Managerial Finance Volume 16 Number 6 1990
Understanding Financial Markets
by Christopher J. Green*, Cardiff Business School, UWCC,
Colum Drive, Cardiff CF1 3EU, United Kingdom.
Abstract
This essay provides a non-technical account of the devel-
opment of thinking about the ways in which financial mar-
kets work. The account is organized by distinguishing
between the "financial approach" and the "monetary ap-
proach" to the study of financial markets. The financial ap-
proach emphasizes the importance of arbitrage in
determining financial asset prices. The monetary approach
utilizes the more traditional tools of supply and demand,
and places greater emphasis on the role of market imper-
fections. The essay evaluates the contribution of each ap-
proach to improving our understanding of financial
markets. It concludes that the central problem in financial
market research remains that of providing a satisfactory
explanation of the determination of asset prices. In the
emerging regime of liberalized, competitive financial mar-
kets both the financial approach and the monetary ap-
proach have a distinctive contribution to make in
understanding how these markets work.
This paper is based on research funded by the Economic
and Social Research Council under grant No. B0023-2151.
* I thank Charles Goodhart and an anoymous referee for
helpful comments on an earlier draft of this paper.
1. Introduction
Financial markets and institutions worldwide are in the
midst of a period of unprecedented change. This has been
marked by the liberalization of markets and institutions,
and by changes in systems of regulation. If there is a single
theme underlying these changes, it is the belief that proper-
ly regulated financial markets should be leftto operate free-
ly with minimal barriers to competition. This immediately
raises two broad questions. First, how in practice do free
financial markets operate; and second, what are the bene-
fits and costs to society of free financial markets? The first
question is one of positive economics: what facts and the-
ories are relevant to an understanding of free financial mar-
kets? The second is a matter of welfare economies: are we
justified in believing that financial markets will perform bet-
ter overall when they are relatively free than when they are
subject to more stringent restrictions?
The second question has recently been addressed by
several authors (for example: Tobin, 1984). However, it will
be apparent that the first question is logically prior to the
second. Before we can appraise the costs and benefits of
a relatively free financial system, we ought to have some
recognized theories and explanations of how such a sys-
1
tem operates. In this essay, I propose to trace the devel-
opment of thinking about the ways in which financial mar-
kets work. It would clearly not be sensible to attempt to
summarize the entire literature on financial markets in a
single article; the present account is therefore highly se-
lective.
Financial markets are an object of study principally in
the fields of monetary and financial economics. I have
therefore chosen to organize my exposition by highlight-
ing the different approaches which have been adopted
within these two fields. Their titles are indicative of their em-
phasis. Monetary economics is particularly concerned
with the role of money in the economy. Financial econo-
mics is more concerned with securities and their pricing
on organized markets, such as the stock market. Fun-
damentally though, the differences between the two fields
stem less from their subject matter and more from a dif-
ference in methodology. This difference has been well
summed-up by Ross (1987), in characterizing the distinc-
tive approach of financial economics. There is a well-
known dictum that it is possible to turn a parrot into a
learned economist by teaching it the two words "supply"
and "demand". Ross remarks that the parrot could, alter-
natively, be turned into a learned financial economist by
teaching it instead the single word "arbitrage". Arbitrage is
the process by which agents take advantage of differen-
ces in price between two closely related markets: arbitra-
geurs buy at the lower price and resell profitably at the
higher price. In finance, it is a central principle that there
are always substantial funds available in securities' mar-
kets to take immediate advantage of any profitable arbi-
trage opportunities. It follows that, if arbitrage
opportunities do occur, they will not persist. For example,
if one stockbroker is selling ICI shares at £10 and another
at £11, the flood of orders to buy at £10 and sell at £11 will
quickly drive the prices back together. Thus, it can reason -
ably be assumed that securities will normally be priced in
such a way that arbitrage opportunities do not in fact exist.
I will call this the "no-arbitrage" principle. Otherwise stated
"no-arbitrage" means that two identical assets must sell at
the same price. This is not necessarily true of goods: two
identical goods may sell at the same time in different retail
outlets for different prices. The no-arbitrage approach also
gives rise to a concept of efficiency in financial markets.
Efficiency is identified with an absence of arbitrage oppor-
tunities.
In monetary economics in contrast, it is more readily
assumed that markets do not adjust instantaneously. Mon-
etary economists set supply equal to demand and argue
that this determines interest rates but, often, the markets
within which this process occurs are imperfect ones.
Transactions and other costs are thought to be important.
2 Managerial Finance Volume 16 Number 6 1990
For example, a stockbroker will buy and sell ICI at differ-
ent prices because brokerage is a costly activity; the dif-
ference in price reflects this cost and cannot be arbitraged
away. In general therefore, market imperfections are em-
phasized and these limit the extent to which it is possible
to carry out profitable arbitrage between one activity and
another. Likewise, arbitrage efficiency is thought of as a
relatively weak concept with which to assess the perfor-
mance of financial markets, and as one which lacks a clear
interpretation in terms of the "desirability" of the associated
allocation of resources.
It is these methodological differences which have pri-
marily distinguished monetary and financial economics,
the problems which have been studied in the two fields,
the ways in which they have been studied, and the results
which have been achieved. Theories and explanations do
not however arise solely as a result of applying a predeter-
mined methodology. They are developed in the light of the
successes and failures of earlier theories in explaining an
evolving real world environment. In recent years, re-
searchers in the monetary and the financial traditions have
increasingly borrowed from each other to create a more
common set of tools and techniques to study monetary
and financial problems. My aim will be to trace some broad
strands of thinking about financial markets in the fields of
money and finance and to indicate the nature of the inter-
action which has occurred. At the cost of some oversim-
plification and considerable selectivity, this approach will,
I hope, bring the subject into sharper relief and make clear
the context within which financial market problems are cur-
rently being tackled.
2. Precursors
Much of the agenda for modern financial market research
was set by Hicks (1935) and Markovitz (1959). The central
aim of Hicks' agenda was to devise and test a general the-
ory of portfolio choices - of individuals, firms and financial
institutions - based on hypotheses about the optimising
behaviour of these agents. This agenda could be con-
trasted with the then predominant Quantity Theory of
Money, which appeared unable to utilize the concepts of
utility and optimization which formed the heart of the new
(as it then was) theory of consumer behaviour. Hicks sug-
gested that there were two major issues requiring analysis.
First, the central problem in portfolio choice is to explain
how investors act in the face of the fact that future returns
on securities are typically risky. Second, the main problem
in monetary theory is to explain why a non-interest- bear-
ing asset (money) is held when interest-bearing assets are
also available.
