Why are financial markets so volatile?

Gabaix and Koijen calculated the effects of fund flows on individual prices as well as the market as a whole. They used a variety of data sources – putting together a picture using various public documents and reports containing information on holdings and flows in the stock and bond markets, generally covering the years 1993 to 2020. Before publishing their article, they asked 102 university researchers in economics and finance to predict what each dollar entering the stock market would have on prices. The prevailing view, shared by just over half of respondents, was that it would have no effect on prices. Of those who said it would have an effect, only three people said it would have a multiplier effect greater than one, as in, every dollar entering the market would drive prices up $2.

But in the inelastic markets hypothesis, money flowing into the stock market leads to stronger price effects because there are essentially a definite number of stocks available, and many of them are not actively traded. Combining their theory with empirical analysis, the researchers estimate that every dollar put on the market raises overall prices by $5.

The researchers say that while this may seem like a large multiplier, it roughly matches what other researchers are finding at the micro level. For example, Andrea Frazzini and Ronen Israel of AQR and Tobias J. Moskowitz of Yale estimated the impact that a large trader had on prices.

Jean-Philippe Bouchaud, president of Capital Fund Management in Paris, published his own research last summer, in which he writes that the “rather impressive recent paper” by Gabaix and Koijen validates what he has found over two decades. . It calculates that the multiplier for dollars invested can be even higher for volatile stocks, or lower for companies where a smaller fraction of market capitalization is actively traded.

“The Mystery of the Stock Market’s Seemingly Random Moves, Hard to Link [to] fundamentals, is replaced by the more manageable problem of understanding the determinants of flows in elastic markets,” write Gabaix and Koijen. Their work, they continue, “could lead to a more concrete understanding of the origins of financial fluctuations in the markets”.

Deconstruct market movements

This logic implies that it is possible to trace market fluctuations back to their cause, which is what Koijen and his colleagues have done. The idea of ​​tracing movements back to investors is not new, but academics abandoned it decades ago, in part because the data was not readily available, or not available at all.

It is now easier to obtain measurements of holdings and fund flows, and compare them to price data. Koijen, Robert J. Richmond of New York University and Motohiro Yogo of Princeton deconstructed the flows of funds in the US stock market of around $50 trillion to determine what and who moves prices. Day traders might like meme stocks, they write, while some pension funds and sovereign wealth funds have a mandate to invest in sustainable and more environmentally friendly companies. Many hedge funds, on the other hand, look for arbitrage opportunities. (Read “Who Determines Stock Prices?” as well as “Investors Who Have the Most Influence on Company Market Capitalization.”)

The researchers developed a framework that starts with a simple model that they applied to the data to identify the characteristics that drive demand and ultimately prices. They then divided investors into eight groups based on investor size and strategy, from huge passive investment advisers to smaller actively managed advisers and hedge funds. Then they imagined a world in which the assets of one of these groups flowed to all other institutional investors.

“For example, we ask by what percentage does the average stock price change if we take assets from BlackRock and redistribute those assets to all other institutional investors,” they write. “Because BlackRock has certain portfolio inclinations, this experiment would lower the stock price in the characteristics that BlackRock favors.”

Performing this portfolio thought experiment leads to many observations, one of which is that certain small active investors have the greatest influence on valuations. Hedge funds own less than 5% of the equity market, find Koijen, Richmond and Yogo – and yet, controlling for size, they are the most influential players in the market, more so than pension funds and insurance companies much more important.

“At the other end of the spectrum, we find that passive investment advisers (small and large) and long-term investors have a relatively small impact on valuations,” the researchers write. This is consistent with the inelastic markets hypothesis that when many players are sitting on the sidelines, those on the ground move prices and are most responsible for fluctuations as well as outright volatility.

The international image

With the international holdings data, Koijen and Yogo performed a similar decomposition exercise, applying the idea to international stock, bond and currency markets. “Global investors hold financial assets in many countries and are exposed to the exchange rate not only through short-term debt, but also through long-term debt and equity,” write- they. “The portfolio decisions of these investors across countries and asset classes matter to currency rates, long-term returns and stock prices.”

While they present a case that demands questions, they don’t say that’s the only thing that matters. Many other forces can move the markets, including government and monetary policies, volatility, sovereign debt ratings and macroeconomic conditions. To distinguish the different forces at work, they developed a model to study what drove exchange rates, long-term bond yields and stock prices in 36 countries between 2002 and 2017. International Monetary Fund’s Coordinated Portfolio Investment Annual Report provided information on investors’ holdings around the world, and they basically mapped investors’ portfolios nationally with asset prices, estimating asset demand.