From the Efficient Market Hypothesis to Econophysics
This chapter suggests that financial-engineering really facilitated the emergence of the 2007 liquidity crisis. It examines how the use of scale free theories might have helped to highlight the preconditions that eventually scaled up into the Dow Jones crash from a high of 14,198 down to 6,469. The Efficient Market Hypothesis (EMH) is one of the key paradigms in finance together with the Capital-Asset Pricing Model, and the Options-Pricing Model. The EMH states that the actions of the many competing participants in the market will cause the actual price to wander randomly about its intrinsic value. The term econophysics was introduced by Morgan Stanley in 1995 at a conference on statistical physics, although early discoveries date as far back as Pareto, Auerbach, and Zipf. Econophysics seems especially useful for describing how stock-trading dynamics shift from the EMH assumptions to become embedded in the development of a bubble build-up to the crash point.