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Discourses on financial markets:
Mainstream models, Chaos, Panic
and Mania
Markets, Cycles and Risk
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Models of market analysis,
risk and forecasting
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The Fundamentalists
The Chartists
The Efficient Market modelers
The Chaos theorists
The Historians
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The fundamentalists
• Oldest way to handle “risk” and understand
how markets operate
• If a stock is rising or falling seek the cause in
a study of the company or the economy
behind it.
• Postulate: the price of a stock , bond,
derivative or currency moves because of
some endogenous (or most of the time
exogenous) event.
• Implicit assumption: if one knows the cause,
one can forecast and manage risk
Problems with the models of
the fundamentalists
– In reality causes are often obscure and not
predictable
– Information can be concealed or misrapresented
(internet bubble, Enron, Parmalat)
– The market mechanisms that links news to price
(cause to effect) is often inconsistent (threat of war
=> some times dollar rises or some time dollar
falls. Ex post link is clear, but ex ante there are
arguments for both ways)
– Investment strategy based on fundamental is
grounded on dubious principle “I know more than
everybody else”.
Enter the Chartists
• Second oldest form of analysis, also called
“technical”. Back in favour in the 1990s and
thriving in currency markets
• Chartists are technicians who look for trend
indicators in graphical charts, usually
depicting price as a function of time, but often
including information on intraday highs & lows
as well as closing price.
• A chartist typically will want to buy into an
uptrend, sell into a downtrend and stay out of
the market for a sideways trend ("momentum
investing").
Problems with the chartists
• Thay are all doing it
• Everybody knows that
everybody else know
about this or that
technical aspect of the
chart (“support points”,
“trading range” etc.)
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• Hence bets are placed accordingly
• Financial astrology is not a basis for understanding
financial markets
Enter the efficient market
modellers
• What business schools call “modern finance”.
• It emerged from maths of chance and stats
• Basic concept:
– Prices are not predictable,HOWEVER
– their fluctuations can be described by the
mathematical laws of ch,ance
– HENCE: their risk is measurable, and
manageable.
Some names
• Harry Markowitz
– the prospect of every stock depends on two number, the reward
(mean) and risk (variance of what you expect the stock will pay)
• William F. Sharpe and Capital Asset Pricing
Model
– Look at relation between individual stock and market.
– Constructs portfolios based on stock’s β (‘beta’), the amount by
which the stock reacts to the market
– It says that the more you risk, the more you expect to be paid
– It says that the most important risk investor face is the general state
of the economy reflected in how markets are doing.
Problems with EMM: shaky
assumptions 1 . . .
• People are rational and aim only to get rich
– People are not always rational and self-interested
• All investors are alike
– Investors but stock sfor different reasons and different length of
time
• Price change is practically continuous
– Price changes are not smooth, but they do jump.
This not only for chaotic rationales (see later) but
also because 80% of quotes end in 0 or a 5,
skipping intermediate digits.
. . . Shaky assumptions 2
• Price changes follow a Brownian motion
– Browniam motion is a term describing the motion
of molecule in a uniformly warm medium and
believed by EMM to apply to price changes.
Based on:
– Independence (price changes last year or
yesterday do not influence today’s price change)
=> wrong
– Statistical stationarity (the process generating
price changes stays the same over time) => wrong
– Normal distribution (price changes follow the
proportions of the bell curve) => wrong
Which chart is real?
Plotting changes in stock prices
• Real
• EMH generated
• Real
• Fractal Model
– (Mandelbrot)
If it is wrong, why it is used?
• “it is the benchmark to which everyone in the
market refers, much the way, say, people talk
abut the temperature in winter even though
whether they actually feel cold also depend
on the wind, the snow, the clouds, their
clothing, and their health. Citigroup’s options
analysts have their Black-Scholes formula in
front of them all the time, in spreadsheets”
(Mandelbrot 2005: 81)
Turbulant Markets
• Turbulence prima facie: erratic peaks and
troughs which tend to cluster together (as in
wind turbulence)
• The study of this turbulence => fractal
geometry, a new branch of mathematics
widely applied to a number of fields
http://classes.yale.edu/fractals/Panorama/wel
come.html)
• This may describe patterns (without
predicting), but cannot provide explanation.
Manias and Panic: Hyman
Minsky model