Jun 2 2 1982

Where Standard Theory of Efficiency Falls Short of Reality: Three International Capital Markets by Adam Lerrick // B. Economics, Princeton University (1977) SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENTS OF THE DEGREE OF DOCTOR OF PHILOSOPHY IN ECONOMICS at the MASSACHUSETTS INSTITUTE OF TECHNOLOGY April 1982 O Adam Lerrick 1982 The author hereby grants to M.I.T. permission to reproduce and to distribute copies of this thesis document in whole or Ln part. Signature of Author Department of Economics April 30, 1982 Certified by ranco Modigl ian i Thesis Supervisor Accepted by Richard S. Eckaus Chairman, Departmental Graduate Committee Archlve" MASSACHUSETTS INSTiTUTE OF TECHNOLOGY JUN 2 2 1982 LIBRARIES WHERE STANDARD THEORY OF EFFICIENCY FALLS SHORT OF REALITY: THREE INTERNATIONAL CAPITAL MARKETS by ADAM LERRICK Submitted to the Department of Economics on April 30, 1982 in partial fulfillment of the requirements for the Degree of Doctor of Philosophy in Economics ABSTRACT international capital markets, by virtue of the size and sophistication of participants and the magnitude of the funds at stake, might be expected to realize the efficient markets, rational expectations theory of economic activity. Yet imperfections not only exist but are found to persist in such markets, offering a profitable income stream to the knowledgeable. Three such capital markets, all of recent origin and rapid growth, were examined; disequilibrium and its causes were identified and a model developed which outperformed market capabilities. Simple ignorance, together with the monopoly power of lenders, as the sole source of funds on a large scale, was responsible for the disbalance in the Eurocredit Market. The divergence of goals between managers and owners accounted for unexploited arbitrage opportunities in the Eurobond/Yankee Bond Market. An influx and outflow of unitiated investors created incorrect pricing of individual options and a speculative bubble on the aggregate level in the Select Sales Market for Thoroughbred Yearlings which typifies a new kind of financial asset. However, signs of change which heralded future optimal ity were also observed. Rather than the instantaneous adjustment, predicated by theorists, a time lag of years rather than months, and decades rather than years, proved to be a real world phenomenon. Thesis Supervisor: Dr. Franco Modigliani Title: Professor of Finance and Economics More than three wise men assisted at the birth of this work. There was the astute critique of Franco Modigliani, made doubly memorable by the views at Martha's Vineyard, the happy circumstance of a visiting year for Robert Shiller, and the early encouragement and final review of Stanley Fischer. There was the generous giving of the fruits of experience in the marketplace, of personal time and private data, by John H. Gutfreund, Managing Partner of Salomon Brothers Inc, Humphrey S. Finney, the patriarch of the thorougbred auction ring, and his son John Finney, both of Fasig-Tipton and Co., Dr. Arthur Davidson, veterinarian, and John Clark who has schooled so many skil led horsemen at "Clark College". Much more has been learned than can be encompassed in these brief pages. CONTENTS I. INTRODUCTION .............................. 5 II. THE SYNDICATED EUROCREDIT MARKET: FAULTY FORECASTS AND EXCESS PROFITS.............. 8 III. THE EURODOLLAR AND YANKEE BOND MARKETS: UNEXPLOITED ARBITRAGE OPPORTUNITIES............. 104 IV. THE MARKET FOR THOROUGHBRED HORSES: A SPECULATIVE RACE........... .................... 127 In a discipline whose primal assumption is the inevitable and instantaneous trend toward perfection, even a transient inefficiency affronts. The imperfection that endures, or persists, if only in the medium term, is suspect. Financial markets provide an intriguing terrain for a challenge to this efficient markets, rational expectations approach to economic activity. The speed of information flows, the centralization of the marketplace, the number of people employed and, most importantly, the size of the pecuniary sums involved, would seem to demand an equilibrium virtually indistinguishable from one where price is fully revealing. Yet, economists who have developed this theoretical background and come to its logical conclusion of quasi-efficiency often ignore the impact of certain phenomena of the asset markets which may cause empirical results to fall short of the dictates of theory. Delays in information diffusion, investor ignorance and inertia, a divergence of goals between principals and agents, geographical boundaries, and lack of arm's length transactions, are all real world features which have been set aside as minor in influence. 