Markovitz's contribution was to show that portfolio
choice in the face of risk could be analysed in a highly oper-
ational way provided "risk" could be interpreted as a single,
quantifiable characteristic. Assets could then be thought
of as having two quantifiable characteristics: an expected
return, and a degree of risk, which Markovitz measured by
the variance of the return on an asset. Markovitz utilized
this framework to develop the concept of (mean-variance)
efficient portfolios. An efficient portfolio is one which has
the lowest variance of return among all portfolios with a
particular mean (or expected) return. There are many effi-
cient portfolios, each one offering a different expected re-
turn. An efficient portfolio with a relatively high variance
(risk) must offer a relatively high expected return. A port-
folio offering relatively high risk and relatively low expected
return is unlikely to be efficient, as it will typically be
possible to construct a portfolio offering less risk for the
same expected return or, equivalently, higher expected re-
turn for the same risk. The construction of efficient portfo-
lios depends on the insight that, whereas the riskiness of
a single asset depends on the insight that, whereas the ris-
kiness of a single asset depends on its own variance, the
riskiness of a portfolio depends also on the covariances
between the returns on its component assets. Intuitively,
the idea is simple. A portfolio of shares in raincoat manu-
facturers and ice-cream manufacturers is likely to be less
risky than a portfolio of raincoat manufacturers and um-
brella makers. Returns on the former portfolio (which will
be negatively correlated) are less vulnerable to the weather
than are returns on the latter (which will be positively corre-
lated). What is less obvious but equally important is that
the raincoat-ice-cream portfolio may dominate the rain-
coat-umbrella portfolio in that for any mix of raincoat and
umbrella shares, it will be possible to find a mix of raincoat
and ice-cream shares offering less risk for the same return,
or higher return for the same risk. In general, the riskiness
of a portfolio will be less, the greater the extent of its diver-
sification, that is: the more widely spread among different
companies are the shareholdings in the portfolio. Intuitive-
ly, this is analagous to "not putting all your eggs in one bas-
ket". Efficient portfolios are constructed from all possible
assets on offer using these basic principles. The set of
mean-variance efficient portfolios dominates all other port-
folios in that it offers the menu of best combinations of risk
and return which are available in the market as a whole.
Markovitz also considered the question of which par-
ticular portfolio an investor would select. He proposed that
investors could be represented as acting so as to maximize
the expected utility of wealth, an hypothesis which could
be interpreted as an extension of the concepts used in con-
sumer theory. Markovitz demonstrated that any plausible
representation of an investor's utility could be satisfactor-
ily approximated by some function of the mean and vari-
ance of return. It seems reasonable to suppose that
investors like return and do not like risk: they are "risk-
averse". If so, investors must limit their portfolio selection
to a choice among the menu of efficient portfolios. If a risk-
averse investor were to hold a portfolio which was not
mean-variance efficient she could do better by switching
to an efficient portfolio. At least one such will exist offering
a higher return for the same risk, or less risk for the same
return, or a combination of the two. Which efficient portfo-
lio is chosen will differ among investors and depends on
Managerial Finance Volume 16 Number 6 1990
each individual's attitude towards risk. In general though,
risk- averse investors can be thought of as trading off port-
folio risk against expected return in making this choice.
Highly risk-averse investors will choose a low-risk low-re-
turn (efficient) portfolio; less risk-averse investors will opt
for an efficient portfolio with higher risk and higher ex-
pected return. In summary, portfolio choice can be viewed
in two stages: first, compute the set of efficient portfolios;
second, choose the best among these portfolios depend-
ing on the investor's individual attitude towards risk.
Markovitz's work was remarkable for its combination
of generality and concreteness. Given the expected re-
turns and the variances and covariances of the securities
on offer, the calculation of the efficient set of portfolios is
tedious but not difficult. Here was a case where, with only
a little exaggeration, it could be said that portfolio mana-
gers were computing efficient portfolios, almost before the
underlying theory had been absorbed into the academic
literature. However, monetary and financial economists
drew rather different conclusions from Markovtiz's work.
To monetary economists it offered a foundation for mod-
elling portfolio choices and thus for implementing Hick's
agenda. The challenge of developing this line of thought
was taken up in particular by Tobin and his associates, in-
deed their early work was contemporaneous with that of
Markovitz. In financial economics however, interest cen-
tred on the efficient set of portfolios. This was thought to
bean especially attractive concept, as its construction was
largely free of assumptions about the nature of individual
preferences.
3. The Monetary Tradition
During the 1950s, monetary theory was constrained by a
widespread (if incorrect) belief that Keynes's (1936)
General Theory implied that money was relatively unim-
portant in the economy. Against this background Fried-
man and Tobin sought in different ways to reinstate the role
of financial variables. Friedman's early work (1956) laid
stress on the importance of a broad spectrum of interest
rates in influencing the demand for money; in this respect
it had as much in common with Tobin's ideas as it did with
the classical Quantity Theory of Money to which it claimed
an affinity. Friedman subsequently moved to the position
for which he is well-known, namely that the quantity of
money is the primary determinant of aggregate money in-
come. On this view, financial markets in general do not
have any special role to play in the economy which is dis-
tinctive from that played by any other market, such as that
for cars or for foodstuffs.
Tobin on the other hand, was concerned with finan-
cial markets in general as well as with money in particular.
He was instrumental in developing the microeconomics of
financial markets using the tools of expected utility and
mean-variance analysis. His first major contribution (1958)
was to state and prove the famous "separation" or "two
fund" theorem. According to this theorem, where there
3
exists a safe asset (i.e. one whose return is known for cer-
tain) along with a large number of risky assets, the best ef-
ficient portfolio of risky assets is unique: it is the same for
all investors irrespective of their preferences. Agents' atti-
tudes towards risk determine what proportion of their as-
sets are held in the safe asset and what proportion are held
in the best portfolio of risky assets, but they do not in-
fluence the composition of the risky portfolio. An investor's
portfolio will therefore consist of just two "funds": the safe
asset and the best portfolio of risky assets. The separation
theorem reinforces the two-stage procedure for portfolio
selection; first compute the best portfolio of risky assets;
then determine what mix of this portfolio and the safe as set
to hold. In principle, this may also provide an argument for
unit trusts: the problem of selecting the best risky portfo-
lio, since it is unique, can be delegated to professionals
with superior information about the market. This does not
however explain why unit trusts may differ widely in their
portfolios and their performance.
Tobin identified the safe asset in his analysis as
"money", and his work is commonly understood to offer a
reinterpretation of Keynes's speculative motive for holding
money in a mean-variance framework. However, it soon
became apparent that Tobin's analysis did not, in fact, pro-
vide a foundation for understanding the demand for
money, if "money" is understood to mean non-interest
bearing cash. The mean-variance approach presumes that
investors will continuously adjust their portfolios as ex-
pected returns change. If so, non-interest bearing cash is
dominated by interest-bearing capital-certain assets such
as building society accounts which can, in principle, be
drawn on immediately before any proposed purchase. The
safe asset must therefore be an interest bearing capital-
certain asset and not non-interest bearing cash.
Holdings of non-interest bearing cash are not, in fact,
continuously adjusted in the manner described above.
Cash is used more like an inventory: a lump sum is with-
drawn at one time and this is used over a period until the
balance is drawn down close to zero. Conversions be-
tween cash and other assets are periodic and determined
largely by the inconvenience involved: in visiting the bank
on the one hand, and running out of cash on the other.
Thus, investors' portfolios of cash and bank or building so-
ciety accounts are likely to be determined to a consider-
able extent by "transactions costs", broadly defined to
include the inconvenience involved in making transactions
among these different assets. This approach, usually
called the inventory or, more recently, the buffer stock ap-
proach, is now generally accepted to provide a reasonably
satisfactory account of the way in which cash and interest-
bearing capital-certain accounts are managed. It provides
a foundation for understanding the demand for money in
which interest rates do have an influence on demand, but
in which the underlying determinants are related to market
imperfections and transactions costs.
4 Managerial Finance Volume 16 Number 6 1990
Although the mean-variance approach does not pro-
vide a satisfactory account of the demand for (non-inter-
est-bearing) money, it does provide a theory of the
demand for risky securities. Tobin's second major con-
tribution (1969) was to show that, given the demands for
risky securities it is straightforward to provide an account
of the determination of interest rates and of a mechanism
by which financial variables impact on savings and expen-
diture decisions in the economy. Tobin's work in this area
emphasizes an approach and a method of analysis as
much as it offers a "general theory" of financial markets.
The approach lays stress on the interdependence of finan-
cial markets and the need to study such markets simulta-
neously. It emphasizes the importance of interest rates:
both as a determinant of portfolio behaviour and as a key
link between financial markets and the rest of the economy.
