A SIMPLE MODEL OF CAP ITAL MARKET EQUILIBRIUM WITH INCOMPLETE INFORMATIONT Working Paper #1869-87 March 1987 Presidential Address, American Finance Associatio New Orleans, December 29, 1986. Forthcoming, in J (July 1987
A SIMPLE MODEL OF CAPITAL MARKET EQUILIBRIUM WITH INCOMPLETE INFORMATIONt Robert C. Merton Working Paper #1869-87 March 1987 tPresidential Address, American Finance Association, New Orleans, December 29, 1986. Forthcoming, in Journal of Finance (July 1987)
A SIMPLE MODEL OF CAPITAL MARKET EQUILIBRIUM WITH INCOMPLETE INFORMATIO. Robert C. Merton x The sphere of modern financial economics encompases finance, micro investment theory and much of the economics of uncertainty. As is evident from its influence on other branches of economics including public finance, industrial organization and monetary theory, the boundaries of this sphere are both permeable and flexible. The complex interactions of time and uncertainty guarantee intellectual challenge and intrinsic excitement to the study of financial economics. Indeed, the mathematics of the subject contain some of the most interesting applications of probability and optimization theory. But for all its mathematical refinement. the research has nevertheless had a direct and significant influence on practice It was not always thus. Thirty years ago, finance theory was little more than a collection of anecdotes, rules of thumb, and manipulations of accounting data with an almost exclusive focus on corporate financial management. There is no need in this meeting of the guild to recount the subsequent evolution from this conceptual potpourri to a rigorous economic theory subjected to systematic empirical examination Nor is there a need
A SIMPLE MODEL OF CAPITAL MARKET EQUILIBRIUM WITH INCOMPLETE INFORMATION Robert C. Merton * I. Prologue The sphere of modern financial economics encompases finance, micro investment theory and much of the economics of uncertainty. As is evident from its influence on other branches of economics including public finance, industrial organization and monetary theory, the boundaries of this sphere are both permeable and flexible. The complex interactions of time and uncertainty guarantee intellectual challenge and intrinsic excitement to the study of financial economics. Indeed, the mathematics of the subject contain some of the most interesting applications of probability and optimization theory. But for all its mathematical refinement, the research has nevertheless had a direct and significant influence on practice. It was not always thus. Thirty years ago, finance theory was little more than a collection of anecdotes, rules of thumb, and manipulations of accounting data with an almost exclusive focus on corporate financial management. There is no need in this meeting of the guild to recount the subsequent evolution from this conceptual potpourri to a rigorous economic theory subjected to systematic empirical examination.1 Nor is there a need
on this occasion to document the wide-ranging impact of the research on finance practice. I simply note that the conjoining of intrinsic intellectual interest with extrinsic application is a prevailing theme of research in financial economics The later stages of this successful evolution has however been marked by a substantial accumulation of empirical anomalies; discoveries of theoretical inconsistencies; and a well-founded concern about the statistical power of 3 many of the test methodologies, Finance, thus finds itself today in the seemingly-paradoxical position of having more questions and empirical puzzles than at the start of its modern development k To be sure, some of the empirical anomalies will eventually be shown to be mere statistical artifacts. However, just as surely, others will not be so easily dismissed I see this new-found ignorance in finance as mostly of the useful type that reflects our., express recognition of what is not yet known, but need s to be known in order to lay the foundation for still more knowledge, ?3 Anomalous empirical evidence has indeed stimulated wide-ranging research efforts to make explicit the theoretical and empirical limitations of the basic finance model with its frictionless markets, complete information, and rational, optimizing economic behavior. Although much has been done, this research line is far from closure. Some hold that the paradigm of rational and optimal behavior must be largely discarded if knowledge in finance is to significantly advance. Others believe that most of the important empirical anomalies surrounding the current theory can be resolved within that traditional paradigm. Whichever view emerges as the dominant theme in finance, our understanding of the subject promises to be greatly enriched by these research programs
III -2- on this occasion to document the wide-ranging impact of the research on 2 finance practice. I simply note that the conjoining of intrinsic intellectual interest with extrinsic application is a prevailing theme of research in financial economics. The later stages of this successful evolution has however been marked by a substantial accumulation of empirical anomalies; discoveries of theoretical inconsistencies; and a well-founded concern about the statistical power of many of the test methodologies.3 Finance, thus finds itself today in the seemingly-paradoxical position of having more questions and empirical puzzles than at the start of its modern development. To be sure, some of the empirical anomalies will eventually be shown to be mere statistical artifacts. However, just as surely, others will not be so easily dismissed. I see this new-found ignorance in finance as mostly of the useful type that reflects our "...express recognition of what is not yet known, but needs to be known in order to lay the foundation for still more knowledge." 5 Anomalous empirical evidence has indeed stimulated wide-ranging research efforts to make explicit the theoretical and empirical limitations of the basic finance model with its frictionless markets, complete information, and rational, optimizing economic behavior. Although much has been done, this research line is far from closure. Some hold that the paradigm of rational and optimal behavior must be largely discarded if knowledge in finance is to significantly advance. Others believe that most of the important empirical anomalies surrounding the current theory can be resolved within that traditional paradigm. Whichever view emerges as the dominant theme in finance, our understanding of the subject promises to be greatly enriched by these research programs
