Persistent noise, investors’ expectations, and market meltdowns
Giovanni Cespa, Xavier Vives 22 April 2014
Since capital flows to and from hedge funds are strongly related to past performance, an exogenous liquidity shock can trigger a vicious cycle of outflows and declining performance. Therefore, ‘noise’ trades – usually thought of as erratic – may in fact be persistent. Based on recent research, this column argues that there can be multiple equilibria with different levels of liquidity and informational efficiency, and that the high-information equilibrium can under certain conditions be unstable. The model provides a lens through which to interpret the ‘Quant Meltdown’ of August 2007 and the recent financial crisis.
The recent financial crisis has revived interest in the question of what triggers crashes and meltdowns in financial markets. An important reason for abrupt and large price dislocations is the lack or ‘slow motion’ of arbitrage capital (Duffie 2010) that weakens the risk-bearing capacity of liquidity providers.
We suggest that there is an alternative explanation based on expectations dynamics in the presence of persistent market noise.
In the market:
liquidity, financial crises, asset prices, noise trading, informational efficiency