A computational view of market efficiency

Abstract

We study market efficiency from a computational viewpoint. Borrowing from theoretical computer science, we define a market to be efficient with respect to resources S (e.g., time, memory) if no strategy using resources S can make a profit. As a first step, we consider memory-m strategies whose action at time t depends only on the m previous observations at times t - m, … , t - 1. We introduce and study a simple model of market evolution, where strategies impact the market by their decision to buy or sell. We show that the effect of optimal strategies using memory m can lead to 'market conditions' that were not present initially, such as (1) market spikes and (2) the possibility for a strategy using memory m' > m to make a bigger profit than was initially possible. We suggest ours as a framework to rationalize the technological arms race of quantitative trading firms.Agent based modelling, Bound rationality, Complexity in finance, Behavioral finance,