Sunday, September 6, 2009

How Financial Markets are like Highways

Cheap Talk makes the interesting point that Finance is like driving in highways, but takes a sour view on arbitrage:

The parallels are clear between financial markets and driving in traffic. Arbitrage is the controlling force. For example, on the freeways arbitrage equalizes the traveling time across lanes, the commuters version of the efficient markets hypothesis.

You don’t have to have spent much time on the freeways to understand why arbitrage is not always efficient. An individual driver can get where he is going faster by changing lanes, but since there is a fixed capacity on the road this is always at the expense of somebody else. In equilibrium the total distance traveled by all is the same as if everybody were required to stay in their lanes. The arbitrage turns out to be a pure social loss due to the increased frequency of accidents.

I take a more sympathetic view to arbitrage (cars careening across highways). Here are three theorems in highway-finance:

1) Inefficient Highways Hypothesis: If not all drivers are willing to change lanes, differences in travel times can persist across lanes. The lack of 'leverage' on highways--you only control your own car--sharply limits efficient travel.

2) Arbitrage is always efficient: Suppose you have two lanes, a fast and slow lane. If enough cars move from the fast to the slow lane so as to equalize the travel times, average speed will decrease for everyone. Moreover, such arbitrage always decreases variance speed across lanes, allowing drivers to better predict travel times.

3) Noise-Drivers are efficient: Suppose drivers randomly change lanes. As drivers spend more time in slow lanes than fast ones, over time highways will move to the efficient solution where travel times are constant (but, by Theorem 1, will probably never reach there).

There are other similarities, in the form of "traffic waves." Like manias, booms, and busts; traffic tends to cluster into times of congestion, which generally can't be fixed by shifts from individual drivers (investors). And just as financial instruments are ultimately a function of the real economy, highway travel ultimately depends on people getting to actual places.

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