economics: agents, information, & markets

Economists are still discovering how markets work. This might be little known to the thousands of market participants who trade in the markets each day. The standard accepted theory is that markets are efficient in that all relevant information is reflected in market prices. As a consequence, if markets contain all information available, any additional research effort leads to returns only enough to compensate the extra effort used to gather the additional information. And usually it is added that miss-pricings in the market, if they exist, last for only a short time so you must be quick to take advantage of them.

A more satisfying explanation of the question of "how markets work" comes from three areas of economics: Theories of Agent Based Market Dynamics, Theories of Information in Prices, and Theories of Trading Strategies & Rational Speculation. The following lists & links will introduce you to some of the people and places where new market theories are being developed. In these theories, markets take on strange behaviors where markets outcomes are described as emerging, evolving, or self-organizing. And where market participants are described as rational, nearly rational, or robots. Market participants may compete, cooperate, or follow some form of adaptive strategy. Together, markets and market participants interact in complex, sometimes chaotic, ways where the passage of time and feedback effects affect outcomes.

What does all this have to do with Derivatives? Derivatives are valued based on certain theories of how agents make decisions. In the case of mortgage derivatives, the common practice is to use simulations to value the derivative. These are often very simple simulations, and use very little of what has been learned from simulations of large numbers of interacting agents, simulations of markets, or simulation of market economies.

People & Places

Dan Friedman and Dan Friedman's Papers and Axel Leijonhufvud and Axel Leijonhufvud's Papers

Agent Based Comput Economics and Economic Science Association (ESA) and Kardi Teknomo's list of Simulation Journals and Leigh Tesfatsion's List of Individuals Engaged in ACE Research and Landscape Dynamics (Friedman and Abraham of the Visual Math Institute) and The Santa Fe Institute and UC Santa Cruz Experimental Laboratory: LEEPS and Univeristy of Trento Experimental Laboratory: CEEL and Efficient Market Hypothesis References.

Books on Informational Economics

Jack Hirshleifer and John G. Riley, The Analytics of Uncertainty and Information

Sanford Grossman, The Informational Role of Prices

Roger E. A. Farmer, Macroeconomics of Self-fulfilling Prophecies - 2nd Edition

Daniel Friedman and Shyam Sunder, Experimental Methods : A Primer for Economists

Daniel Friedman and John Rust, The Double Auction Market: Institutions, Theories, and Evidence (Santa Fe Institute Studies in the Sciences of Complexity Proceedings)

Alessandra Cassar and Daniel Friedman, Economics Lab: An Intensive Course in Experimental Economics (Routledge Advances in Experimental and Computable Economics)

Jean-Jacques Laffont, The Economics of Uncertainty and Information

Dissertation: Noisy Rational Expectations with Stochastic Fundamentals (Cover, Introduction, Chapter One, Chapter Two, Chapter Three):

Cover Pages, Table of Contents, Abstract Dissertation UC Santa Cruz, 1995. (Pdf)

Financial Crisis of 2008 Presentation:

"Troubled Assets: Elements of the Mortgage Crisis" UCSC Economics Seminar Presentation, October 2008. (Pdf)

Papers where I contributed as research assistant:

Timothy Cason and Daniel Friedman, "Price Formation in Single Call Markets" Econometrica, 65(2), 1997.

Papers with citations of my papers:

Daniel Friedman, "Market Theories Evolve, And so Do Markets" Journal of Economic Behavior & Organization, 2007.