Investment Decisions Under Uncertainty For Financial Markets Essay.

Financial Investment and uncertainty:

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Introduction Arestis et.al (2012)

The development of the financial sector ever since the financial liberalization process, which started in the early 1970s, and the great evolution of financial investment through this period suggest that serious consideration of this complex phenomenon is in order. The increasing importance of financial activities also exerts another effect on accumulation via uncertainty.

The development of financial activities, which has permitted the appearance of new activities and financial assets without a strong regulation of them has boosted speculation, thereby promoting the creation of financial bubbles. According to this view, an increase in uncertainty means that businessmen face difficulties in their attempt to foresee the future, which is less predictable now.

Our model also highlights a negative incidence of uncertainty on accumulation, since this phenomenon makes it more difficult for businessmen to foresee the future.

The financial liberalization process paved the way for the emergence of the financial sector which along with the progress of financial investment has brought this intricate issue to the forefront. Accumulation is also affected by the rapidity of financial activities via uncertainty. Financial bubbles originate from increasing speculation which is a result of the lack of regulation on financial activities and assets. Rising uncertainly implies the failure of corporate houses to anticipate the future. Our model emphasizes the adverse effect of uncertainty on accumulation.

Rigotti & Shannon (2005)

Knight (1921) argues that uncertainty, however, creates frictions that these institutions may not be able to accommodate. Ellsberg (1961) suggests a more precise definition of uncertainty, in which an event is uncertain or ambiguous if it has unknown probability. In particular, Ellsberg’s paradox illustrates important consequences of this distinction by showing that individuals may prefer gambles with precise probabilities to gambles with unknown odds.

According to Knight (1921), uncertainty gives way to conflicts that such corporations might fail to absorb. Uncertainty, according to Ellsberg (1961), is defined as an event which is associated with an unknown probability. Ellsberg’s paradox posits situations where gambles with given probabilities are preferred to gambles with unspecified odds.

(Davidson 1991)

According to the Keynesian literature, the investment decision has to be taken in a context characterized by the presence of uncertainty and the absence of perfect information. In this uncertain world, there is no room to apply probability as the ultimate way to predict the expected values of economic variables (Davidson 1991).

Keynesian literature suggests that investment decisions have to be made under uncertainty and lack of perfect information. Davidson (1991) claims that probability cannot be used as a fundamental instrument to forecast the expected values of economic variables.

Keynes, 1973

Keynes’ views about uncertainty have been explored at great length by Shackle, Vickers,

Davidson and others. For Keynes, the information needed to make an optimal investment

decision - the future net revenues that will be generated by each potential investment project - does not exist and therefore cannot be known at the moment of choice. It is not “out there” for agents to find. For Keynes, the future is created by current and future agent decisions that are inherently unpredictable: “About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know” (Keynes, 1937, p. 214). Nonetheless, firms and wealth holders must make investment and portfolio selection decisions; they cannot avoid the decision- making dilemma created by Keynesian uncertainty. “We do not know what the future holds. Nevertheless, as living and moving beings, we are forced to act” (Keynes, 1973, p. 124).

According to Keynes (1973), the complete set of information that an optimal investment decision requires – the potential return from each investment project - is not available and hence cannot be accounted for at the point of decision-making. He suggests that the future is an end result of the decisions taken by economic agents in the present and future which again cannot be foreseen. However, investment and portfolio decisions have to be made by corporations and investors who are subject to the dilemma that Keynesian uncertainty generates.

Keynes, 1973

Keynes, by way of contrast, outlined a solution to this problem: he adopted a theory of conventional decision making. Keynes theorized an expectations formation process based on custom, habit, tradition, rules of thumb, instinct, and other socially constituted practices.5 He argued that in “normal” times at least, agents base their forecasts on conventional assumptions such as: (1) the future will look like the relevant past extrapolated (“modified only to the extent that we have more or less definite reasons for expecting a change” [Keynes, 1936, p. 148]); and (2) while individual agents understand themselves to be inescapably ignorant of the future, the collective or average opinion or the “conventional wisdom” is seen as reasonably or even scientifically well informed.

As an alternative solution, Keynes (1973) opted for conventional decision-making. He suggested the generation of expectations according to the custom, tradition, habit, instinct, rules of thumb and other social phenomenon. According to Keynes, generally economic agents form anticipations in accordance with conventional assumptions: (1) the future is a reflection of an accurately deduced past, (2) Though individual agents may be unaware about the future, the mass collaboration is considerably well informed.

