transaction costs

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pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

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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, mortgage debt, 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, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

Similarly, the realized cost TC$,realized would likely measure a high cost stemming from the difference between the high execution price and the lower price that will likely prevail the next day, when the market has rebounded. 5.3. ESTIMATING EXPECTED TRANSACTION COSTS Suppose that you have measured the transaction cost TCi for each of many trade executions, enumerated by i =1, … I. These are noisy observations of the expected transaction costs. Assuming that the expected transaction cost is constant for all these trades, we can estimate the expected transaction cost as the average observed costs: This expected transaction cost is useful in deciding which trading strategy to use, how frequently to trade, and so on. Furthermore, our estimate of expected transaction costs tells us how to adjust a backtest for transaction costs. Of course, transaction costs differ across securities. Small stocks with low trading volume tend to have larger transaction costs than large stocks, for instance. Furthermore, as discussed above, transaction costs can depend on the trade size.

As mentioned, the annual transaction costs of a managed futures strategy are typically about 1 to 4% for a sophisticated trader, possibly much higher for less sophisticated traders, and higher historically given higher transaction costs in the past. Transaction costs depend on a number of things. Transaction costs increase with rebalance frequency if the portfolio is mechanically rebalanced without transaction-cost optimization (although more frequent access to the market can also be used to source more liquidity) and transaction costs are higher for short-term trend signals than long-term trends. Hence, larger managers—for whom transaction costs play a more important role—may allocate a larger weight to medium- and long-term trend signals and relatively lower weight to short-term signals. Figure 12.5. Gross Sharpe ratios at different rebalance frequencies. This figure shows the Sharpe ratios gross of transaction costs of the 1-month, 3-month, 12-month, and diversified time series momentum strategies as a function of the rebalancing frequency.

You should strive for a robust process that works even if you adjust it a little. Adjusting Backtests for Trading Costs Transaction costs reduce the returns of a trading strategy. A backtest is therefore much more realistic if it accounts for transaction costs. To adjust a backtest, we first need to have an estimate of the expected transaction costs for all securities and trading sizes. You can often obtain such estimates from brokers, or you can estimate the expected transaction costs, as discussed in section 5.3. Given these expected transaction costs, we can adjust the backtest in the following simple way. Each time a trade takes place in our backtest, we compute the expected transaction cost and subtract this cost from the backtest returns. For instance, if we have a monthly portfolio rebalance rule, then each month of the backtest, we do the following: • Compute the return on the portfolio, • Compute the new security positions and the implied trades, • Compute the expected trading costs for every security and add them up, and • Subtract the total expected trading cost from the portfolio return.


pages: 224 words: 13,238

Electronic and Algorithmic Trading Technology: The Complete Guide by Kendall Kim

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algorithmic trading, automated trading system, backtesting, corporate governance, Credit Default Swap, diversification, en.wikipedia.org, family office, financial innovation, fixed income, index arbitrage, index fund, interest rate swap, linked data, market fragmentation, natural language processing, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, short selling, statistical arbitrage, Steven Levy, transaction costs, yield curve

Basket analytics can judge the overall risk in a basket, its exposure to different industries, and the potential implicit costs of the basket. 10.5 Conclusion The interest in transaction cost research is widely attributable to increasing competition for lower transaction costs, and regulatory pressure. Investment managers are pushed to measure and manage transaction costs to increase investment returns, retain clients, attract new prospects, and satisfy regulators. When investment managers began to be judged by transaction costs, this began the push for algorithms and other advanced electronic execution tools. One universally known method of rating quality of execution is through achieving or exceeding the Volume-Weighted Average Price (VWAP). Broker-dealers have responded to the growing pressure from regulators and investment firms’ desire for lowering transaction costs. Investment managers increasingly want to reduce implicit costs, and broker-dealers must fulfill this demand in order to retain client business.

Leinweber, Trading and Portfolio Management: Ten Years Later, California Institute of Technology, May 2002. transaction costs, with the cooperation of a fund manager providing data. Trade sizes ranged from 100 shares to blocks of more than 400,000 shares. Exhibit 9.2 shows the predictions of what is expected. Costs and Management Style Can transaction costs be predicted through investment management style? Patient disciplines such as value and growth investing with longer time horizons may be expected to have lower transaction costs. Investment strategies that depend on quicker execution to capture the market’s reaction to differences between expected and actual earnings may have higher transactions. Index funds tracking small capitalization stocks would theoretically be expected to have larger transaction costs because of the characteristics of smaller stock made up in those indexes.

Firms are increasingly looking to outsource their trading desks to increase their capacity and to execute more volume. Brokerage commissions are at an all-time low, and a general reduction in trading personnel in favor of advanced electronic resources is further driving down transaction costs. Transaction cost research will play an increasingly important role in selecting the proper algorithm integrated with an order management system. Buy-side traders and money managers will view transaction cost research as another critical piece in making a trading decision with their national best bid or offer. The need to curb transaction costs and market impact for highvolume trades, direct market access, and front-end automation is starting to converge. Buy-side firms such as hedge funds are now starting to have greater access to algorithms from brokers via an order management system, as well as algorithmic trading capabilities provided by third-party software companies.

Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernie Chan

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algorithmic trading, asset allocation, automated trading system, backtesting, Black Swan, Brownian motion, business continuity plan, compound rate of return, Elliott wave, endowment effect, fixed income, general-purpose programming language, index fund, 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, systematic trading, transaction costs

This averaging over parameters will further help ensure that the actual trading performance of the model will not deviate too much from the backtest result. Sensitivity Analysis TRANSACTION COSTS No backtest performance is realistic without incorporating transaction costs. I discussed the various types of transactions costs P1: JYS c03 JWBK321-Chan September 24, 2008 13:52 Printer: Yet to come Backtesting 61 (commission, liquidity cost, opportunity cost, market impact, and slippage) in Chapter 2 and have given examples of how to incorporate transaction costs into the backtest of a strategy. It should not surprise you to find that a strategy with a high Sharpe ratio before adding transaction costs can become very unprofitable after adding such costs. I will illustrate this in Example 3.7. Example 3.7: A Simple Mean-Reverting Model with and without Transaction Costs Here is a simple mean-reverting model that is due to Amir Khandani and Andrew Lo at MIT (available at web.mit.edu/alo/www/Papers/ august07.pdf).

For example, in Figure 2.1, you can see that the longest drawdown goes from around February 2001 to around October 2002. So the maximum drawdown duration is about 20 months. Also, at the beginning of the maximum drawdown, the equity was about $2.3 × 104 , and at the end, about $0.5 × 104 . So the maximum drawdown is about $1.8 × 104 . How Will Transaction Costs Affect the Strategy? Every time a strategy buys and sells a security, it incurs a transaction cost. The more frequent it trades, the larger the impact of transaction costs will be on the profitability of the strategy. These transaction costs are not just due to commission fees charged by the broker. There will also be the cost of liquidity—when you buy and sell securities at their market prices, you are paying the bid-ask spread. If you buy and sell securities using limit orders, however, you avoid the liquidity costs but incur opportunity costs.

