ressource: "the history of economic thoughts"

Discussion in 'Economics' started by harrytrader, Dec 16, 2003.


    Exerpt on EMH (Efficient Market Hypothesis)
    Finance theory

    [...] A particularly disturbing finding was that it seemed that prices tended to follow a random walk. More specifically, as documented already by Louis Bachelier (1900) (for commodity prices) and later confirmed in further studies by Holbrook Working (1934) (for a variety of price series), Alfred Cowles (1933, 1937) (for American stock prices) and Maurice G. Kendall (1953) (for British stock and commodity prices), it seemed as there was no correlation between successive price changes on asset markets.

    The Working-Cowles-Kendall empirical findings were greeted with horror and disbelief by economists. If prices are determined by the "forces of supply and demand", then price changes should move in particular direction towards market clearing and not randomly. Not everyone was displeased with these results, however. Many viewed them as proof that the "fundamentalist" theory was incorrect, i.e. that financial markets really were wild casinos and that finance was thus not a legitimate object of economic concern. Yet others crowed that it proved the failure of traditional "statistical" methods to illuminate much of anything. High-powered time series methods were used by Clive Granger and Oskar Morgenstern (1963) and Eugene F. Fama (1965, 1970), but they came up with the same randomness result.

    The great breakthrough was due to Paul A. Samuelson (1965) and Benoit Mandelbrot (1966). Far from proving that financial markets did not work according to the laws of economics, Samuelson interpreted the Working-Cowles-Kendall findings as saying that they worked all too well! The basic notion was simple: if price changes were not random (and thus forecastable), then any profit-hungry arbitrageur can easily make appropriate purchases and sales of assets to exploit this. Samuelson and Mandelbrot thus posited the celebrated "Efficient Market Hypothesis" (EMH): namely, if markets are working properly, then all public (and, in some versions, private) information regarding an asset will be channelled immediately into its price. (note that the term "efficient", as it is used here, merely means that agents are making full use of the information available to them; it says nothing about other types of "economic efficiency", e.g. efficiency in the allocation of resources in production, etc.). If price changes seem random and thus unforecastable it is because investors are doing their jobs: all arbitrage opportunities have already been exploited to the extent to which they can be.

    The "Efficient Markets Hypothesis" was made famous by Eugene Fama (1970) and later connected to the rational expectations hypothesis of New Classical macroeconomics. It did not please many practioners. "Technical" traders or "chartists" who believed they could forecast asset prices by examining the patterns of price movements were confounded: the EMH told them that they could not "beat the market" because any available information would already be incorporated in the price. It also had the potential to annoy some fundamentalist practioners: the idea of efficient markets rests on "information" and "beliefs", and thus does not, at least in principle, rule out the possibility of speculative bubbles based on rumor, wrong information and the "madness of crowds".

    More disturbingly, the EMH has not pleased economists. EMH is probably one of the more resiliant empirical propositions around (albeit, see Robert Shiller's (1981) critique), yet it does not seem to have a clearly sound theoretical standing. It all seems to collapse on one particular objection: namely, that if all information is already contained in prices and investors are fully rational, then not only can one not profit from using one's information, indeed, there might not be any trade at all! These peculiar, contradictory implications of rational expectations were demonstrated by Sanford J. Grossman and Joseph E. Stiglitz (1980) and Paul Milgrom and Nancy Stokey (1982). Intuitively, the objection can be put this way (and here we are oversimplifying a bit). The efficient markets hypothesis effectively implies that there is "no free lunch", i.e. there are no $100 bills lying on the pavement because, if there were, someone would have picked them up already. Consequently, there is no point in looking down at the pavement (especially if there is a cost to looking down). But if everyone reasons this way, no one looks down at the pavement, then any $100 bills that might be lying there will not be picked up by anyone. But then there are $100 bills lying on the pavement and one should look down. But then if everyone realizes that, they will look down and pick up the $100 bills, and thus we return to the first stage and argue that there are not any $100 bills (and therefore no point in looking down, etc.) This circularity of reasoning is what makes the theoretical foundations of the efficient markets hypothesis somewhat shaky.
  2. I didn't realize that Mandelbrot was a pioneer of EMH.
  3. Well it's from American Economic Association which is rather affiliated with the dominant Chicago Business School (Fama and other Quants) and so EMH propagandists :D.

