Editorial: Understanding markets

Oct 15 2013, 03:49 IST
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SummaryEconomics Nobel is for the trio who helped do this

Five years after the global financial crisis started, few really know how to price the complicated assets—ABS, CDO—that were at the root of the problem. Which is why, while they generate relatively high returns, the markets for such products are a fraction of what they used to be in 2008 as investors don’t trust them any more. Stocks and bonds, by contrast, trade in large volumes. Why? This, in large part, is due to the work done by the trio who won this year’s Economics Nobel—Eugene F Fama, Lars Peter Hansen (both University of Chicago) and Robert J Shiller (Yale)—to help investors understand the pricing of these assets. Just like the Economics Nobel is actually a prize given by the Swedish Central Bank in Alfred Nobel’s memory, the trio didn’t really work jointly, but their work collectively enhanced the understanding of pricing of risk.

In the short-term, asset prices are volatile and impossible to predict accurately. However, in the 1960s, Fama and his co-authors demonstrated new information is factored into stock prices and this makes medium-term (3 to 5 years) prices more predictable. This opened up new areas for research. In deviation from adage that research by economists (especially of theoretical kind) rarely has relevance, market practices changed and index funds (used by more risk-averse individuals) emerged, reflecting trends of assorted stock market indices. This takes one to Shiller in the 1980s. Shiller’s work found stock prices are more volatile than indicators like dividends. But over the medium-term, when stock prices are high, the ratio of prices to dividends declines; when stock prices are low, the ratio of prices to dividends increases. In other words, there was a well-behaved relationship between the price of a stock and its dividend. This then takes us to Hansen, also in the 1980s. Given uncertain prices, rational individuals can be presumed to act in a certain way—when there is greater risk, a premium is needed for holding risky assets and that’s the way such investors are rewarded, through high future returns. This led to “rational” theories of asset pricing, although there are theories that deviate from rational behaviour too (some of Shiller’s work). In a nutshell, Hansen’s work helped develop theory and statistical/econometric techniques to test it. Taken together, the three examined theory and empirical testing and also influenced changes in market practices, a rare combination.

Given the controversy over 1997 Merton-Scholes prize for work

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