To see how this approach works in practice, it is help-
ful to use as a framework the matrix of flows of funds in the
economy (Bank of England, 1987). Each row (i) of the ma-
trix represents an asset market, and each column (j) a sec-
tor (households, companies, etc.). Any cell (i, j) in the
matrix shows net acquisitions or sales of asset i by sector
j during the time period under consideration. Net acquisi-
tions of liabilities are shown as equivalent to net sales of
assets. The row sums of the matrix are zero as net pur-
chases of an asset must equal net sales, and each column
(j) sums to the j'th sector's surplus or deficit: this is its total
net acquisition of financial assets.
The flow of funds matrix is transformed into a model
by assuming that each cell in the matrix contains a variable
to be explained by an asset demand function, which could
be, but does not have to be based on mean-variance con-
siderations. The column sums are equivalent to sector
budget constraints. Meanwhile, the row sums may be re-
interpreted as market clearing or equilibrium conditions.
They state that, in equilibrium, desired net purchases of an
asset must equal desired net sales. The desired net pur-
chases or sales are determined by the asset demand func-
tions. Equilibrium in financial markets is typically brought
about by movements in interest rates. Given any arbitrary
set of interest rates, desired net purchases of an asset may
not equal desired sales. Interest rates and asset prices
must therefore adjust until desired net purchases and sales
are equal, and markets are in equilibrium. In some markets
it is possible that interest rates and asset prices do not form
the equilibrating mechanism. A good example is afixed ex-
change rate system. In this case, the exchange rate is
pegged by the monetary authorities buying and selling the-
oretically unlimited quantities of foreign exchange at a
fixed price. When there is excess demand for foreign ex-
change the authorities must sell to the market and vice-
versa. The foreign exchange row of the flow of funds matrix
sums to zero, but the equilibrating variable is the monetary
authorities' holdings (and the corresponding matrix cell)
and not the price of foreign exchange or an interest rate.
The representation of financial markets provided by a
flow of funds model can therefore be thought of as follows.
At the start of any time period, each sector holds a given
stock of assets and liabilities. The sector surpluses or defi-
cits, the sectoral asset demands, and the market clearing
conditions combine to determine the flow of funds and the
structure of interest rates and asset prices. The end-of-peri-
od values of the stocks of assets and liabilities are then
equal to the sum of: the beginning of period stocks, the
flow of funds thus determined, and capital gains or losses
on beginning-of-period stocks. The equilibrium in each
period is, however, temporary, forthe end-of-period stocks
are carried over to the next period and, together with a new
set of sector surpluses and deficits and asset demands,
will determine a new temporary equilibrium. A long-run
equilibrium is one in which stocks are stationary from peri-
od to period in some well-defined sense, but such long-run
equilibria are of more theoretical than practical interest.
4. Empirical Monetary Models
Since the early 1970s, numerous empirical studies of the
portfolio behaviour of individual sectors have been carried
out, and all large-scale econometric models now include
a detailed financial sub-model. However, models of the fin-
ancial markets as a whole typically embody a view which
does not reflect Tobin's flow of funds approach but one
which I will describe for convenience as the "demand-for-
money-cum-rate-tree" (DEMRAT) approach. It can be
summarized as follows. The demand for money is deter-
mined by a short list of variables including income and in-
terest rates. The supply of money is determined by the
authorities, for example as the residual in the identity which
links the Public Sector Borrowing Requirement, bank lend -
ing to the private sector, sales of government securities to
the private sector, external flows, and the change in M3.
The condition that the demand and supply of money be
equal determines a pivotal interest rate, usually a short-
term rate. Given this interest rate, the remaining interest
rates are then determined by a "tree", that is by equations
which each explain one rate of interest directly by vari-
ations in the key short-term rate. Such equations also in-
clude variables intended to represent variations in a risk
premium or a liquidity premium which are thought to cause
movements in the differential between the key short-term
rate and other rates.
The DEMRAT approach implies that there is only a
loose connection between interest rates and flow of funds;
whereas the Tobin approach produces a much tighter con-
nection between these variables. This difference has im-
portant implications for the ways in which the two kinds of
model can be used in policy analysis. In the DEMRAT ap-
proach the premium of one interest rate over another is
determined directly by the variables which enter the rate
tree equation. If, as is common, only interest rates enter
these equations, then the premium for risk or liquidity is es-
sentially fixed in the long-run. This in turn implies that the
Managerial Finance Volume 16 Number 6 1990
monetary authorities are largely confined in their influence
to the key short-term interest rate. All other rates will move
in a fixed way, though perhaps after a lag, in response to
movements in this key rate. The authorities will therefore
be unable to have any permanent influence on the struc-
ture of interest rates, either by trading in securities or by
other means such as announcements.
In contrast, in the Tobin approach, changes in relative
interest rates affect demands for specific assets. (This also
follows from the mean-variance framework). This implies
that the monetary authorities can influence both the level
and structure of interest rates by altering asset supplies
through open market operations. For example, given the
private demand for bonds, an increase in supply by the
authorities must produce a change in the structure of in-
terest rates in order to restore equilibrium. Typically, the
bond rate must rise as a result of this action; other interest
rates may rise or fall depending on which other assets were
exchanged for bonds by the authorities. In general, the ex-
tent to which different interest rates change depends on
the degree of substitutability among different assets in pri-
vate portfolios. The premium of one interest rate over an-
other is not fixed, but depends on private sector asset
preferences and the relative supplies of assets.
The practical difficulty in implementing Tobin's flow of
funds approach is that models which do follow this ap-
proach quickly become large and unwieldy. The number
of parameters of interest escalates rapidly - roughly in pro-
portion to the square of the number of variables of inter-
est. For example, my (1984) flow of funds model of the UK
has just 32 equations but 702 parameters. The DEMRAT
approach produces models which are less comprehens-
ive but more manageable. Indeed, Johnson (1970) has
criticised the Tobin approach as being "long on elegant
analysis of theoretical possibilities, but short on testable or
tested theoretical propositions", producing models in
which "everything depends on everything else" and noth-
ing clear-cut can be said. While this may be a valid criti-
cism of the approach as applied to strictly theoretical
models, the usefulness of an empirical model depends in
large part on its ability to illuminate issues in a consistent
way under changing conditions. There is no point in pro-
ducing an easily interpreted or very precise answer which
is however misleading. The Tobin approach may be less
likely to produce clear-cut theoretical answers but it does
produce empirical models with sufficient structure to illumi-
nate factors such as: possible sources of conflict over the
outcome of a particular policy, the critical parameters in
this conflict, and the sensitivity of the outcome to changes
in assumptions about these parameters. It is this structure
which gives the Tobin approach its strength vis-a-vis the
"simpler" DEMRAT approach.
Financial modelling utilizing both the DEMRAT and
Tobin approaches has, however, been marked by numer-
ous disappointments, both in the UK and elsewhere. The
5
DEMRAT approach requires that the premium of one inter-
est rate over another be essentially fixed. This has been
conclusively rejected for all pairs of interest rates of any
concern. Risk premia vary systematically over time in ways
which are not fully understood and rate tree equations typi-
cally break down easily, especially in the face of changes
in the underlying policy regime. In principle, the Tobin ap-
proach is more structural but it has proven exceedingly dif-
ficult to implement in practice. The Tobin approach places
more emphasis on the study of asset demands and sup-
plies. However, financial assets are, in general, very close
substitutes for one another. Insofar as equilibrium in asset
markets is brought about by movements in interest rates,
the rates on assets which are close substitutes will tend to
move closely together, making it difficult to identify the sep -
arate effects of each interest rate on each asset demand.
