When I attended graduate school at MIT in the late 1970s, the perfect market paradigm was fast emerging as a framework to analyze the financial markets. It had already revolutionized the study of economics, and for academics the perfect market paradigm promised, for the first time, to provide a rigorous mathematical approach to understanding and interpreting the financial markets. I became enthralled with this promise after taking a course from Bob Merton, one of those rare men who is both a brilliant researcher and a great teacher. I had embarked on my graduate work with the intention of changing the underdeveloped world through developmental economics, but ultimately the elegance of financial economics was more alluring. My dissertation....
IMPERFECTIONS IN THE PERFECT PARADIGM
The perfect market paradigm assumes that markets are efficient—that is, that all information is imbedded in the market price. In an efficient market, no trader can make money trading on news; by the time a trader gets the news all the other market participants will have the news as well, and the price will have adjusted to the correct level given that information before any trade can be made.
Take a trip to a Wall Street trading floor and it is easy to see how one might end up making the efficient market assumption. Traders are news junkies. The typical trading floor is peppered with screens showing CNN and CNBC; electronic tickers streaming around the room; a half-dozen or so screens surrounding every trader, flashing red or green for each downtick and uptick; and other news screens displaying only a headline for breaking stories and slightly more information for stories that are a few minutes old. There is a phone bank with direct lines to the brokerage houses; no waiting even for a speed dial—a press of the button and the market maker is on the other end of the line.