If you are trading S&P 500 stocks, for example, the average transaction cost (excluding commissions, which depend on your brokerage) would be about 5 basis points (that is, five-hundredths of a percent). Note that I count a round-trip transaction of a buy and then a sell as two transactions—hence, a round trip will cost 10 basis points in this example. If you are trading ES, the E-mini S&P 500 futures, the transaction cost will be about 1 basis point. Sometimes the authors whose strategies you read about will disclose that they have included transaction costs in their backtest performance, but more often they will not. If they haven’t, then you just to have to assume that the results are before transactions, and apply your own judgment to its validity. As an example of the impact of transaction costs on a strategy, consider this simple mean-reverting strategy on ES.


pages: 354 words: 26,550

High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems by Irene Aldridge

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algorithmic trading, asset allocation, asset-backed security, automated trading system, backtesting, Black Swan, Brownian motion, business process, capital asset pricing model, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, diversification, equity premium, fault tolerance, financial intermediation, fixed income, high net worth, implied volatility, index arbitrage, interest rate swap, inventory management, law of one price, Long Term Capital Management, Louis Bachelier, margin call, market friction, market microstructure, martingale, New Journalism, p-value, paper trading, performance metric, profit motive, purchasing power parity, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, Small Order Execution System, statistical arbitrage, statistical model, stochastic process, stochastic volatility, systematic trading, trade route, transaction costs, value at risk, yield curve

Furthermore, when the trading operation is tasked with outperforming a particular benchmark, µ, the optimization problem is reformulated as follows: max T (E[R p,t ] − λV [R p,t ]), s.t. t=1 T E[R p,t ] ≥ µ, t=1 I xi = 1 (14.9) i=1 Portfolio Optimization in the Presence of Transaction Costs The portfolio optimization model considered in the previous section did not account for transaction costs. Transaction costs, analyzed in detail in Chapter 19, decrease returns and distort the portfolio risk profile; depending on the transaction costs’ correlation with the portfolio returns, transaction costs may increase overall portfolio risk. This section addresses the portfolio optimization solution in the presence of transaction costs. The trading cost minimization problem can be specified as follows: min E[TC] s.t.V [TC]≤K (14.10) where E[TC] is the average of observed trading costs, V[TC] is the variance of observed trading costs, and K is the parameter that specifies the maximum trading cost variance.

Holding periods for positions in market microstructure trading can vary in duration from seconds to hours. The optimal holding period is influenced by the transaction costs faced by the trader. A gross average gain for a position held just several seconds will likely be in the range of several basis points (1 basis point = 1 bp = 1 pip = 0.01%), at most. To make such trading viable, the expected gain has Trading on Market Microstructure 129 to surpass the transaction costs. In an institutional setting (e.g., on a proprietary trading desk of a broker-dealer), a trader will often face transaction costs of 1 bp or less on selected securities, making a seconds-based trading strategy with an expected gain of at least 2 bps per trade quite profitable. Other institutional players, such as hedge funds, can expect their transaction costs to range anywhere from 3 bps to 30 bps per trade, mandating strategies that call for longer holding periods.

However, profit-taking opportunities still exist for powerful high-frequency trading systems with low transaction costs. Indexes and ETFs Index arbitrage is driven by the relative mispricings of indexes and their underlying components. Under the Law of One Price, index price should be equal to the price of a portfolio of individual securities composing the index, weighted according to their weights within the index. Occasionally, relative prices of the index and the underlying securities deviate from the Law of One Price and present the following arbitrage opportunities. If the price of the index-mimicking portfolio net of transaction costs exceeds the price of the index itself, also net of transaction costs, sell the index-mimicking portfolio, buy index, hold until the market corrects its index pricing, then realize gain.


pages: 313 words: 95,077

Here Comes Everybody: The Power of Organizing Without Organizations by Clay Shirky

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Andrew Keen, Berlin Wall, bioinformatics, Brewster Kahle, c2.com, crowdsourcing, en.wikipedia.org, hiring and firing, hive mind, Howard Rheingold, Internet Archive, invention of agriculture, invention of movable type, invention of the printing press, invention of the telegraph, jimmy wales, Kuiper Belt, lump of labour, Mahatma Gandhi, means of production, Merlin Mann, Nash equilibrium, Network effects, Nicholas Carr, Picturephone, place-making, Pluto: dwarf planet, prediction markets, price mechanism, prisoner's dilemma, profit motive, Richard Stallman, Ronald Coase, Silicon Valley, slashdot, social software, Stewart Brand, supply-chain management, The Nature of the Firm, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, transaction costs, ultimatum game, Yogi Berra

You can think of this as a Coasean ceiling, the point above which standard institutional forms don’t work well. Coase’s theory also tells us about the effects of small changes in transaction costs. When such costs fall moderately, we can expect to see two things. First, the largest firms increase in size. (Put another way, the upper limit of organizational size is inversely related to management costs.) Second, small companies become more effective, doing more business at lower cost than the same company does in a world of high transaction costs. These two effects describe the postwar industrial world well: Giant conglomerates like ITT in the 1970s and GE in recent years used their management acumen to get into a huge variety of businesses, simply because they were good at managing transaction costs. At the same time there has been an explosion of small- and medium-sized businesses, because such businesses were better able to discover and exploit new opportunities.

When the small group is a bunch of teenage girls trying to get or remain dangerously thin, against the judgment of their horrified parents and friends, then we disapprove. But the basic mechanism of mutual support remains the same. Falling transaction costs benefit all groups, not just groups we happen to approve of. The thing that kept phenomena like the Pro-Ana movement from spreading earlier was cost. The transaction costs of gathering a group of like-minded individuals, especially in an anonymous fashion, has historically been large, and self-funded and socially approved groups like AA were the only ones that could take on those costs. Once the transaction costs fell, however, the difficulties of putting such groups together disappeared; the potential members of such a group can now gather and set their own goals without needing any sort of social sponsorship or approval.

Every transaction it undertakes—every contract, every agreement, every meeting—requires it to expend some limited resource: time, attention, or money. Because of these transaction costs, some sources of value are too costly to take advantage of. As a result, no institution can put all its energies into pursuing its mission; it must expend considerable effort on maintaining discipline and structure, simply to keep itself viable. Self-preservation of the institution becomes job number one, while its stated goal is relegated to number two or lower, no matter what the mission statement says. The problems inherent in managing these transaction costs are one of the basic constraints shaping institutions of all kinds. This ability of the traditional management structure to simplify coordination helps answer one of the most famous questions in all of economics: If markets are such a good idea, why do we have organizations at all?


pages: 356 words: 103,944

The Globalization Paradox: Democracy and the Future of the World Economy by Dani Rodrik

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affirmative action, Asian financial crisis, bank run, banking crisis, bilateral investment treaty, borderless world, Bretton Woods, British Empire, capital controls, Carmen Reinhart, central bank independence, collective bargaining, colonial rule, Corn Laws, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, currency manipulation / currency intervention, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, Doha Development Round, en.wikipedia.org, eurozone crisis, financial deregulation, financial innovation, floating exchange rates, frictionless, frictionless market, full employment, George Akerlof, guest worker program, Hernando de Soto, immigration reform, income inequality, income per capita, joint-stock company, Kenneth Rogoff, labour market flexibility, labour mobility, land reform, Long Term Capital Management, low skilled workers, margin call, market bubble, market fundamentalism, Martin Wolf, Mexican peso crisis / tequila crisis, microcredit, Monroe Doctrine, moral hazard, night-watchman state, non-tariff barriers, offshore financial centre, oil shock, open borders, open economy, price stability, profit maximization, race to the bottom, regulatory arbitrage, savings glut, Silicon Valley, special drawing rights, special economic zone, The Wealth of Nations by Adam Smith, Thomas L Friedman, Tobin tax, too big to fail, trade liberalization, trade route, transaction costs, tulip mania, Washington Consensus, World Values Survey

The market-supporting institutions that do exist are local and vary across nations. As a result, international trade and finance entail inherently higher transaction costs than domestic exchanges. But there is more. The higher transaction costs are not just due to the absence of the requisite international institutions. Domestic arrangements geared to the needs of national markets also impede global commerce frequently. National rules inhibit globalization. The most obvious examples include government-imposed tariffs on trade or regulations that restrict international lending or borrowing. Whatever domestic purpose such restrictions may serve—social and political stability, encouragement of domestic entrepreneurship, or pure cronyism—they constitute clear transaction costs on international exchanges. The taxes that finance social safety nets and other public investments can also necessitate some restrictions on international exchange in order to prevent footloose professionals or capitalists from evading them.

The abolition of the East India Company following the Indian Mutiny of 1858, and its replacement by direct colonial rule from London, provides another perfect example of the transition. When the private firm and its armies were no longer up to the task, the sovereign had to step in with his own, more effective powers of persuasion. Overcoming Transaction Costs A contemporary economist would summarize the argument thus far by saying that the role played by the Hudson’s Bay Company, the East India Company, and other chartered trading companies was to reduce the “transaction costs” in international trade to enable some degree of economic globalization. It is worth spending some time on this concept, as it holds the key to understanding globalization—what restricts or deepens it—and will recur throughout our discussion. Economists like to think that the propensity to “truck, barter, and trade,” in Adam Smith’s evocative (but careful)13 phrasing, is such an ingrained element of human nature that it makes “free trade” the natural order of things.