The result is that estimated interest rate effects frequently
have implausible signs and magnitudes or are statistically
insignificant. One possible response to this problem is to
retain the framework, but to use theory to cut down the
number of parameters to be estimated. This idea has been
pursued by Keating (1985), but the assumptions required
in his exercise border on the heroic and would be regarded
as unacceptably strong by most researchers.
5. The Financial Tradition
In the finance literature, Markovitz's work spurred interest
particularly in the analysis of mean-variance efficient port-
folios. Sharpe (1964), Lintner (1965) and Black (1972) built
this analysis into a widely utilized theory of asset price
determination: the Capital Asset Pricing Model (CAPM).
The Sharpe-Lintner CAPM builds directly on Tobin's sep-
aration theorem. In the presence of a safe asset there is a
unique portfolio of risky assets which will be held by all in-
vestors; this is commonly termed the market portfolio. As
Tobin had earlier demonstrated, investors holding a port-
folio consisting of a safe asset and the market portfolio face
a linear trade-off between risk and return. Here, risk is
measured by the portfolio standard deviation (the positive
square root of the variance). This linear trade-off which is
available in the market, is termed the capital market line
and its slope is called the market price of risk.
Suppose now that asset supplies are given exogen-
ously, and asset markets are in equilibrium. Since the mar-
ket portfolio is held by all investors, its characteristics must
in some measure be reflected in the characteristics of asset
prices. This observation suggests that we can exploit the
properties of the market portfolio to make statements
about asset prices, and to answer the important question:
how are assets in the market portfolio priced? The key in-
sight in constructing efficient portfolios is that risk can, to
some extent, be diversified away by combining assets in
certain proportions. If the calculation and construction of
efficient portfolios can be carried out costlessly, then the
market should not reward investors for this process. In-
stead they should be rewarded for bearing risk which can-
6 Managerial Finance Volume 16 Number 6 1990
not be diversified away. That part of the risk on an asset
which cannot be diversified away is called undiversifiable
or systematic risk, and this depends on the extent of the
positive correlation of the returns on an asset with returns
on other assets, or, since there is only one unique market
portfolio, with the return on the market portfolio. The higher
is the positive correlation of an asset with the market port-
folio, the larger is its systematic risk and therefore the
higher should be its return.
The relationship between the return on an individual
security and the return on the market portfolio is called the
security market line. Like the capital market line, this rela-
tionship is linear and its slope is determined by the covari-
ance of an asset's return with the market. In fact, the slope
of the security market line is equal to a regression coeffi-
cient: the one obtained by regressing the return of the
asset on the return of the market portfolio; and it is termed
the "beta coefficient" of the asset. In general therefore the
CAPM seems to offer a simple, testable proposition: high-
beta assets should earn a high return because they involve
relatively high systematic risk; low-beta assets should earn
a relatively low return because they involve relatively low
systematic risk. This also gives rise to a practical invest-
ment rule, namely: buy low- beta stocks if they enjoy an
above-average return and are therefore trading at a below-
average price; sell high-beta stocks if they earn a below-
average rate of return and are therefore trading at an
above-average price, as sooner or later, their prices will be
re-rated in line with their betas.
Despite its intuitive appeal, the CAPM is in some re-
spects, a curious theory. It is normal to think of prices in a
market being determined by supply and demand. In the
CAPM, the supply of securities in the market is taken as
given but there appears to be no role for demand beyond
the assumption that agents are risk-averse. For some time,
this appeared to be an advantage of the theory, as se-
curities could be priced without having to make assump-
tions about the preferences of individual investors. It soon
became apparent, however, that this conclusion depends
on the assumption that there is a safe asset. Properly
speaking, Sharpe's CAPM is a theory of efficient portfolios
and not a theory of security prices. The existence of a safe
asset makes the risk return trade-off linear. This in turn
identifies which particular efficient portfolio must be the
unique market portfolio (this is where "demand" comes in),
and hence determines the prices of securities. Black
showed that the same relationships among security prices
and efficient portfolios still hold good if there is no safe
asset. In this case however, every efficient portfolio is li-
nearly related to the return on any asset. There is no unique
market portfolio but a set of efficient portfolios; and differ-
ent investors will choose a different efficient portfolio de-
pending on their attitudes towards risk. Without reference
to individual preferences therefore, asset prices cannot be
determined.
The CAPM bears a direct relationship to the present
value rule for pricing securities. In the absence of risk, the
price of a security is given by the present val ue of its future
returns, that is: its future returns discounted to the present
at the market rate of interest. In practice, future returns are
uncertain. Prior to the development of the CAPM, this un-
certainty was handled by introducing an arbitrary correc-
tion factor for risk, either to the stream of expected returns,
or to the discount rate. The difference between the return
on a risky security and the safe rate of return is therefore
the correction factor for risk, and is equivalent to the risk
premium on that risky security. Under CAPM, the risk pre-
mium is not arbitrary but is determined by the covariance
of a security with the market portfolio (its beta) and the mar-
ket price of risk (the slope of the capital market line). Thus,
the CAPM provides a rationale and method for risk correc-
tion in security valuation.
If there is no safe asset, the risk premium on a security
can still be expressed as a function of its covariance with
the return on a "market portfolio". However, this return is
simply the weighted average return on all securities avail-
able on the market. Loosely, it is analagous to the return
on the Financial Times (FT) index and it does not necess-
arily reflect a portfolio which is actually held by any individ-
ual investor. The market price of risk is a portfolio-weighted
average of all individual agents' attitudes towards risk.
Black has shown that this construction is equivalent to that
when there is a safe asset but with the return on the safe
asset replaced by the return on the "zero-beta" portfolio.
This is the portfolio whose return is uncorrelated with that
on the market portfolio. However, this interpretation is less
useful because of the non-uniqueness of the market port-
folio and hence of the zero-beta portfolio, in the absence
of a safe asset.
The explanation of the risk premium on a security of-
fered by the CAPM is closely analagous to that provided
in the monetary tradition by Tobin's approach. In this ap-
proach, as we have seen, the structure of interest rates and
hence of risk premia on different assets is closely related
to the substitutability of assets and hence to variations in
asset supplies. In principle, the CAPM can be interpreted
as providing a more specific theory of why assets might be
less than perfect substitutes. According to the CAPM, im-
perfect substitutability arises because the returns on as-
sets are imperfectly correlated with one another and hence
with the market portfolio. Variations in an asset's covari-
ance with the market alter its substitutability for other as-
sets and this will generate changes in the risk premium on
the asset.
Early tests of the CAPM tended to support the theory.
However, an important paper by Black, Jensen, and
Scholes (1972) found that betas appeared to have a rela-
tionship with expected returns which was the opposite of
that predicted by the CAPM. Subsequent work has quali-
fied but not reversed their conclusion. This research cul-
Managerial Finance Volume 16 Number 6 1990
minated in a well-known critique of the CAPM by Roll
(1977), the main point of which is that the CAPM is a the-
ory which is exceedingly weak and difficult to test. The only
testable hypothesis of the CAPM is that the market portfo-
lio is mean-variance efficient. Other predictions, such as
the relationship between betas and expected returns, fol-
low directly from the mean-variance efficiency of the mar-
ket portfolio and cannot be interpreted as independent
propositions. For some time Roll's critique was not widely
appreciated because of a common confusion in interpre-
ting the CAPM. There is a convenient simplification avail-
able in applying the CAPM called "the single index model".
In this model the beta of an asset is approximated by the
regression of its return on some market factor, usually a
security price index such as the FT index. Index models
are not equivalent to the CAPM, though the estimated
betas are commonly employed as if they were. The point
here is that an index such as the FT index is not equivalent
to the market portfolio. The difficulty is compounded be-
cause of the fact that any sample of observations on se-
curity returns can be used to construct efficient portfolios.