Hong Bo and Robert Lensink (2007)

the outcome of empirical study may be explained by the fact that, on the one hand, an increase in uncertainty increases the investment threshold, whereas, on the other hand, an increase in uncertainty increases the probability that the investment threshold will be hit.

A rising uncertainty pushes up the investment threshold as well as the probability that this threshold will be reached.

Lucas 1981, p. 224).

Lucas has argued that “in cases of uncertainty, economic reasoning will be of no value” (1981, p. 224).

Lucas (1981) asserts that economic logic will be non-functional under uncertainty.

Chuliá et.al 2013

The effects of uncertainty on equity prices and other financial variables have also been analyzed. In this stream, Bansal and Yaron (2004) provide a model in which markets dislike uncertainty and worse long-run growth prospects reduce equity prices. In the same line, Bekaert et al. (2009) find that uncertainty plays an important role in the term structure dynamics and that it is the main force behind the counter-cyclical volatility of asset returns.

According to Bansal and Yaron (2004), in which uncertainty reduces equity prices via effects on long-run growth. Bekaert et al. (2009) suggest that the counter-cyclical volatility of asset returns emerges from uncertainty.

Chuliá et.al 2013

Empirical studies have frequently relied on proxies of uncertainty, most of which have the advantage of being directly observable. Such proxies include stock returns or their implied/realized volatility (i.e., VIX or VXO), the cross-sectional dispersion of firms’ profits (Bloom, 2009), estimated time-varying productivity (Bloom et al., 2014), the cross-sectional dispersion of survey-based forecasts (Dick et al., 2013; Bachmann et al., 2013), credit spreads (Fendoǧlu, 2014), and the appearance of ‘uncertainty-related’ key words in the media (Baker et al., 2013). Although these uncertainty proxies have provided key insights to the comprehension of uncertainty, and have been reliable starting points for the analysis of the economic impacts of uncertainty on economic variables, most of them have come under criticism, most notably from Scotti (2013) and JLN. On the one hand, volatility measures blend uncertainty with other notions (such as risk and risk-aversion), owing to the fact that they do not usually take the forecastable component of the variation into account before calculating uncertainty.

Empirical studies have often been based on proxies of uncertainty such as stock returns or their implicit / acquired volatility, the cross-sectional dispersion of firms’ profits, estimated time-varying productivity, cross-sectional dispersion of survey-based forecasts, credit spreads and the display of ‘uncertainty-related’ key words in the media. These proxies have rendered considerable perceptions to the analysis of uncertainty and to the analysis of the effects of uncertainty on economic parameters. However, they have time and again been criticized. Since volatility measures do not account for the predictable component of variation before determining uncertainty, they can combine uncertainty with other issues such as risk and risk-aversion.

Crotty 1993

confidence in the meaningfulness of the forecasting process will shatter, and key behavioral equations may become extremely unstable. These are the points of crisis and panic that have pride of place in Keynesian, Minskian, and Marxian theories of investment instability, but are prohibited by assumption in neoclassical investment theory because they are incompatible with its Vision.

The validity of the anticipation process will fade out and the main behavioral equations may be subject to tremendous instability. These points are highlighted in the Keynesian, Minskian and Marxian theories of investment instability. However, in the neoclassical investment theory, these are rues out by assumption due to stark contradictions.

Mishkin 1997

A dramatic increase in uncertainty in financial markets, due perhaps to the failure of a prominent the financial sector, a recession, political instability, or a stock market crash, makes it harder for lenders to screen out good from bad credit risks. The increase in uncertainty, therefore, makes information in the financial markets even more asymmetric and may worsen the adverse selection problem. The resulting inability of lenders to solve the adverse selection problem renders them less willing to lend, leading to a decline in lending, investment, and aggregate activity.

Differentiating between good and bad credit risks has become difficult for lenders due to the growing prevalence of uncertainty in financial markets. The reasons behind this may be a recession, political instability or a collapse of the stock market. Thus, the asymmetry of information in the financial markets and the issue of adverse selection are further magnified. This naturally results in the reluctance of lenders to lend because of the difficulty of adverse selection which in turn reduces investment and aggregate economic activity.

Aistov and Kuzmicheva, 2012

Theoretical and empirical research singles out several mechanisms (channels) through which uncertainty affects investment. Nevertheless most studies specify the negative effect of uncertainty on investment.

The effects of uncertainty on investment have been segregated through theoretical and empirical research. As an inference, both suggest the negative influence of uncertainty on investment.

