10.2 THE ROLE OF NEWS
To understand risk in financial markets, we must understand the mechanism by which news influences security returns. Variations in security returns are the algebraic manifestation of price changes over time. Price changes arise due to an imbalance between the numbers of willing buyers and the number of willing sellers at the current price. The willingness of the buyers and sellers of a particular financial asset to transact is a function of two processes, which we call “have to” trades and “want to” trades.
Financial market participants often trade financial assets because they “have to” do so. The classic example of this is forced liquidation of a position by a hedge fund or other leveraged investor who gets a margin call. Another example is a mutual fund manager who experiences large redemptions by investors and must provide cash within a few trading days. On the other hand, most financial literature in asset pricing has focused on “want to” trades, those transactions motivated by investor expectations of abnormal risk-adjusted returns in the future. Almost all “want to” trades are responses to flows of information to financial market participants and the resultant investor willingness to pay liquidity providers to accommodate their desired transactions.
Financial markets are driven by the arrival of information in the form of “news” (truly unanticipated) and in the form of “announcements” that are anticipated with respect to time but not with respect to ...
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