Economists like to think that the propensity to “truck, barter, and trade,” in Adam Smith’s evocative (but careful)13 phrasing, is such an ingrained element of human nature that it makes “free trade” the natural order of things. They even have coined a general term for different types of friction that prevent mutually beneficial trade or render it more difficult: “transaction costs.” Transaction costs are in fact rampant in the real world, and if we fail to see them all around us it is only because modern economies have developed so many effective institutional responses to overcome them. Think of all the things that we take for granted that are absolutely essential for trade to take place. There must be some way—a marketplace, bazaar, trade fair, an electronic exchange—to bring the two parties to a transaction together. There must be a modicum of peace and security for them to engage in trade without risk to life and liberty or concern for theft.


pages: 443 words: 51,804

Handbook of Modeling High-Frequency Data in Finance by Frederi G. Viens, Maria C. Mariani, Ionut Florescu

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algorithmic trading, asset allocation, automated trading system, backtesting, Black-Scholes formula, Brownian motion, business process, continuous integration, corporate governance, discrete time, distributed generation, fixed income, Flash crash, housing crisis, implied volatility, incomplete markets, linear programming, mandelbrot fractal, market friction, market microstructure, martingale, Menlo Park, p-value, pattern recognition, performance metric, principal–agent problem, random walk, risk tolerance, risk/return, short selling, statistical model, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process

Mariani, Marc Salas, and Indranil SenGupta 13.1 13.2 13.3 13.4 Introduction, 347 Method of Upper and Lower Solutions, 351 Another Iterative Method, 364 Integro-Differential Equations in a Lévy Market, 375 References, 380 14 Existence of Solutions for Financial Models with Transaction Costs and Stochastic Volatility 383 Maria C. Mariani, Emmanuel K. Ncheuguim, and Indranil SenGupta 14.1 Model with Transaction Costs, 383 14.2 Review of Functional Analysis, 386 14.3 Solution of the Problem (14.2) and (14.3) in Sobolev Spaces, 391 14.4 Model with Transaction Costs and Stochastic Volatility, 400 14.5 The Analysis of the Resulting Partial Differential Equation, 408 References, 418 Index 421 Preface This handbook is a collection of articles that describe current empirical and analytical work on data sampled with high frequency in the financial industry.

Prog Electromagn Res 2008;78:361–376. 29. He JH. Homotopy perturbation technique. Comput Meth Appl Mech Eng 1999;178:257–262. Chapter Fourteen Existence of Solutions for Financial Models with Transaction Costs and Stochastic Volatility MARIA C. MARIANI Department of Mathematical Sciences, University of Texas at El Paso, El Paso, TX EMMANUEL K. NCHEUGUIM Department of Mathematical Sciences, New Mexico State University, Las Cruces, NM I N D R A N I L S E N G U P TA Department of Mathematical Sciences, University of Texas at El Paso, El Paso, TX 14.1 Model with Transaction Costs In a complete financial market without transaction costs, the celebrated Black–Scholes model [1] provides not only a rational option pricing formula, but also a hedging portfolio that replicates the contingent claim. In the Black–Scholes analysis, it is assumed that hedging takes place continuously, Handbook of Modeling High-Frequency Data in Finance, First Edition.

The timestep is assumed to be small, thus the number of assets traded after a time δt is ν= ∂C ∂ 2C ∂C ∂ 2C (S + δS, t + δt) − (S, t) = δS 2 + δt + ··· ∂S ∂S ∂S ∂t∂S 385 14.1 Model with Transaction Costs √ Since δS = σ S δt + O(δt), keeping only he leading term yields ν √ ∂ 2C σ S δt. 2 ∂S Thus, the expected transaction cost over a timestep is 2 √ 2 2 ∂ C E[κS|ν|] = κσ S 2 δt, π ∂S √ where 2/π is the expected value of ||. Therefore, the expected change in the value of the portfolio is 2 ∂ C ∂C 1 2 2 ∂ 2 C 2 2 δt. E(δ) = − κσ S σ S ∂t 2 ∂S 2 πδt ∂S 2 If the portfolio is a hedging portfolio standard no arbitrage arguments imply that the portfolio will earn the riskfree interest rate r, and ∂C E(δ) = r C − S δt. ∂S Hence, Hoggard, Whalley, and Wilmott derive the model for option pricing with transaction costs as ∂C ∂ 2C 1 ∂C + σ 2 S 2 2 + rS − rC − κσ S 2 ∂t 2 ∂ S ∂S 2 π δt 2 ∂ C ∂S 2 = 0, (S, T ) ∈ (0, ∞) × (0, T ) (14.2) with the terminal condition C(S, T ) = max(S − E, 0), S ∈ (0, ∞) (14.3) for European call options with strike price E, and a suitable terminal condition for European puts.


pages: 350 words: 103,988

Reinventing the Bazaar: A Natural History of Markets by John McMillan

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accounting loophole / creative accounting, Albert Einstein, Andrei Shleifer, Anton Chekhov, Asian financial crisis, congestion charging, corporate governance, crony capitalism, Dava Sobel, Deng Xiaoping, experimental economics, experimental subject, fear of failure, first-price auction, frictionless, frictionless market, George Akerlof, George Gilder, global village, Hernando de Soto, I think there is a world market for maybe five computers, income inequality, income per capita, informal economy, invisible hand, Isaac Newton, job-hopping, John Harrison: Longitude, John von Neumann, land reform, lone genius, manufacturing employment, market clearing, market design, market friction, market microstructure, means of production, Network effects, new economy, offshore financial centre, pez dispenser, pre–internet, price mechanism, profit maximization, profit motive, proxy bid, purchasing power parity, Ronald Coase, Ronald Reagan, sealed-bid auction, second-price auction, Silicon Valley, spectrum auction, Stewart Brand, The Market for Lemons, The Nature of the Firm, The Wealth of Nations by Adam Smith, trade liberalization, transaction costs, War on Poverty, Xiaogang Anhui farmers, yield management

Transaction costs use up resources in ways that are unrelated to the actual value of the business to be done. In the extreme, transaction costs can cause markets to be dysfunctional. If market information is so inadequate that a buyer is unable to locate more than one seller, then that seller can exploit the fact that the buyer is locked in by charging an exorbitant price. A still more extreme market malfunction occurs if the costs of transacting are so high as to swamp any potential benefits from the deal. Transaction costs can thwart exchanges that would otherwise be worthwhile. Unemployment exists, for example, not simply because there are too few jobs, but also because transaction costs in the labor market prevent some employers and job seekers from connecting with each other. A new way of doing business that lowers transaction costs can benefit everyone. Modern markets are sophisticated organizations.

Market design consists of the mechanisms that organize buying and selling; channels for the flow of information; state-set laws and regulations that define property rights and sustain contracting; and the market’s culture, its self-regulating norms, codes, and conventions governing behavior. While the design does not control what happens in the market—as already noted, free decision-making is key—it shapes and supports the process of transacting.10 A workable market design keeps in check transaction costs—the various frictions in the process of making exchanges. These costs include the time, effort, and money spent in the process of doing business—both those incurred by the buyer in addition to the actual price paid, and those incurred by the seller in making the sale.11 Transaction costs are many and varied. Transaction costs can arise before any business is done. Locating potential trading partners may be costly and time-consuming. Comparing alternative sellers and choosing among them takes effort by the buyer. The quality of the goods for sale is often not immediately apparent, and the buyer may have to go to some trouble to evaluate it.

