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algorithmic trading, automated trading system, Bernie Madoff, buttonwood tree, commoditize, computerized trading, corporate governance, cuban missile crisis, financial innovation, Flash crash, Gordon Gekko, High speed trading, latency arbitrage, locking in a profit, Mark Zuckerberg, market fragmentation, Ponzi scheme, price discovery process, price mechanism, price stability, Sergey Aleynikov, Sharpe ratio, short selling, Small Order Execution System, statistical arbitrage, transaction costs, two-sided market, zero-sum game
It was not due to small supply and rabid demand. One algorithm was pricing the book at 1.27 times the price of the other algorithm, which in turn would revise its price to 0.998 times the price of the first algorithm, creating a positive feedback loop. Momentum ignition is extremely damaging to long-term investors. It does not cost pennies; it costs them quarters, and it ferociously distorts the price discovery process. How the World Began to Learn About HFT While HFT has been steadily expanding since the millennium and exponentially since the implementation of the SEC’s Reg NMS in 2007, it stayed out of the mainstream media until mid-2009. Over the July 4 weekend, Sergey Aleynikov was arrested by the FBI at Newark Airport for stealing code from his prior employer, Goldman Sachs, and trying to bring it to his new job as an HFT programmer at Teza Technologies, where he was set to triple his $400,000 salary.
The proposals called for dark pool indications of interest to be treated like regular quotes and therefore required to be visible to all investors; real time disclosure of the identity of the dark pool that executed a trade; and any dark pool that traded more than 0.25% of a stock had to display those orders in the public quote.8, 9 Ironically, Reg ATS in 1998 was supposed to force more orders into the public quote to aid in the price discovery process. However, it resulted in almost one-third of orders being executed away from the public quote and in dark pools. With the flash order and dark pool proposals, it appeared that the SEC was serious about increasing transparency. The SEC received hundreds of comment letters, most by industry participants who wanted to maintain the status quo. Unfortunately, even though proposed in 2009, the SEC has yet to approve any parts of either proposal.
Investors who thought they were protecting themselves with the prudent use of stop orders were left with fills that were far away from the closing price. Today’s severe market drop should never have happened. The U.S. equity market had been hailed as the best, most liquid market in the world. The market action of May 6 has demonstrated that our equity market has major systemic risks built into it. There was a time today when folks didn’t know the true price and value of a stock. The price discovery process ceased to exist. High frequency firms have always insisted that their mini-scalping activities stabilized markets and provided liquidity, and on May 6 they just shut down. Money began pouring out of the equity market, as nervous investors lost confidence. The SEC responded almost five months later, issuing a report titled “Findings Regarding Market Events of May 6, 2010.” The report placed a good piece of blame on one midwestern money manager.
Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo
Albert Einstein, Alfred Russel Wallace, algorithmic trading, Andrei Shleifer, Arthur Eddington, Asian financial crisis, asset allocation, asset-backed security, backtesting, bank run, barriers to entry, Berlin Wall, Bernie Madoff, bitcoin, Bonfire of the Vanities, bonus culture, break the buck, Brownian motion, business process, butterfly effect, capital asset pricing model, Captain Sullenberger Hudson, Carmen Reinhart, Chance favours the prepared mind, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, Diane Coyle, diversification, diversified portfolio, double helix, easy for humans, difficult for computers, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, interest rate derivative, invention of the telegraph, Isaac Newton, James Watt: steam engine, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, merger arbitrage, meta analysis, meta-analysis, Milgram experiment, money market fund, moral hazard, Myron Scholes, Nick Leeson, old-boy network, out of africa, p-value, paper trading, passive investing, Paul Lévy, Paul Samuelson, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, quantitative hedge fund, quantitative trading / quantitative ﬁnance, RAND corporation, random walk, randomized controlled trial, Renaissance Technologies, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, Robert Shiller, Robert Shiller, short selling, sovereign wealth fund, statistical arbitrage, Steven Pinker, stochastic process, survivorship bias, The Great Moderation, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Malthus, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Triangle Shirtwaist Factory, ultimatum game, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game
Every economic transaction has a buyer and a seller, each trying to come to a mutually satisfying agreement, Jevons’s “the double coincidence of wants.” Economists call this negotiation the price discovery process, as we saw in chapter 1 in the cobweb model of the hog cycle. However, this negotiation doesn’t always conclude with a consummated trade and a price. If a seller refuses to lower the asking price to a level a buyer wishes to pay, no transaction will take place. That potato chip shaped like Jay Leno’s head, currently offered on eBay for one hundred dollars, may never get sold if the seller is unwilling to lower the price. This might be a rational decision on the seller’s part. On the other hand, it might reflect a lack of awareness of what a buyer is willing to pay. The price discovery process in a well-functioning market requires its participants to engage in a certain degree of cause-and-effect reasoning.