    Nevertheless Mandelbrott point of view is not anti-EMH it's "only" anti RMH (Random Market Hypothesis) that's the very reason they now say that RMH implies EMH but that EMH doesn't imply RMH which is statistically true: as I said in the other thread

    "The problem is worsened if market doesn't follow a random walk because the jumps are rare events and that rare event are even more unpredictable stochastically. Random walk is the first kind of risk which is assimilated to usual noise, the jumps are a second kind of risk some calls uncertainty that is "more unpredictable" than the usual noise. "

    Mandelbrott's theory is about the occurence of rare events, in stochastic modelling rare events are even more unpredictable than random event : Mandelbrott cannot make prediction about these events he only says that it is fat tailed so that traditional portfolio theory and hedging are flawed today. So Mandelbrott dismiss Markowizt - I remind that Markowizt received not so far ago the Nobel prize for his portfolio theory - whereas he cannot dismiss EMH since EMH means unpredictability and that at the moment Mandelbrott worsen this predictability and so reinforce EMH.

    It is true that with time they have "cheated" by changing the definition of EMH. Before EMH originally comes from economic equilibrium theory and optimal ressources allocation whereas EMH means today unpredictability of second degree which is the opposite of optimal ressources allocation since when things are so unpredictable optimal ressources allocation notably in economy are just impossible that is to say market is the source in fact of inefficiencies not only for the portfolio managers who use Markowiz theory based on equilibrium theory but also for the economy since economy is also based on this equilibrium theory.

  4. jem


    thank you harry.
  5. great site
  6. 12-16-03 04:47 PM harrytrader wrote:

    I can see where there are technical (random processes)
    definitions consistent with EMH, but what is the technical
    definition of "Random Market Hypothesis" in the literature?
    A search did not come up with anything.
  7. Perhaps here :

    Random Walk Hypothesis
    "A random walk is one in which future steps or directions cannot be predicted on the basis of past actions."
    Malkiel "One of the earliest and most enduring models of the behavior of security prices is the random walk hypothesis, an idea that was conceived in the 16th century as a model of games of chance."
    COOTNER, Paul H. (Edited by), The Random Character of Stock Market Prices, 1964.
    "But with the benefit of hindsight and the theoretical insights of LeRoy (1973) and Lucas (1973), it is now clear that efficient markets and the random walk hypothesis are two distinct ideas, neither one necessary nor sufficient for the other. The reason for this distinction comes from one of the central ideas of modern financial economics mentioned above: the necessity of some trade-off between risk and expected return. If a security's expected price change is positive, it may br just the reward needed to attract investors to hold the asset and bear the corresponding risks. Indeed, if an investor is sufficiently risk averse, he or she might gladly pay to avoid holding a security which has unforecastable returns. In such a world, prices do not need to be perfectly random, even if markets are operating efficiently and rationally."
    COOTNER, Paul H. (Edited by), The Random Character of Stock Market Prices, page ix, 1964.

    The EMH and the RWH are two distinct ideas, neither one necessary nor sufficient for the other, due to the necessity of some trade off between risk and expected return, see LeRoy (1973) and Lucas (1978).
  8. Yeah there are very interesting articles.

  9. Trajan


    So, what does this have to the Carlyle Group?

    Just kidding, nice article. Reading up on time series and the work of Granger is on my to do list for the holidays. I won't be taking the time series class until next spring(05), but I'll need to kind of know it before then.
  10. Don't worry about Carlyle and others: they belong to my rotating portfolio of subjects. I will switch to these commodities sooner or later :D

    #10     Dec 18, 2003