In putting an agreement together, there are further transaction costs. Negotiations can be drawn out. Bargainers sometimes overreach in trying to squeeze out a good bargain, causing an impasse and spoiling what could have been a mutually beneficial deal. After the fact, there are still other transaction costs. Monitoring work costs time and money. The enforcement of contracts and the prevention and settling of disputes do not come for free. If agreements are not watertight, productive opportunities may be forgone. A manufacturer making components like computer chips or car seats may make a uniform item and sell it to several firms rather than customizing to a single firm’s specific needs, because customizing its production, though it would create more value, would leave it vulnerable to the sole customer’s whims. Transaction costs use up resources in ways that are unrelated to the actual value of the business to be done.


pages: 369 words: 128,349

Beyond the Random Walk: A Guide to Stock Market Anomalies and Low Risk Investing by Vijay Singal

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Andrei Shleifer, asset allocation, capital asset pricing model, correlation coefficient, cross-subsidies, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, index arbitrage, index fund, locking in a profit, Long Term Capital Management, loss aversion, margin call, market friction, market microstructure, mental accounting, merger arbitrage, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk-adjusted returns, risk/return, Sharpe ratio, short selling, transaction costs, Vanguard fund

In both cases, the market impact of the order has the effect of increasing the trading costs. Anomalies with high transactions costs may persist because large institutions or arbitrageurs may be reluctant to trade if large dollar positions cannot be taken without moving the price or if the bid-ask spreads are large. For example, the January effect has been known 15 16 Beyond the Random Walk for decades and is caused by tax-loss selling of small-size stocks. Nonetheless, the January effect persists because it is necessary to trade hundreds of small-size stocks. Small stocks have high bid-ask spreads and low liquidity, making the potential benefit insufficient to offset the transaction costs. PROFIT POTENTIAL IS INSUFFICIENT Certain anomalies may generate small profits that cannot be multiplied easily.

However, since the transaction cost is close to zero, the net return is about 1.8 percent over a five-day period. Therefore, index mutual funds are a superior vehicle for capturing the December effect. NASDAQ 100 In addition to the S&P 500, the Nasdaq 100 represents a group of large stocks. Since the Nasdaq 100 is constructed solely on the basis of market capitalization and consists of only 100 stocks, instead of 500 as in the S&P 500, it is likely to reflect a greater concentration of large stocks. However, on the downside, the Nasdaq 100 is significantly riskier and more volatile than the S&P 500. The five-day returns for the Nasdaq 100 index are reported in Table 2.6. It can be seen that the Nasdaq 100 generates a whopping return of 3.18 percent (and 3.08 percent after transaction costs) over the five-day period in December compared with a 1.56 percent return for the S&P 500.

. • It is easier to forecast returns for smaller firms than for larger firms. Note, however, that the evidence presented does not account for transaction costs. Since those costs are high for small firms, and sometimes prohibitively high, it may be necessary to alter the above recommendations for implementation of a trading strategy. Though it is important to keep the practicability of a trading strategy in mind, evidence reveals that copying the large trades (more than 10,000 shares) of top executives is profitable. Outsiders can mimic these trades and earn a return of 7 percent for purchases and 4.9 percent for sales over a twelve-month period after adjusting for the market and accounting for transaction costs. If all trades (large and small) based on a six-month period are considered, the insider purchases outperform insider sales by 7.8 percent over the next twelve-month period.


pages: 220 words: 73,451

Democratizing innovation by Eric von Hippel

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additive manufacturing, correlation coefficient, Debian, hacker house, informal economy, inventory management, iterative process, James Watt: steam engine, knowledge economy, meta analysis, meta-analysis, Network effects, placebo effect, principal–agent problem, Richard Stallman, software patent, transaction costs, Vickrey auction

Consumers know this too, and few will be so foolish as to contact a major soup producer like Campbell’s with a request for a special, “just-right” can of soup. But what about manufacturers that specialize in custom products? Isn’t it their business to respond to special requests? To understand which way the innovate-or-buy choice will go, one must consider both transaction costs and information asymmetries specific to users and manufacturers. I will talk mainly about transaction costs in this chapter and mainly about information asymmetries in chapter 5. I begin this chapter by discussing four specific and significant transaction costs that affect users’ innovate-or-buy decisions. Next I review a case study that illustrates these. Then, I use a simple quantitative model to further explore when user firms will find it more cost-effective to develop a solution—a new product or service—for themselves rather than hiring a manufacturer to solve the problem for them.

In the model that follows, Baldwin and I ignore most of these and consider a simple base case focused on the impact of transaction costs on users’ innovate-or-buy considerations. The model deals with manufacturing firms and user firms rather than individual users. We assume that user firms and manufacturer firms both will hire designers from the same homogeneous pool if they elect to solve a user problem. We also assume that both user firms and manufacturer firms will incur the same costs to solve a specific user problem. For example, they will have the same costs to monitor the performance of the designer employees they hire. In this way we simplify our innovate-or-buy problem to one of transaction costs only. If there are no transaction costs (for example, no costs to write and enforce a contract), then by Coase’s theorem a user will be indifferent between making or buying a solution to its problem.

If there are no transaction costs (for example, no costs to write and enforce a contract), then by Coase’s theorem a user will be indifferent between making or buying a solution to its problem. But in the real world there are transaction costs, and so a user will generally prefer to either make or buy. Which, from the point of view of minimizing overall costs of obtaining a problem solution, is the better choice under any given circumstances? Let Vij be the value of a solution to problem j for user i. Let Nj be the number of users having problem j. Let Whj be the cost of solving problem j, where W = hourly wage and hj = hours required to solve it. Let Pj be the price charged by a manufacturer for a solution to problem j. Let T be fixed or “setup” transaction costs, such as writing a general contract for buyers of a solution to problem j. Let t be variable or “frictional” transaction costs, such as tailoring the general contract to a specific customer.


pages: 678 words: 216,204

The Wealth of Networks: How Social Production Transforms Markets and Freedom by Yochai Benkler

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affirmative action, barriers to entry, bioinformatics, Brownian motion, call centre, Cass Sunstein, centre right, clean water, dark matter, desegregation, East Village, fear of failure, Firefox, game design, George Gilder, hiring and firing, Howard Rheingold, informal economy, invention of radio, Isaac Newton, iterative process, Jean Tirole, jimmy wales, market bubble, market clearing, Marshall McLuhan, New Journalism, optical character recognition, pattern recognition, pre–internet, price discrimination, profit maximization, profit motive, random walk, recommendation engine, regulatory arbitrage, rent-seeking, RFID, Richard Stallman, Ronald Coase, Search for Extraterrestrial Intelligence, SETI@home, shareholder value, Silicon Valley, Skype, slashdot, social software, software patent, spectrum auction, technoutopianism, The Fortune at the Bottom of the Pyramid, The Nature of the Firm, transaction costs

It certainly should not be that these volunteers will beat the largest and best-financed business enterprises in the world at their own game. And yet, this is precisely what is happening in the software world. 120 Industrial organization literature provides a prominent place for the transaction costs view of markets and firms, based on insights of Ronald Coase and Oliver Williamson. On this view, people use markets when the gains from doing so, net of transaction costs, exceed the gains from doing the same thing in a managed firm, net of the costs of organizing and managing a firm. Firms emerge when the opposite is true, and transaction costs can best be reduced by [pg 60] bringing an activity into a managed context that requires no individual transactions to allocate this resource or that effort. The emergence of free and open-source software, and the phenomenal success of its flagships, the GNU/ Linux operating system, the Apache Web server, Perl, and many others, should cause us to take a second look at this dominant paradigm. 18 Free software projects do not rely on markets or on managerial hierarchies to organize production.

It is enough that the net value of the information produced by commons-based social production processes and released freely for anyone to use as they please is no less than the total value of information produced through property-based systems minus the deadweight loss caused by the above-marginal-cost pricing practices that are the intended result of the intellectual property system. 211 The two scarce resources are: first, human creativity, time, and attention; and second, the computation and communications resources used in information production and exchange. In both cases, the primary reason to choose among proprietary and nonproprietary strategies, between marketbased systems--be they direct market exchange or firm-based hierarchical production--and social systems, are the comparative transaction costs of each, and the extent to which these transaction costs either outweigh the benefits of working through each system, or cause the system to distort the information it generates so as to systematically misallocate resources. 212 The first thing to recognize is that markets, firms, and social relations are three distinct transactional frameworks. Imagine that I am sitting in a room and need paper for my printer. I could (a) order paper from a store; (b) call [pg 108] the storeroom, if I am in a firm or organization that has one, and ask the clerk to deliver the paper I need; or (c) walk over to a neighbor and borrow some paper.

