Saturday, February 6, 2010

On the Theory of Speculation

Bachelier’s Theory of Speculation gives rise to the practical use of higher mathematics (traditionally utilized for natural sciences) to the field of finance. In my opinion, however, it overlooks the fact that stock prices, among other observable financial data, form only a part of the market’s true identity. People also make-up the complex entity, that is the financial market. In fact, it probably gives rise to a question of whether the market ultimately influences the people or if people with all their thoughts, emotions and distinct trait of self-awareness keep the absolute quantifiability of financial markets illusive. Though the concept of randomness would imply that the market should be expected to ignore the past, because the market is composed of humans who give regard to the past, expectations may be influenced by previous facts, data and figures. Further reinforcing how market players remember the past is the evolution of technology, which has allowed finance professionals and analysts to look back to the past and continuously re-update themselves with the present. I believe that it then becomes a paradox with market players trying to outdo each other by anticipating the anticipants. Though there are instances of complete predictability in what investors may do, it may probably be due to instinctual survival behavior (e.g., when investors traditionally flood to the relative safety of US Treasuries during times of turmoil and highlights the EV theory of maximizing returns for minimal risk), if not simply grounded on simple, although non-absolute, academic training that US Treasuries are the best safe havens of money.

Investing in options is called a zero-sum game, even so, I think what makes it distinct from simple long positions in securities (say stocks) is that it encapsulates the amount of money that can be lost or gained given a timeframe. Options serve as instruments of speculation that integrate all the factors that influence expected prices.

Methodologies presented are for the observation of natural sciences and was eventually applied on asset pricing. Humans are natural creatures, measurable in many ways but unpredictable in others as well. Price is a function of value, but value is measured by human orientation, psyche and belief so it may be possible although not conclusive to say that price determination or the location of equilibrium will always vary.  Interestingly as markets become integrated, price/value become absolute anywhere people are able to value an object based on the “going rate”. This however may still involve the market setting a price that everyone will agree on. Markets may perhaps be inefficient, but it attempts to beat itself by continuously locating the true price of an object of interest.  Self discerning and with market players attempting to beat one another, methods and concepts in making money may ultimately be self defeating for everyone in the market. Some will succeed, but the approach is not a universal law, because unlike inanimate objects, people in the market attempt to outthink each other. People may be governed by natural forces as well measurable by mathematical approaches meant for the natural sciences, but their activities are still self-conscious and of free will. Interactions in the market are of people and not of molecules, atoms or anything fundamentally consisting of the universe.  Probability may still be an appropriate way to measure and study the market since proximity to the likelihood of human behavior takes into regard minute outliers to the ordinary.

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