Aurora Borealis
1 November 2013 CFA Institute Journal Review

Financial Markets and Investment Externalities (Digest Summary)

  1. Michal Szudejko

The author describes a relationship between participation shocks, investment choices, and the externalities these choices can create. He differentiates between shocks occurring in equity and debt markets and notes that such shocks may have an impact on the real economy by affecting market prices and, eventually, real-life investment decisions.

What’s Inside?

The author presents two models that describe the relationship between participation shocks and investment choices. The first model is designed to analyze the relationship in the equity market, and the second, the relationship in the credit market. The mechanism behind these two models depends on the causal relationship between investment decisions and market prices. The models assume that participation shocks may cause a change in the market price of a given asset, which could force market participants to take certain actions that, together with associated externalities, may affect the prices of other assets. Therefore, participation shocks may have an effect on the real economy. They may influence both asset allocation and prices, resulting in benefits or costs to market players and implications for the economy in general.

How Is This Research Useful to Practitioners?

To begin, the author draws on several pieces of the literature—in particular, Grossman and Stiglitz’s (American Economic Review 1980) noisy rational expectations model. He supplements his research with the literature on externalities related to investment decisions.

In the equity market model, innovation or investment in a given industry may result in additional funds flowing to, or stock acquisition of, complementary firms or industries. The more information asymmetry is included in the model, the more visible such phenomena become. In the credit market model, increased participation in the market surrounding one asset—for example, a rise in demand for housing preceded by the relaxation of mortgage credit spreads—may lead to a decrease in price. This movement may then be amplified by certain externalities that arise—for instance, during an economic downturn. These externalities could include a decrease in maintenance spending or a drop in the quality of the neighborhood, driving house prices even lower. In this way, a small decrease in mortgage spreads can result in a significant drop in housing prices.

The author discusses potential extensions of his research, including the relationship between capital investments and the labor market or between shocks to the financial markets and investment expenditures. Participation shocks can also fuel innovation. Interestingly, shocks to debt markets are more likely to influence investment in existing assets because debt financing requires collateralization for which these assets may be used.

The article may be interesting to policymakers because it can help with the interpretation of recent shocks to the financial markets and their leverage in the real economy. It may also be useful for investment professionals and academics, serving as a guideline for making judgments on certain behaviors of market participants and the effects of such behaviors.

How Did the Author Conduct This Research?

The author summarizes the existing literature and his own conceptual work. He outlines the two models in the context of the technology bubble in the 1990s and early 2000s, as well as the housing credit boom and bust in the mid-2000s. In the process, he observes a positive correlation between quarterly stock results and aggregate economic activity as well as a lack of correlation between stock results and future dividend payouts. Based on the former relationship, the author questions the value of stock results as an explanatory variable for future cash flows. With regard to the credit markets, he analyzes the correlation between loosening credit spreads and economic activity levels.

Participation shocks in the equity and debt markets, because of their different externalities and the different types of information they convey, have different leverage in the real economy even though they tend to happen simultaneously. Participation shocks concern not only certain assets and their complements but also their structure and the cost of financing used to acquire and maintain them. The author notes that because shocks can result in a shift in resources between debt and equity, an integrated model combining the two participation shocks is necessary.

A key challenge in putting the implications of this research into practice is the interpretation of stock market movements. It is difficult to identify movements that result from changes in participation levels rather than changes in fundamentals. It is also apparent that top-level policymakers may have access to some nonpublic information that helps them make such interpretations, primarily in the case of credit market shocks. This knowledge may help them reduce overall volatility in financial markets.

Abstractor’s Viewpoint

In my view, the author touches on a very important topic. He presents a framework that seems coherent and logical and is supported by real-life examples. The concepts are up-to-date and should be of interest to policymakers and participants in the investment industry. The only drawback I see is the limited number of examples used to prove that the models presented are sufficiently universal. In my opinion, they should now be transformed into a quantitative model and verified empirically.

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