Financial Investment and Instability:

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The hypothesis of financial instability was developed by economist Hyman Minksy.  He argued that financial crisis are endemic in capitalism because periods of economic prosperity encouraged borrowers and lender to be be progressively reckless. This excess optimism creates financial bubbles and the later busts. Therefore, capitalism is prone to move from periods of financial stability to instability. This is a type of market failure and needs government regulation.

Economist Hyman Minsky developed the hypothesis of financial instability. He suggests that the incautiousness of the borrowers and lenders during phases of economic prosperity leads to incessant financial crisis. The optimistic expectations on the part of the agents generate financial bubbles and consequent bursts. Hence capitalism is subject to fluctuations from periods of stability to those of instability. This necessitates government intervention to prevent the market failure.

Minsky 1985

Indeed, he maintains that the capitalist system is flawed and prone to cyclical boom and bust. He believes modern complex financial markets to be responsible for their own crisis, by getting tangled up in risky credit structures. He states in his Financial Instability Hypothesis (FIH), that periods of stability make borrowers and lenders more and more reckless, which ultimately fuels asset bubbles. Minsky states that economy goes from hedge borrowing to speculative borrowing and eventually to Ponzi borrowing, when borrowers are most likely to default. Banks keep lending hoping that increased asset prices will enable repayment, but ponzi lending is not sustainable. People start selling their assets to keep up with other payments and this pushed assets prices down and causes crises. Later economist termed this as “Minsky moment”

He suggests that the deficiency of the capitalist system stems from the fact that it is subject to cyclical boom and bust. According to him, financial markets pave the way for their own crisis due to their involvement in risky credit frameworks. His Financial Instability Hypothesis proclaims that temporary phases of stability turn borrowers and lenders inattentive and this ultimately culminates in asset bubbles. According to Minsky, an economy shifts from hedge borrowing to speculative borrowing to Ponzi borrowing and borrowers tend to default in the last stage. Banks endlessly lend in anticipation of rising asset prices that will ease repayment of loans. However, this lending procedure is unsustainable. In order to meet repayment mandates, people end up selling their assets thus bringing down asset prices and setting off financial crises. This is popularly known as “Minsky movement”.

Minsky 1985

The financial instability hypothesis, therefore, is a theory of the impact of debt on system behavior and also incorporates the manner in which debt is validated.

The financial instability theory describes the effect of debt on system behavior and also reflects on the procedure of debt validation.

Wolfson (1986)

Wolfson (1986) not only presents a compilation of data on the emergence of financial relations conducive to financial instability, but also examines various financial crisis theories of business cycles.

Financial crisis theories have been studied by Wolfson (1986) in addition to collection of data relevant to financial instability.

Evans 2007

Evans, differently from mainstream macroeconomists, underlines the importance of money and financial markets in a capitalist economy. Firms invest in various type of assets (i.e., diversification) to reduce risk if one of the assets fail. Although financial system has diversified certain risks, it has the potential to cause instability for the system as a whole.

Money and financial markets play a crucial role in the capitalist economy according to Evans (2007). Firms diversify their investment portfolio to hedge risk. The financial system despite being vital to the diversification of risks is itself exposed to instability.

Evans 2007

Since the 1970s, the financial systems in the developed capitalist countries have all

experienced a major increase in size and complexity as a result of an extensive process of innovation, deregulation and internationalisation.

Although the financial system has succeeded in diversifying certain forms of risk, we believe that it has created new sources of potential instability that increase the risk of a major crisis for the system as a whole.

The financial liberalization has led to an expansion of the size and complications of the financial framework in the developed capitalist economies. This is an end result of widespread upheaval, deregulation and exposure to the global economic forum. On one hand, the financial system has eased the diversification of risks in certain forms. On the other hand, it has generated new sources of instability that magnifies the risk of a vital crisis for the entire economy.

Mishkin 1997

The causes of financial instability occurs when shocks to the financial system interfere with information flows so that the financial system can no longer do its job of channeling funds to investment opportunities. The asymmetric information analysis we have used to understand the structure of the financial system suggests that there are four categories of factors that lead to financial instability: increases in interest rates, increases in uncertainty, asset market effects on balance sheets, and problems in the banking sector.

Financial instability stems out of intervention from shocks into the financial system which deviate the channel of funds from investment opportunities. Asymmetric information analysis provides four main causes of financial instability: increases in interest rates, increases in uncertainty, asset market effects on balance sheets and problems in the banking sector.

