Explaining financial prices

How does one create market prices for public obligations? Researcher Siri Valseth proposes some answers in her doctoral thesis. (Photo: Colourbox)

Financial markets do not always behave the way classical economic theory prescribes. According to this theory, new and relevant information that has a bearing on prices in a given market - bonds or shares - are immediately reflected in prices. This means that prices should always reflect all relevant information.

The reality, however, is often quite different. Researchers are fascinated by mysteries like these, and the possibilities they present of finding new pieces in the financial puzzle.

Examining the trade

For her doctoral thesis at the BI Norwegian Business School, financial researcher Siri Valseth has studied trading in Norwegian government bonds between 1999 and 2005, concentrating on the seven most active players in this period. 

Studies of the microstructure of financial markets show that new information is impounded into prices via two channels; one direct and one indirect.

• Via the direct channel, prices change as an immediate response to new public information, such as new figures on consumer prices or growth in the GDP.
• Via the indirect channel, prices are adjusted gradually, in line with purchases by market players who may possess private information that has a bearing on the market. As the term suggests, private information is not available to everyone. This information includes knowledge about circumstances that may affect investors' risk willingness or liquidity in the market. Private information may also constitute market players’ qualified understanding of financial data.

25 percent via indirect channels

Financial researchers regard Norway as an ideal laboratory for gaining a better understanding of the mysteries of the financial markets due to its access to high-quality and detailed data.

Valseth has been interested in finding out how much of the daily price changes - measured in interest rates - in Norwegian government bonds occurs via the indirect channel. To find the answer, she has followed order flows, which represent the sum of all transactions initiated by buyers and sellers in the course of one day of trading.

Order flows explain one quarter of the daily change in interest rates in the given market. Then market players contribute in different ways to this process, and the contributions they make depend not only on how big they are, but also on the degree to which they initiate trade with others.

Predicts changes

Researcher Siri Valseth has taken her docotoral degree in financial economy. (Photo: BI)

Valseth also proves that information that lies in the market players’ buying and selling of government bonds can be used to predict changes in the prices of bonds. Daily order flows can be used to predict bond rates for the following day, while monthly order flows can be used to predict monthly changes in interest rates.

“If you trade along these lines, you may be able to earn money," the researcher points out.

She has also been able to examine the seven market players very closely, to find out whether they differ in any way. The order flows for different market players have varying abilities to predict changes in interest rates.

“Some banks are better than others,” she says, without revealing who tops the Norwegian government bonds market.

According to Valseth, there are two reasons why some banks are better than others: “One of them is that they have customers who possess private information. The other is that they are better at interpreting order flows and what effect public information has on future bond prices.”

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Read this article in Norwegian at forskning.no