Category: Stock Exchanges

On Financial Markets: The Problematic Assumptions

More than half of the dissertations and theses in India are on financial markets. Various aspects such as pricing of options, efficiency of markets, volatility of markets, its impact on the real sector, futures markets, effect of foreign trade, etc are analysed. Financial markets refer to the stock market, the derivatives market, the commodity markets, etc. For our purposes, we will take into account only the stock/share market as it is the one that is most well-understood in comparison to the rest. This blog post echoes a lot of my concerns with the way financial markets are analysed, and also indicates some of the broader concerns about econometric work in general. I have been greatly motivated and moved by Benoit Mandelbrot’s and Richard Hudson’s book The (Mis)Behaviour of Markets in writing this post. All quotations in this post are from their book.

On attending several pre-submission, post-submission, work-in-progress and viva-voce seminars, I have often wondered about economists fascination with the ‘normality assumption’. We assume that price changes follow a normal distribution, that is, outliers (both small and large) do not significantly affect the average/expected value. That is, standard theories of finance ‘assume the easier, mild form of randomness. Overwhelming evidence shows markets are far wilder, and scarier, than that.’ Now, in natural sciences, this is a common enough assumption. Is there any empirical evidence supporting the use of such a distribution in economics, mainly the analysis of changes in prices and quantities’ One wonders. In fact, it is this distribution which underlies the most commonly used tool in regression ‘ the method of least squares. Most studies (academic and corporate) measure volatility using variance or standard deviation of the normally distributed variables. As Mandelbrot asks, ‘is this the only way to look at the world”

Apart from the normality assumption, orthodox financial theory makes the following assumptions. This list is directly based on Mandelbrot’s book. (1) People are rational and aim only to get rich. (2) All investors are alike and they are price-takers, not makers. (3) Price change is practically continuous. (4) Price changes follow a Brownian motion, that is each price change appears independently from the last, the price changes are statistically stationary and that the price changes are normally distributed.

Assumptions (1) and (2) need no discussion, owing to their obvious falsity. Now it is assumption (3) that allows the use of continuous and differential functions; whereas, the reality is that ‘prices do jump, both trivially and significantly’ and that discontinuity is an ‘essential ingredient of the market.’ The meaning of independent price changes is that, price at t+1 is not dependent on price at t. In other words, prices have no memory. An example from tossing a fair coin will illustrate this better. Suppose a fair coin is tossed once, we get a head. The outcome of the next toss is not based on the outcome of the previous one. Again, how true this is of stock markets or of prices is questionable. How can such an assumption cope up with ‘expectations’ of investors’ The statistical stationarity of price changes implies that the process generating the price changes stays the same over time.

Very often, in research, we do not have the time to question these assumption; not only that, these assumptions function as received wisdom. However, as Mandelbrot comments, ‘They work around, rather than build from and explain, the contradictory evidence’ because ‘It gives a comforting impression of precision and competence.’ For, a high kurtosis (the measure of how closely the data fits the bell curve) has been found in the prices of commodities, stocks and currencies.

To conclude, how does one as a researcher overcome such problematic/unreal/easy assumptions’ Is this what academic ‘discipline’ means’ Or are we to learn adequate mathematics and statistics so that we can find a way around it’ Or do we cooperate and seek help from mathematicians and statisticians’ Mandelbrot has developed tools and concepts such as ‘fractal analysis’ and ‘long memory’ which can aid economics, which is inherently not a study of normally distributed variables.

Select Stock Indices of the World

Usually, we are aware about the details of only a few stock indices in the world. This post aims to widen your horizon. The table has enumerated some of the facts about 10 other countries’ stock index generally quoted, other than India.

Country Stock Index Stock Exchange No of Companies Birth year Index kind
Brazil Bovespa Sao Paulo Exchange 56 1968 capitalization-weighted
China SE Shang composite Shanghai Stock Exchange (Unavailable) 1990 capitalization-weighted
France CAC Paris Stock Exchange 40 1987 capitalization-weighted
Germany DAX Frankfurt Stock Exchange 30 1988 capitalization-weighted
Hong Kong Hang Seng Index Hong Kong Stock Exchange 33 1969 (Unavailable)
India Sensex Bombay Stock Exchange 30 1986 capitalization-weighted
Japan Nikkei Tokyo Stock Exchange 225 1949 price-weighted
Korea KOSPI Korean Stock Exchange 200 1964 capitalization-weighted
Mexico Mexbol Mexican Stock Exchange (Unavailable) 1978 capitalization-weighted
US Nasdaq composite Nasdaq Stock Market 5540* 1971 capitalization-weighted
UK FTSE London Stock Exchange 100 1984 capitalization-weighted

*Subject to change

Capitalization weighted: It means that firms with the largest market value have the greatest influence on the indices’ value.

Price weighted: A stock index in which each stock influences the index in proportion to its price per share. Stocks with a higher price will be given more weight and, therefore, will have a greater influence over the performance of the index.

NOTE: The number of companies refer to the number of companies included in the computation of the indices.

Indian Stock market: The basics

I am writing this post because two of my friends wanted me to. I will be just dealing with the Secondary market in general and the BSE or SENSEX in particular.
The Financial market in India is broadly divided into
1) Money market- for short term money
2) Capital market- for long term money
Money market consists of the Treasury bills, the call money market etc. I won’t be going more into it. Coming to the capital market, it’s further classified into
1) Primary market
2) Secondary market
The primary market deals with the Initial public offerings (IPO) or sales of shares by companies to the public for the first time. The recent IPO’s that took place in BSE can be viewed here. Once the IPO’s are completed all further transactions of the sold shares take place in the secondary market, more commonly known as stock markets or as bourses (jargon in finance). The major stock exchanges in India are the BSE and the NSE.

