April 26, 2008
The Undercover Economist: How markets keep abreast of the news
If markets are efficient, you will never make profitable trades as a result of reading the Financial Times. Efficient markets move quickly and respond to any new headlines – disappointing earnings, a cut in interest rates, a fraud or a safety incident. Markets will sometimes overreact, drifting backwards after a lurch, or underreact, taking time to digest the true impact of the new information – but overreactions and underreactions should balance out. And when no news is available, the prices of an efficient market won’t change much.
But do markets really react efficiently to news? It would be easy to tell if it were easy to identify all genuine news. Sadly, it is not. Yet two inventive new academic papers claim to have solved the problem of identifying news, in two very different contexts. The studies could not be more unalike. One looks second-by-second at trading data from one of the world’s most active financial exchanges. The other analyses market information that is more than two centuries old.
Karen Croxson and J. James Reade of Oxford University studied the Betfair exchange, a sports betting site that supports many more trades than the London Stock Exchange. Betfair allows punters to bet on football games, and the market stays open throughout the match. Croxson and Reade studied how the price of different bets varied as goals were scored during English league games.
The remainder of this column can be read here. Please post comments below.
There’s a really nice paper on this: Maloney, Michael T. & Mulherin, J. Harold, 2003.
“The complexity of price discovery in an efficient market: the stock market reaction to the Challenger crash,” Journal of Corporate Finance, Elsevier, vol. 9(4), pages 453-479, September.
The found out the the markets discounted the stock of the responsible manufacturer within an hour of the explosion, while the inquiry took months.
Posted by: Alison Kemper | April 26th, 2008 at 3:46 am | Report this commentThis raises an interesting question about the definition of market efficiency. It seems to me that a market could be highly volatile because it was very efficient in reflecting changes in perceptions of market participants. If market participants start jumping at shadows when information is delayed, could this be just part of the logic of life?
Posted by: Winton Bates | May 1st, 2008 at 2:12 am | Report this commentI imagine that sports betting markets would also be highly susceptible to rumour e.g. if a rumour circulated at half time that a key player was not fit to continue in the second half. However, that is just conjecture.