The “cobweb” model of the hog cycle with oscillations that eventually converge to the equilibrium (P*, Q*). Start at Q 0, with expected price P0; actual price is P1, which yields supply Q1; Q1 yields actual price P2, and so on; the spiral continues until supply equals demand at (P*, Q*). the results of two recent German-language papers written separately by an American and an Italian, Henry Schultz and Umberto Ricci. Schultz and Ricci had independently examined what might happen if the price discovery process along the supply and demand curves wasn’t smooth or instantaneous, but if it instead took place in discrete lumps of time, like the turns in a game. To their surprise, Schultz and Ricci discovered that under those conditions, prices tended to move in cycles around the equilibrium point. In some cases, prices even diverged from the sweet spot of equilibrium entirely. Kaldor called this the “cobweb” theorem, due to the resemblance of the resulting supply and demand graphs to a spider’s web (see figure 1.3).
However, when we look at the details of their extraordinary track records, as well as those of many other wildly successful hedge fund managers, we have to wonder whether something else is going on. The Efficient Markets Hypothesis poses a related paradox for investors. In 1980, the economists Sanford Grossman and Joseph Stiglitz argued that without the opportunity to profit from market imperfections, investors have no reason to gather and analyze the information the market uses to discover prices.3 After all, what would be the point? The price discovery process isn’t free, and in the absence of economic incentives—in other words, profit opportunities, also known as market inefficiencies—liquid financial markets will simply cease to exist. According to Grossman and Stiglitz, a perfectly efficient market is, in fact, impossible. The Adaptive Markets Hypothesis elegantly resolves these difficulties by first observing that prices don’t automatically reflect all available information—how could they?
bank run, barriers to entry, bash_history, Bernie Madoff, computerized markets, computerized trading, Flash crash, housing crisis, index fund, locking in a profit, London Whale, market microstructure, merger arbitrage, prediction markets, price discovery process, Sergey Aleynikov, Spread Networks laid a new fibre optics cable between New York and Chicago, transaction costs, zero day
Overall, dark pools and broker internalization facilities aren’t unquestionably bad, but it’s hard to make a compelling case for any significant benefit. For professionals in particular, they make it easier to shoot oneself in the foot. For the public, the lack of transparency doesn’t inspire confidence. And for the markets themselves, there is a legitimate question about whether or not they detract from the price discovery process. For these reasons, I believe that the default destination for retail customer orders should always be the public markets. If customers want to “opt in” and select a dark pool or internalizer for their orders, that’s fine, but it should be a choice the customer makes – not a choice that the broker makes for them. The Impossibility of Getting Full and Precise Information Lewis, now embedded in the offices of IEX, walks us through a discussion of how IEX might provide information to the customers of the banks about how the banks and IEX handle their orders.