Thus, on the one hand, it is difficult to measure the market
portfolio and, on the other, if the measured portfolio is
mean-variance efficient, it provides no direct information
about whether the market portfolio is mean-variance effi-
cient. In short, the CAPM is exceedingly difficult to test
properly and, to date, it is not clear that many such tests
have been provided.
6. Extensions and Alternatives to The Capital Asset
Pricing Model
Roll's critique has reduced but not eliminated the enor-
mous volume of research on the CAPM. The popularity of
this model reflects, in part, its operational relevance. More-
over, Roll's strictures on the difficulty of measuring the mar-
ket portfolio appear overstated. All economic and financial
data are, to some extent, imperfect and, if Roll's logic were
pursued comprehensively, virtually all empirical economic
research would cease. However, Roll's emphasis on the
need to test explicitly the mean-variance efficiency of the
market portfolio has led researchers to devise new empiri-
cal methodologies; some of these are discussed in Sec-
tion 7 of this essay. In this section I review a second result
of Roll's critique, namely, the development of new theories
aimed at improving or supplanting the Sharpe-Lintner-
Black CAPM.
In the CAPM, investors select their portfolios, and as-
sets are priced using information about returns over a
single period. In practice, portfolio selection problems in-
volve uncertainty about a future which is often far-distant.
Individuals investing for retirement have a different time
horizon from those investing to pay for next year's vaca-
tion. It would be useful to know how far the conclusions of
the CAPM can be carried over to an intertemporal setting.
This issue was addressed by the Intertemporal Capital
Asset Pricing Model (ICAPM), developed initially by Mer-
7
ton (1973, and numerous other contributions), and sub-
sequently by Breeden (1979). This model relies on a rather
difficult branch of mathematics called stochastic calculus,
but the main insights of the analysis are quite simple. In
this ICAPM, agents choose portfolios and trade securities
so as to maximize the expected utility of consumption over
their lifetime in the face of possible changes in the under-
lying forces determining security prices. This is the stand-
ard method of formalizing the idea of choice over time to
allow, for example, trade-offs between consumption now
and in the future. In the unlikely event that consumption
and investment opportunities do not change over time, the
ICAPM collapses to the CAPM and the two-fund theorem
continues to hold; otherwise a "generalized" separation
theorem holds. Instead of constructing their portfolios from
just two funds or unit trusts, investors now choose their
portfolios from a large number of funds ("N + 2") which
are constructed as follows. Fund number one is the safe
asset as before. Fund number two is the mean-variance ef-
ficient portfolio of risky assets; this too is the same as be-
fore and is often called "the speculative portfolio". The
remaining "N" funds are new and are commonly thought
of as hedging portfolios. Their number is uncertain be-
cause there must be one such portfolio for every possible
source of unanticipated variation in consumption and in-
vestment opportunities. Clearly therefore "N" is likely to be
a large number.
To see how these hedging portfolios are constructed,
considerthe following example. Suppose I have a liking for
orange marmalade. Over my lifetime my taste will be sat-
isfied by regular purchases of marmalade. The price of
marmalade in the future may change. However, I could
hedge against such changes if there existed futures mar-
kets in orange marmalade for every date over the rest of
my lifetime. In practice such markets do not exist. How-
ever, as a second best, I can purchase certain other se-
curities. For example, orange juice futures provide a
futures contract in a product whose price will move close-
ly with the price of oranges. I could also buy shares in com-
panies which produce marmalade. Thus, if the price of
marmalade rises because of an unanticipated rise in de-
mand, I will be partially protected against this price rise
through my share in the increased profits of the manufac-
turers. In short, I can construct a portfolio which imperfect-
ly hedges my future consumption of orange marmalade.
More prosaically, citizens whose homes are heated by gas
can hardly fail to hold some shares in the monopoly sup-
plier: British Gas. Likewise, an argument that workers and,
more particularly their pension fund should not hold shares
in their own company is that they are not hedged against
its bankruptcy. The additional message in the ICAPM
therefore is that investors will construct portfolios to hedge
against changes in factors impinging on their future con-
sumption and investment opportunities. Moreover, the
ICAPM provides a more plausible theory of unit trusts; in
principle the N hedging portfolios can each be thought of
8 Managerial Finance Volume 16 Number 6 1990
as an opportunity for a different unit trust. Each such trust
will perform differently because it is constructed to hedge
against a particular source of possible change in con-
sumption and investment opportunities.
While the ICAPM is intuitively appealing, it is clearly
impossible to specify all possible sources of changing con-
sumption and investment opportunities. It is therefore dif-
ficult to give an empirical meaning to the N hedging
portfolios, and, thus to test the ICAPM. The contribution of
Breeden was to prove the remarkable result that, under
mild assumptions, the N hedging portfolios and the one
speculative portfolio all collapse into a single portfolio.
Breeden's insight is that, for many purposes, we are inter-
ested not in an individual's consumption of a host of indi-
vidual products but in her aggregate consumption. If this
is so, the separation theorem can now be shown to imply
that investor portfolios can be constructed from just two
funds: the safe asset, and a unique portfolio of risky assets
aimed at hedging aggregate consumption risks.
In the CAPM the risk premium on a security is repre-
sented by its beta: its covariance with the market portfolio.
In Merton's ICAPM the risk premium on a security has to
be interpreted as a multi-beta model, with a different beta
associated with each of the N hedging portfolios, as well
as with the speculative portfolio. However, in Breeden's
ICAPM the risk premium on a security collapses back into
a single beta which is equivalent to the covariance of the
return on that security with the proportional change in ag-
gregate consumption. Moreover this result generalizes to
the setting in which there are many individuals and many
goods, in the same way as the CAPM generalizes to many
individuals with different levels of wealth. The advantage of
Breeden's interpretation is that betas can be associated
with consumption goods rather than with the rather ab-
stract notion of consumption and investment oppor-
tunities. Thus, for example, if we split consumption into the
seven component categories used in th UK national ac-
counts, we immediately have the interpretation that the risk
premium on a security can be expressed as a seven-beta
model: one beta for each category of consumption.
In principle aggregate consumption is easier to
measure than the true market portfolio on which Roll has
insisted. Aggregate consumption data are generally more
reliable than portfolio data. Nevertheless, the results of
testing the ICAPM, mainly in the United States, are as yet
mixed. The tests typically imply very widely varying esti-
mates of the parameter representing the aggregate econ-
omy-wide degree of risk-aversion. Since this parameter is
a weighted average of individual attitudes to risk we would
expect it to be relatively stable over time and certainly
across different studies of the same time period. Neither of
these properties has been realised so far with estimates of
this parameter varying from as little as 0.07 to as much as
150. Since consumption betas depend on this parameter,
it is difficult to put much faith in these results.
While the ICAPM amounts to an extension of the
CAPM, Ross's (1976) Arbitrage Pricing Theory (APT) is a
competing theory based more directly on the no-arbitrage
principle. The idea is that, by definition any diversified port-
folio will have no unsystematic risk. Since the only risk in
such a portfolio is systematic, it must be common to all
well-diversified portfolios. This in turn implies that any well-
diversified portfolio must be a perfect substitute (or perfect
hedge) for any other; and security portfolios that are so
hedged must earn the same rate of return. This is equival-
ent to asserting that there are no risk- free arbitrage oppor-
tunities among well-diversified portfolios in the market. If it
is then assumed that the return on any security can be ap-
proximated by a linear statistical model, then the risk pre-
mium on a security can be expressed as a linear function
of the deviations of the systematic components of returns
from the risk-free rate, with coefficients given by "beta-like"
expressions. The systematic part of the returns can be re-
garded as factors which determine the prices of individual
securities. Such factors might include the value of the
whole market. In principle therefore, the Sharpe-Lintner
CAPM can be regarded as a special case of the APT with
the factors limited in number to one. The ICAPM can also
be regarded as a special case of the factor generating pro-
cess underlying the APT with each of N + 1 factors being
associated with a different portfolio of risky assets. In
general though, there is no clear guide as to what particu-
lar factors might generate asset returns. If we are to give a
full economic interpretation to the model this is an import-
ant omission, and, in practice, tests of the APT are often
rather difficult to interpret.
