Efficient Markets vs. Innovation: No Such Thing as a Free Lunch

By James Kwak

Our little Internet debate about reverse convertibles (my contribution here) prompted this post by Mike at Rortybomb. To simplify a little, some commentators defended reverse convertibles by saying, “it’s basically the same as writing a put option” – or, looking at it from the other side of the trade, “there are valid reasons to want insurance against a stock price falling.” To which Mike says, “just sell (or buy) the put option.”

But this is just a specific case of an important point that Mike has made before, but that is more clear when seen in the context of a specific security. Mike’s basic point is that efficient markets imply that financial innovation does not create value. The efficient markets hypothesis says that the prices of financial assets already reflect all available information; in other words, there is no such thing as a free lunch.

Here’s Mike’s example for those who may be unfamiliar with the idea:

Let’s look at regular markets: Let’s say that everyone knows that the energy market is a big deal over the next 10 years. You could buy land where oil is buried very deep and innovate digging techniques, you could start an innovative research firm to get better solar energy going, you could try and make an innovative super-carburetor. All of these, if you pull them off, are going to be very profitable and welfare enhancing. Markets work, so you’ll probably find capital and labor more willing to work with you.

Now what about financial markets. Let’s say that everyone knows that the energy market is going to be a big deal over the next 10 year. If you invest in energy stocks, are you going to make a killing? No. The prices of energy stocks have already been bid up to account for the fact that everyone knows this. The price of financial instruments moves to handle all possible information that is available. This is what it means for financial markets to be efficient.

If markets are efficient, the only way you can get higher expected returns is by taking on more risk. If some broker comes to you with a new product that offers higher returns with the same or lower risk – like a super-senior, “safer than AAA” tranche of a collateralized debt obligation – then there are two possibilities: (a) the product exploits some market inefficiency; or (b) the product doesn’t do what the broker says it does. Mike says that if you believe that markets are efficient, you also have to believe that (b) is more likely to be the case than (a). (The corollary is that financial innovation does create value when it exploits some market inefficiency.)

But wait, you may be thinking, didn’t the crisis just prove that markets are not efficient? Well, yes and no. I’ve been reading Justin Fox’s new book, The Myth of the Rational Market, which is basically an intellectual history of financial economics in the twentieth century, centered on the rise and fall of the efficient markets hypothesis. The strong form of the efficient markets hypothesis is that market prices, such as stock prices, accurately reflect fundamental values; in Eugene Fama’s words, “the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value” (Fox’s book, p. 97). This proposition has not held up well recently – and has been on the defensive since at least the 1980s – unless you are willing to let prices wander very, very far from intrinsic values.

But there’s another version of the efficient markets hypothesis that I happen to believe holds for many markets: in the short term, you cannot beat the market. For example, stock prices can be irrationally, crazily high – when I was at Ariba, our market valuation went up to $40 billion, even though our annual revenues were less than $300 million and we had never turned a profit – but you still have no way of knowing if they will go up or down in the short term. That’s exactly what happens in a bubble; everyone knows that prices are no longer related to fundamentals, but enough people think they will be able to sell before the bubble bursts that prices keep on going up.

And if this is true for stocks, then it is even more true for derivatives linked to stocks, since the value of an equity-linked derivative is just a function of expectations about the price of the underlying stock. So coming back to reverse convertibles, if the basic purpose is to sell a naked put option on a stock, then you should go to the market and sell a naked put option instead of buying a reverse convertible, which has all sorts of complicated features. Here’s how Mike puts it:

I believe the best price of a put option on a stock is going to the market and getting the price of a put option. I believe that the implied price of a put option, married with odd extra risks and transaction costs, in this reverse convertible bond instrument is a worse price for the put option than the market one, because I believe the more markets vet prices the better they are. Nemo’s point is absolutely correct – if they were much different, the market would be arbitraging them away.

So . . . if you think the stock price of Coca-Cola will be higher in 2019 than the market thinks, then it may make sense for you to buy it, since it’s possible that the price is irrationally low at the moment. (Of course, it could be irrationally even lower in 2019.) But if you think you found a way to get a higher price for a one-year put option on Coca-Cola stock than just going to the market for one-year put options, you are probably wrong.

This brings us back to the main question: Why do these things exist?

Some defenders of financial innovation say that because reverse convertibles exist, they must have value. This is the old “Chicago-school” assumption that even though individuals are irrational, markets behave as if people are perfectly rational. This assumption is at least plausible (though almost certainly wrong) when it comes to prices for heavily-traded stocks; there the argument is that a few well-capitalized, rational hedge fund managers are enough to counteract the irrational hordes. But the assumption completely breaks down when you are dealing with complex products that are sold by individual brokers to individual retail investors; it would be crazy for the retail investor in that situation to assume that the price must be fair, because otherwise the broker wouldn’t be offering it. (Do you make the same assumption about a used car salesman?) Or, as Larry Summers wrote in a now-famous though unpublished paper, “THERE ARE IDIOTS. Look around” (Fox, p. 199).