To succeed, therefore, peer-production systems must also incorporate mechanisms for smoothing out incorrect self-assessments--as peer review does in traditional academic research or in the major sites like Wikipedia or Slashdot, or as redundancy and statistical averaging do in the case of NASA clickworkers. The prevalence of misperceptions that individual contributors have about their own ability and the cost of eliminating such errors will be part of the transaction costs associated with this form of organization. They parallel quality control problems faced by firms and markets. 219 The lack of crisp specification of who is giving what to whom, and in exchange for what, also bears on the comparative transaction costs associated with the allocation of the second major type of scarce resource in the networked information economy: the physical resources that make up the networked information environment--communications, computation, and storage capacity. It is important to note, however, that these are very different from creativity and information as inputs: they are private goods, not a [pg 113] public good like information, and they are standardized goods with well-specified capacities, not heterogeneous and highly uncertain attributes like human creativity at a given moment and context.

Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies by Jeremy J. Siegel

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asset allocation, backtesting, Black-Scholes formula, Bretton Woods, buy low sell high, California gold rush, capital asset pricing model, cognitive dissonance, compound rate of return, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fixed income, German hyperinflation, implied volatility, index arbitrage, index fund, Isaac Newton, joint-stock company, Long Term Capital Management, loss aversion, market bubble, mental accounting, new economy, oil shock, passive investing, prediction markets, price anchoring, price stability, purchasing power parity, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, technology bubble, The Great Moderation, The Wisdom of Crowds, transaction costs, tulip mania, Vanguard fund

Costs Return Risk % in Market No. of Switches 8.63% 17.3% 62.9% 350 Subperiods 1886 - 1925 9.08% 23.7% 9.77% 17.7% 8.11% 18.0% 57.1% 122 1926 - 1945 6.25% 31.0% 11.10% 21.8% 9.44% 22.7% 62.7% 60 1946 - 2006 11.23% 16.0% 10.21% 14.2% 8.70% 15.1% 67.4% 168 1990 - 2006 11.76% 14.7% 6.60% 16.9% 4.30% 18.3% 73.7% 74 11.30% 20.5% 10.80% 16.5% 9.23% 17.2% 64.2% 334 17.72% 25.9% 15.75% 14.24% 22.1% 71.2% 44 Excl. 1929 - 1932 Crash 1886 - 2006 1926 - 1945 21.3% years. In later years if this strategy is pursued with index futures or ETFs, the transactions costs would be lower. Each 0.1 percentage point increase of transactions costs lowers the compound annual returns by 29 basis points. Although the excess returns from the timing strategy disappear when transactions costs are considered, the major gain from the timing strategy is a reduction in risk. Since the market timer is in the market less than two-thirds of the time, the standard deviation of returns is reduced by about one-quarter. This means that on a risk-adjusted basis, the return on the 200-day moving-average strategy is quite impressive, even when transactions costs are included. Unfortunately, the timing strategy has broken down in the last 17 years. The year 2000 was particularly disastrous for the timing strategy.

His analysis shows that the average oneway cost to either buy or sell a stock has dropped from over 1 percent of value traded as late as 1975 (before the deregulation of brokerage fees) to under 0.18 percent today. The fall in transactions costs suggests that the price of obtaining and maintaining a diversified portfolio of common stocks, which is necessary to replicate index returns, could have easily cost from 1 to 2 percent per year over much of the nineteenth and twentieth centuries. Because of these costs, investors in earlier years purchased fewer stocks than in an index and were less diversified, thereby assuming more risk than implied by stock indexes. Alternatively, if investors attempted to buy all the stocks, their real returns could have been as low as 5 percent per year after deducting transactions costs. The collapse of transactions costs over the past two decades means that stockholders can now acquire and hold a completely diversified portfolio at an extremely low cost.11 It has been well established that liquid securities—that is, those assets that can be sold quickly and at little cost on short notice in the public market—command a premium over illiquid securities.

With the Dow Industrials meandering most of the year above and below the 200-day moving average, the investor pursuing the timing strategy was whipsawed in and out of the market, executing a record 16 switches in and out of stocks. Each switch incurs transactions costs and must overcome the 1 percent pricing band. As a result, even ignoring transactions costs, the timing strategist lost over 28 percent in 2000 while the buy-and-hold strategist lost less than 5 percent. Since 1990, the buy-and-hold strategy 300 PART 4 Stock Fluctuations in the Short Run has returned 11.76 percent annually whereas the timing strategy has returned only 6.60 percent, even before transactions costs.12 The timing strategy did avoid some nasty bear markets over the past decade. A timing strategist would have exited the market on June 25, 2001, and avoided the entire drop associated with the terrorist attacks.

Trade Your Way to Financial Freedom by van K. Tharp

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asset allocation, commodity trading advisor, compound rate of return, computer age, Elliott wave, high net worth, margin call, market fundamentalism, pattern recognition, prediction markets, random walk, risk tolerance, short selling, statistical model, transaction costs

You will have to make many more trades in order to make a profit. And if you cannot tolerate a lot of small losses, which many traders and investors cannot, then tight stops will be your downfall. Second, tight stops dramatically increase your transaction costs. Transaction costs are a major part of doing business. In fact, I seldom see a system that over a number of years produces profits that are much bigger than the transaction costs it generates-that is, if a system generates a million dollars in net profits, then it probably generates more than a million dollars in transaction costs. If you are in and out of the market all the time, then such transaction costs can eat your profits down to nothing. This becomes a major factor if you are trading small size, so that your cost per trade is much higher than it should be. Losing much less money when you abort a trade is probably an exciting prospect to most of you.

In addition, the psychological pressures of short-term trading are I mtense. I’ve had people call me who will say something like: I make money almost every day, and I haven’t had a losing week in almost 2 years. At least until now. Yesterday, I gave back all my profits of the last 2 years. Keep that in mind before you decide that short-term trading is for you. Your profits are limited. Your transaction costs are high. Most ,,.Importantly, the psychological pressures could destroy you. Transaction costs are high and can add up. Most day traders get many opportunities each day. This type of trading is very exciting and stimulating. Excitement usually has nothing to do with making money-it’s a psychological need! If you have a methodology with an expectancy Of 50 cents or more per dollar risked, you may never have a losing month-x even week.

When you do your entry testing, if entry reliability is your objective, then the only thing you are looking at is how often it is profitable after the selected time periods. You have no stops, so that is not a consideration. When you add stops, the reliability of your system will go down because some of your profitable trades will probably be stopped out at a loss. You also do not consider transaction costs (i.e., slippage and commissions) in determining its reliability As soon as you add transaction costs, your reliability will go down. You want to know that the reliability of your entry is significantly better than chance before these elements are added. Some concepts seem brilliant when you first observe them. ‘,you might find that you have a hundred examples of great moves. : Your idea is common to all of them. As a result, you get very excited about it.


pages: 345 words: 86,394

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

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Albert Einstein, asset allocation, Black-Scholes formula, Brownian motion, butterfly effect, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Norbert Wiener, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

The asymptotic analysis simplifies a problem that would otherwise have to be solved numerically. Although asymptotic analysis has been used in financial problems before, for example in modelling transaction costs, this was the first time it really entered mainstream quantitative finance. References and Further Reading Avellaneda, M, Levy, A & Parás, A 1995 Pricing and hedging derivative securities in markets with uncertain volatilities. Applied Mathematical Finance 2 73-88 Avellaneda, M & Parás, A 1994 Dynamic hedging portfolios for derivative securities in the presence of large transaction costs. Applied Mathematical Finance 1 165-194 Avellaneda, M & Parás, A 1996 Managing the volatility risk of derivative securities: the Lagrangian volatility model. Applied Mathematical Finance 3 21-53 Avellaneda, M & Buff, R 1997 Combinatorial implications of nonlinear uncertain volatility models: the case of barrier options.

Second decide when to hedge based on the conflicting desires of wanting to hedge as often as possible to reduce risk, but as little as possible to reduce any costs associated with hedging. Example The implied volatility of a call option is 20% but you think that is cheap, volatility is nearer 40%. Do you put 20% or 40% into the delta calculation? The stock then moves, should you rebalance, incurring some inevitable transactions costs, or wait a bit longer while taking the risks of being unhedged? Long Answer There are three issues, at least, here. First, what is the correct delta? Second, if I don’t hedge very often how big is my risk? Third, when I do rehedge how big are my transaction costs? What is the correct delta? Let’s continue with the above example, implied volatility 20% but you believe volatility will be 40%. Does 0.2 or 0.4 go into the Black-Scholes delta calculation, or perhaps something else? First let me reassure you that you won’t theoretically lose money in either case (or even if you hedge using a volatility somewhere in the 20 to 40 range) as long as you are right about the 40% and you hedge continuously.