The most celebrated application of the no-arbitrage
principle is the Black and Scholes (1973) option pricing
model. Options are securities with the following character-
istics. A call option is an option to buy a security at a fixed
price, called the strike price, during a specified time peri-
od; a put option is an option to sell. If the price of a security
rises above the strike price, it will, in principle, pay the
holder of a call option to "exercise her option". Options are
said to be "written" by the originator who, in the case of a
call option, must supply the security if the option holder
chooses to exercise her option rights. Options are traded
in the market like any other security. A little thought should
persuade the reader that they are somewhat analogous to
insurance contracts.
To determine the price of an option, Black and
Scholes noted that it is possible to create a safe asset by
simultaneously buying a risky asset and selling short (i.e.
writing) call options on the same asset. Since this transac-
tion creates a (synthetic) safe asset, the no-arbitrage prin-
ciple implies that it should earn the same rate of return in
equilibrium as the existing safe asset. Clearly, the synthetic
asset is only safe for as long as the life of the option, and
if the price of the security does not move sharply. How-
ever, if the price of the security does move, a new safe po-
sition can be created by further transactions in the option.
Managerial Finance Volume 16 Number 6 1990
In the absence of transactions costs therefore, it follows
that a long position in securities is perfectly hedged by a
short position in options, provided the position in options
can be continuously adjusted in line with variations in the
price of the security. Overall, the safe position must earn
the safe rate of return. Since this argument shows that the
change in the option position is determined by the change
in the option price and the change in the security price, in
principle, it should be possible to work out the level of the
option price. This is made technically possible by the
knowledge that, at maturity, the option is always equal
either to the excess of the security price over the strike
price, or to zero if the security price is less than the strike
price.
The power of the Black-Scholes argument arises from
its implication that any security, no matter how complex,
can be priced directly if it can be combined with other se-
curities in the market to produce a riskless asset. The re-
sulting "synthetic security" must, in equilibrium, earn the
risk-free rate of return. This insight illustrates the manner
in which the no- arbitrage principle can be used, and the
Black-Scholes argument provided the foundation for a
wide range of discoveries. For example, the equities and
loan stock of a firm can be priced by interpreting equity as
a call option on the loan stock. At maturity of the loan stock,
equity-holders can either "exercise the option" by repaying
the firm's debt or "not exercise the option", effectively de-
claring the firm bankrupt. Synthetic securities of this kind
are more usually called "contingent claims" or "derivative
assets" (Rubinstein, 1987). A derivative asset replicates
some portfolio of already-existing securities, and there-
fore, by the no-arbitrage principle, must be priced to earn
the same expected return as this portfolio. It should be em-
phasized however, that the application of derivative assets
analysis to price securities is not necessarily inconsistent
with the CAPM; indeed the Black-Scholes option pricing
formula can be shown to be an application of the CAPM.
The point is that the formula is reached by a different route:
utilizing the no- arbitrage principle and thus largely free of
assumptions about individual preferences.
7. Expectations and Financial Markets
A central difference between the research strategies in
monetary economics and finance has been that the former
have concentrated more on explaining the quantities of as-
sets demanded and supplied, whereas the latter have fo-
cused directly on the determination of asset prices and
returns. To some extent, this difference reflects differences
of belief about causation. In markets studied by monetary
economists, central banks have played a key role in set-
ting interest rates and it is logical to think of causation as
running from interest rates to asset demands. In contrast,
in organized markets such as the stock market, with free
trading and no official intervention, it seems more reason-
able to think of causation running from quantities traded
to prices.
9
Relatively free financial markets present a problem for
the traditional methodology in monetary economics. In this
methodology, the private demand for an asset (say,
bonds) is typically estimated directly and is explained by
variations in interest rates and other variables. Here, loose-
ly, causation runs from interest rates to the demand for
bonds. Next, the demand for bonds is set equal to the sup-
ply and this condition is used to determine the interest rate
on bonds. The model is then used to study the impact of
changes in asset supplies on interest rates, in this case on
bonds. However, this usage of the model implies a belief
(again, loosely) that causation actually runs from asset
supplies to interest rates. Thus there is an element of in-
consistency in applying the traditional methods of mon-
etary economics to the study of free financial markets. It
might therefore be thought that the deregulation of finan-
cial markets should lead to increased interest in the meth-
ods of finance with their emphasis on the determination of
asset prices and returns. However, Roll's critique indicates
a need to study the properties of the market portfolio and
this suggests that researchers should be interested in
quantities at least as much as in prices.
It is, in fact, misleading to think of asset holdings caus-
ing asset prices or vice-versa. If there is a driving force in
financial markets it emanates rather from the formation of
expectations. Organized financial markets set the prices
of securities; security returns are only established over
time when the changes in their prices are known. Loosely, .
causation runs from expectations of future prices and re-
turns to asset demands. Asset demands and supplies then
combine to determine simultaneously asset prices and
asset holdings. This process also determines actual re-
turns from the previous time period; returns on current
holdings of securities are not determined, however, until
next period's prices are known. In this scheme of price
determination, available information is exceedingly import-
ant in influencing expectations. New information may have
a sharp effect on prices, depending on how it affects inves-
tor expectations.
Once stated, this argument may appear transparent.
However, until fairly recently, expectations had played a
relatively minor role in empirical financial models in the
monetary tradition. This may go some way towards ex-
plaining why such models performed unsatisfactorily. In-
sofar as asset demands depend on expected future prices,
the evolution of observed interest rates and risk premia de-
pends on unobservable, and probably changing expecta-
tions. This, of course, poses a further problem: if
unobservable expectations are the main driving force in
financial markets, how is it possible to understand the be-
haviour of such markets?
The problem of measuring expectations also arises in
testing the Sharpe-Lintner-Black CAPM, which predicts
certain relationships among the expected returns, varian-
ces and covariances between securities. The theory is
10
however silent on how these data are to be computed.
Tests of the CAPM to which I referred above confronted
this problem by using historical data on security returns,
their variances and covariances. Obviously, such data may
not be a reliable guide to future risks and returns but they
have been universally used as such.
A partial answer to this problem, is provided by the
Rational Expectations (RE) hypothesis, a theory which was
accepted more readily in the finance literature than in econ-
omics generally. The idea of RE will be familiar to many
readers. Briefly, it states that information is scarce and will
not be wasted; agents will use information in the most ef-
ficient possible way in forming expectations. Formally, this
implies that they make use of economic models. Infor-
mally, it merely suggests that agents are not naive. Sup-
pose it were announced on budget day, March 1 st, that the
tax on spirits is to be doubled with effect from March 8th.
"Orthodox" economic theory predicts that the budget an-
nouncement has no effect at all until March 8th when the
price of spirits will rise, because of the tax increase, and
the demand for spirits will fall. RE, on the other hand, sug-
gests that the budget announcement contains information
on which agents can act; they will, of course, bring forward
as far as possible their purchases of spirits prior to March
8th. It is likely therefore that the impact of the tax change,
or any other intervention, depends critically on whether
and precisely when it is pre-announced. RE motivates the
formal analysis of this kind of phenomenon, which, evi-
dently, is of considerable importance.
