Efficiency transmission: a crisis perspective
2017-02-28T03:46:27Z (GMT) by
The recent financial crisis has highlighted the role of a number of procyclical behaviours in amplifying financial system stress. The easing of credit terms during the period of low market volatility and high liquidity preceding the crisis contributed to the significant growth in leverage during this time. When market conditions reversed in 2007 credit was abruptly tightened, in some cases forcing highly leveraged market participants to liquidate their holdings, which further exacerbated existing market conditions. Within perfectly efficient markets, new information is impounded simultaneously into cash, futures and their associated derivative markets. However, institutional factors which incorporate transactional based impediments such as liquidity or transaction costs may in-turn influence the sequential relationship between information and efficiency. The use of terms such as ‘market success’ or ‘market failure’ implies the ability to correctly calibrate the criteria for these parameters. The whole exercise becomes meaningful, however, only on the presupposition that one can isolate those elements which contribute to a fully functioning market. In more specific terms, market success is defined as the attainment of efficiency in the allocation of valued and limited resources. If attainable, the interpretive value from price information enhances regulators ability to accurately adjust policy. Take for example the use of breakeven inflation as a determinant of inflation expectations. The measure forms a critical role in forecasting the domestic outlook for inflation via the Phillips curve and Mark-up models. Equity prices implicitly signal the cost at which limited funds are channeled to the most productive investment opportunities providing regulators with insight into capital investment. Dislocation in capital markets can be exacerbated by the regulatory response. The level of futures margins represents a liquidity cost to participants, particularly, when capital is already constrained. Equally, basis and the transmission between markets can be observed via replication of a debt instrument within equity markets. A consistent non-zero steady state provides information on the connectedness of these two markets under crisis conditions. The affects of crises are embedded in varying ways and transmitted accordingly across markets. The culmination of these examples provides an overview of the ability of markets to respond in crisis moments, and their subsequent affects upon dislocation. Broadly, results indicate that policy could be adjusted to enable flexibility in such times. Equally, the reliability of data throughout these periods should be viewed with caution, specifically when conducting long-run policy or asset allocation decisions.