3-Milestones Page 83 Wednesday, February 4, 2004 12:47 PM
Milestones in Financial Modeling and Investment Management 83UNDERSTANDING VALUE: MODIGLIANI AND MILLER
At about the same time that Markowitz was tackling the problem of
how investors should behave, taking asset price processes as a given,
other economists were trying to understand how markets determine
value. Adam Smith had introduced the notion of perfect competition
(and therefore perfect markets) in the second half of the eighteenth cen-
tury. In a perfect market, there are no impediments to trading: Agents
are price takers who can buy or sell as many units as they wish. The
neoclassical economists of the 1960s took the idea of perfect markets as
a useful idealization of real free markets. In particular, they argued that
financial markets are very close to being perfect markets. The theory of
asset pricing was subsequently developed to explain how prices are set
in a perfect market.
In general, a perfect market results when the number of buyers and
sellers is sufficiently large, and all participants are small enough relative
to the market so that no individual market agent can influence a com-
modity’s price. Consequently, all buyers and sellers are price takers, and
the market price is determined where there is equality of supply and
demand. This condition is more likely to be satisfied if the commodity
traded is fairly homogeneous (for example, corn or wheat).
There is more to a perfect market than market agents being price
takers. It is also required that there are no transaction costs or impedi-
ments that interfere with the supply and demand of the commodity.
Economists refer to these various costs and impediments as “frictions.”
The costs associated with frictions generally result in buyers paying
more than in the absence of frictions, and/or sellers receiving less. In the
case of financial markets, frictions include:■ Commissions charged by brokers.
■ Bid-ask spreads charged by dealers.
■ Order handling and clearance charges.
■ Taxes (notably on capital gains) and government-imposed transfer fees.
■ Costs of acquiring information about the financial asset.
■ Trading restrictions, such as exchange-imposed restrictions on the size
of a position in the financial asset that a buyer or seller may take.
■ Restrictions on market makers.
■ Halts to trading that may be imposed by regulators where the financial
asset is traded.