There is a close connection between rational expec-
tations and no-arbitrage efficiency. A key condition for
agents to be able to eliminate profitable arbitrage oppor-
tunities is that they must be well-informed about present
and prospective future price movements. In particular,
agents must make the best use of all available information
in forecasting future prices, otherwise they may miss some
such opportunities. However, this itself is merely a state-
ment of the RE hypothesis. Thus, in the context of the
CAPM, RE implies that agents will aim to estimate the true
expectations, variances and covariances of securities in
reaching portfolio decisions. A first approximation to such
estimates is provided by the historical data. Here, it is worth
noting the striking and curious fact that security analysts,
many of whom tend to regard the RE hypothesis as a rather
eccentric aberation of academic economists, do indeed
use historical data in security analysis. Yet, the use of such
data implies a belief in a form of RE. Indeed, it is virtually
impossible to provide a complete test of the CAPM with-
out employing RE. Historical data on the means, varian-
ces, and covariances of returns are only of use in
constructing efficient portfolios if these statistics behave in
a systematic and, to some extent, predictable way over
time.
It transpires that the methods of linear regression and
correlation provide a central link between expectation for-
Managerial Finance Volume 16 Number 6 1990
mation, actual behaviour, and research methodology.
Under mild assumptions, the forecasts provided using re-
gression models can be regarded as "optimal" and there-
fore "rational" in certain respects. This leads immediately
to two conclusions: first, agents whose expectations are
formed rationally will use regression models to help pro-
cess the information they possess and thus to help form
their expectations. Moreover, such behaviour can produce
arbitrage efficiency in financial markets. Second, research
in financial markets and other fields can model expecta-
tion-formation by assuming that expectations are the out-
come of forecasts from regression models. In other words,
rational agents will act "as if" they use regression models
to form expectations. Expected movements in security
prices can be identified as those movements which are
forecastable using regression techniques; unanticipated
movements can be identified with the residuals from the
regression equation.
This interpretation of RE makes it possible to focus at-
tention on the role of information in determining expecta-
tions, actions, and, therefore ultimately, asset prices. It
implies a research strategy which does not focus on sup-
ply and demand curves but on the direct determinants of
asset prices and, in particular, on distinguishing between
anticipated and unanticipated events. Since asset prices
should reflect anticipated future returns, price changes
should reflect alterations in expectations engendered by
new information, or "news" which becomes available in the
intervals between price changes. A considerable volume
of research has therefore been carried out studying the im-
pact of news on asset prices.
Consideration of the implications of RE has also sug-
gested new tests of the CAPM which involve studying the
formation of expectations rather than the efficiency of the
market portfolio. If securities are priced in accordance with
the CAPM, rational expectations of future prices must
themselves be consistent with the CAPM. This has the im-
plication that a common method for forming expectations
must apply to each security because, in diversified portfo-
lios, security-specific factors are diversified away. Interes-
tingly, this form of test can be applied equally to highly
disaggregated stock market data which are typically used
in finance, and to highly aggregated portfolio data and the
wider range of markets usually studied in monetary econ-
omics. So far, the results of these tests on the relatively
high-quality stock market data are more supportive of the
CAPM than are those of tests based on the broader but
lower quality aggregative portfolio data.
The RE approach has proved extremely fruitful in
yielding information about the responsiveness of security
prices to new information; notably it suggests why, under
certain circumstances, asset prices move in a rather vo-
latile way. Current events which "cast a long shadow" into
the future may affect the returns on a security over a sub-
stantial period and hence have a dramatic impact on its
Managerial Finance Volume 16 Number 6 1990
current price. As an example, the shares in asbestos com-
panies were substantially reduced in price as the hazards
of that material became apparent. There are however,
some exceedingly unsatisfactory features of this research.
Paraphrasing Tobin, it is a methodology in which failure is
described as success. A good example is provided by the
literature aimed at testing whether monetary policy can in-
fluence long-term interest rates (Mishkin, 1981). The tradi-
tional answer is that it certainly can. However, if
expectations are rational and markets exhibit no-arbitrage
efficiency, then interest rates can only be influenced by un-
anticipated monetary policy. This gives rise to a testing
strategy in which the risk premium on long-term bonds is
regressed on variables such as unanticipated money
growth, itself estimated using a regression model. The
market is deemed efficient, expectations rational, and
monetary policy ineffective if unanticipated money growth
has no impact on the risk premium. It is not difficult to ob-
tain such a result. Most economic and financial data are
very "noisy. A research strategy aimed at proving that
there is no "signal" amidst the noise is likely to have a rather
high success rate unless the signal is exceptionally strong.
A related set of criticisms has been raised in research
initiated by Shiller (1984 and other papers). The prices of
long- term securities appear to be very volatile. If expecta-
tions are rational and assets priced in accordance with the
"no-arbitrage" principle, this implies that investors believe
that future earnings on securities will also behave in a high-
ly volatile way. In fact, exactly the opposite is true: earn-
ings on securities appear to be extremely stable compared
to the volatility of the prices which, in principle, constitute
a forecast of these earnings. There are certain methodo-
logical problems with Shiller's original work on this topic.
In particular, unanticipated movements in earnings could
be interpreted as permanently altering the entire future
path of earnings and, if so, prices may be expected to move
sharply in response to small earnings movements. How-
ever, it is not easy to see why all earnings movements
should be seen as permanent, particularly if, as in practice,
they are sometimes reversed. A further argument is that
expectations may respond in a volatile way to new infor-
mation, in the form of announcements, which is not sub-
sequently reflected in actual earnings. However, if this
were so, investors would surely learn to treat such an-
nouncements sceptically. Moreover, only a very small frac-
tion of actual security price movements can be explained
by a wide range of data coming underthe heading of news.
The worldwide stock-market crash of October 1987 graphi-
cally illustrates these points. No doubt stocks were some-
what overvalued in relation to "fundamentals" before the
crash. However, it is difficult to accept the argument that
the size of the correction was due entirely to the informa-
tion provided in US administration (or any other) an-
nouncements which triggered the crash. In short, it is hard
to escape the conclusion that there are forces at work over
and above those suggested by models of rational security
pricing.
11
8. Liberalization and Market Imperfections
From the exposition thus far, it might seem fair to conclude
that it is the finance tradition which dominates current
thinking about financial markets. To some extent this re-
flects the fact that this essay has an empirical bias. Mod-
els of frictionless markets in which no-arbitrage is
uppermost are easier to test than models in which imper-
fections are important. It is for just this reason that the em -
pirical monetary tradition is more ad hoc than is the
empirical finance tradition. Academic journals contain
numerous untested theoretical models of imperfect mar-
kets.
As the UK and other countries move to an increasing-
ly liberal financial environment, it could be argued that fin-
ancial markets will approximate ever more closely to the
no-arbitrage ideal of a large number of securities being
continuously traded in frictionless markets. It would be
natural to study this environment using exclusively the
traditional techniques of the finance literature. Yet, even as
markets are liberalized, it remains the case that numerous
interesting and important questions seem to concern the
imperfections of these markets. Some examples will help
to illustrate this point.
Derivative assets such as options are a central feature
of current financial markets. We have seen how the no-ar-
bitrage principle can be used to price such securities. The
problem is this: since derivative assets replicate some
combination of already-existing securities why should
such derivative assets ever be created? They are surely re-
dundant. It would appear that market imperfections and
utility-based theories (such as the ICAPM) must have some
role to play in explaining the existence of these securities.
Swaps, for example, developed partly as a means of avoid -
ing certain effects of UK exchange controls. However, the
abolition of exchange controls did not result in the disap-
pearance of swaps; indeed their growth has accelerated.
