A Network Value Theory of a Market, and Puzzles

Robert Snigaroff and David Wroblewski

Financial Analysts Journal, 2011, vol. 67, issue 5, 69-85

Abstract: By considering the stock market as a network that impounds liquidity and information production, the authors were able to study its influence on aggregate stock value and value from dividends. Market participants and practitioners impart value through the network of activity they form. The authors offer a network value model that can price this value and help solve such financial economic puzzles as the equity premium, stocks’ inverse inflation relationship, and lack of news. We argue that the supply of activities of market participants (the market’s network value) produces value, which is added value apart from the dividend stream produced by the listed companies. In other words, the market’s mere existence and proper functioning raise the prices of securities. In our study, we measured the value of this network that arises from network traffic: trading activity. This value not only describes aggregated stock market prices better than it would were it not included, but it also helps explain such well-known puzzles as the equity premium puzzle, the inverse inflation puzzle, and the news puzzle (i.e., the stock market’s propensity for large movements without any material news about a prospective change in earnings).By considering the stock market as a network that impounds liquidity and information production, we were able to study the network’s influence on aggregate stock value, in addition to value from dividend cash flows. We built a network value model to price this value, and we then used real-world data to fit our model. By not making the limiting assumption that markets are perfectly complete, we were able to see that changes in the value of a market’s function are useful for describing prices and for solving financial economic puzzles. Because we focused explicitly on the production function of the investment sector—and because we assumed that this value grows and shrinks similarly to that of other networks (e.g., communication networks) or products—we referred to this concept not as an “externality” but, rather, as a “network value.” We made a strong case that the investment sector contributes real value in its provision of information, liquidity, and even confidence; we measured this value over 100 years for the U.S. market.

Date: 2011
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DOI: 10.2469/faj.v67.n5.8

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