Financial Market Dynamics

inSight

09 May 2002

Financial Market Dynamics

Financial market dynamics are complex and constantly changing. It is important, both for regulators and market practitioners, that we obtain a better understanding of them - and of the risks to which they give rise.

In my university days I came across a simple introduction to market dynamics. There was this example of a market in which the demand curve was steeper than the supply curve, and there was the additional assumption that supply of the imaginary commodity responded to demand for it with a time lag. The theoretical model then demonstrated how the market would fail to achieve equilibrium in which supply met demand at a stable price. Instead, the market would be highly unstable with the price of the commodity, and the volume of the commodity produced and consumed, exhibiting greater and greater volatility, leading in the end to a collapse of the market. This dynamic market phenomenon was portrayed in the traditional supply and demand diagram in the form of a cobweb, which was also the name of that market dynamics theory.

While this theory was academically fascinating, it was difficult then to appreciate its application or to find clear empirical evidence of it. The markets for some agricultural commodities, the production of which was highly seasonal, came close to it in the old days. But as the futures markets for such commodities developed, the probability of the type of explosive market dynamics of the cobweb theory occurring in the real world diminished even further. Indeed, the dampening of market volatility was one objective for the establishment of the futures (and other derivatives) markets.

In the financial world, the market dynamics are a lot more complex. They also appear to be changing all the time, more recently in particular in response to the globalisation of financial markets, the institutionalisation of the management of domestic savings, and the emergence of large and complex financial conglomerates. For example, decisions in the purchases and sales of large volumes of securities by institutional investors have become much more dependent on certain triggers in terms of price levels, or ratings of all kinds. And the process whereby those decisions are arrived at has also become much more mechanical and, it is often claimed, more scientific. The rating and stock price triggers are arrived at by analysts through examining the relevant financial information such as cash flow, net asset value, earnings, the level of debt and the amount of collateral, the interest rate premium paid, and so on, available in most cases with some time lag. These are obviously in turn affected by activities of the institutional investors in the market. It is not difficult to appreciate the possibility of some explosive market dynamics here, although it will not be easy to articulate it in such clear and simple terms as that of the cobweb theory. It is possible, for example, that a single rating decision by a rating agency can seal the fate of a borrower.

There is a need, I think, to gain a better appreciation of financial market dynamics nowadays. This is important for the regulator responsible for the maintenance of market integrity and stability. It is important for the institutional investors entrusted with the money of the small savers. It is also important for the managements of companies making use of financial markets to raise funds for their economic activities. There is a need to address the additional, arguably more important, question of how the risks of explosive dynamics, if any, could be managed for the benefit of all. It may be that greater disclosure is one answer, certainly concerning, for example, the rating methodology of the rating agencies, but it seems unrealistic to expect institutional investors to disclose the market price triggers that they are working with. Financial market dynamics is a fascinating subject, for academics and market practitioners and regulators, and is likely to be a subject of increasing interest in international discussions.

 

Joseph Yam

9 May 2002

 

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