When I
attended graduate school at MIT in the late 1970s, the perfect market paradigm
was fast emerging as a framework to analyze the financial markets. It had
already revolutionized the study of economics, and for academics the perfect
market paradigm promised, for the first time, to provide a rigorous
mathematical approach to understanding and interpreting the financial markets.
I became enthralled with this promise after taking a course from Bob Merton,
one of those rare men who is both a brilliant researcher and a great teacher. I
had embarked on my graduate work with the intention of changing the
underdeveloped world through developmental economics, but ultimately the
elegance of financial economics was more alluring. My dissertation....
IMPERFECTIONS IN THE PERFECT PARADIGM
The perfect market
paradigm assumes that markets are efficient—that is, that all information is
imbedded in the market price. In an efficient market, no trader can make money
trading on news; by the time a trader gets the news all the other market
participants will have the news as well, and the price will have adjusted to
the correct level given that information before any trade can be made.
Take
a trip to a Wall Street trading floor and it is easy to see how one might end
up making the efficient market assumption. Traders are news junkies. The
typical trading floor is peppered with screens showing CNN and CNBC; electronic
tickers streaming around the room; a half-dozen or so screens surrounding every
trader, flashing red or green for each downtick and uptick; and other news
screens displaying only a headline for breaking stories and slightly more
information for stories that are a few minutes old. There is a phone bank with
direct lines to the brokerage houses; no waiting even for a speed dial—a press
of the button and the market maker is on the other end of the line.
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