algorithmic trading, asset allocation, automated trading system, backtesting, Black Swan, Brownian motion, business continuity plan, compound rate of return, Edward Thorp, Elliott wave, endowment effect, fixed income, general-purpose programming language, index fund, John Markoff, Long Term Capital Management, loss aversion, p-value, paper trading, price discovery process, quantitative hedge fund, quantitative trading / quantitative ﬁnance, random walk, Ray Kurzweil, Renaissance Technologies, risk-adjusted returns, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, systematic trading, transaction costs
Prior to early 2001, stock prices in the United States were quoted in multiples of one-sixteenth and one-eighteenth of a penny. Since April 9, 2001, all U.S. stocks have been quoted in decimals. This seemingly innocuous change has had a dramatic impact on the market structure, which is particularly negative for the profitability of statistical arbitrage strategies. The reason for this may be worthy of a book unto itself. In a nutshell, decimalization reduces frictions in the price discovery process, while statistical arbitrageurs mostly act as market makers and derive their profits from frictions and inefficiencies in this process. (This is the explanation given by Dr. Andrew Sterge in a Columbia University financial engineering seminar titled “Where Have All the Stat Arb Profits Gone?” in January 2008. Other industry practitioners have made the same point to me in private conversations.)
Rigged Money: Beating Wall Street at Its Own Game by Lee Munson
affirmative action, asset allocation, backtesting, barriers to entry, Bernie Madoff, Bretton Woods, buy low sell high, California gold rush, call centre, Credit Default Swap, diversification, diversified portfolio, estate planning, fiat currency, financial innovation, fixed income, Flash crash, follow your passion, German hyperinflation, High speed trading, housing crisis, index fund, joint-stock company, money market fund, moral hazard, Myron Scholes, passive investing, Ponzi scheme, price discovery process, random walk, risk tolerance, risk-adjusted returns, risk/return, too big to fail, trade route, Vanguard fund, walking around money
He gives the broker an order to buy 100,000 shares of Acme Corporation. It doesn’t matter if it is a mutual fund, registered investment adviser (RIA), or a hedge fund, the point is that when dealing with a pool of money, the trades get big. This affects your money regardless of whether you own individual stocks or pool it with a manager. The market doesn’t care who you are. Now we enter the point of price discovery. price discovery The process of determining the price of an asset in the marketplace through the interactions of buyers and sellers. Also known as reality versus what you think a security is worth. You may discover that nobody wants to buy your stock unless the price is very low. Or, you may discover that in order to buy a stock you must pay a premium to get someone to sell it to you. market maker A dying breed.
asset-backed security, bank run, banking crisis, break the buck, Bretton Woods, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Doha Development Round, fear of failure, financial innovation, fixed income, housing crisis, income inequality, London Interbank Offered Rate, Long Term Capital Management, margin call, money market fund, moral hazard, Northern Rock, price discovery process, price mechanism, regulatory arbitrage, Ronald Reagan, Saturday Night Live, short selling, sovereign wealth fund, technology bubble, too big to fail, trade liberalization, young professional
Investors ran away from securities that made them nervous—driving the current yield of 30-day ABCP up to 6 percent (from 5.28 percent in mid-July)—and began to accumulate Treasury bonds and notes, long the safest securities on the planet. This classic flight-to-quality nearly resulted in a failed auction of four-week bills on August 21, when massive demand for government paper so muddied the price discovery process that, ironically, some dealers pulled back from bidding to avoid potential losses. As a result, there were barely enough bids to cover the auction, so yields shot up despite the strong real demand. Karthik Ramanathan, head of Treasury’s Office of Debt Management, had to reassure global investors that the problems stemmed from too much demand, not too little. In the end, the Treasury auctioned off $32 billion in four-week bills at a discount rate of 4.75 percent, nearly 2 percentage points higher than the prior day’s closing yield.
Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen
activist fund / activist shareholder / activist investor, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, money market fund, mortgage debt, Myron Scholes, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative ﬁnance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, survivorship bias, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond
While the market price (shown by the dashed line) moves up as a result of the catalyst, it initially underreacts and therefore continues to go up for a while. A trend-following strategy buys the asset as a result of the initial upward price move and therefore capitalizes on the subsequent price increases. At this point in the life cycle, trend-following investors contribute to the speeding up of the price discovery process. Figure 12.1. Stylized plot of the life cycle of a trend. Source: Hurst, Ooi, and Pedersen (2013). Research has documented a number of behavioral tendencies and market frictions that lead to this initial underreaction:3 i. Anchor-and-insufficient-adjustment. People tend to anchor their views to historical data and adjust their views insufficiently to new information. ii. The disposition effect.
Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business process, capital asset pricing model, capital controls, central bank independence, collateralized debt obligation, commoditize, Commodity Super-Cycle, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, diversification, diversified portfolio, equity premium, family office, fiat currency, fixed income, follow your passion, full employment, George Santayana, Hyman Minsky, implied volatility, index fund, inflation targeting, interest rate swap, inventory management, invisible hand, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, market microstructure, moral hazard, Myron Scholes, North Sea oil, open economy, peak oil, pension reform, Ponzi scheme, prediction markets, price discovery process, price stability, private sector deleveraging, profit motive, purchasing power parity, quantitative easing, random walk, reserve currency, risk tolerance, risk-adjusted returns, risk/return, savings glut, selection bias, Sharpe ratio, short selling, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, survivorship bias, The Great Moderation, Thomas Bayes, time value of money, too big to fail, transaction costs, unbiased observer, value at risk, Vanguard fund, yield curve, zero-sum game
Then they hide it through beta, sometimes through difficult-to-see exotic betas. Alpha seeking is, however, a positive sum game for society. You need to have people in there chasing alpha to make markets more efficient. And by efficiency I am not talking about providing liquidity to the market. Rather, you need to have people constantly trying to evaluate the right price, who are ready to trade on that belief, pushing the market towards equilibrium in a price discovery process. That way we get better allocation of resources in the real economy and fewer bubbles. If there had been more John Paulsons in the market during the last few years, and fewer gullible institutional investors in subprime, the global economy would have been much better off. But alpha in a strict sense is a zero-sum game, although with beneficial externalities for society. What else did you learn in 2008?
Bakken shale, Climategate, Climatic Research Unit, deindustrialization, energy security, failed state, Francis Fukuyama: the end of history, income per capita, Intergovernmental Panel on Climate Change (IPCC), means of production, mutually assured destruction, oil shale / tar sands, oil shock, out of africa, peak oil, price discovery process, rising living standards, sceptred isle, South China Sea, University of East Anglia, uranium enrichment, Yom Kippur War
Paper Money Collapse: The Folly of Elastic Money and the Coming Monetary Breakdown by Detlev S. Schlichter
bank run, banks create money, British Empire, capital controls, Carmen Reinhart, central bank independence, currency peg, fixed income, Fractional reserve banking, German hyperinflation, global reserve currency, inflation targeting, Kenneth Rogoff, Long Term Capital Management, market clearing, Martin Wolf, means of production, money market fund, moral hazard, mortgage debt, open economy, Ponzi scheme, price discovery process, price mechanism, price stability, pushing on a string, quantitative easing, reserve currency, rising living standards, risk tolerance, savings glut, the market place, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, Y2K
The quick and, indeed, instantaneous change in most prices that can be assumed in a model economy will communicate the facts quickly to everybody. The time and space for some consumers and some producers to err and to develop the patterns described above is very restricted in the context of pure models. However, the more we move away from the unrealistic model assumptions and consider a real-life economy, in which spending is not ongoing but discontinuous and intermittent, and price-discovery therefore periodic, these processes will be unavoidable. In any case, the imperfections of a real-life economy, when compared to the purity of the theoretical model, enhance the phenomena we just described; they do not cause them. What causes the processes described here is the lack of full transparency, which leads to potential misinterpretation. Some economic agents will confuse additional nominal spending with a rise in real demand that can only result from changes in consumer preferences or true entrepreneurial success.
Alvin Roth, barriers to entry, conceptual framework, correlation coefficient, discrete time, disintermediation, distributed generation, experimental economics, financial intermediation, index arbitrage, information asymmetry, interest rate swap, inventory management, market clearing, market design, market friction, market microstructure, martingale, price discovery process, price discrimination, quantitative trading / quantitative ﬁnance, random walk, Richard Thaler, second-price auction, selection bias, short selling, statistical model, stochastic process, stochastic volatility, transaction costs, two-sided market, ultimatum game, zero-sum game