Although I must confess to a traditional view on the central role of rational behavior in finance, i also believe that financial models based on frictionless markets and complete information are often inadequate to capture the complexity of rationality in action. For example, in the modern tradition of finance, financial economic organizations are regarded as existing primarily because of the functions they serve and are, therefore, endogenous to the theory. Yet, derived rational behavior in a perfect-market setting rarely provides explicit and important roles for either financial institutions, complicated financial instruments and contracts, or regulatory constraints, despite their observed abundance in the real financial world Moreover, the time scale for ad justments in the structures of financial institutions, regulations and business practices is wholly different than the one for either ad justment of investor portfolios or changes in security prices. Thus, even if all such structural changes served to accommodate individuals'otherwise unconstrained optimal plans, current (and perhaps suboptimal) institutional forms can significantly affect rational financial behavior for a considerable period of time Consider, for instance, the perfect-market assumption that firms can instantly raise sufficient capital to take advantage of profitable investment opportunities. This specification may be adequate to derive the general properties of investment and financing behavior by business firms on a time scale of sufficiently-long duration. It is, however, almost surely too crude an abstraction for the study of the detailed microstructure of speculative markets. On the time scale of trading opportunities, the capital stock of dealers, market makers and traders is essentially fixed. Entry into the dealer business is neither costless nor instantaneous. Thus, margin and other
-3- Although I must confess to a traditional view on the central role of rational behavior in finance, I also believe that financial models based on frictionless markets and complete information are often inadequate to capture the complexity of rationality in action. For example, in the modern tradition of finance, financial economic organizations are regarded as existing primarily because of the functions they serve and are, therefore, endogenous to the theory. Yet, derived rational behavior in a perfect-market setting rarely provides explicit and important roles for either financial institutions, complicated financial instruments and contracts, or regulatory constraints, despite their observed abundance in the real financial world. Moreover, the time scale for adjustments in the structures of financial institutions, regulations and business practices is wholly different than the one for either adjustment of investor portfolios or changes in security prices. Thus, even if all such structural changes served to accommodate individuals' otherwise unconstrained optimal plans, current (and perhaps, suboptimal) institutional forms can significantly affect rational financial behavior for a considerable period of time. Consider, for instance, the perfect-market assumption that firms can instantly raise sufficient capital to take advantage of profitable investment opportunities. This specification may be adequate to derive the general properties of investment and financing behavior by business firms on a time scale of sufficiently-long duration. It is, however, almost surely too crude an abstraction for the study of the detailed microstructure of speculative markets. On the time scale of trading opportunities, the capital stock of dealers, market makers and traders is essentially fixed. Entry into the dealer business is neither costless nor instantaneous. Thus, margin and other
regulatory capital requirements can place an effective constraint on the number of opportunities that these professionals may undertake at a given point in time. Hence, these institutional factors may cause the short-run marginal cost of capital for these financial firms to vary dramatically over short time intervals. Therefore, to abstract from these factors may be to neglect an order-one influence on the short-run behavior of security prices Similarly, models that posit the usual tatonnement process for equilibrium asset-price formation do not explicitly provide a functional role for the complicated and dynamic system of dealers, market makers and traders observed in the real world. It would, thus, be no surprise that such models generate limited insights into market activities and price formation on this time scale. The expressed recognition of a nontatonnement process for speculative- price formation is probably only important in studies of very short-run behavior. The limitations of the perfect-market model are not however confined solely to such analyses The acquisition of information and its dissemination to other economic units are, as we all know, central activities in all areas of finance, and especially so in capital markets. As we also know, asset pricing models typically assume both that the diffusion of every type of publicly available Information takes lace instantaneously among all investors and that investors act on the information as soon as it is received. Whether so simple an Information structure is adequate to describe empirical asset-price behavior depends on both the nature of the information and the time scale of the anal. It may, for example, be reasonable to expect rapid reactions in prices to the announcement through standard channels of new data (e.g
-4- regulatory capital requirements can place an effective constraint on the number of opportunities that these professionals may undertake at a given point in time. Hence, these institutional factors may cause the short-run marginal cost of capital for these financial firms to vary dramatically over short time intervals. Therefore, to abstract from these factors may be to neglect an order-one influence on the short-run behavior of security prices. Similarly, models that posit the usual tatonnement process for equilibrium asset-price formation do not explicitly provide a functional role for the complicated and dynamic system of dealers, market makers and traders observed in the real world. It would, thus, be no surprise that such models generate limited insights into market activities and price formation on this time scale. The expressed recognition of a nontatonnement process for speculativeprice formation is probably only important in studies of very short-run behavior. The limitations of the perfect-market model are not however confined solely to such analyses. The acquisition of information and its dissemination to other economic units are, as we all know, central activities in all areas of finance, and especially so in capital markets. As we also know, asset pricing models typically assume both that the diffusion of every type of publicly available information takes -,Mace instantaneously among all investors and that investors act on the information as soon as it is received. Whether so simple an information structure is adequate to describe empirical asset-price behavior depends on both the nature of the information and the time scale of the analysis. It may, for example, be reasonable to expect rapid reactions in prices to the announcement through standard channels of new data (e.g