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20 - The Information Content of Prices

from PART VIII - MARKET DYNAMICS AT THE MESO-SCALE

Published online by Cambridge University Press:  26 February 2018

Jean-Philippe Bouchaud ,
Julius Bonart ,
Jonathan Donier  and
Martin Gould
Jean-Philippe Bouchaud
Affiliation:
Capital Fund Management, Paris
Julius Bonart
Affiliation:
University College London
Jonathan Donier
Affiliation:
Capital Fund Management
Martin Gould
Affiliation:
CFM - Imperial Institute of Quantitative Finance
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Summary

Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

(John Maynard Keynes)

After our deep-dive into the microstructural foundations of price dynamics, the time is ripe to return to one of the most important (and one of the most contentious!) questions in financial economics: what information is contained in prices and price moves? This question has surfaced in various shapes and forms throughout the book, and we feel that it is important to devote a full chapter to summarise and clarify the issues at stake. We briefly touched on some of these points in Section 2.3. Now that we have a better handle on how markets really work at the micro-scale, we return to address this topic in detail.

The Efficient-Market View

Traditionally, market prices are regarded to reflect the fundamental value (of a stock, currency, commodity, etc.), up to small and short-lived mispricings. In this way, a financial market is regarded as a measurement apparatus that aggregates all private estimates of an asset's true (but hidden) value and, after a quick and efficient digestion process, provides an output price. In this view, private estimates should only evolve because of the release of a new piece of information that objectively changes the value of the asset. Prices are then martingales because (by definition) new information cannot be anticipated or predicted. In this context, neither microstructural effects nor the process of trading itself can affect prices, except perhaps on very short time scales, due to discretisation effects like the tick size.

Major Puzzles

This Platonian view of markets is fraught with a wide range of difficulties that have been the subject of thousands of academic papers in the last 30 years (including those with renewed insights from the perspective of market microstructure). The most well known of these puzzles are:

  • • The excess-trading puzzle: If prices really reflect value and are unpredictable, why are there still so many people obstinately trying to eke out profits from trading? […]

    • Type
    Chapter
    Information
    Trades, Quotes and Prices
    Financial Markets Under the Microscope
     , pp. 366 - 380
    Publisher: Cambridge University Press
    Print publication year: 2018

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