The National Stock Exchange or NSE was incorporated in November 1992 as a tax-paying company unlike other stock exchanges in the country. The NSE’s index is known as S&P CNX Nifty which is a 50 stock index which covers almost 25 sectors of the economy.
Bombay Stock Exchange Limited is the oldest stock exchange in Asia. The Exchange has a nation-wide reach with a presence in 417 cities and towns of India. The BSE’s index is the SENSEX which is a 30 stock index. The SENSEX is an acronym for Sensitive index of the BSE.

Current scenario
The price of shares/scrips is fixed in the market by the invisible forces of demand and supply. When the purchase price is more than the selling price, the prices of share rise i.e. if A wants to sell a TCS share at Rs 40 but B is willing to buy the share at Rs 45, then automatically the transaction is carried out by the computer, and the price of the share increases.
The regulator of the Indian capital market is the Securities and exchange board of India (SEBI). It makes sure that the small investors are not cheated and ensures transparency of the transactions.
Recently, our markets witnessed a drastic fall, owing to the pull out of the foreign institutional investors (FII). The recent Mumbai blasts have also affected it.

My views
The investors in these markets form consortiums among themselves such that, a group of these investors are able to make changes in the overall market indices. FII’s are one such group. When they think, the time has come to book profits; they take up a selling position. This causes the market to fall and when the market falls, these groups again buy the shares; thus making profits again out of their buying back the shares. This phenomenon is possible only if the group’s transactions can exercise a considerable influence in the concerned market.
Market sentiments play an increasingly important role in the fixing of share prices. News such as decrease in interest rates, good rainfall, etc promotes investment thereby raising the price of the indices in the process. But bad news such as a bomb blast or an earthquake quake the investors see, thereby lowering the indices. The reasons for the markets showing a buoyant face during good news in understood clearly. A reduction in interest rates, promotes cheaper borrowing, thus facilitating more investment. While a good rainfall increases agricultural production, which has an impact on the various industries which make use of agricultural inputs. But, during a bomb blast, what I believe happens is that, investors (very much attached to their money) tend to sell. Game theory helps in explaining how the investors react. The typical example of game theory is that of the prisoner’s dilemma. When an investor hears a bad news, he thinks that other investors will pull out their investment owing to increased need of contingency funds. When all the investors think alike, a large scale selling occurs. I classify it as a typical group phenomenon, arising out of an individualistic tendency.

Some related information
There are other financial instruments in the market known as the Mutual Fund (MF). They are specialised institutional investors who mobilise funds from the public and invest in the capital markets. The people consider investing in such MF’s less risk than shares. It is a booming market but has not utilised its full potential. MF’s are a good option for those investors who do not have time to make a detailed analysis about the economics of the capital market.
Recently investment gurus have been stressing the importance of commodity markets. They are gaining importance in the Indian market.
Some economists and finance analysts believe that when an industry is overvalued, a correction takes place. Say, if the asset prices are increasing but the intrinsic value has remained almost the same, then a bubble is said to occur, which is sure to burst in the near future. Likewise, some believe that the Indian markets were overvalued and the recent crash which occurred was just a correction.

Indicator’
In the previous months, we might all have come across the headline that Indian economy is booming with the stock market touching its record peak of 12,000. The market indices are just indicators of the investor’s confidence levels and the business enthusiasm levels. We should not view the markets in isolation and say that the economy is doing well.

Jargons used
Bear- a selling spree where the prices are falling
Bull-a buying trend with rising prices
short & long position-you can view it here
Bourses-stock market

Hope this post has been of use to my friends and others. If you have liked it, please do let me know in my comments. If you have any questions or clarifications, do let me know.

Irrational exuberance

I had come across the term ‘irrational exuberance’ many a times in newspapers and magazines in recent times. Today I decided to look up what it means.
The Oxford dictionary defines ‘irrational‘ as ‘without reason’ and ‘exuberance‘ as ‘full of high spirits or growing profusely.’

Origin of the term
The term “irrational exuberance” derives from some words that Alan Greenspan, former chairman of the Federal Reserve Board in Washington, used in a black-tie dinner speech entitled “The Challenge of Central Banking in a Democratic Society” before the American Enterprise Institute at the Washington Hilton Hotel December 5, 1996.
Fourteen pages into this long speech, which was televised live on C-SPAN, he posed a rhetorical question: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade'” He added that “We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs and price stability.”
Immediately after he said this, the stock market in Tokyo, which was open as he gave this speech, fell sharply, and closed down 3%. Hong Kong fell 3%. Then markets in Frankfurt and London fell 4%. The stock market in the US fell 2% at the open of trade. The strong reaction of the markets to Greenspan’s seemingly harmless question was widely noted, and made the term irrational exuberance famous.

In the limelight
In the year 2000, Robert J. Shiller authored a book titled ‘Irrational exuberance‘. It was about the society’s obsession with the stock market and how it fuelled volatility in the financial markets. He said the people were infatuated with the stock markets and had forgotten about the potential of real assets, such as income from our livelihoods and homes.
In recent times, the newspapers and magazines have repeatedly been using this term when writing about the stock markets, especially regarding its volatility. I have seen it in The Hindu Business Line and Frontline in recent years.

Is it significant’
I feel it’s the apt word for the recent volatility in the stock markets. It tells us the reason for the increased presence of volatility in the markets and it’s not because of important changes in the economy or the company that the share prices fluctuate. Market news and sentiments of the people affect the market too. Neither should a market with strong fundamentals nor investors who have fundamentals resort to irrational behaviour.