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Dynamics of Markets

Joseph L. McCauley

posted on 17 November 2004

reviewed by Paolo Laureti

Neo-classical economic theory is not a good approximation of real markets, as many have argued in the past and more insistently in the last decade. Very rarely, on the other hand, criticisms are so accurately motivated as in this text. In fact the author uncovers both theoretical and empirical inconsistencies of standard economics text books, showing the reader a path towards a re-foundation of finance theory. A new model of option pricing, based on the empirical distribution of returns, is proposed therein.
After a brief introduction to the mathematics involved, the book presents, for each subject treated, the standard economic approach and a different point of view. It then falsifies the former and illustrates the latter with clear examples: an effective pedagogical procedure.

In the first part the main ideas of the dominant microeconomic theory, which assumes stable global equilibrium, are reviewed critically. Physicists learn that the quest for a global solution of nonlinear systems of equations is very rarely successful. Nevertheless it is widely believed that global deregulation leads to an efficient market, the mythical stable optimum theorized by neo-classical economics.
Standard finance theory is introduced in the core of the book. The author's precise criticisms hit the often misused notion of equilibrium and the Modigliani-Miller theorem. This states that a firm's market price is independent from its debt-to-equity ratio, whereas Enron' s collapse seems to provide evidence of the opposite. Special attention is devoted to portfolio selection theories and to the Black-Scholes equation for pricing options in particular.
Then the author illustrates his empirically based theory of market dynamics, which is a markovian stochastic process where the diffusion coefficient is not constant. Options can be priced accordingly, using the empirical distribution of returns –instead of the Gaussian one.
The last part of the book discusses other applications of the physics of complex systems to finance. The author argues that thermodynamic analogies fail in economics, describing the example of a hedging strategy. Scaling and correlations are also treated in this part, before a brief review of the main conclusions drawn by various physicists who analyzed financial data.

The author guides readers of any level through the chapters they could be interested in and provides them with an accurate bibliography. But this book is not only a useful contribution to econophysics and finance theory. Especially after American elections, neo-libaral policies are going to receive a strong support from the Bush administration. McCauley demonstrates that their claims are not at all supported by empirical evidence nor by scientific rigor.