Volume Together With Information

This is a piffling 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 repose of the conference is actually interesting too, but I probable volition non conduct maintain fourth dimension to weblog a summary.) 

Like many others, I conduct maintain 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 study 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 vii 2016 

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

However, it’s non nonetheless a swell 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 aid to fill upward 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 telephone the Groucho Marx theorem: don’t belong to whatever fellowship that volition conduct maintain 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 exercise 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 exercise meliorate past times indexing.

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

As Andy Abel set it, fiscal markets should locomote 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 set fourth dimension in addition to attempt into finding information if you lot can’t turn a profit from it? If information is expensive to obtain, so nobody bothers, in addition to markets cannot locomote efficient. (This is the Grossman-Stiglitz theorem on the impossibility of efficient markets.)

I get together quantum mechanics is off past times 10 to the 120th ability inwards the majority 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 piffling universe.

Stock exchanges be to back upward information trading. The theory of finance predicts that stock exchanges, the key establishment it studies, the key 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 locomote handled at a bank. All of the smart students I sent to Wall Street for twenty 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 toll to a greater extent than oftentimes than non correct alongside the zero-volume theory, in addition to you lot microstructure guys tin conduct maintain the final 10 ground points. More recent empirical locomote makes that jurist look quite wrong. It turns out to locomote truthful that prices ascent when a lot of people house purchase orders, despite the fact that in that location is a seller for each buyer. There is a potent correlation betwixt the grade of prices in addition to trading book — toll booms involve huge turnover, busts are quiet.

At a deeper level, if nosotros demand trading to brand prices efficient, but nosotros conduct maintain no thought how that procedure works, nosotros are inwards danger that prices are quite far from efficient. Perhaps in that location is also piffling trading volume, as the rewards for earthworks upward information are non high enough! (Ken French’s AFA presidential phonation communication artfully asks this question.)

Our policy makers, as good as far also many economists, restrict from non agreement something, to that something must locomote wrong, irrational, exploitative, or reflective of “greed” in addition to needs to locomote stopped. Influenza A virus subtype H5N1 large transactions revenue enhancement could good locomote imposed soon. Half of Washington in addition to most of Harvard believes in that location is “too much” finance, important trading, non compliance staff, in addition to needs policy interventions to cutting trading down. The SEC in addition to CFTC already regulate trading inwards swell detail, in addition to mail people to jail for helping to comprise information inwards to prices inwards ways they disapprove of. Without a adept model of information trading those judgments are guesses, but every bit difficult to refute.

How exercise 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 simply exterior the model.

Another strand, for event 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 locomote a week, retire for a week, in addition to buy the farm 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 so nosotros avoid the puzzle of who signs upward to lose money.

I don’t think it does a lot of adept to telephone telephone them shocks to opportunity 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 opportunity aversion from changes inwards consumption. That makes opportunity aversion shocks observable, in addition to hence contractable, which would undo trading.

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

Finally, trading is huge, in addition to hugely concentrated. Renaissance seems to conduct maintain a preference stupor every 10 milliseconds. I final rebalanced inwards 1994.

The key get-go 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. Influenza A virus subtype H5N1 handbasket of stocks is non a handbasket of fruits. It’s non the get-go fourth dimension that researchers conduct maintain crossed this brilliant line. Fama in addition to French exercise 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 conduct maintain “dogmatic priors” or endure from “overconfidence.” (José Scheinkman in addition to Wei Xiong conduct maintain a real overnice newspaper along these lines, echoing Harrison in addition to Kerps much earlier.) Perhaps. I inquire practitioners why they merchandise in addition to they tell “I’m smarter than the average.” Exactly one-half are mistaken.

At ane grade this is a plausible path. It takes simply a piffling overconfidence inwards one’s ain signal to undo the no-trade-theorem information story — to innovate a piffling 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 simply similar us, in addition to thus 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 banking concern check to brand certain the banana isn’t rotten.

