provide back-office support and funds transfer. As part of this strategy, the centralised funds inquiry system would now enable consolidation of banks' current accounts across all branches of the Reserve Bank.

With the smooth transition to Y2K dateline, the stage has been set for reinforcing efforts to integrate the financial markets and improve the systemic stability and efficiency. The approach should continue to be to avoid disruptions that may occur from any big-bang strategy. What is needed, however, is to implement the conceived changes in the financial system and to put in place supportive measures to enforce transition of the financial system along competitive and efficient lines.

With the on-going efforts to revitalise the payment system and structure it along modern lines (with the system being largely run through electronic media), it would be possible to make more rapid strides towards connecting various financial market segments. This would help promote informational efficiency in financial markets, align prices and return on various financial assets on an efficient basis, reduce risks and prevent fraudulent practices and help improve financial integration. The RTGS could facilitate further financial innovation as new cash management products could emerge. Since RTGS transactions would be collateralised, repo activity could widen in terms of number of players as well as the term structure itself, helping emergence of benchmark term rates in the process. The payment system cannot be looked at in isolation, but needs to be developed in tandem with development of other segments of the financial markets.

Public ownership of banks, while contributing to systemic stability, has thrown a challenge to the integrity of the organisational structure in the banking system to improve the competitive provision of financial services. The changes brought about in the banking structure since 1992-93, when the Reserve Bank granted 'in-principle' approval for the establishment of new banks in the private sector, have helped to restructure the industry on more competitive lines Provision for private shareholding in public sector banks, blurring up of distinctions among providers of various financial services and increasing integration of various market segments have generated greater competition. However, there is a scope to improve the markets further, especially the debt and the forex markets, so that the financial entities are able to manage their risks more effectively.

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