Short gamma you lose only 32% of the time, but they will be large losses. • In practice φ is not normally distributed: the fat tails, high peaks we see in practice will make the above observation even more extreme, perhaps a long gamma position will lose 80% of the time and win only 20%. Still the mean will be zero. How much will transaction costs reduce my profit? To reduce hedging error we must hedge more frequently, but the downside of this is that any costs associated with trading the underlying will increase. Can we quantify transaction costs? Of course we can. If we hold a short position in delta of the underlying and then rebalance to the new delta at a time δt later then we will have had to have bought or sold whatever the change in delta was. As the stock price changes by δS then the delta changes by δS Γ. If we assume that costs are proportional to the absolute value of the amount of the underlying bought or sold, such that we pay in costs an amount κ times the value traded then the expected cost each δt will be where the appears because we have to take the expected value of the absolute value of a normal variable.

Social Capital and Civil Society by Francis Fukuyama

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Berlin Wall, blue-collar work, Fall of the Berlin Wall, feminist movement, Francis Fukuyama: the end of history, George Akerlof, German hyperinflation, Jane Jacobs, Joseph Schumpeter, Kevin Kelly, labor-force participation, low skilled workers, p-value, postindustrial economy, principal–agent problem, RAND corporation, Silicon Valley, The Death and Life of Great American Cities, transaction costs, World Values Survey

Everyone who has worked in a hierarchical organization knows that there is a constant struggle going on between superiors and subordinates to control information ; the withholding of information is frequently a subordinate’s most important source of leverage over a superior. In addition to principal-agent problems, organizations suff er from other diseconomies of scale related to information-processing. Many transaction costs are internal to organizations and are created by the difficulties in passing information up and down a large hierarchy. W e have all worked in hierarchical organizations in which Department X doesn’t know what Department Y on the next floor is doing. Ideally, information ought to be processed as close to its source within the organization as possible. Some decisions require higher-level monitoring and therefore the transaction costs of that monitoring; in other cases, organizations assign monitoring responsibilities unnecessarily, incorrectly, or inefficiently. This, in a sense, was the central economic failure of socialism; as Ludwig von Mises and Friedrich A .

Professional education is consequently a major source of social capital in any advanced, postindustrial society and provides the basis for decentralized, flat organization. I would argue that social capital is important to certain sectors and certain forms of complex production precisely because exchange based on informal norms can avoid the internal transaction costs of large hierarchical organizations, as well as the external transaction costs of arms-length market transactions. The need for informal, norm-based exchange becomes more important as goods and services become more complex, difficult to evaluate, and differentiated. The increasing importance of social capital can be seen in the shift from low-trust to high-trust manufacturing, among other places. FROM LOW-TRUST TO HIGH-TRUST PRODUCTION The Taylorite factory, as implemented in Henry Ford’s Highland Park facility and countless other twentieth-century large manufacturing facilities, was a hierarchical organization characterized by a high degree of formality.

It is clear that corporations seek to develop reputations for trustworthiness not out of ethical concerns, but because it benefits them do do so. There is a large law-and-economics literature using game theoretic methods to describe the emergence of spontaneously generated informal norms regulating economic behavior. Much of this literature originates from the so-called Coase theorem, which states that when transaction costs are zero, a change in the formal rules of liability will have no effect on the allocation of resources.2 Put differently, in a zero-transaction-cost world it is not necessary 1 Robert Axelrod, The Evolution of Cooperation (New York: Basic Books, 1984). 2 Strictly speaking, Coase himself did not postulate a “Coase theorem”: Ronald H. Coase, “The Problem of Social Cost,” Journal of Law and Economics 3 (1960) : 1-44. This article is the single most commonly cited article in the legal literature today. 45 8 Tanner Lectures on Human Values for governments to intervene to regulate polluters or other producers of negative externalities, because the parties negatively impacted will have a rational incentive to organize and buy off the miscreant.


pages: 242 words: 68,019

Why Information Grows: The Evolution of Order, From Atoms to Economies by Cesar Hidalgo

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Ada Lovelace, Albert Einstein, Arthur Eddington, Claude Shannon: information theory, David Ricardo: comparative advantage, Douglas Hofstadter, frictionless, frictionless market, George Akerlof, Gödel, Escher, Bach, income inequality, income per capita, invention of the telegraph, invisible hand, Isaac Newton, James Watt: steam engine, Jane Jacobs, job satisfaction, John von Neumann, New Economic Geography, Norbert Wiener, p-value, phenotype, price mechanism, Richard Florida, Ronald Coase, Silicon Valley, Simon Kuznets, Skype, statistical model, Steve Jobs, Steve Wozniak, Steven Pinker, The Market for Lemons, The Nature of the Firm, The Wealth of Nations by Adam Smith, total factor productivity, transaction costs, working-age population

It is important to remark that the preexisting nature of social ties does not invalidate Coase’s arguments on the cost of links. On the contrary, transaction cost theory and economic sociology are complementary, since the economic effects of preexisting social networks can be interpreted in terms of the cost of links. In the words of Fukuyama: “Certain societies can save substantially on transaction costs because economic agents trust one another in their interactions and therefore can be more efficient than low trust societies, which require detailed contracts and enforcement mechanisms.”12 James Coleman, a sociologist well known for his work on social capital, has also emphasized the ability of trust to reduce transaction costs. In his seminal paper on social capital Coleman described the transactions between Jewish diamond merchants in New York, who have the tradition of letting other merchants inspect their diamonds in private before executing a transaction.

It is analogous to the personbyte, but instead of requiring the distribution of knowledge and knowhow among people, it requires them to be distributed among a network of firms.3 The factors that limit the size of firms—and imply a second quantization threshold—have been studied extensively in a branch of the academic literature known as transaction cost theory or new institutional economics. Additionally, the factors that limit the size of the networks humans form—whether firms or not—have been studied extensively by the sociologists, political scientists, and economists working on social capital and social networks. Since this is an extensive literature, I will review the basics of the new institutional economics in this chapter and leave the discussion of social capital theories for the next chapter. Transaction cost theory, or new institutional economics, is the branch of economics that studies the costs of transactions and the institutions that people develop to govern them.

So in Coase’s view, hiring a worker was a form of contract in which a person was hired to do a task that had not yet been specified, since what a worker will be asked to do a few months down the road is rarely known when she is hired. Coase dedicated much of his academic career to explaining the existence and boundaries of these islands of power. His answers become known as the transaction cost theory of the firm. Coase’s explanation of the boundaries of a firm was brilliant and simple. It was based on the idea that economic transactions are costly and not as fluid as the cheerleaders of the price mechanism religiously believed. Often, market transactions require negotiations, drafting of contracts, setting up inspections, settling disputes, and so on. These transaction costs can help us understand the boundary of the firm, since according to Coase, a parsimonious way of understanding the islands of central planning that we know as firms is to search for the point at which the cost of transactions taking place internally within the firm equals the cost of market transactions.


pages: 263 words: 75,455

Quantitative Value: A Practitioner's Guide to Automating Intelligent Investment and Eliminating Behavioral Errors by Wesley R. Gray, Tobias E. Carlisle

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Albert Einstein, Andrei Shleifer, asset allocation, Atul Gawande, backtesting, Black Swan, capital asset pricing model, Checklist Manifesto, cognitive bias, compound rate of return, corporate governance, correlation coefficient, credit crunch, Daniel Kahneman / Amos Tversky, discounted cash flows, Eugene Fama: efficient market hypothesis, forensic accounting, hindsight bias, Louis Bachelier, p-value, passive investing, performance metric, quantitative hedge fund, random walk, Richard Thaler, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, statistical model, systematic trading, The Myth of the Rational Market, time value of money, transaction costs

In practice, all of this rebalancing incurs transaction costs. Investment simulations must take into account these transaction costs from the rebalancing. The more frequently the portfolio is rebalanced, the better the returns in the investment simulation, but the higher the transaction costs in the real world. It's possible that the transaction costs are so great as to erode all the expected return. Incorporating transaction costs into an investment simulation is difficult. Different investors will have different cost structures, tax statuses, and trading and execution skills. Cost assumptions for one group of investors will be a degree of magnitude larger (or smaller) for another set of investors. We try to minimize the distortions caused by transaction costs in our analysis by limiting ourselves to a yearly rebalance and trading in only relatively large, liquid stocks.

