Volume Together With Information

This is a petty essay on the puzzle of volume, disguised as comments on a newspaper past times Fernando Alvarez in addition to Andy Atkeson, presented at the Becker-Friedman Institute Conference inwards Honor of Robert E. Lucas Jr. (The relaxation of the conference is actually interesting too, but I probable volition non receive got fourth dimension to weblog a summary.) 

Like many others, I receive got been real influenced past times Bob, in addition to I owe him a lot personally as well. Bob pretty much handed me the basic thought for a "Random walk inwards GNP" on a Ag platter. Bob's review of a written report to the OECD, which he powerfulness rather forget, inspired the Grumpy Economist many years later. Bob is a straight-arrow icon for how academics should acquit themselves. 

On Volume:  (also pdf here) 

Volume in addition to Information. Comments on “Random Risk Aversion in addition to Liquidity: a Model of Asset Pricing in addition to Trade Volumes” past times Fernando Alvarez in addition to Andy Atkeson 

John H. Cochrane

Oct seven 2016 

This is a cracking economic science newspaper inwards the Bob Lucas tradition: Preferences, technology, equilibrium, predictions, facts, welfare calculations, total stop.

However, it’s non silent a cracking finance paper. It’s missing the motivation, vision, methodological speculation, calls for futurity enquiry — inwards short, all the BS — that Bob tells you lot to leave of absence out. I’ll follow my comparative advantage, then, to assist to create total this yawning gap.

Volume is The Great Unsolved Problem of Financial Economics. In our canonical models — such as Bob’s classic consumption-based model — trading book is essentially zero.

The argue is beautifully laid out inwards Nancy Stokey in addition to Paul Milgrom’s no-trade theorem, which I telephone phone the Groucho Marx theorem: don’t belong to whatever social club that volition receive got you lot as a member. If someone offers to sell you lot something, he knows something you lot don’t.

More deeply, all trading — whatever difference of portfolios from the value-weighted marketplace index — is null sum. Informed traders practice non brand coin from us passive investors, they brand coin from other traders.

It is non a puzzle that informed traders merchandise in addition to brand money. The deep puzzle is why the uninformed trade, when they could practice amend past times indexing.

Here’s how markets “should” work: You think the novel iPhone is great. You seek to purchase Apple stock, but you lot run inwards to a wall of indexers. “How nearly $100?” “Sorry, nosotros solely purchase in addition to sell the whole index.” “Well, how nearly $120?” “Are you lot deaf?” You move on trying until you lot bid the cost upward to the efficient-market value, but no shares merchandise hands.

As Andy Abel seat it, fiscal markets should function similar the marketplace for senior economists: Bids fly, prices change, nobody moves.

And, soon, seeing the futility of the whole business, nobody serves on committees whatever more. Why seat fourth dimension in addition to endeavor into finding information if you lot can’t turn a profit from it? If information is expensive to obtain, in addition to so nobody bothers, in addition to markets cannot move efficient. (This is the Grossman-Stiglitz theorem on the impossibility of efficient markets.)

I assemble quantum mechanics is off past times 10 to the 120th ability inwards the volume of empty space, which determines the fate of the universe. Volume is a puzzle of the same order, in addition to importance, at to the lowest degree inside our petty universe.

Stock exchanges be to back upward information trading. The theory of finance predicts that stock exchanges, the primal establishment it studies, the primal origin of our data, should non exist. The tiny amounts of trading you lot tin generate for life wheel or other reasons could all easily last handled at a bank. All of the smart students I sent to Wall Street for xx years went to participate inwards something that my theory said should non exist.

And it’s an of import puzzle. For a long time, I think, finance got past times on the presumption that we’ll acquire the cost by in addition to large correct with the zero-volume theory, in addition to you lot microstructure guys tin receive got the final 10 ground points. More recent empirical function makes that approximate appear quite wrong. It turns out to last truthful that prices ascension when a lot of people house purchase orders, despite the fact that at that topographic point is a seller for each buyer. There is a rigid correlation betwixt the grade of prices in addition to trading book — cost booms involve huge turnover, busts are quiet.

At a deeper level, if nosotros demand trading to brand prices efficient, but nosotros receive got no thought how that procedure works, nosotros are inwards danger that prices are quite far from efficient. Perhaps at that topographic point is also petty trading volume, as the rewards for excavation upward information are non high enough! (Ken French’s AFA presidential oral communication artfully asks this question.)

Our policy makers, as good as far also many economists, jump from non agreement something, to that something must last wrong, irrational, exploitative, or reflective of “greed” in addition to needs to last stopped. H5N1 large transactions taxation could good last imposed soon. Half of Washington in addition to most of Harvard believes at that topographic point is “too much” finance, pregnant trading, non compliance staff, in addition to needs policy interventions to cutting trading down. The SEC in addition to CFTC already regulate trading inwards cracking detail, in addition to mail people to jail for helping to contain information inwards to prices inwards ways they disapprove of. Without a adept model of information trading those judgments are guesses, but as difficult to refute.