Here’s one answer, suggested by a friend of mine (who has been working in the financial sector for the last two decades):

I think given the existing array of financial instruments available, it is generally possible to construct a return profile of most things you can imagine, so it is hard to create something that has value over existing alternatives. [He gives a positive example, but it isn't reverse convertibles.] . . .

I think that people may buy these instruments because they are new. Outside the financial sector, “new” generally implies “better” or “improved”. Computers, cars, phones, detergent, etc. all get a marketing lift on new models, since in order to stay competitive in most of these industries, your products have to get better and better. In finance, almost everything is zero sum, so generally there is no better, just different packaging. So unless the packaging has some value (which in some cases it does), consumers are not getting a better product. But since it’s “new”, people might assume that they are getting something better.

That sounds about right to me.

(Note: In following Mike’s links I found that Ezra Klein raised this question about financial innovation a couple months ago on his old blog; he now blogs here.)

Comments

[Living4Divi...:]

Hi thanks for the insightful post. Warren Buffett put it best when he said:

"Derivatives are financial weapons of mass destruction. "

Jun 22 09:27 AM

[Marc Gerstein:]

When it comes to Warren Buffett, you really have to separate the human being from the PR-machine. That latter talks about financial weapons of mass destruction. Te former actually uses derivatives.


On Jun 22 09:27 AM Living4Dividends wrote:

> Hi thanks for the insightful post. Warren Buffett put it best when
> he said:
>
> "Derivatives are financial weapons of mass destruction. "

Jun 22 12:57 PM

[Graham and ...:]

I would amend the statement "In short, you cannot beat the market" to read, "In the short term, you cannot beat the market." The key is to look at things long term.

It's been my experience, that I cannot successfully day trade. But I've been successful taking a 5-10 year view; sometimes 5-10 months.

Just not 5-10 hours, and only rarely, 5-10 days.

Jun 22 01:05 PM

[Marc Gerstein:]

James,

First, if you want to know why reverse convertibles exist, and you must really want to know it since this is the second time you've publicly asked, might I suggest you check here:

seekingalpha.com/artic...

Also, I notice from your bio that you're a law student. Cool. I used to be one. I also used to be a finance student.

Based on the latter, might I suggest that you "reserve judgment" (a phrase you'll come to love after you're out of law school!) on the efficient market hypothesis (EMH) until after you've put in more time and gained more experience in the market.

EMH often sounds flawless to students and the academicians with whom they necessarily interact. But when you've spent more time in the real world and seen more things (not all of which are cleanly expressible as mathematical functions), you see there's quite a bit more to it than the theoreticians suggest. (Heck, you'll find the same thing in law after you finish school -- wait till you see how different practice is!)

As to EMH, I might even toss the whole thing back . . . if all this stuff (active management, product innovation, etc.) really was worthless, then none of it would be around. But it is around, lots and lots and lots of it. Is it possible that the EMH crowd are the only ones who are smart while everyone else is dumb or deluded? Perhaps. Or perhaps the theoreticians are missing something and it's value is well above zero.

Jun 22 01:11 PM

[Thomas J. G...:]

One form of the efficient market's hyposthesis I heard from Roll was that a person with above average intelligence can't make more "extra" in the stock market than they could in other realms where humans are competing to make money. A smart person could make extra money in the stock market but they could also make extra money being a brain surgeon.

Jun 22 01:23 PM

[ValueInvestor:]

Does financial innovation create value?

Only for the broker. But since the markets are generally a zero sum game, NO, its simply a new method or avenue for money to change hands.

Jun 22 02:42 PM

[greg weitzner:]

I still don't get your point. Should we pay regulators to deem certain derivatives or options "not good for society" and eliminate them. The basis of this argument is very flimsy. A share of company is a derivative but clearly it has a place in society. I don't think the government or regulatory agencies should be going around saying which securities are good and which ones are bad. Obviously all securities can be used in good and bad ways. We don't need to protect people from small commissions when it comes to a simple instrument such as this. If anything the banks make money off of them which is not particularly objectionable right now.

Jun 22 02:43 PM

[dw57:]

depends. do you think its a good idea for your neighbor to buy insurance on your house with them selves as the beneficiary?
or they buy insurance on your life with themselves as beneficiaries?


or that the seller of insurance doesn't save the money to make the payment to your life insurance beneficiaries?
all of these are the same as a CDS.
we just don't make sure that these 2 things happen.

we have regulators (or police if you will)
who already make judgments based on what is good for society why would this be any different?