Only in 1995 and 2004 to 2006, when strong economic growth generated earnings that caught up with earlier predictions, do forecasts actually hit the mark. When economic growth accelerates, the size of the forecast error declines; when economic growth slows, it increases. Transaction Costs We must decide at the outset of the investment simulation how we will manage the weight of each stock in the portfolio, and how this will affect rebalancing and transaction costs. Even simple methods of weighting introduce complexity and will require substantial rebalancing and incur transaction costs. If, for example, we employ a constant equal-weighting scheme, and the portfolio holds 100 stocks in equal weights and at the next rebalancing, 20 stocks are sold off and replaced by 20 new stocks. The turnover is not 20 percent because the proportion of the sales will be greater than 20 percent if we sell winners, and less than 20 percent if we sell losers.

See Look-ahead bias Price ratios analysis of compound annual growth rates alpha and adjusted performance risk-adjusted performance and absolute measures of risk value premium and spread book-to-market composite formed from all metrics formed from the “best” price ratios top-performing earnings yield EBIT variation, outperformance by enterprise yield (EBITDA and EBIT variations) forward earnings estimate free cash flow yield gross profits yield long-term study methods of studying Princeton-Newport Partners PROBM model Procter & Gamble Profit margins growth maximum stability Pronovost, Peter Puthenpurackal, John Quality and Price, improving compared with Magic Formula finding Price finding Quality Quantitative value checklist Quantitative value strategy examining, results of analysis legend beating the market black box, looking inside man versus machine risk and return robustness Greenblatt's Magic Formula bargain price examination of findings good business Quality and Price, improving compared with Magic Formula finding Price finding Quality simplifying strategy implementation checklist tried-and-true value investing principles Quinn, Kevin The Random Character of Stock Market Prices (Bachelier) Random walk theory Regression analysis Representativeness heuristic “Returns to Trading Strategies Based on Price-to-Earnings and Price-to-Sales Ratios” (Nathan, Sivakumar, & Vijayakumar) Ridgeline Partners Risk-adjusted performance and absolute measures of risk R-squared Ruane, William Scaled net operating assets (SNOA) Scaled total accruals (STA) Schedule 13D Security Analysis (Graham & Dodd) See's Candies Self-attribution bias Sequoia Fund Sharpe, William Sharpe ratio Shiller, Robert Short selling Shumway, Tyler Simons, Jim Singleton, Henry Sloan, Richard Small sample bias “Some Insiders Are Indeed Smart Investors” (Giamouridis, Liodakis, & Moniz) Sortino ratio Stock buybacks, issuance, and announcements Stock market, predicting movements in sustainable alpha quantitative value strategy simplifying tried-and-true value investing principles model, testing benchmarking data errors historical data versus forward data size of portfolio and target stocks small sample bias transaction costs universe, parameters of Super Crunchers: Why Thinking-by-Numbers Is the New Way to Be Smart (Ayres) “The Superinvestors of Graham-and-Doddsville” (Buffett) Survivorship bias Sustainable alpha Taleb, Nassim Teledyne Tetlock, Philip Theory of Investment Value (Williams) Third Avenue Value Fund Thorp, Ed Total enterprise value (TEV) Transaction costs Tsai, Claire Tversky, Amos Value investors'errors Value portfolio Value premium and spread Wellman, Jay What Works on Wall Street (O'Shaughnessy) Whitman, Martin J. Williams, John Burr WorldCom Z-score Zur, Emanuel


pages: 206 words: 70,924

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

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Albert Einstein, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John von Neumann, Joseph Schumpeter, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, naked short selling, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

It is a simple relationship between the expected value of a financial asset E(RA), the risk-free rate of return Rf, the expected market return E(RM), and a measure of relative standard deviations in the market and the asset: E(R A) = R f + (E(R M ) − R f ) rAM sAs M /sM s M = R f + (E(R M ) − R f ) sAM /sMM The expression sAM /sMM is simply the standard deviation between the new asset and the market relative to the market standard deviation. Ever since this formulation of the CAPM, we call this relative variance the beta , and interpret it as a relative measure of the required return of the asset over the market return, commensurate with its risk. Embedded in this elegant approach to pricing an individual security are a number of assumptions. First, we assume that the market is perfect. By this we mean that there are no transactions costs or taxes, that no trader has the power to influence prices and all are equally and costlessly informed, that assets can be traded in infinitely divisible amounts, and that expectations are homogenous while investors are rational maximizers in the domain of security means and variances. In addition, the market portfolio must contain all securities in proportion to their relative capitalization, and each security is efficiently priced according to its risk.

In fact, there is likely to be a different set of expectations of probabilities between current and future shareholders. This asymmetry has been treated by financial behaviorists who have developed psychologically based asset pricing models as an alternative to the CAPM.2 Extensions of the CAPM More complicated versions of the CAPM, including the subsequent work by John Lintner, included taxes and transactions costs that were originally omitted from the CAPM model. Perhaps less problematic is that the CAPM model also assumes that shares can be infinitely divisible, even if there are often premiums to be paid when securities are purchased in lots smaller than 100, and there cannot be fractional shares. The CAPM was initially developed as a static model, not an intertemporal and dynamic model, with a securities price determined at each instant over a dynamic time path.

Certainly, no one would deny that past observed measures of risk ought to influence expected returns, even if one can imagine other forces that could impinge as well. Of course, expected returns are not an observable variable. Our regressions are based on realized returns, with all their attendant noise from other unrelated factors. Indeed, the CAPM has constantly evolved to include other factors. Taxes, dividend yields, transactions costs, and intertemporal versions have all augmented its conceptual usefulness. Certainly, the CAPM’s principal ambassador, William Sharpe, and the only surviving academician of its founding four developers has always held faith in the utility of his model. When asked if he thought the model was something big, he responded: I didn’t know how important it would be, but I figured it was probably more important than anything else I was likely to do.


pages: 200 words: 54,897

Flash Boys: Not So Fast: An Insider's Perspective on High-Frequency Trading by Peter Kovac

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bank run, barriers to entry, bash_history, Bernie Madoff, 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

Here’s what Vanguard, the world’s largest single mutual fund manager, wrote to the SEC on the topic: “While the data universally demonstrate a significant reduction in transaction costs over the last ten to fifteen years, the precise percentages vary (estimates have ranged from a reduction of 35% to more than 60%). Vanguard estimates are in this range, and we conservatively estimate that transaction costs have declined 50 bps, or 100 bps round trip. This reduction in transaction costs provides a substantial benefit to investors in the form of higher net returns. For example, if an average actively managed equity mutual fund with a 100% turnover ratio would currently provide an annual return of 9%, the same fund would have returned 8% per year without the reduction in transaction costs over the past decade. Today's investor with a 30 year time horizon would see a $10,000 investment in such a fund grow to approximately $132,000 in 30 years, compared to approximately $100,000 with the hypothetical return of 8% associated with the higher transaction costs.

As we’ll see in Chapter 4, the computerization of the markets wrought by high-frequency traders have reduced transaction costs dramatically in the past ten to fifteen years – by at least 0.50% of invested value. These estimates are not based on someone’s invalid extrapolation from a single trade, but rather are the result of comprehensive analyses of market-wide volume.[19] Using this data and Lewis’ value for daily market volume, one would find a tax rebate of $1.1 billion per day. If these markets are rigged, they are rigged in the investor’s favor. Or, ask the broker who handles more retail trades online than anyone else. As TD Ameritrade’s CEO Fred Tomczyk sums it up, “The retail investor is better off today than they’ve ever been in history. Their transaction costs are down probably 80% in the last ten years.”[20] Chapter 3: Trying to Connect the Dots Co-location Ronan Ryan’s experience at Radianz rings true.

