Financial Markets: Friction, Efficiency, and Volatility
Channel: Sam Vaknin's Musings
Date: 2012-10-29

It is an open question whether frictionless markets are more efficient. Traders and investors need time to digest new information; incorporate it in models and theories regarding the markets and specific securities; map out the full implications of recent developments; and decide how to act. We call this time lapse "friction" and it guarantees that players and agents act more or less rationally and consistently. In a frictionless market, panics, crashes, and bubbles are far more likely, rendering it less efficient, not more so.

Three of the most important functions of free markets are: price discovery, the provision of liquidity, and capital allocation. Honest and transparent dealings between willing buyers and sellers are thought to result in liquid and efficient marketplaces. Prices are determined, second by second, in a process of public negotiation, taking old and emergent information about risks and returns into account. Capital is allocated to the highest bidder, who, presumably, can make the most profit on it. And every seller finds a buyer and vice versa.
Volatility is considered the most accurate measure of risk and, by extension, of return, its flip side. The higher the volatility, the higher the risk - and the reward. That volatility increases in the transition from bull to bear markets seems to support this pet theory. But how to account for surging volatility in plummeting bourses? At the depths of the bear phase, volatility and risk increase while returns evaporate - even taking short-selling into account.