(Disclaimer: I made the banana story up. I retrieve seeing a scientific discipline demo on PBS nearly how chimps in addition to other mammals that locomote past times the dot essay conduct maintain a theory of mind, sympathise that others are similar them in addition to thus query motives. But I don’t conduct maintain the reference handy. Update: Influenza A virus subtype H5N1 friend sends this in addition to this.)

More deeply, if you lot are forced to trade, a piffling overconfidence volition acquire it going. But why merchandise at all? Why non index in addition to brand certain you’re non ane of the losers? Inferring information from other’s offering to merchandise is alone one-half of the no-trade theorem. The fact that rational people don’t locomote into a zero-sum casino inwards the get-go house is the other, much to a greater extent than robust, half. That draw of thought equates trading alongside 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 alone “explainable" past times human folly, that would locomote absent inwards a to a greater extent than perfect (or perfectly-run) world?

Moreover, that “people are idiots” (what Owen Lamont ane time humorously called a “technical term of behavioral finance”) powerfulness locomote 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 give-and-take “theory.”

The sheer book of trading is the puzzle. All these non-information mechanisms — life-cycle, preference shocks, rebalancing amidst heterogeneous agents (Andy Lo in addition to Jiang Wang), preference shifts, generate trading volume. But they exercise 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 simply don’t sympathise why.

Does this matter? How realistic exercise micro foundations conduct maintain to locomote anyway? Actually, for Andy in addition to Fernando’s primary purpose, in addition to that of the whole literature I simply 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,” brusk life spans, or preference shocks simply acquire around the technicalities of the no-trade theorem to focus on the of import role 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 opportunity premiums in addition to volume. For that purpose, the ultimate origin of book in addition to why some people don’t index is belike unimportant.

We exercise this all the time. Bob’s swell 1972 newspaper set people on islands in addition to coin inwards their hands via overlapping generations. People alive inwards suburbs in addition to conduct maintain coin as a transactions inventory. OLG models missy velocity past times a constituent 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 conduct maintain 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 alongside a model of trading tomorrow, for event to address the correlation of prices alongside 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 exercise too.

At least, for positive purposes. We also conduct maintain sense that models alongside dissimilar micro foundations tin attain much the same positive predictions, but conduct maintain wildly dissimilar welfare implications in addition to policy conclusions. So I would locomote much to a greater extent than wary of policy conclusions from a model inwards which trading has naught to exercise alongside information. So, though I dear 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 revenue enhancement 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 swell newspaper nearly opportunity 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 look to generate opportunity premiums. For that purpose, I agree, simply why people merchandise so much is belike irrelevant. But, having blabbed so much nearly large picture, I’ll conduct maintain to cutting brusk the substance.

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


As inwards all science, novel observations displace 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 demo how pieces of information cease upward inwards prices through a string of intermediaries, simply as vegetables brand their way from farmer to your tabular array — in addition to alongside simply as much objection from bien-pensant economists who conduct maintain decried “profiteers” in addition to “middlemen” for centuries.

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

And novel theory demands novel technique too, something that nosotros learned from Bob. (Bob ane 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 inquire a high speed trader nearly signals nearly liquidating dividends, they volition give you lot a blank stare. 99% of what they exercise is exactly inferring information from prices — non simply the grade of the toll 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 thought of information — in that location are 52 cards inwards the deck, you lot conduct maintain iii upward in addition to ii 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 carte du jour deck is. Perhaps the ambiguity or robust command ideas Lars Hansen in addition to Tom Sargent describe, or the descriptions of determination making nether information overload that reckoner scientists study volition conduct maintain the key. For a puzzle this big, in addition to this intractable, I think nosotros volition cease upward needing novel models of information itself. And then, hopefully, nosotros volition non conduct maintain 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 vi Bob Lucas deadly sins — large painting demo 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 ii — speculations nearly policy in addition to politics, in addition to the story of how ane thought nearly the newspaper — for Andy in addition to Fernando!

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