Dr. P.V. Viswanath

pviswanath@pace.edu

Recurring Themes in Finance

• Equilibrium
• Economic Agents react to external events
• Economic Agents react to each other
• Institutions Matter

Equilibrium

When looking at the effect of an action/intervention/event on prices or quantities, it is important to keep in mind that free markets tend to equilibrium, i.e. that the price tends to gravitate to that level where demand equals supply.

Economic Agents react to external events

Producers and consumers adjust to the action/intervention – hence the effect of an act could be quite different from that intended.  Thus, when the government requires everybody to wear a seat belt, drivers might take additional risks that they would not have taken otherwise. 
Another effect of this is that information gets incorporated into prices.  Thus, the value of information may depend on when we get it and how many other people have got it and reacted to it.  Thus, if we get information that will affect the earnings of a company, then the staleness of this information and the fact that a lot of people have already reacted to it would make it less valuable because the price would have adjusted to the information.  On the other hand, if we get information about an impending storm, then we can use it even though a lot of other people have already got it and reacted to it.

Economic Agents react to each other

Often, but not always, economic agents take into account how other agents will react to what they do.  This is most likely when there are a few agents whose actions affect each other.  On the other hand, if there are a lot of agents, they are less likely to take this into account.  This accounts for the Kitty Genovese effect, where nobody did anything to stop Kitty Genovese being stabbed to death even though there many witnesses to the crime. Often in financial markets in developed countries, there are a lot of actors; as a result, everybody often behaves as if his/her behavior will have no effect on other people's behavior. This can lead to self-fulfilling predictions, such as prices that keep going up or keep going down. (see http://pengstwocents.blogspot.com/2009/07/efficient-market-is-one-of-many-nash.html)

Institutions

Institutions Matter -- information asymmetry often causes markets to self-destruct. For example, it is not in the interest of any particular company to provide information when nobody else is providing information because a)investors may not believe the information if there is no external authority guaranteeing the truth of the information and b) the information provided may be used by competitors to the detriment of the company. As a result, markets may end up being opaque and inefficient. But if there is a requirement that companies provide information to investors and there are penalties for not providing information or providing false information and these regulations are implemented and enforced, then companies will provide information and investors will be able to believe that information and act on it and financial asset prices will reveal information.

Law of One Price

Arbitrage

Marginal Investors