Research Examines Wealth Divide in Financial Markets

New research in quantitative finance indicates that the wealth divide in financial markets may be both mental and structural--not a matter of large investors’ access to faster computers for stock trading or a factor of their personal connections.

In a paper to appear in Quantitative Finance, NYU Polytechnic School of Engineering Professor Charles S. Tapiero examined a classic financial pricing model in which investors were not financial equals. His analysis showed that investors big enough to affect a market hold an arbitrage advantage.

Tapiero observed a rift between what traders are willing to pay—a factor of their wealth and risk preference—and what they actually pay—determined by the amount that all traders are willing to pay collectively. Unlike traditional pricing models, this one assumes that each agent is “Cournot-gaming” the consumption market, a reference to the economic model in which players make choices independently and simultaneously, and their choices affect each other’s pricing.

The market-making agents value returns (and thus future consumption) less than poorer agents, the study found. The wealthiest therefore end up paying less than they would be willing to spend.

“While poorer agents adjust their consumption levels to a price equal to the market price, the wealthier ones profit from a premium they can use to reinvest for future consumption.  As a result, the rich get richer, the poor get poorer,” Tapiero explained.

Tapiero is the Topfer Distinguished Professor of Financial Engineering and Technology Management and chair of the Department of Finance and Risk Engineering.  The Alfred P. Sloan Foundation supported the research. The full paper is available here.