The price discovery mechanism

Some cross-cultural differences are enduringly fascinating. In India, "speculation" is a bad word while "arbitrage" is almost okay. In the US, "speculation" is mostly okay while "arbitrage" was until recently a bad word. "Volatility" is bad in both.

In India, most people think that the government should "do something" to reduce volatility. On the evening of June 1, an often expressed idea was that the rupee should float freely, except when "speculators" start trading. In this case, the RBI should "control things" (i.e. move the rupee back into a direction desired by policy-makers).

This is an area fraught with conceptual confusion, especially amongst economists who spent their formative years without modern financial markets. Modern financial economics suggests some very different ideas: (a) speculation and arbitrage -- appropriately defined -- are socially beneficial activities, and (b) market efficiency is an important issue in public policy, volatility is not.

Trading on financial markets is about obtaining prices. A good financial market is "an efficient market", where forecasts about future risk and return determine valuation. The price observed at an instant in time on the ideal efficient market is a good assessment of future risk and return. This price is not constant, because new information is being constantly generated in the economy. This leads to two facts:

Many people dislike volatility because of its financial implications. These people need financial derivatives to hedge away their risk. Their discomfort with volatility should not influence public policy to "reduce volatility on the market". In this sense, the advent of derivatives exchanges is important in enabling the withdrawal of government from the role of "stabilising" prices.

Once derivatives exist, volatility will have a much lower political cost, and it will become possible for governments to embark on better economic policy on currencies, commodity prices and interest rates. In the absence of these markets, governments would be constrained by the political constituency which desires low volatility, and does not understand the costs of such stabilisation efforts.

Speculation is often mixed up in the public imagination with market manipulation or with systemic risk -- visions of a payments crises at the BSE come to mind. One question often raised is that manipulation or systemic risk have no place in a modern financial system. The development of market institutions would diminish the extent of market manipulation and systemic risk. Modern exchanges invest considerable sophistication in doing surveillance to diminish the extent of market manipulation. Like the clearing corporation, they serve to eliminate the possibility of a payments crises. Once these two issues are addressed, there need be no reservations about speculation.

The modern understanding of financial markets emphasises the role of speculation in markets with open access -- where anyone can become a speculator in an anonymous market -- in order to obtain market efficiency. At the end of four decades of research in financial economics, we do not know how direct government intervention into the market (to influence the price) can be done to enhance market efficiency. Even with the best of intentions and the absence of political interference, it is unlikely to find the staff of a RBI or a Sebi being able to understand the "true value" of a security better than the overall market. This idea is hardly surprising in the modern market economy. It is hard to imagine a Planning Commission that has the analytical capacity to take a view on the price of the rupee, if we think that it does not have the analytical capacity to take a view on the price of a shirt.

Government agencies placed in such roles are quite likely to come under political pressures motivated by an unsophisticated aversion for market volatility, or compulsions to prop up the rupee or share prices prior to an election. The activities of a government agency trying to influence prices is often a case of mere market manipulation. In international financial circles, people often joke about how the activities of central banks on currency markets would easily yield prison sentences in the better, regulated equity markets. Distorted prices generate an inferior resource allocation in the economy, regardless of whether the manipulation is done by a Harshad Mehta or by a government agency.

Arbitrage is also an area where confusion often rules. If bread is costly in Mumbai and cheap in Pune, then arbitrageurs buy bread in Pune and sell it in Mumbai. They serve to equalise prices and restore market efficiency. A central idea in modern finance is the "law of one price" where two portfolios with the same risk and return should have the same price. If, for any reason, shares of ITC are cheap on NSE and expensive in Calcutta, then arbitrageurs play an important social role by buying ITC in Calcutta and selling on NSE.

The operation of a modern financial system always involves trading in redundant assets. Strictly speaking, if interest rates are known and gold spot prices are known, then there is nothing "new" about a gold futures price, which is based on the cost of carrying gold to the future date. When gold futures trade, there will always be small frictions where the futures and the cash price go out of step. In these situations, arbitrageurs perform a valuable function by restoring market efficiency, by ensuring that the law of one price is not violated.

In India, we've had decade of experience with multiple stock exchanges, and "line operators" who do arbitrage is a fairly well-accepted idea. In contrast, on the NYSE, the equity community had little experience with arbitrage prior to the rise of index derivatives. Traditional stock-pickers were dismayed in the early 80s when the rise of index futures generated a large volume of arbitrage. They would think "there is something dangerous when a person buys a stock without knowing anything about it". Significant efforts were made to put limitations on stock index arbitrage. It is a comment on the quality of economists in the US that these restrictions did not come about.

Similarly, as we embark into a liberalised economy where financial markets are at the centre-stage of the modern Indian economy, it is time for our economists to speak with clarity about financial markets.

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