If We Understand the Mechanisms, Why Don't We Understand Their Output?

Abstract:     
Despite the considerable research that has occurred over the twenty years following the publication of Ronald Gilson's and Reinier Kraakman's article, The Mechanisms of Market Efficiency, there still remains a fundamental puzzle concerning the price fluctuations of securities. The explanatory power - the R squared - of various models used by financial economists to explain security price fluctuations is quite low, in the range of .20 to .30. What accounts for the other 70% to 80% of price fluctuations? This paper explores the challenges this puzzle poses to our understanding of security markets, the role played by mechanisms of market inefficiency (noise traders) as well as various mechanisms of market efficiency (information revelation via trading; the firm as arbitrageur) and the impact of legal institutions and practices on the operation of security markets.

Number of Pages in PDF File: 17

JEL Classification: G12, G18, K22

Accepted Paper Series