How practice nosotros leave of absence of this conundrum? Well, so far, past times a sequence of ugly patches.

Grossman in addition to Stiglitz added “noise traders.” Why they merchandise rather than index is merely exterior the model.

Another strand, for instance Viral Acharya in addition to Lasse Pedersen’s liquidity based property pricing model, uses life wheel motives, what you lot hither would recognize as an overlapping generations model. They imagine that people function a week, retire for a week, in addition to popular off without descendants. Well, that gets them to trade. But people are non fruit flies either.

Fernando in addition to Andy adopt some other mutual play a joke on — unobservable preference shocks. If merchandise fundamentally comes from preferences rather than information in addition to so nosotros avoid the puzzle of who signs upward to lose money.

I don’t think it does a lot of adept to telephone phone them shocks to peril aversion, in addition to necktie them to habit formation, as enamored as I am of that formulation inwards other contexts. Habit formation induces changes inwards peril aversion from changes inwards consumption. That makes peril aversion shocks observable, in addition to hence contractable, which would undo trading.

More deeply, to explicate book inwards private securities, you lot demand a daze that makes you lot to a greater extent than peril averse to Apple in addition to less peril averse to Google. It tin last done, but it is less attractive in addition to pretty unopen to preferences for shares themselves.

Finally, trading is huge, in addition to hugely concentrated. Renaissance seems to receive got a preference daze every 10 milliseconds. I final rebalanced inwards 1994.

The key offset regulation of modern finance, going dorsum to Markowitz, is that preferences attach to coin — to the payoffs of portfolios — non to the securities that brand upward portfolios. H5N1 handbasket of stocks is non a handbasket of fruits. It’s non the offset fourth dimension that researchers receive got crossed this brilliant line. Fama in addition to French practice it. But if it is a necessary status to generate volume, it’s awfully unpalatable. Do nosotros actually demand to throw out this most basic insight of modern finance?

Another strain of literature supposes people receive got “dogmatic priors” or endure from “overconfidence.” (José Scheinkman in addition to Wei Xiong receive got a real dainty newspaper along these lines, echoing Harrison in addition to Kerps much earlier.) Perhaps. I enquire practitioners why they merchandise in addition to they nation “I’m smarter than the average.” Exactly one-half are mistaken.

At 1 grade this is a plausible path. It takes merely a petty overconfidence inwards one’s ain signal to undo the no-trade-theorem information story — to innovate a petty dubiety into the “if he’s offering to sell me something he knows something I don’t” recursion.

On the other hand, agreement that other people are merely similar us, in addition to thence inferring motives behind actions, is real deep inwards psychology in addition to rationality as well. Even chimps, offered to merchandise a banana for an apple, volition cheque to brand certain the banana isn’t rotten.

(Disclaimer: I made the banana story up. I retrieve seeing a scientific discipline exhibit on PBS nearly how chimps in addition to other mammals that transcend the dot examine receive got a theory of mind, sympathise that others are similar them in addition to thence enquiry motives. But I don’t receive got the reference handy. Update: H5N1 friend sends this in addition to this.)

More deeply, if you lot are forced to trade, a petty overconfidence volition acquire it going. But why merchandise at all? Why non index in addition to brand certain you’re non 1 of the losers? Inferring information from other’s offering to merchandise is solely one-half of the no-trade theorem. The fact that rational people don’t acquire inwards a zero-sum casino inwards the offset house is the other, much to a greater extent than robust, half. That delineate of thought equates trading with gambling — also a puzzle — or other fundamentally irrational behavior.

But are nosotros actually satisfied to solid ground that the existence of exchanges, in addition to the fact that information percolates into prices via a serial of trades, are facts solely “explainable" past times human folly, that would last absent inwards a to a greater extent than perfect (or perfectly-run) world?

Moreover, that “people are idiots” (what Owen Lamont 1 time humorously called a “technical term of behavioral finance”) powerfulness last a trenchant observation on the human condition. But, past times existence capable of “explaining” everything, it is non a theory of anything, as Bob Lucas uses the discussion “theory.”

The sheer book of trading is the puzzle. All these non-information mechanisms — life-cycle, preference shocks, rebalancing alongside heterogeneous agents (Andy Lo in addition to Jiang Wang), preference shifts, generate trading volume. But they practice non generate the astronomical magnitude in addition to concentration of book that nosotros see.

We know what this huge book of trading is about. It’s nearly information, non preference shocks. Information seems to demand trades to percolate into prices. We merely don’t sympathise why.

Does this matter? How realistic practice micro foundations receive got to last anyway? Actually, for Andy in addition to Fernando’s original purpose, in addition to that of the whole literature I merely seemed to brand fun of, I don’t think it’s much of a occupation at all.

