The Diversity, Uniformity and Perfection of Financial Markets
It is now necessary to return to the market, where the assumption of homogeneity in support of perfect competition is said to be most naturally satisfied. Just to start, note that the entire mechanism of market efficiency that operates in financial markets is based on the difference between diversity and homogeneity in the form of the definition of alpha returns and beta returns.
The former is idiosyncratic, and based on the diversity of an asset’s returns, while the latter represents the market’s uniform performance. The only justification for paying an asset manager is the ability to identify alpha returns, that is, returns that have not yet been homogenized by the market. Of course, once they are recognized, competition should cause conformity with market performance.But, there is a more important example of this conflation of diversity and homogeneity The very conception of an equilibrium market price requires diversity of expectations of the future movement in price on the two sides of a market exchange, since a buyer will only buy expecting a rise, and a seller will expect to avoid a decline in price. Equilibrium, and the determination of price, thus requires diversity of expectation, while rational expectations require full information and uniform assessment of all current information in prices. As the story goes, a Chicago finance professor will never bend down to pick up a $100 bill since he knows that in an efficient market someone will already have picked it up. Note that if everyone believes this, there should be a lot of $100 bills laying around on the streets of the South Side of Chicago!
Of course, note the implications of the idea that it is impossible to beat the market, so you should always buy the market. If there are no sellers, then it always goes up and by definition you cannot beat the market, but in order to have any transactions, you need sellers, and even in the presence of “liquidity” sellers (i.e., you need to sell to get money to pay the doctor bills), as long as they do not dominate, the market still cannot beat a market that only rises!
Finally, consider modern financial markets where financial innovation dominates.
Now,just exactly what is financial innovation? As already noted, financial markets, pace Walras, are based on the distinction between diverse, idiosyncratic alpha risks, and market or homogeneous beta risks. Things like consumer loans, auto loans, credit card loans, and especially home mortgages were all once considered iconic idiosyncratic risks. They were all essentially, idiosyncratically different, so that that the market process of uniformity and homogenization could not work. They could not be treated in the same way as bonds or shares. Every share of a given class issued by IBM is the same as any other, and any bond of a given class issued by IBM is the same as any other. A loan to John Smith to buy a Porsche is not the same as a loan to Adam Smith to buy a Chevrolet; a mortgage to John Smith to buy a house on Broadway is not the same as a mortgage to Adam Smith to buy a house on Park Place. They differ in terms of the borrower as well as in the underlying asset and the location that is being purchased. There is no way to compare the two, and thus there is no market and no market prices.5.