This is a petty essay on the puzzle of volume, disguised as comments on a newspaper past times Fernando Alvarez in addition to Andy Atkeson, presented at the Becker-Friedman Institute Conference inward Honor of Robert E. Lucas Jr. (The relaxation of the conference is actually interesting too, but I probable volition non receive got fourth dimension to weblog a summary.)
Like many others, I receive got been real influenced past times Bob, in addition to I owe him a lot personally as well. Bob pretty much handed me the basic thought for a "Random walk inward GNP" on a Ag platter. Bob's review of a written report to the OECD, which he mightiness rather forget, inspired the Grumpy Economist many years later. Bob is a straight-arrow icon for how academics should bear themselves.
On Volume: (also pdf here)
Volume in addition to Information. Comments on “Random Risk Aversion in addition to Liquidity: a Model of Asset Pricing in addition to Trade Volumes” past times Fernando Alvarez in addition to Andy Atkeson
John H. Cochrane
Oct vii 2016
This is a swell economic science newspaper inward the Bob Lucas tradition: Preferences, technology, equilibrium, predictions, facts, welfare calculations, total stop.
However, it’s non however a swell finance paper. It’s missing the motivation, vision, methodological speculation, calls for time to come enquiry — inward short, all the BS — that Bob tells yous to leave of absence out. I’ll follow my comparative advantage, then, to aid to create total this yawning gap.
Volume is The Great Unsolved Problem of Financial Economics. In our canonical models — such as Bob’s classic consumption-based model — trading book is essentially zero.
The argue is beautifully laid out inward Nancy Stokey in addition to Paul Milgrom’s no-trade theorem, which I telephone phone the Groucho Marx theorem: don’t belong to whatever lodge that volition receive got yous as a member. If someone offers to sell yous something, he knows something yous don’t.
More deeply, all trading — whatever divergence of portfolios from the value-weighted marketplace position index — is null sum. Informed traders exercise non brand coin from us passive investors, they brand coin from other traders.
It is non a puzzle that informed traders merchandise in addition to brand money. The deep puzzle is why the uninformed trade, when they could exercise amend past times indexing.
Here’s how markets “should” work: You think the novel iPhone is great. You seek to purchase Apple stock, but yous run inward to a wall of indexers. “How most $100?” “Sorry, nosotros entirely purchase in addition to sell the whole index.” “Well, how most $120?” “Are yous deaf?” You travel along trying until yous bid the cost upwards to the efficient-market value, but no shares merchandise hands.
As Andy Abel seat it, fiscal markets should operate similar the marketplace position for senior economists: Bids fly, prices change, nobody moves.
And, soon, seeing the futility of the whole business, nobody serves on committees whatever more. Why seat fourth dimension in addition to endeavour into finding information if yous can’t turn a profit from it? If information is expensive to obtain, in addition to then nobody bothers, in addition to markets cannot travel efficient. (This is the Grossman-Stiglitz theorem on the impossibility of efficient markets.)
I get together quantum mechanics is off past times 10 to the 120th ability inward the majority of empty space, which determines the fate of the universe. Volume is a puzzle of the same order, in addition to importance, at to the lowest degree inside our petty universe.
Stock exchanges be to back upwards information trading. The theory of finance predicts that stock exchanges, the primal establishment it studies, the primal origin of our data, should non exist. The tiny amounts of trading yous tin generate for life wheel or other reasons could all easily survive handled at a bank. All of the smart students I sent to Wall Street for twenty years went to participate inward something that my theory said should non exist.
And it’s an of import puzzle. For a long time, I think, finance got past times on the presumption that we’ll acquire the cost by in addition to large correct with the zero-volume theory, in addition to yous microstructure guys tin receive got the final 10 ground points. More recent empirical operate makes that jurist look quite wrong. It turns out to survive truthful that prices rising when a lot of people house purchase orders, despite the fact that at that topographic point is a seller for each buyer. There is a potent correlation betwixt the degree of prices in addition to trading book — cost booms involve huge turnover, busts are quiet.
At a deeper level, if nosotros demand trading to brand prices efficient, but nosotros receive got no thought how that procedure works, nosotros are inward danger that prices are quite far from efficient. Perhaps at that topographic point is also petty trading volume, as the rewards for earthworks upwards information are non high enough! (Ken French’s AFA presidential speech communication artfully asks this question.)
Our policy makers, as good as far also many economists, boundary from non agreement something, to that something must survive wrong, irrational, exploitative, or reflective of “greed” in addition to needs to survive stopped. Influenza A virus subtype H5N1 large transactions taxation could good survive imposed soon. Half of Washington in addition to most of Harvard believes at that topographic point is “too much” finance, pregnant trading, non compliance staff, in addition to needs policy interventions to cutting trading down. The SEC in addition to CFTC already regulate trading inward swell detail, in addition to post people to jail for helping to comprise information inward to prices inward ways they disapprove of. Without a skillful model of information trading those judgments are guesses, but every bit difficult to refute.