Grossman in addition to Stiglitz, in addition to their followers, desire to study information traders, liquidity providers, bid-ask spreads, in addition to other microstructure issues. Noise traders, “overconfidence,” curt life spans, or preference shocks merely acquire around the technicalities of the no-trade theorem to focus on the of import utilisation of the model, in addition to the phenomena inwards the information it wants to match. Andy in addition to Fernando desire a model that generates the correlations betwixt peril premiums in addition to volume. For that purpose, the ultimate origin of book in addition to why some people don’t index is in all likelihood unimportant.

We practice this all the time. Bob’s cracking 1972 newspaper seat people on islands in addition to coin inwards their hands via overlapping generations. People alive inwards suburbs in addition to direct maintain coin as a transactions inventory. OLG models fille velocity past times a element of 100 too. (OLG coin in addition to life-cycle book models are closely related.) So what? Economic models are quantitative parables. You acquire nowhere if you lot fuss also much nearly micro foundations of peripheral parts. More precisely, nosotros receive got sense in addition to intuition that roughly the same results come upward from dissimilar peripheral micro foundations.

If I were trying to come upward up with a model of trading tomorrow, for instance to address the correlation of prices with book (my “Money as stock” left that hanging, in addition to I’ve ever wanted to come upward dorsum to it), that’s what I’d practice too.

At least, for positive purposes. We also receive got sense that models with dissimilar micro foundations tin attain much the same positive predictions, but receive got wildly dissimilar welfare implications in addition to policy conclusions. So I would last much to a greater extent than wary of policy conclusions from a model inwards which trading has cipher to practice with information. So, though I dearest this paper’s response (transactions taxes are highly damaging), in addition to I tend to similar models that attain this result, that is no to a greater extent than honest than most transactions taxation thought, which is also an response eternally inwards search of a question.

At this point, I should summarize the actual contributions of the paper. It’s actually a cracking newspaper nearly peril sharing inwards incomplete markets, in addition to less nearly volume. Though the micro foundations are a fleck artificial, it real nicely gets at why book factors appear to generate peril premiums. For that purpose, I agree, merely why people merchandise so much is in all likelihood irrelevant. But, having blabbed so much nearly large picture, I’ll receive got to cutting curt the substance.

How volition nosotros actually solve the book puzzle, in addition to related merely what “liquidity” means? How does information brand its way into markets via trading? With many PhD students inwards the audience, allow me emphasize how deep in addition to of import this enquiry is, in addition to offering some wild speculations.


As inwards all science, novel observations movement novel theory. We’re learning a lot nearly how information gets incorporated inwards prices via trading. For example, Brian Weller in addition to Shrihari Santosh exhibit how pieces of information terminate upward inwards prices through a string of intermediaries, merely as vegetables brand their way from farmer to your tabular array — in addition to with merely as much objection from bien-pensant economists who receive got decried “profiteers” in addition to “middlemen” for centuries.

Also, at that topographic point is a lot of trading after a discrete slice of information hits the marketplace symmetrically, such as a modify inwards Federal Funds rate. Apparently it takes trading for people to figure out what the information means. I abide by this observation especially interesting. It’s non merely my signal in addition to your signal.

And novel theory demands novel technique too, something that nosotros learned from Bob. (Bob 1 time confessed that learning the math behind dynamic programming had been actually hard.)

What is this “information” anyway? Models specify a “signal” nearly liquidating dividends. But 99% of “information” trading is non nearly that at all. If you lot enquire a high speed trader nearly signals nearly liquidating dividends, they volition give you lot a blank stare. 99% of what they practice is exactly inferring information from prices — non merely the grade of the cost but its history, the history of quotes, volumes, in addition to other data. This is the machinery nosotros demand to understand.

Behind the no-trade theorem lies a classic stance of information — at that topographic point are 52 cards inwards the deck, you lot receive got 3 upward in addition to 2 down, I infer probabilities, in addition to so forth. Omega, F, P. But when nosotros think nearly information trading inwards property markets, nosotros don’t fifty-fifty know what the menu deck is. Perhaps the ambiguity or robust command ideas Lars Hansen in addition to Tom Sargent describe, or the descriptions of conclusion making nether information overload that reckoner scientists study volition direct maintain the key. For a puzzle this big, in addition to this intractable, I think nosotros volition terminate upward needing novel models of information itself. And then, hopefully, nosotros volition non receive got to throw out rationality, the implication that trading is all due to human folly, or the basic principles of finance such as preferences for coin non securities.

Well, I think I’ve hitting four of the half dozen Bob Lucas deadly sins — large painting exhibit motivation, comments nearly around whole classes of theories, methodological musings, in addition to wild speculation nearly futurity research. I’ll leave of absence the final 2 — speculations nearly policy in addition to politics, in addition to the story of how 1 thought nearly the newspaper — for Andy in addition to Fernando!