Capital, information, and the determination of securities pricing

Re-thinking the equilibrium process of securities pricing

With respect to goods pricing, Marx (2004) states that price exists because goods contain the general social labor of human beings, which reflects their commercial and use value under the conditions of professional division and exchange. Menger (1990) states that commercial value is the foundation of exchange; if goods cannot bring utility to people, there is no value and, consequently, no price. The value of a financial product lies in both the ownership and the claim of surplus returns. However, in fact, this value is realized to a great extent by investor’s buying and selling behavior and the equilibrium between demand and supply.²⁸ Therefore, the price of securities has an internal logical link with the demand-supply relation. Despite this, we do not believe that price is essentially determined by demand and supply. Furthermore, we must consider what factors affect demand and supply. In financial markets, although there are remarkable differences in risk preference, investment techniques, and financial management skills among investors, every investor participates in transactions and decides demand and supply with the goal of maximizing profits. That is, all investors are subjectively rational. Some investors, such as big traders, could influence other investors’ subjective expectations on profit maximization using the resources in their control. Consequently, demand and supply in the market are affected objectively. Then, the transaction price of securities is affected or even determined by a proportion of investors. This phenomenon is frequently observed in reality. Therefore, the main reason why the explanation of the price mechanism by traditional models is challenged is the inconsistency between market and theoretical price. The theoretical price cannot explain the market price. Moreover, there is a lack of essential considerations regarding transaction manipulation, information asymmetry, and the factors affecting the trader’s ability to bargain. Thus, our analysis starts with the most important resources in securities market: capital and information. Then, we show how these resources affect securities prices and explain the associated mechanism. Based on the analysis, we raise a novel theoretical proposition for the determination of securities prices to explain the problem in reality at a deeper level.

Market manipulation is an unavoidable issue for the study of securities price determination. Manipulative behavior refers to exerting market influence to obtain benefits from that influence. Practically speaking, as long as there is a wide gap in the quantity of capital or funds among traders or asymmetrical information, manipulation or influence is inevitable whether intentional or unintentional. Allen and Gale (1992) classify this influence into acts, information, and transaction manipulation. Acts and information manipulation are generally considered illegal, so they are strictly supervised. Transaction manipulation is the most difficult to eliminate or supervise because it simply uses trading strategies to stimulate other investors’ expectations without any observable behavior to change the value of firms, such as dispersing false messages as part of “pump and dump” schemes.²⁹

Studies on transaction manipulation and information asymmetry can be divided into two categories: theoretical and empirical. Theoretical studies build models of certain types of manipulation and discuss their feasibility and welfare impacts. For instance, De Long, Shleifer, Summers and Waldmann (1990) describe how informed traders use positive feedback from traders to control the market price and profits based on the information advantage. Zhang and Fang (2007) note that a necessary condition for transaction manipulation to realize profits is that positive feedback traders account for a fairly large proportion of the market, and the sheep-flock effect (also called herd behavior) is sufficiently large. Empirical studies conduct data mining to verify the existence of manipulation and search for prevention measures and supervision methods. For instance, Khw'aja and Mian (2003) use data from the Pakistan stock market and confirm the existence of pump and dump schemes.

Since the influence of the informed and the big traders on trading prices exists, some researchers study institutional pricing strategies from the perspective of games among institutions and small and medium investors. For instance, Laffont and Maskin (1990) develop a game model to show the stock pricing strategy of risk neutral institutional investors. Based on this study, Xiao and Tian (2002) depict the pricing strategy of risk-averse institutions that have negative exponential utility functions. The studies all note that big traders use their capital and information advantage to influence the market price and seek interests, which is feasible in theory and exists in reality. However, these studies have limitations. The studies mainly focus on explaining the feasibility of the manipulation while ignoring the essence of the issue, which is that the purpose of manipulation is to distribute the trading surplus. Manipulation is realized through pricing power formed by the resources on hand, not others.³⁰ In other words, the existing literature focuses on the interpretation of superficial phenomena and on handling the technicalities while ignoring the analysis of the original problem, that is, the effects and impacts of the economic power structure on micro-economic behavior, the trading surplus, social welfare distribution, and market efficiency.

The essential purpose of engaging in economic activities is the pursuit of maximum interests. While interests are obtained through distribution, market transaction prices reflect the distribution relationship of the trading surplus between the demand and the supply side. Therefore, transaction prices determine the interest distribution among traders. The fundamental purpose of big traders is to maximize their own interests. So what do the big traders rely on to influence the transaction price? What is the mechanism?

We believe that the formation of interest distribution mechanisms results from various forms of power games. In the securities markets, the economic power of large traders is embodied in the influence on transaction prices. The influence is related to two factors: capital and information. Since there is a huge difference in capital between big traders and medium and small investors, they are not in perfect competition. In fact, the medium and small investors are the price takers. This finding can be interpreted in two ways. On the one hand, big traders unintentionally influence the price. However, due to the huge trading volume, their selling and buying behavior influences the medium and small investors’ expectations regarding securities. Then, the price is affected by market demand and supply. For example, a common behavior is to follow the market maker. Although big traders do not intervene the price initiatively, their actions are perceived as making market by small investors who willingly follow the big traders, and then result in price change. Shi (2003) finds that the intentions of market makers is an important type of information that individual investors in securities market are greatly concerned with.

On the other hand, big traders influence the transaction price intentionally, which means they try to change market expectations using their enormous resources to hand. Big traders may even conspire and collude with each other. In this way, they can induce other investors to operate following their hints, and the stock price will change. Information superiority is embodied in the accuracy, availability, and promptness of information. Big traders can hire specialized personnel to conduct information collection and field research on industries of interest. However, medium and small investors typically do not have the time, energy, and resources for such work. Gu and Liu (2004) note that the proportion of investors who obtain information is correlated with the equilibrium price of assets. Moreover, the higher the proportion of investors with information, the lower the risk premium level for the whole market. Essentially, this implies that the higher the proportion, the more balanced trader’s impact on price and the lower the likelihood that certain individual investors will influence the transaction price. Therefore, the possibility of price bubbles will be much lower. That is, information symmetry has significant influence on the transaction price as we have emphasized.

In summary, the influence and control that big traders have on the transaction price through their superior resources, such as capital and information, could be viewed as economic power—pricing power in securities markets. Depending on this power, big traders could influence or even completely change the expectations of the small and medium traders and then affect the demand and supply in the market. Ultimately, they could affect or even decide the transaction price. In other words, big traders can exert influence on the distribution of market trading surplus to obtain excess profits.