Dynamics of Value-Tracking in Financial Markets

The efficiency of a modern economy depends on what we call the Value-Tracking Hypothesis: that market prices of key assets broadly track some underlying value. This can be expected if a sufficient weight of market participants are valuation-based traders, buying and selling an asset when its price i...

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Bibliographic Details
Published inIDEAS Working Paper Series from RePEc
Main Authors Beale, Nicholas CL, Gunton, Richard M, Bashe, Kutlwano L, Battey, Heather S, MacKay, Robert S
Format Paper
LanguageEnglish
Published St. Louis Federal Reserve Bank of St. Louis 01.01.2019
Subjects
Securities markets
Valuation
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Summary:The efficiency of a modern economy depends on what we call the Value-Tracking Hypothesis: that market prices of key assets broadly track some underlying value. This can be expected if a sufficient weight of market participants are valuation-based traders, buying and selling an asset when its price is, respectively, below and above their well-informed private valuations. Such tracking will never be perfect, and we propose a natural unit of tracking error, the 'deciblack'. We then use a simple model to show how large tracking errors can arise if enough market participants are not valuation-based traders, regardless of how much information the valuation-based traders have. We find a threshold above which value-tracking breaks down without any changes in the underlying value of the asset. Because financial markets are increasingly dominated by non-valuation-based traders, assessing how much valuation-based investing is required for reasonable value tracking is of urgent practical interest.