3 ms·

Aren't markets expected to figure out the true price of things and do other similar stuff? And doesn't that imply that the state of the market should always be

by danbruc 12y ago

Aren't markets expected to figure out the true price of things and do other similar stuff? And doesn't that imply that the state of the market should always be close to the global optimum and market force should drive it even further into this direction? Sounds very much like a stable system to me, so how can it run away unless the current state is just a local optimum and a correction to the global optimum - or a better local optimum - happens?

evanpw 12y ago
The vast majority of the time, this is true. Notice that after the Flash Crash, most prices came back to basically where they started within a few minutes. At the micro level, the problem is uncertainty. The "true" or "fair" price of a security isn't something you can just calculate: it's uncertain and subject to change when new information is introduced into the system. So theoretically, when the price gets very far from the fair value, market makers should become more and more eager to trade, since they'll make a large profit when the price comes back. But in practice, they never know whether the person on the other side of the trade is just panic-selling and moving the price farther from equilibrium, or if they know something the market maker doesn't and are moving the price closer to a new equilibrium. As the price gets farther from its previous stable value, the probability that the counterparty is informed grows, and eventually no market maker is willing to trade and the market dissolves. This failure mode is related to the "Market for Lemons" problem: asymmetric information causing a market breakdown (http://en.wikipedia.org/wiki/The_Market_for_Lemons http://en.wikipedia.org/wiki/The_Market_for_Lemons).
bandrami 12y ago
And doesn't that imply that the state of the market should always be close to the global optimum God no. How many stocks even pay dividends any more? The ones that don't are, strictly, "worthless", so their global optimum price should be zero (I'm simplifying; if they come with voting rights then there's a non-zero value to that, but you get the point). It's a bunch of baseball cards at a swap meet. The disconnect here is that there are agent effects. People make money selling and buying them, so they are incented to push the idea that selling and buying them is a good thing.

by danbruc 12y ago

evanpw 12y ago

The vast majority of the time, this is true. Notice that after the Flash Crash, most prices came back to basically where they started within a few minutes. At the micro level, the problem is uncertainty. The "true" or "fair" price of a security isn't something you can just calculate: it's uncertain and subject to change when new information is introduced into the system. So theoretically, when the price gets very far from the fair value, market makers should become more and more eager to trade, since they'll make a large profit when the price comes back. But in practice, they never know whether the person on the other side of the trade is just panic-selling and moving the price farther from equilibrium, or if they know something the market maker doesn't and are moving the price closer to a new equilibrium. As the price gets farther from its previous stable value, the probability that the counterparty is informed grows, and eventually no market maker is willing to trade and the market dissolves. This failure mode is related to the "Market for Lemons" problem: asymmetric information causing a market breakdown (http://en.wikipedia.org/wiki/The_Market_for_Lemons http://en.wikipedia.org/wiki/The_Market_for_Lemons).

bandrami 12y ago

And doesn't that imply that the state of the market should always be close to the global optimum God no. How many stocks even pay dividends any more? The ones that don't are, strictly, "worthless", so their global optimum price should be zero (I'm simplifying; if they come with voting rights then there's a non-zero value to that, but you get the point). It's a bunch of baseball cards at a swap meet. The disconnect here is that there are agent effects. People make money selling and buying them, so they are incented to push the idea that selling and buying them is a good thing.