On Jun 22 02:43 PM greg weitzner wrote:

> I still don't get your point. Should we pay regulators to deem certain
> derivatives or options "not good for society" and eliminate them.
> The basis of this argument is very flimsy. A share of company is
> a derivative but clearly it has a place in society. I don't think
> the government or regulatory agencies should be going around saying
> which securities are good and which ones are bad. Obviously all securities
> can be used in good and bad ways. We don't need to protect people
> from small commissions when it comes to a simple instrument such
> as this. If anything the banks make money off of them which is not
> particularly objectionable right now.

Jun 22 03:08 PM

[Marc Gerstein:]

Financial innovation creating value only for the broker? You can't be serious.

Have you noticed that unlike the first half of the last century, our financial markets remain viable and functioning despite one crash-crisis after another. Have you noticed how, despite a horrendous financial crisis, nobody's savings account was vaporized. Innovation in every walk of life happens in fits and starts so not surprisingly, there have been some financial innovations that have been duds. But many have been working quite nicely, not just for brokers but for society as a whole: FDIC, options, futures (imagine the commodities crises we'd have if producers could only make current sales for cash), etc. etc. etc. etc.


On Jun 22 02:42 PM ValueInvestor wrote:

> Does financial innovation create value?
>
> Only for the broker. But since the markets are generally a zero
> sum game, NO, its simply a new method or avenue for money to change
> hands.

Jun 22 07:50 PM

[Moon Kil Woong:]

Financiers have found a new easier way to make money than trying to beat the market. Rather than get smarter they have found it's much easier to make the market dumber.

This usually means finding someone dumber than the market and get them to buy stuff you can't sell into the market. Othertimes, it means making instruments so hard to price you benefit off asymmetrical information because the other person can't easily compare it to anything but is dumb enough to buy it. Still othertimes it means selling defective and damaged products as new (home motrgage backed junk bonds with an AIG AAA derivatives contract attached to it)

Generally speaking, if they did this in other markets it would be called misrepresentation or outright fraud.

Jun 23 07:08 AM

[Trent Hauck:]

First I'd like to preface this saying I am a student as well - undergrad in accounting.

But it is interesting to think about what all these algorithmic trading bots have done to market efficiency. Many claim to increase market efficiency because they narrow the ask/bid difference, but they also are able to parse information much faster than any human trader could and because of their high volumes they can move the market to reflect the information much faster. So I would be willing to say that while its clear the market is not completely efficient it is moving closer because of the digital age and thus it is become even more difficult to make money in the short term due to high volatility as measured by the VIX.

Jun 23 12:18 PM

[ValueInvestor:]

Like I was saying, financial innovation does not CREATE value. Everything you noted only PROTECTS value.

On Jun 22 07:50 PM Marc Gerstein wrote:

> Financial innovation creating value only for the broker? You can't
> be serious.
>
> Have you noticed that unlike the first half of the last century,
> our financial markets remain viable and functioning despite one crash-crisis
> after another. Have you noticed how, despite a horrendous financial
> crisis, nobody's savings account was vaporized. Innovation in every
> walk of life happens in fits and starts so not surprisingly, there
> have been some financial innovations that have been duds. But many
> have been working quite nicely, not just for brokers but for society
> as a whole: FDIC, options, futures (imagine the commodities crises
> we'd have if producers could only make current sales for cash), etc.
> etc. etc. etc.

Jun 23 01:23 PM

[Thomas J. G...:]

Mark G. I would argue that no one's savings account was vaporized because of the fdic, not because of any financial market innovation. In the depression people losing their checking/savings account was a big deal. But I don't think you can give a financial innovation credit for the gov't making sure everyone's checking/savings account was whole. Agree? I'm not saying I don't agree with you that financial innovation is important and makes people better off.

Jun 23 01:29 PM

[Thomas J. G...:]

People's Brokerage (Schwab, Fidelity, etc) accounts have been kept whole throught this crisis without an explicit gov't gaurantee, I think the brokerage account gauranteess are private, industry sponsored, insureance. That may be proof of financial innovation making people better off. I wonder where more of people's wealth is now, in bank checking and savings, or in brokerage accounts?

Jun 23 01:36 PM

[Simon Smelt:]

Nice argumentation but it overlooks:
(i) The possibility of genuine innovation in financial markets that adds value just like innovation in other markets - to put it another way, markets may be efficient and at the production possibility frontier, but that frontier moves overtime.
(ii) In a complex world, different players have different and changing interests, so there are a galaxy of constantly changing possibilities for e.g. doing pairs of offsets, such as CDS on a bilateral basis.
Your car seller example is odd. The car yard makes its money from margin on sales, not speculating on the inherent value of what it sells. A perfect market would equilibriate prices between yards, but then a perfect market (perfectly informed buyers and sellers, zero price of info) could do away with the need for intermediation. Thus, the presence of intemediaries in financial markets shows they are not perfect, but does not prevent them being efficient within given information costs and market complexities.

Jun 23 03:32 PM