Friday, November 12, 2004

When a crisis really is a crisis

In a paper to be presented at the upcoming American Finance Association Meetings, Pasquariello asks the interesting question "
Are Financial Crises Indeed 'Crises?'

The question is interesting for several reasons and on multiple levels.

For starters, if it is a crisis and has economic repercussions, then we may want to invest more to prevent the crisis in the first place. On the other hand, if the currency crisis is a media induced frenzy with no lasting consequences, then we can learn to live with the so-called crisis.

From a different perspective (and this is really the main point of this paper), how the market handles and reacts to the "said-crisis" is interesting and yields insights into investors' thought processes, how the markets work, and the limits of market efficiency. In the author's own words:
"The word 'crisis' is instead suggestive of market breakdowns or failures, seemingly irrational behavior of investors and speculators, or inefficient allocation of resources and risks, hence, in short, of the occurrence of unusual,possibly irrational phenomena."

Conclusion? Pasquariello finds that they so called crises really are crises. As evidence he shows that the law of one price in the ADR market was violated much more frequently around these crisis periods.

Longer version:

With a great sense of timing, in this week's Tuesday Morning QB (easily my favorite read of the week! If you like football, you owe it to yourself to read it!) Gregg Easterbrook of the Brookings Institute suggests a general "word inflation:"

"Contemporary editorialists and politicians never speak of a "problem," they speak of a "crisis;" nowadays you hear the phrase "serious crisis" invoked because "crisis" is so overused the word has been hollow. Critics don't call movies or music "good" or "bad," everything is either "brilliant" or "terrible.""
So given that introduction by Easterbrook, it only makes sense to investigate whether economic crisis really are crisis. Pasquariello does this investigation by examining the trading of ADRs (American Depository Receipts).

The law of one price (that is that same assets must sell for the same price or else there is an arbitrage opportunity) dictates that the same shares must sell for the same price. If they do not sell for the same price, then there is a temporary "money machine: that arbitrager can make money by pushing the prices back to equilibrium.

The author finds that this law of one price generally holds in the ADR market (which is good for market efficiency adherents), but that this relationship tends to break down when the market (and investors) are stressed by the currency crisis.

Pasquariello also studies the relationship of ADR returns and global sources of risk. Here he finds: "evidence that, during recent episodes of financial turmoil (Mexico (1994), East Asia (1997), Russia (1998), Brazil (1999), and Argentina(2002)), those normal market conditions were in fact violated."
"Based on this evidence, we conclude that, during the various episodes of financial turmoil that took place over the last decade, the market for emerging ADRs was, on average, less efficient, more segmented, and relatively more sensitive to domestic sources of risk than during more tranquil times."

Or to translate 'academic speak' into the the vernacular: the market went 'wacky' during these times of turmoil. Which is another small knowck on teh perfection that some believe the market possesses.

Interesting piece!

The paper is also available through SSRN.

Suggested Citation
Pasquariello, Paolo, "Are Financial Crises Indeed 'Crises?' Evidence from the Emerging ADR Market" (March 1, 2004). EFA 2004 Maastricht Meetings Paper No. 2715.

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