How exercise nosotros leave of absence of this conundrum? Well, so far, past times a sequence of ugly patches.
Grossman in addition to Stiglitz added “noise traders.” Why they merchandise rather than index is but exterior the model.
Another strand, for event Viral Acharya in addition to Lasse Pedersen’s liquidity based property pricing model, uses life wheel motives, what yous hither would recognize as an overlapping generations model. They imagine that people operate a week, retire for a week, in addition to snuff it without descendants. Well, that gets them to trade. But people are non fruit flies either.
Fernando in addition to Andy adopt some other mutual fob — unobservable preference shocks. If merchandise fundamentally comes from preferences rather than information in addition to then nosotros avoid the puzzle of who signs upwards to lose money.
I don’t think it does a lot of skillful to telephone phone them shocks to run a peril aversion, in addition to necktie them to habit formation, as enamored as I am of that formulation inward other contexts. Habit formation induces changes inward run a peril aversion from changes inward consumption. That makes run a peril aversion shocks observable, in addition to hence contractable, which would undo trading.
More deeply, to explicate book inward private securities, yous demand a daze that makes yous to a greater extent than run a peril averse to Apple in addition to less run a peril averse to Google. It tin survive done, but it is less attractive in addition to pretty unopen to preferences for shares themselves.
Finally, trading is huge, in addition to hugely concentrated. Renaissance seems to receive got a preference daze every 10 milliseconds. I final rebalanced inward 1994.
The key outset regulation of modern finance, going dorsum to Markowitz, is that preferences attach to coin — to the payoffs of portfolios — non to the securities that brand upwards portfolios. Influenza A virus subtype H5N1 handbasket of stocks is non a handbasket of fruits. It’s non the outset fourth dimension that researchers receive got crossed this brilliant line. Fama in addition to French exercise it. But if it is a necessary status to generate volume, it’s awfully unpalatable. Do nosotros actually demand to throw out this most basic insight of modern finance?
Another strain of literature supposes people receive got “dogmatic priors” or endure from “overconfidence.” (José Scheinkman in addition to Wei Xiong receive got a real overnice newspaper along these lines, echoing Harrison in addition to Kerps much earlier.) Perhaps. I enquire practitioners why they merchandise in addition to they state “I’m smarter than the average.” Exactly one-half are mistaken.
At 1 degree this is a plausible path. It takes but a petty overconfidence inward one’s ain signal to undo the no-trade-theorem information story — to innovate a petty doubtfulness into the “if he’s offering to sell me something he knows something I don’t” recursion.
On the other hand, agreement that other people are but similar us, in addition to so inferring motives behind actions, is real deep inward psychology in addition to rationality as well. Even chimps, offered to merchandise a banana for an apple, volition banking corporation check to brand certain the banana isn’t rotten.
(Disclaimer: I made the banana story up. I retrieve seeing a scientific discipline demo on PBS most how chimps in addition to other mammals that travel past times the dot examine receive got a theory of mind, empathize that others are similar them in addition to so inquiry motives. But I don’t receive got the reference handy. Update: Influenza A virus subtype H5N1 friend sends this in addition to this.)
More deeply, if yous are forced to trade, a petty overconfidence volition acquire it going. But why merchandise at all? Why non index in addition to brand certain you’re non 1 of the losers? Inferring information from other’s offering to merchandise is entirely one-half of the no-trade theorem. The fact that rational people don’t travel inward a zero-sum casino inward the outset house is the other, much to a greater extent than robust, half. That trace of thought equates trading with gambling — also a puzzle — or other fundamentally irrational behavior.
But are nosotros actually satisfied to nation that the existence of exchanges, in addition to the fact that information percolates into prices via a serial of trades, are facts entirely “explainable" past times human folly, that would survive absent inward a to a greater extent than perfect (or perfectly-run) world?
Moreover, that “people are idiots” (what Owen Lamont in 1 lawsuit humorously called a “technical term of behavioral finance”) mightiness survive a trenchant observation on the human condition. But, past times beingness capable of “explaining” everything, it is non a theory of anything, as Bob Lucas uses the give-and-take “theory.”
The sheer book of trading is the puzzle. All these non-information mechanisms — life-cycle, preference shocks, rebalancing alongside heterogeneous agents (Andy Lo in addition to Jiang Wang), preference shifts, generate trading volume. But they exercise non generate the astronomical magnitude in addition to concentration of book that nosotros see.
We know what this huge book of trading is about. It’s most information, non preference shocks. Information seems to demand trades to percolate into prices. We but don’t empathize why.
Does this matter? How realistic exercise micro foundations receive got to survive anyway? Actually, for Andy in addition to Fernando’s top dog purpose, in addition to that of the whole literature I but seemed to brand fun of, I don’t think it’s much of a employment at all.