Financial Investment and global crisis:  

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Evan 2007

While the financial system plays a major role in promoting investment and growth in a capitalist economy, it can also lead to major disruption. In the nineteenth and early twentieth

century, as first Britain and then the US and other European countries industrialised and built

up their financial systems, major financial crises occurred about once a decade, culminating in the great crash of 1929.

Financial system in addition to stimulating growth and investment might also rapidly distort a capitalist economy. Extensive financial crises that collectively led to the great crash of 1929 were actually consequences of the developing financial systems in the industrialized Britain, US and other European countries in the nineteenth and early twentieth centuries.

Crises stem, in part, from the nature of credit. A credit involves a promise to pay, but if companies are unable sell all their output, despite the best of intentions, they might be unable to meet a promise to pay. Because banks are engaged in extensive networks of borrowing and

lending, both amongst themselves and with firms and households, the impact of a default can be transmitted rapidly throughout the financial system. This danger is exacerbated by a widely

noted tendency for banks to over-lend during periods of rapid business expansion, sometimes prompting a sharp contraction of lending – a ‘credit crunch’ – when they find themselves overstretched, or when they fear that the expansion is about to end, something that can then set off the downturn they feared.

Such instability can be reinforced by the behaviour of financial markets. The price of financial assets is strongly influenced by expectations: if the price of an asset is expected to rise, then the demand for it will increase and its price will tend to rise. In the course of a business expansion, a rise in asset prices can set off a speculative bubble, and, as a bubble takes hold,

investors might borrow in order to take advantage of the rising price of shares, or of property or raw materials. But when a bubble bursts, this prompts widespread sales as investors seek to avoid a further loss, thereby exacerbating the fall in asset prices. Investors who borrowed money might now find themselves unable to repay their loans, thereby putting pressure on the banks.

The credit market gives way to financial crises. Companies might unwillingly fail to meet their credit terms if they cannot sell their entire produce. Substantial borrowing and lending operations executed by banks amongst themselves and with households have exposed the entire financial system to any default on the part of the bank. Banks tend to worsen this situation by over-lending in the massive business expansion phases. When they become too overstretched or anticipate the end of the business expansion, they assert credit-crunch or shrinking lending. Financial markets further fortify such instability. Expectations largely determine the price of financial assets – when individuals expect the price of an asset to rise in the near future, their demand for that asset also rises thereby actually pushing up the price of the underlying asset. During the period of business expansion, rising assert prices are likely to commence a speculative bubble. As the bubble comes to the forefront, investors tend to borrow such that they can benefit from the increasing share prices, property prices and resource prices. When the bubble bursts, investors in an attempt to secure themselves against further losses, sell off the assets thereby setting a decreasing trend in asset prices. As a consequence of this, they may not be able to repay their loans to the banks thereby subjecting the latter to financial pressures.

Evan 2007

The period of greater financial liberalisation which began in the 1970s has also been associated with a notable increase in financial instability.

The major central banks are, however, by no means sanguine about the future, and they have begun to hold internationally-coordinated exercises in which they rehearse their responses to a

major financial breakdown. The pressure to achieve higher returns has led banks and other financial institutions to adopt much riskier investment positions, fuelled by the massive

growth of the derivatives market, and driven by the highly leveraged activities of hedge funds and private equity funds. Although the risk of a major crisis might still be relatively low, if a

financial breakdown were to spin out of control, it would have a devastating economic and social impact.

Financial liberalization beginning in the 1970s was accompanied by financial instability.

Uncertainty about the future has led the major central banks to acquire internationally-coordinated exercises in which they prepare beforehand for any drastic financial collapse. Banks and other financial institutions have subject themselves to highly risky investment positions in anticipation of higher returns. The main driver behind this is the tremendous development of the derivatives market coupled with highly leveraged activities of hedge funds and private equity funds. A financial collapse will adversely affect the socio-economic scenario. However, the probability of the occurrence of one is comparatively low.

Barnes, P. (2010)

The financial consequences of the 2007-9 financial crisis were similar to those in 1866 and 1987 in other ways. With the loss of confidence in investments and their difficulty in continuing to provide high returns, investment schemes were put under pressure. Not surprisingly, there were many failures in investment banking as a result of their dependence on profits from the boom and Ponzi schemes were discovered and collapsed.

The financial crisis of 2007-09 resulted in the reduction of conviction on investments and high return prospects due to which investment schemes were subject to pressure. Investment banking failed because of their reliance on the boom for profit. Ponzi schemes subsided on discovery.