RDP 9501: Modern Approaches to Asset Price Formation: A Survey of Recent Theoretical Literature 1. Introduction

Over the past half dozen years or so there has been renewed academic interest in how prices are determined in asset markets such as stock markets and foreign currency markets. In part, this renewed interest is due to some exceptional events in those markets in the past decade and, in part, it is due to the increased interaction between market participants and academic economists. As a consequence there has been considerable re-assessment and re-evaluation of the more traditional models of asset price determination, as well as a greater appreciation by academics of the role played by institutional features of real-world asset markets. Not surprisingly, this has led to the development of a number of new theoretical models which attempt to incorporate explicitly, in an internally consistent framework, some of these more conspicuous features of contemporary financial markets. In the process, academic economists have moved closer to the views of actual market practitioners as to the key factors underlying observed asset price movements.

The mainstream of the academic literature over most of the post-war^[1] period has stressed the ability of financial markets to keep asset prices moving in line with changes in their fundamental determinants. It has been unsympathetic to market and popular views that emphasised the role played by such factors as self-fulfilling expectations, mass psychology, herd behaviour and other seemingly irrational behaviour in influencing asset price movements.

The formal statement of the mainstream academic position was embodied in the Efficient Market Hypothesis (EMH)^[2], which postulates that all information relevant to determining the intrinsic value of an asset will, by virtue of the actions of rational, profit-maximising traders, be embodied in the actual market price. As a consequence, asset prices will fully reflect all relevant information, and will move only upon the receipt of new information. If asset markets do not act as efficient aggregators and processors of relevant information, the resulting disparity between market prices and intrinsic values would present traders with easily identifiable and riskless profit opportunities. In exploiting such opportunities (i.e. purchasing underpriced assets and selling overpriced ones), rational speculators would quickly drive asset prices back towards their intrinsic values, thereby having a stabilising influence on asset markets. Speculators who did not behave in this manner – that is, investors whose conduct may be characterised as irrational and destabilising – would make losses and be forced to exit the market.

While there are many other implications of the EMH, some of which would receive the support of market participants as well as academic economists, there are at least two aspects which have never been accepted by market participants:

• the implication that the price of an asset moves if and only if the market receives new information on the asset's underlying economic fundamentals; and
• that the actions of speculators must be stabilising, in that they move the price of an asset towards its intrinsic value rather than away from it.

Market participants have always been conscious of the importance of other influences on asset prices, but they have not been very rigorous in articulating their views. Proponents of the EMH concede the existence of these additional influences but have tended to regard them as of minor or passing importance. Sustained rises in prices, apparently inexplicable in terms of changes in market conditions, have been around since the times of Dutch “Tulipmania” of 1636 to 1637 and the South Sea and Mississippi bubbles of 1719 to 1720^[3], but they have never had much of an effect on academic views because they were difficult to formalise in an internally consistent theoretical framework.

This state of affairs has begun to change. Academic economists are increasingly recognising that there are several important features of trading in modern asset markets which can be quantified and formalised, and which are clearly contrary to the sort of behaviour implied by the EMH. For example:

• the widespread use of chartism and technical analysis assumes that publicly available information, such as past asset price movements, can be profitably exploited to predict future movements in an asset price. If the EMH fully explained behaviour in asset markets, chartism should die out, yet its importance seems to have increased in some markets.^[4]
• the extensive use of stop-loss orders, i.e. selling orders which are activated once the asset price has fallen by a certain pre-determined amount. This means that, rather than buying an asset as its price falls, investors trigger additional selling and so push the asset price down further. Past movements in price can therefore influence future asset price movements.
• the growth of dynamic hedging strategies such as portfolio insurance, which involve investors selling into a falling market and buying into a rising one.

Each of these practices or strategies involve basing investment decisions on past movements in price. Their presence is also consistent with the view that investors in asset markets can often behave in a destabilising manner.

The central issue is whether these “real world” characteristics of contemporary asset markets are important enough to have a significant effect on asset price behaviour, or whether they cause minor and temporary aberrations. If the latter, there would be little need to review economists' formal models of asset pricing. In recent years, however, several events suggested that destabilising behaviour in asset markets could have far reaching implications for asset prices and that a serious rethinking of asset price determination was in order:

• in the two years to early 1985, the US dollar appreciated by about 40 per cent, and then depreciated by about the same amount over the following two years. Examination of factors usually thought of as relevant to the determination of the exchange rate has not identified anything that could give rise to a movement of this magnitude.
• on 19 October 1987, US stock prices fell by 22 per cent on the one day. Again, no one can identify any important economic news at the time that could account for a fall of this size.
• the Japanese “Bubble Economy”, a term used to describe the Japanese economy in the second half 1980s when it was gripped by feverish asset speculation. Some commentators have begun to characterise this as the most extreme episode of financial mania witnessed this century.^[5]

