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When studying financial economics, three concepts appear everywhere

  • Equilibria (investors maximise utility, markets clear and aggregated demand equals aggregated supply)
  • Completeness (there are enough (linear independent) assets to match the number of states of nature, i.e. payoffs can be hedged/replicated)
  • Absence of arbitrage (there is no free lunch, no self-financing trading strategy with zero initial cost can generate positive payoffs with positive probability whilst negative payoffs are impossible). I guess a weaker form would be the law of one price.

Are today's financial markets close to be in equilibrium, complete and free of arbitrage (at least most of the time)? Of course, there are some frictions and nothing is as perfect as in theory but all in all, what is the academic consensus?

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Equilibria: in the macroeconomic sense of aggregate equilibrium where all markets clear, markets are most likely never in any equilibrium but rather in constant flux between different equilibria, because the market clearing macroeconomic equilibrium always depends on real and also in short run nominal factors which constantly change. Hence it does not make sense to say whether the markets are currently in equilibrium or not. However, textbooks use the concept of such equilibrium because it is very useful way of describing states toward which the markets gravitate - you can imagine them as a screenshot of a continuously playing movie.

Completeness: this condition, in Arrow-Debreu sense, requires there to be very small or non-existent transaction cost and perfect information, this is almost definitely not satisfied in many cases and consequently you will see a lot of research that looks at what happens when there are transaction costs and information asymmetries in markets.

Arbitrage: empirically arbitrage opportunities are definitely present in financial markets but they are usually small (i.e. no million dollar bucks left laying on a side walk) and they tend to disappear really quickly for example many studies of covered interest parity in foreign exchange markets show that arbitrage opportunities usually don’t last more than few hours, sometimes even seconds and arbitrage opportunities lasting few days are already considered long (Mark, 2000). History also shows longer arbitrage windows but they usually come from times where information technology was not as sophisticated as now. So you could say that the condition of no arbitrage in real life holds most of the time approximately.

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  • $\begingroup$ Yet again an outstanding answer, thank you very much! Just one question: What do you mean with " flux between different equilibria"? What different equilibria are there? $\endgroup$ – Alex Apr 27 at 16:13
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    $\begingroup$ @Alex I am glad you liked my answer. By being in flux I mean that in real life equilibrium is not static as discussed in most entry level textbooks. For example, aggregate demand even in normal non-recession time fluctuates slightly, the technology based on which aggregate supply depends constantly develops and so on. Consequently, the equilibrium is constantly being disrupted in small ways. Small changes in AS or AD will move the equilibrium point to some new position but before the economy even gets there other small changes move it elsewhere. Hence economy is in constant flow or flux... $\endgroup$ – 1muflon1 Apr 27 at 16:43
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    $\begingroup$ between these equilibrium points. Also note here I refer to multiple equilibria across time. In economics you can get also multiple equilibria at the same time and then economy might gravitate towards one of those but that’s not what I was referencing here. Here I mean by that just that what market clearing equilibrium is constantly changes over time - even in absence of big shocks that are the only changes usually mentioned in entry level textbooks. $\endgroup$ – 1muflon1 Apr 27 at 16:46
  • $\begingroup$ that makes very much sense. I see what you mean: Aggregate demand and supply change continuously due to underlying forces (technology, labour force changes etc), thus equilibrium prices and allocations alter continuously. Would you say that financial markets tend to be reasonably close these changing equilibria or do we sometimes deviate far away from them? I suppose if there are sudden demand/supply shocks and we're far away from an equilibrium, prices adjust quite quickly (see the oil futures price from last week)? $\endgroup$ – Alex Apr 27 at 17:04
  • $\begingroup$ Another implication of your answer would be that general equilibrium models such as the CAPM are theoretically stronger yet empirically weaker than no-arbitrage pricing frameworks because no-arbitrage is easier to impose than a model for equilibrium prices? $\endgroup$ – Alex Apr 27 at 17:09

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