A Global Village
Issue 5 » Uncertainty & Risk

A Disequilibrium View of Market Fluctuations

Joachim Klindworth, Imperial College Business School

In an ideal world, financial markets can be considered as an inherently stable system that fluctuates about an optimal point. The financial tsunami of 2008, however, compelled us to reconsider the existing notion of stable equilibrium. This article will introduce the paradigm of an inherently unstable market1, employing concepts in risk management, and illustrate how wild fluctuations and avalanches caused by correlation between assets can force the market to stray far away from equilibrium. This potential for persistent disequilibrium requires new and innovative legislation to protect the critical and vulnerable in society.

Economist Eugene Fama pioneered the theory that markets are in the state of equilibrium, or the efficient market hypothesis. In his seminal paper2, Fama defined the efficient market as ‘a market where there are large numbers of rational, profit-maximisers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.’ Modelling financial markets as random walks, he concluded that the market price (of, for example, a stock) is an unbiased estimate of the true value of an investment. Fluctuations about the equilibrium are random and uncorrelated, and that there is an equal chance that a particular stock is under or over valued at any point in time.

Movements from equilibrium
are often subject to feedback
cycles pushing prices further
from equilibrium thus
enabling non-equilibrium
behaviour to persist

The financial tsunami, however, highlighted the shortcomings of the efficient market hypothesis. The market behaved in a highly correlated manner, with overwhelming negative feedback cycles. The sudden downturn in mainly high-risk US sub-prime mortgages led banks to stop lending. As credit dried up, many businesses faltered, and much debt was rendered un-payable. However, the negative feedback cycle ran deeper. Through financial derivatives such as Collateralized Debt Obligations (CDOs), the risk associated with sub-prime mortgages was heavily traded internationally as a commodity. Huge losses were incurred as the extent of the exposure of banks to this risk became clear, and many global institutions failed. Such a description of the events of late 2008 is admittedly hugely simplified; however, the role of correlation and feedback cycles in driving markets away from equilibrium is clearly evident.

Risky Business
In the aftermath of the credit crunch, risk management, which attempts to hedge financial positions against unlikely negative events, or so-called ‘Black Swan’ events, has been brought into the spotlight. Prior to the events of 2008, risk management was seen as a rigorous and scientifically sound method to minimize losses, preserving a company’s credibility even in adverse market conditions. Yet during the early months of the crisis, markets behaved in a manner unseen before, characterised by high volatility and an unusually high correlation through all assets.

A critical social structure
that perhaps deserves
regulatory intervention
is the food market

Much of the difficulty stems from the fact that risk is far more complex than its counterpart return. An investment today will result with certainty in a specific return tomorrow: either a profit or a loss. On the other hand, risk is a highly diversified concept. There is systematic risk – market risk – and idiosyncratic risk – company specific risk. A standard definition of market risk is the volatility in the returns of a certain stock market index. Because market risk is an aggregate measure over the entire market, it cannot be avoided by diversification, and so is of greater interest to regulatory bodies.

Another issue is that in computing risk, a normal distribution of returns is commonly assumed. This implies that negative and positive movements in the market occur with similar frequencies on the left and right hand side of a distribution. However, real market data clearly demonstrates that there are far more extreme negative movements, which can result in a strong discrepancy in calculating risk measurements. In the worst case the actual risk is underestimated and investors suffer losses.

These market movements can be connected back to feedback cycles, which occur not only during global economic downturns, but also in more everyday situations. Consider a company with raising share prices. From an elementary perspective, a higher share price gives the company the ability to raise more capital than competitors, which in turn gives them a competitive advantage. The company can then use its new capital to buy out competitors or to expand existing operations. It is then likely that share prices will rise even higher, far from equilibrium.

Similarly, a company with a strong credit rating is normally able to borrow at attractive rates. However, a downgrade from a credit rating agency is likely to increase the amount of collateral the company must pledge to back its obligations, thus reducing liquidity, hampering business operations and possibly precipitating a further downgrade. The role of correlation is demonstrated again: movements from equilibrium are often subject to feedback cycles pushing prices further from equilibrium thus enabling non-equilibrium behaviour to persist. As mentioned above, these feedback cycles can cause market movements that do not follow the generally assumed distributions, one factor in incorrect assessment of risk.

Stabilising Factors
Against this background of volatility, it can be said that the perception of risk, specifically liquidity risk, has changed. Stability may not be taken for granted. Before the credit crunch, mitigating market risk was the responsibility of investors, whereas controlling systemic risk was the role of the State. However, if markets are inherently prone to strong feedback cycles, market risk can easily lead to systemic risk. Furthermore, making a direct analogy to the infamous Tragedy of the Commons, no individual actor can smoothen out feedback cycle yet all actors can and will take advantage of those cycles and worsen its negative effects3. Therefore, legislation must recognize the inherent instability of markets.

A path towards stabilising
legislation is introducing
more transparency in
the financial system

A path towards stabilising legislation is introducing more transparency in the financial system. Before the credit crunch investors had no knowledge about the individual risk exposures to industry sectors or sovereign debt of financial institutions. The new European bank stress test analyses various aspects of risk-bearing capability, including how a bank can withstand market fluctuations caused by possible credit defaults of individual countries. While imperfect, it is hoped that with increased transparency and wider availability of information, these tests will lead to a smoothening of market fluctuations, as negative news will be disseminated more gradually and systematically.

Another strategy to reduce the risk of future shocks is decoupling highly correlated markets from fundamental and critical social structures. Drawing a line between markets that are allowed to fluctuate at will and those that should be ‘pinned’ to equilibrium is not an exact science. However, one can make the argument that markets in which one has no choice but to participate deserve particular regulation. For example, coupling an ordinary man’s saving to a volatile market with which he likely has little contact is unwise. Legislation such as the Glass–Steagall Act of 1933, which separated commercial and investment banking in the USA, is a good example of legislative attempts to decouple such markets. The Gramm–Leach–Bliley Act of 1999, however, repealed it, allowing commercial banks, investment banks, securities firms, and insurance companies to consolidate.

A critical social structure that perhaps deserves regulatory intervention is the food market, which is unparalleled in its direct influence on the literal survival of so many, remains virtually unregulated and prone to speculation from commodity investors. Joachim von Braun, the head of the International Food Policy Research Institute (IFPRI)4, warns that the “food market remains seriously exposed to short-term flows of indexed funds into commodity exchanges.” Correlation between the food markets and the volatile global economy is not only dangerous but also potentially fatal to many, and requires international efforts to curb speculation.

The disequilibrium view of markets as illustrated above offers a new paradigm for regulatory intervention. If market equilibrium is an illusion, the State should isolate critical social infrastructure from volatile and unpredictable markets and seek to increase market transparency.

Joachim Klindworth is a MSc student at the Imperial College Business School.

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[1] Soros G. (2008) The New Paradigm for Financial Markets. New York: PublicAffairs.
[2] Fama E. F. (1965) Random Walks In Stock Market Prices. Financial Analysts Journal. 21(5): 55-59.
[3] Schwarcz S. L. (2008) Systemic Risk. Georgetown Law Journal. 97(1): 193-249.
[4] Watts J. (2009) Food Supplies at Risk from Price Speculation. The Guardian, 19 August.