The issue of informational efficiency in the evolution of asset prices is examined using data on equity markets in Jordan, Turkey, and Pakistan. These three markets are of interest because, for the sample periods analyzed, they represent a market that remained relatively open and where, in particular, no special regulations affected investment by nonresidents (Jordan during 1986-92); a market that underwent substantial liberalization, including the withdrawal of restrictions on foreign investors trading in listed equities (Turkey during 1988-93); and a market where restrictive financial market regulations remained in place, with foreign investors prohibited from trading in equities (Pakistan during 1986-91).
The analysis is carried out in two steps. First, the key determinants of agents’ dynamic consumption and investment decisions (the coefficient of relative risk aversion and subjective discount rate) are estimated for each country. The values of these parameters, along with data on market fundamentals (current and future levels of aggregate private consumption and the stream of current and future dividends), are then used to construct an implied equity market price. This price is based, at any time t, on the assumption that consumers know the future time path of consumption, dividends, and the terminal price of the equities. Next, this implied price is compared with the actual evolution of equity market prices for each country to assess the informational efficiency of these markets by checking for the presence of excess volatility.
A key finding is that while the informational efficiency of each of the three markets is deficient, the causes of the inefficiency vary. While it appears that a large negative shock to economic activity in the late 1980s caused Jordanians to discount market fundamentals, in Turkey and Pakistan the illiquidity of equity markets influenced the determination of actual equity market prices. This result highlights the important role that financial market liberalization, and particularly the opening up of previously autarkic equity markets to foreign investors, can play in improving the efficiency with which equity markets mobilize resources for growth-enhancing investment.