Their existence is difficult to explain without reference to
agents' wishes to arrange consumption and investment
plans in particular ways and to market imperfections which
make it difficult for them to do this in the absence of a swap.
Market imperfections cover a wide variety of phe-
nomena. First is transaction costs. These include the di-
rect cash costs of trading in securities; the information
costs of uncovering the properties of specific securities
which induce brokerage firms to operate costly research
departments; and the presence of taxation, particularly dif-
ferential income and capital gains taxation which can either
provide incentives to trade or to abstain from trading.
Transactions costs act in two ways. First, they create "fuzzy
zones" in which prices can move without there being an
arbitrage incentive to trade. These zones are larger, the
larger are the transaction costs. In addition they create a
"memory" in the financial markets. Prices may not respond
immediately and fully to new information but only after a
lag. It may appear that there is an opportunity for arbitrage
12
but the level of transactions costs is such that the profit
from arbitrage will not pay the transaction costs. Where
transaction costs are important, "no-arbitrage" has a
weaker interpretation.
A second kind of imperfection arises through legal and
conventional restrictions on trading which limit agents'
ability to hedge against many kinds of unforeseen changes
in the environment. Wide groups of securities are not read-
ily marketable, notably: life insurance policies, pension
rights, mortgages, and commercial bank loans. It is clear
that this is regarded to some extent as an impediment in
financial markets, otherwise it is difficult to explain the rapid
growth of "securitization" which essentially aims to improve
the marketability of certain kinds of security such as these.
On the other hand, securitization is far from complete, even
where absence of legal restrictions would permit it, sug-
gesting in turn that agents find some advantages in non-
marketability.
Probably the main imperfection that arises in financial
markets has to do with the provision of information. Finan-
cial markets provide services whose quality is rather intan-
gible and bound up with the solvency of the institution
providing the service. Life insurance contracts are a good
example. First, the service is only provided after the pur-
chaser is deceased; clearly she herself has no remedy if
her heirs find the service to be unsatisfactory. Second,
where life insurance is linked to long- term savings con-
tracts, the consumer can only make her choice of a con-
tract on the basis of promises of future investment
performance by the insurance companies. Typically, these
promises are made very conservatively and offer no real
basis for choice, even though actual performance may
vary widely from contract to contract. Thirdly, performance
is bound up with the solvency of the institution. If the com -
pany goes bankrupt the consumer has no remedy, but it
is only in the event of bankruptcy (or more often, during
the course of action taken to stave off bankruptcy) that the
consumer can become aware that the product purchased
is of low quality. Considerations such as these suggest the
need for legal regulations and a first step in this direction
was taken in the UK with the passing of the Financial Ser-
vices Act.
In the academic literature, there exists a substantial
and mostly theoretical body of research concerned with
the transmission of information in financial markets. A large
proportion of this literature can, with some imprecision, be
placed under the heading of what is called the "principal-
agent" problem (Ross, 1973). This problem arises when
someone (the principal) delegates another person or in-
stitution (the agent) to carry out a task on her behalf in ex-
change for payment. Shareholders of firms as principals
delegate to their agents, the management, the responsi-
bility for running a firm. The relationship between a finan-
cial institution and its customers is one of principal and
agent. Often, this is bi-directional: banks can be interpreted
Managerial Finance Volume 16 Number 6 1990
as agents of their depositors; but borrowers can be inter-
preted as agents of the bank. Unit trust managers are evi-
dently agents of the unitholders.
In most principal-agent situations, the agent is typi-
cally better informed about the task than the principal, that
is why the task is delegated to the agent. This however
makes it difficult for the principal to design the best con-
tract for hiring the agent: the contract that will, on the one
hand, ensure that the agent performs her appointed tasks
as well as possible, and on the other hand, ensures that
the principal obtains a satisfactory return on her invest-
ment. The agent always has an incentive to "cheat" the prin -
cipal. "Golden parachutes" set up by management in
response to an attempted takeover of the firm they man-
age are an obvious example of such "cheating", the prin-
cipals here being the shareholders of the firm. The various
financial scandals in the UK coming in the wake of liberali-
zation after "Big Bang" emphasize that the monitoring and
pricing of the services of agents in financial sector activities
are not straightforward, and may be particularly difficult for
individual investors to undertake unless they are protected
to some extent by an appropriate regulatory framework.
9. Concluding Remarks
Clearly we are not in possession of a single theory or set
of theories which provides a complete account of how fin-
ancial markets work. Indeed, the search for such theories
is somewhat akin to the search for the nature of matter: we
are unlikely ever to find an explanation which does not
prompt further inquiry. In this essay I have sought to ex-
plain the interaction between the different methodologies
for studying financial markets. For convenience rather than
with complete accuracy, I have labelled these methodo-
logies the monetary and the financial tradition.
Referring back to Hicks's agenda for financial market
research, explaining the demand for a non-interest bear-
ing asset ("money") appears now as a rather unimportant
area, especially given that new payments technologies are
likely to make such assets increasingly redundant. How-
ever, the new payments technologies are increasingly as-
sociated with the provision of a wide range of financial
services by deregulated financial institutions. These ser-
vices are provided in market environments which are in-
variably subject to many of the imperfections discussed in
Section 8. Analysing the functioning and performance of
these markets will be a major task in the years ahead. The
other item on Hicks's agenda concerned the analysis of
decision- making in the fact of risk. Here too, much has
been learned about portfolio choice and the demand and
supply of financial assets. However, there remains a wide
gap between understanding the demand and supply of as-
sets on the one hand, and the determination of asset prices
on the other. Quite simply, it is not possible to explain by
any quantitative means most of the actual variation in se-
curity prices. This fact was underlined by the inadequacy
of ex-post explanations of the October 1987 world-wide
Managerial Finance Volume 16 Number 6 1990
stock market crash. More mundane movements in security
prices are often equally hard to explain - either ex-ante or
even ex-post. It is therefore no mere platitude to state that
more research is needed to understand security price
determination.
In this essay I have generally sought to avoid judge-
ments about the costs and benefits of free financial mar-
kets. Nevertheless, it seems clear that free financial
markets are likely to perform more efficiently in circumstan-
ces in which virtually all the relevant information about the
security or service being sold is summed up in its publi-
cally available price. Conversely, they perform less effi-
ciently in situations in which little or no information can be
deduced from the price and most has to be garnered by
individual negotiation, such as between a principal and an
agent. In the latter framework, bluffing and strategic beha-
viour play a substantial role in determining the outcome. It
is not surprising therefore that, where securities are freely
traded, it is the methods of finance and the no-arbitrage
approach which have come to dominate research in finan-
cial markets. Conversely, where information is not freely
available it is the methods concerned with transactions
costs and imperfect information, which are the most use-
ful. The monetary tradition cannot claim exclusive rights
over these methods, but it is clear that they fit more com-
fortably in this tradition than in that of finance. The prob-
lem with these models of imperfect markets is that they
have so far produced a high ratio of theoretical to empiri-
cal results. If there is a single most important priority in the
field, it is to convert these models into a form in which they
can more easily be tested.
In summary, it appears distinctly premature to claim
that liberalization of financial markets will automatically
produce sweeping benefits for society. It is more accurate
to assert that under certain circumstances free financial
markets may work more efficiently, but in many other (if
not most) circumstances some degree of regulation is re-
quired. The major obstacle to determining the appropriate
nature and extent of such regulation is that there is still a
considerable amount to be learned about the workings of
financial markets. Understanding financial markets may be
a more mundane task than understanding the nature of
matter but, in view of the volume of resources which is
transmitted through these markets, it can scarcely be said
to be less important.
13
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