These events brought home the fact that even in very deep and well-informed markets, it was possible to have large price movements, lasting for months or even years, that could not be explained in terms of the EMH framework. It also led to the re-interpretation of earlier events such as the bull market in US stocks that took the Dow to the 1,000 level in January 1966, where it languished for seventeen years before it decisively exceeded that barrier again in 1983. How could rational investors have pushed stock prices so high that, in aggregate, they would not exceed these values again for seventeen years, even though other relevant nominal variables such as output, producer prices, and profits continued to grow?^[6]

As stated earlier, the two most troubling characteristics of the EMH were the implication that future prices are not influenced by past movements in the asset price, and that speculation can have only a stabilising influence upon asset markets. While these two characteristics are interrelated, they can be thought of separately for expository purposes.

On the first point, it is clear that past prices do influence the behaviour of investors and traders. As well as the mechanical influences listed above such as chartism, stop-loss orders and portfolio insurance, there are more fundamental ones based on human behaviour. Typically, many investors do not enter a market as buyers until after they have heard of the fortunes being made there – that is, until after it has already risen. The influx of buyers into the Australian share market in the latter stages of the “minerals boom” of the late sixties is an example of this. Greed is not always the motivation; sometimes it is fear. Many people, who had been content to rent houses when house prices were relatively stable, fear that they might be permanently priced out of the market when house prices begin to rise sharply. They thus enter a rising housing market as buyers.

The concept of a market price that returns to its intrinsic (or underlying) value as the result of the activities of speculators (or arbitrageurs) also has its difficulties. The major one is that in some markets there is no satisfactory model of what the underlying price should be. In the bond market, models of the underlying price are fairly well defined and accepted, but there is a spectrum of other markets for which the models become less and less clear. The foreign exchange market is probably at the other extreme. Economists have not been able to explain variations in the exchange rate with any degree of precision. Neither can they forecast it a year ahead, even in the hypothetical case in which they use the actual values of the explanators.^[7] If the experts cannot tell what the equilibrium value should be, or even what variables should determine it, how are market participants able to move the price toward the equilibrium value? Also, how are economists to know, after the event, whether any movement initiated by speculators was in the direction of the intrinsic value, or away from it?

The purpose of this paper is to survey the rapidly burgeoning literature which attempts to come to grips with some of the phenomena outlined above. As would be expected, the main purpose of the literature has been to provide sound theoretical arguments as to why asset markets may display behaviour not in accordance with the central propositions of the EMH – specifically why they sometimes show departures from, what subsequently turn out to have been, their intrinsic values.

There are several appealing features of this new view of asset markets, apart from the fact that they permit the possibility that observed asset prices will not always be at their equilibrium. Some of these models incorporate the behaviour only of investors who behave rationally, while others incorporate different groups of investors some of which behave rationally and others in an irrational way. This degree of realism is clearly desirable, partly because this literature comes to the conclusion that “bubbles” are quite consistent with rational behaviour. A further important strand of this group of models concerns the way that information is processed and analysed in asset markets, including the information content of trading behaviour.

For purposes of this survey, the literature is classified into the following three strands:

1. rational speculative bubbles, which are dealt with in Section 2;
2. fads, irrational Bubbles, and noise traders, in Section 3; and
3. inefficiencies that are due to imperfect and heterogenous information, in Section 4.

Section 5 is the Conclusion.

Footnotes

Seminal contributions in establishing the predominant post-war view were Friedman (1953), Samuelson (1965) and Fama (1970). [1]

Fama (1970) is generally credited with introducing into general usage the term efficient capital markets. Fama's general definition of asset market efficiency was that the asset prices arising from such a market fully reflected all of the information in some relevant information set. He went on to distinguish three versions of the concept of market efficiency depending on the particular specification of the “information set”. These were (i) “weak-form efficiency”, (2) “semistrong-form efficiency” and (3) “strong-form efficiency” corresponding to information sets which contain respectively only (i) past prices and returns, (ii) all publicly available information, (iii) all information, both publicly available as well as “insider” or private information. [2]

For an excellent account and discussion of these and other major episodes of speculative manias and financial panics see Kindleberger (1989). [3]

Frankel and Froot (1990a) report on the type of models employed by foreign exchange forecasting services. In a survey conducted in 1978, only 2 out of the 23 used chartism and technical analysis, while in 1989, the proportion had increased to 18 out of 31. Allen and Taylor (1990) reports the results from a survey of London foreign exchange dealers conducted on behalf of the Bank of England; at least 90 per cent of the respondents attached some weight to chartist methods and technical analysis. [4]

See Wood (1992). [5]

See Kurz (1992). [6]

See Meese and Rogoff (1983) and Meese (1990). [7]