6. Actual participants in the financial markets are surprised and somewhat bemused by this stance. True, there may be markets, the most highly developed and liquid such as that of U.S. Treasury Bills, which provide evidence of efficiency, but these are the least profitable to participants and employ a relatively small number of people. As a partner in one of the major Wall Street firms quipped, "... if it were not for all these 'minor influences', we would probably be jobless and certainly not as rich as we are". In this thesis, three as yet unexplored capital markets have been sought out for analysis in an attempt to gauge the significance of these peripheral factors in the functioning of asset marketplaces. Each fulfilled the major theoretical preconditions for efficiency and yet provided empirical evidence against such optimality. Each market had an understandable justifying cause for the persistent disequilibrium, but persistent the disequilibrium had been! Youth was a quality common to all three markets. They were new in terms of the calendar or new in their present form. Recent growth at an exponential rate was another common denominator, as was the backdrop for this development -- a time of high and violently fluctuating costs of money. Ignorance, the inevitable outcome of rapid change, abounded; its partner, excess profits, was annexed by the skilled few. For each one of the triad, evidence of inefficiency was clear and 7. the source identified. For each, the opportunity to develop a profitable income stream appeared. For each, a model was derived from readily available information which was found to predict far in excess of market capabilities. But, also for each, a small trend emerged as a harbinger of change. Excess profits began to decline; industry practices began to alter; even within a mania, aggregates began to track a rational, though divergent path. However, the transition time was far longer than most proponents of the perfect market believe possible. Years instead of months, decades rather than years, delimit the evolutionary cycle. In this era of information which is international in scope and instantaneous in electronic processing, it might be expected that this time lag between the young, imperfect marketplace and its mature counterpart wil I grow ever shorter. THE SYNDICATED EUROCREDIT MARKET: FAULTY FORECASTS AND EXCESS PROFITS CONTENTS Introduction. ....... ...................... 10 I. What Are the Maturity Premia of the Market?..... .... 22 11. A Model of Expectations Formation........................... 28 Ill. Does Market Accuracy Change as the Time Horizon Increases?. 40 IV. General Versus Relative Error as the Time Horizon Increases. 43 V. Has Market Accuracy Improved Over Time?..................... 51 VI. General Versus Relative Error Over Time.................... 54 VII. Is the Market Operating at Optimum?............. ........... 56 VIII. Toward Optimal Maturity Differentials.......... .......... 89 IX. Monopoly Power or Market Ignorance?.............. ........... 92 What is now the world's principal source of external finance is a market virtually unknown to the public, inaccessible to investors, and the private province of large universal banks. It is the Syndicated Eurocredit marketplace which plays the key role in the recycling of funds from oil-rich surplus countries to less-developed nations attempting to expand in an environment of world-wide recession and high energy costs, as well as to industrialized nations seeking to mitigate the decline in domestic economies. The rise to preeminence of the Eurocredit dates to the 1970's, a time when it mushroomed from U.S. $21 billions in 1973 to U.S. $ 74 billions by 1978, a compound annual rate of twenty-nine percent before leveling off at the decade's end. During the past eight years, it has provisioned U.S. $347 billions or sixty percent of all international borrowings from private sources. (See Table I.) The importance of the Eurocredit to developing economies cannot be overemphasized. Private financial markets, as a group, have played ov ever-increasing role in funding ldc's, with a contribution to 11. TABLE I THE DOMINANCE OF EUROCURRENCY CREDITS IN THE INTERNATIONAL CAPITAL MARKETS 1973-80 1973 192A 1975 1976i 1977 (U.S. $ MiIIions) Foreign Bonds 5,347 7,763 12,301 18,943 16,610 International Bonds 4,702 4,512 10,520 15,368 19,483 Eurocurrency Credits 20,801 28,508 20,554 28,703 34,185 Eurocurrency Credits 67% 70% 47% 46% 49% as % of Total International Borrow ings 192 1979. 1980 (U.S. $ Mi 1I ions) Foreign Bonds 21,542 19,965 15,753 International Bonds 15,940 17,799 22,506 Eurocurrency Credits 73,695 70,249 70,386 Eurocurrency Credits 66% 65% 65% as % of Total International Borrowings Source: Borrowing in International Capital Markets, 1973-80 IBRD. 12. col lective external public debt which rose from twenty-four

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