Grossman in addition to Stiglitz, in addition to their followers, desire to study information traders, liquidity providers, bid-ask spreads, in addition to other microstructure issues. Noise traders, “overconfidence,” curt life spans, or preference shocks but acquire around the technicalities of the no-trade theorem to focus on the of import purpose of the model, in addition to the phenomena inward the information it wants to match. Andy in addition to Fernando desire a model that generates the correlations betwixt run a peril premiums in addition to volume. For that purpose, the ultimate origin of book in addition to why some people don’t index is likely unimportant.
We exercise this all the time. Bob’s swell 1972 newspaper seat people on islands in addition to coin inward their hands via overlapping generations. People alive inward suburbs in addition to lead maintain coin as a transactions inventory. OLG models missy velocity past times a constituent of 100 too. (OLG coin in addition to life-cycle book models are closely related.) So what? Economic models are quantitative parables. You acquire nowhere if yous fuss also much most micro foundations of peripheral parts. More precisely, nosotros receive got sense in addition to intuition that roughly the same results come upwards from dissimilar peripheral micro foundations.
If I were trying to come upwards up with a model of trading tomorrow, for event to address the correlation of prices with book (my “Money as stock” left that hanging, in addition to I’ve ever wanted to come upwards dorsum to it), that’s what I’d exercise too.
At least, for positive purposes. We also receive got sense that models with dissimilar micro foundations tin arrive at much the same positive predictions, but receive got wildly dissimilar welfare implications in addition to policy conclusions. So I would survive much to a greater extent than wary of policy conclusions from a model inward which trading has zippo to exercise with information. So, though I honey this paper’s response (transactions taxes are highly damaging), in addition to I tend to similar models that arrive at this result, that is no to a greater extent than honest than most transactions taxation thought, which is also an response eternally inward search of a question.
At this point, I should summarize the actual contributions of the paper. It’s actually a swell newspaper most run a peril sharing inward incomplete markets, in addition to less most volume. Though the micro foundations are a fleck artificial, it real nicely gets at why book factors look to generate run a peril premiums. For that purpose, I agree, but why people merchandise so much is likely irrelevant. But, having blabbed so much most large picture, I’ll receive got to cutting curt the substance.
How volition nosotros actually solve the book puzzle, in addition to related but what “liquidity” means? How does information brand its way into markets via trading? With many PhD students inward the audience, permit me emphasize how deep in addition to of import this inquiry is, in addition to offering some wild speculations.
As inward all science, novel observations cause novel theory. We’re learning a lot most how information gets incorporated inward prices via trading. For example, Brian Weller in addition to Shrihari Santosh demo how pieces of information terminate upwards inward prices through a string of intermediaries, but as vegetables brand their way from farmer to your tabular array — in addition to with but as much objection from bien-pensant economists who receive got decried “profiteers” in addition to “middlemen” for centuries.
Also, at that topographic point is a lot of trading after a discrete slice of information hits the marketplace position symmetrically, such as a alter inward Federal Funds rate. Apparently it takes trading for people to figure out what the information means. I honour this observation especially interesting. It’s non but my signal in addition to your signal.
And novel theory demands novel technique too, something that nosotros learned from Bob. (Bob in 1 lawsuit confessed that learning the math behind dynamic programming had been actually hard.)
What is this “information” anyway? Models specify a “signal” most liquidating dividends. But 99% of “information” trading is non most that at all. If yous enquire a high speed trader most signals most liquidating dividends, they volition give yous a blank stare. 99% of what they exercise is exactly inferring information from prices — non but the degree of the cost but its history, the history of quotes, volumes, in addition to other data. This is the machinery nosotros demand to understand.
Behind the no-trade theorem lies a classic persuasion of information — at that topographic point are 52 cards inward the deck, yous receive got 3 upwards in addition to 2 down, I infer probabilities, in addition to so forth. Omega, F, P. But when nosotros think most information trading inward property markets, nosotros don’t fifty-fifty know what the carte deck is. Perhaps the ambiguity or robust command ideas Lars Hansen in addition to Tom Sargent describe, or the descriptions of conclusion making nether information overload that calculator scientists study volition lead maintain the key. For a puzzle this big, in addition to this intractable, I think nosotros volition terminate upwards needing novel models of information itself. And then, hopefully, nosotros volition non receive got to throw out rationality, the implication that trading is all due to human folly, or the basic principles of finance such as preferences for coin non securities.
Well, I think I’ve striking four of the half dozen Bob Lucas deadly sins — large pic motivation, comments most around whole classes of theories, methodological musings, in addition to wild speculation most time to come research. I’ll leave of absence the final 2 — speculations most policy in addition to politics, in addition to the story of how 1 thought most the newspaper — for Andy in addition to Fernando!
