July 22, 2003

Notes: Steve Ross: Finance a Theory of Sharks, Not of Rational Portfolio Allocation

Steve Ross:

Neoclassical finance is a theory of sharks and not a theory of rational homo economicus, and that is the principal distinction between finance and traditional economics. In most economic models aggregate demand depends on average demand and for that reason, traditional economic theories require the average individual to be rational. In liquid securities markets, though, profit opportunities bring about infinite discrepancies between demand and supply. Well financed arbitrageurs spot these opportunities, pile on, and by their actions they close aberrant price differentials.

Of course, this leaves such things as the determination of the low-risk real interest rate and the risk premium flapping wildly in the breeze...

Posted by DeLong at July 22, 2003 07:30 PM | TrackBack

Comments

“Well financed arbitrageurs spot these opportunities, pile on, and by their actions they close aberrant price differentials.” Then why did we have a stock market bubble? How was it that 3COM spun off Palm with a 5% float, and yet the capitalization of Palm exceeded that of 3COM? This aberrant price differential persisted for quite some time. One problem is going short is much more difficult and risky than going long. In the case of Palm, you couldn’t borrow the shares with 3COM holding 95% of the stock, so short sellers couldn’t correct the price. I don’t think you could buy or sell a LEAP on Palm. For this and other reasons, the stock market seems to have an irrational upward bias. I don’t think efficient market theory is any longer sustainable. Better pick up that $20 bill.

Posted by: A. Zarkov on July 22, 2003 11:45 PM

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(some) financial markets may also be beyond belief riddled with inefficiencies due to asymmetric information and moral hazard. Been there and saw all that.

Posted by: econBras on July 23, 2003 07:10 AM

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Yes, the emphasis on Arbitrage to the exclusion of considerations of demand/supply leaves issues of the risk-free rate and the risk premium flapping in the wind.

More damaging, in my opinion, is the often under-appreciated reliance of the Arbitrage logic on expectations. After all, it is one thing to argue that Gold cannot simultaneously sell at two different prices. But it is quite another thing to invoke the Arbitrage logic when most intertemporal arbitrage opportunities can be defined only relative to a model of possible future prices (and "expectations," in the latter sense).

This naturally leads to homogeneity and aggregation issues. Why would the homogeneity of those "at the margin" - the well-financed arbitrageurs - be any any less of a concern, qualitatively, than is the case when one deals with the entire population and Aggregate Demand (or "average demand")?

Thus, the demand and supply of options, and the like, are in theory no different from "Aggregate Demand" in their susceptibility to notions of "rationality," shifts in beliefs, and potentially everything else that plagues the divide between theory in traditional economics and reality.

Surely, the story of Long Term Capital is a testament to the hubris of the logic of Arbitrage in the above sense.

Posted by: Guest on July 23, 2003 11:13 AM

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In the late '60's, I met Edward M. Miller, an incredibly creative and unconventional economist at Abt Associates. Every sentence he wrote had a sold idea behind it. At the time, Miller was interested in the economics of natural resources.

Years later, after having taught himself finance, he wrote "Risk, Uncertainty, and Divergence of Opinion" in the September 1977 Journal of Finance. There, he suggested that restrictions on short-selling would lead to non-efficient securities prices. Miller's paper is consistent with A. Zarkov's comments above.

Posted by: Richard H on July 23, 2003 02:07 PM

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Zarkov, a small point that does not necessarily apply in this case but a company could quite easily be worth less than one of its holdings. The obvious way is if the company has debts but equally if the rest of the company is loss making.

My own favorite example of the markets apparently failing ot arbitrage a price comes from when HSBC had two listings, one in London and one in Hong Kong. The shares where identical in every respect except for the location of the listing -- voting rights, dividends etc, and eventually they merged yet their prices could diverge by more than 8 per cent.

However the defence is the Churchill, it is better than all the other theories and the more it is believed, the more likely it is to be true, it is not a victim of Goodhart's law. I'm not sure that it doesn't determine the low risk nominal interest rate, at least at the long end of the yield curve, but there is no reason why the risk premium should not be left flapping in the wind is there? Politically correct respect for religion aside I mean. It is unmeasurable, unpredictable and not even necessarily well formulated or unique. Mostly it is a convenient way for market commentators to describe market psychology but quantitatively you might as well use personal preference. Anyway, when would you use it without some arbitrage consideration being involved, perhaps implicitly?

Posted by: Jack Evans on July 23, 2003 05:20 PM

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I'd note that this view of finance is actually contradictory; these hypothesised "well-financed arbitrageurs" are meant to be large enough to drive the price down to its equilibrium level, but small enough that they do so *immediately* (rather than waiting for prices to get further out of line and make a bigger profit). So they're price-makers with respect to the market as a whole, but operate in a perfectly competitive market as price-takers with respect to a subset of the market.

Posted by: dsquared on July 23, 2003 11:12 PM

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Brad quotes Ross: Neoclassical finance is a theory of sharks and not a theory of rational homo economicus, and that is the principal distinction between finance and traditional economics. In most economic models aggregate demand depends on average demand and for that reason, traditional economic theories require the average individual to be rational.

Is what Ross says true? I don't know what the whole class of "traditional economic theories" econmpasses, but I would have thought it a fair generalisation that average demand depends upon aggregate demand, the opposite of what Ross says, and that aggregate demand is determined by actors at the margin, and hence that one only need suppose rational marginal actors.

This, I take it, is what a theory of shark would be. But isn't all sensible economics about sharks, or at least about the leading sharks on both sides of every margin?

Surely the belief that economic theory depends upon everybody, or even "the average" being rational is simply incorrect?

What am I missing?

Posted by: David Lloyd-Jones on July 28, 2003 12:21 PM

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Traditional finance paradigm seeks to understand financial markets using models in wich agents are rational. But some financial phenomena can be better explained using models were agents are not rational.
Well most poreminent traders and/or trend followers know markets are irrational. Just look at their expetionnal returns : it's an empirical evidence.

Posted by: FRANZ on January 12, 2004 04:22 AM

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