Today's investor with a 30 year time horizon would see a $10,000 investment in such a fund grow to approximately $132,000 in 30 years, compared to approximately $100,000 with the hypothetical return of 8% associated with the higher transaction costs. This roughly 25% decrease in the end value of the investment demonstrates the impact of reduced transaction costs on long-term investors. Thus, any analysis of "high frequency trading" must recognize the corresponding benefits that long-term investors have experienced through tighter spreads and increased liquidity.”[45] It’s worth reading this a second time. The world’s largest mutual fund manager writes that when you retire, your investment would be 25% smaller without the benefit of the decreased costs wrought by computerized trading. This is incredibly important. Lewis does admit that, “spreads in the market had narrowed – that much was true.”


pages: 515 words: 126,820

Blockchain Revolution: How the Technology Behind Bitcoin Is Changing Money, Business, and the World by Don Tapscott, Alex Tapscott

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Airbnb, altcoin, asset-backed security, autonomous vehicles, barriers to entry, bitcoin, blockchain, Bretton Woods, business process, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, clean water, cloud computing, cognitive dissonance, corporate governance, corporate social responsibility, Credit Default Swap, crowdsourcing, cryptocurrency, disintermediation, distributed ledger, Donald Trump, double entry bookkeeping, Edward Snowden, Elon Musk, Erik Brynjolfsson, ethereum blockchain, failed state, fiat currency, financial innovation, Firefox, first square of the chessboard, first square of the chessboard / second half of the chessboard, future of work, Galaxy Zoo, George Gilder, glass ceiling, Google bus, Hernando de Soto, income inequality, informal economy, interest rate swap, Internet of things, Jeff Bezos, jimmy wales, Kickstarter, knowledge worker, Kodak vs Instagram, Lean Startup, litecoin, Lyft, M-Pesa, Mark Zuckerberg, Marshall McLuhan, means of production, microcredit, mobile money, Network effects, new economy, Oculus Rift, pattern recognition, peer-to-peer lending, performance metric, Peter Thiel, planetary scale, Ponzi scheme, prediction markets, price mechanism, Productivity paradox, quantitative easing, ransomware, Ray Kurzweil, renewable energy credits, rent-seeking, ride hailing / ride sharing, Ronald Coase, Ronald Reagan, Satoshi Nakamoto, Second Machine Age, seigniorage, self-driving car, sharing economy, Silicon Valley, Skype, smart contracts, smart grid, social graph, social software, Stephen Hawking, Steve Jobs, Steve Wozniak, Stewart Brand, supply-chain management, TaskRabbit, The Fortune at the Bottom of the Pyramid, The Nature of the Firm, The Wisdom of Crowds, transaction costs, Turing complete, Turing test, Uber and Lyft, unbanked and underbanked, underbanked, unorthodox policies, X Prize, Y2K, Zipcar

In fact, another Nobel Prize–winning economist (yes, there do seem to be a lot of them in this story), Joseph Stiglitz, argued that the sheer size and seeming complexity of these firms have increased agency costs even as a firm’s transaction costs have plummeted. Hence, the huge pay gap between CEO and front line. So where does blockchain technology come in and how can it change how firms are managed and coordinated internally? With smart contracts and unprecedented transparency, the blockchain should not only reduce transaction costs inside and outside of the firm, but it should also dramatically reduce agency costs at all levels of management. These changes will in turn make it harder to game the system. So firms could go beyond transaction cost to tackle the elephant in the boardroom—agency cost. Yochai Benkler told us, “What’s exciting to me about blockchain technology is that it can enable people to function together with the persistence and stability of an organization, but without the hierarchy.”27 It also suggests that managers should brace themselves for radical transparency in how they do coordinate and conduct themselves because shareholders will now be able to see the inefficiencies, the unnecessary complexity, and the huge gap between executive pay and the value executives actually contribute.

These platforms hold promise for protecting user identity, respecting user privacy and other rights, ensuring network security, and dropping transaction costs so that even the unbanked can take part. Unlike incumbent firms, they don’t need a brand to convey the trustworthiness of their transactions. By giving away their source code for free, sharing power with everyone on the network, using consensus mechanisms to ensure integrity, and conducting their business openly on the blockchain, they are magnets of hope for the many disillusioned and disenfranchised. As such, blockchain technology offers a credible and effective means not only of cutting out intermediaries, but also of radically lowering transaction costs, turning firms into networks, distributing economic power, and enabling both wealth creation and a more prosperous future. 1.

In the financial system, however, the problem is compounded because there has been no clean transition from one technology to the next; there are multiple legacy technologies, some hundreds of years old, never quite living up to their full potential. Why? In part, because finance is a monopoly business. In his assessment of the financial crisis, Nobel laureate Joseph Stiglitz wrote that banks “were doing everything they could to increase transaction costs in every way possible.” He argued that, even at the retail level, payments for basic goods and services “should cost a fraction of a penny.” “Yet how much do they charge?” he wondered. “One, two, or three percent of the value of what is sold or more. Capital and sheer scale, combined with a regulatory and social license to operate allows banks to extract as much as they can, in country after country, especially in the United States, making billions of dollars of profits.”11 Historically, the opportunity for large centralized intermediaries has been enormous.


pages: 402 words: 110,972

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

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AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, butterfly effect, buttonwood tree, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, Internet Archive, John Nash: game theory, Khan Academy, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, moral hazard, mutually assured destruction, natural language processing, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, Richard Stallman, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra

Slow computers, sending information to slow humans over slow lines, were easy marks for early algo warriors willing to buy faster machinery and smart enough to code the programs to use it. This aspect of the arms race continues unabated today. Algos for the Buy Side: Transaction Cost Control It didn’t take long to notice that these new electronic trading techniques had something to offer to the buy side. Financial journals offered a stream of opinion, theory, and analysis of transaction costs. Firms like Wayne Wagner’s Plexus Group—now part of Investment Technology Group, Inc. (ITG)—made persuasive, well-supported arguments about the importance of transaction costs. Pension plan sponsors, sitting at the top of the financial food chain, were convinced in large numbers. Index managers did not have to be convinced. With no alpha considerations in the picture, they observed that it was possible to run either a lousy index fund or a particularly good one.

The all-time classic paper on trading costs is “Implementation Shortfall” by Andre Perold, published in the Journal of Portfolio Management (Spring 1988). It is a hot A Gentle Intr oduction to Computerized Investing 133 topic in algo trading, so a search may be overwhelming. Perold was the first to demonstrate the significance of trading costs in such a persuasive manner. The transaction cost measurement industry, which followed, was really originated by one firm, Plexus Group, founded by Wayne Wagner and now part of Investment Technology Group, Inc. (ITG). Wayne’s personal perspective is found in “The Incredible Story of Transaction Cost Management: A Personal Recollection,” Journal of Trading 3, no. 3 (Summer 2008). 8. See “Founders of Modern Finance” ((c) 1991, Research Foundation of the Institute of Chartered Financial Analysts, www.aimr.org) for the goods from the founders themselves, or Capital Ideas by Peter Bernstein for the salient points, intellectual history, and best stories. 9.

Institutional trading costs for US stocks average about 50 basis points. Source: Paul Tetlock, Maytal Saar-Tsechansky, and Sofus Macskassy, “More Than Words: Quantifying Language (in News) to Measure Firms’ Fundamentals,” Journal of Finance 63 ( June 2008): 1437–1467. discussion of overcoming the transaction cost hurdle in Chapter 5. When the authors factor in the cost of trading, they find that the positive 21 percent drops below zero when round-trip trading costs rise over 9 basis points. Round-trip costs of only 9 basis points would be truly spectacular trading. Most studies of actual transaction costs, including commissions and market impact, show one-way costs in the neighborhood of 50 basis points. This means that additional filtering of news would be needed for a profitable real-world strategy. eAnalyst: “Can Computerized Language Analysis Predict the Market?”


pages: 304 words: 80,965

What They Do With Your Money: How the Financial System Fails Us, and How to Fix It by Stephen Davis, Jon Lukomnik, David Pitt-Watson

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Admiral Zheng, banking crisis, Basel III, Bernie Madoff, Black Swan, centralized clearinghouse, clean water, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, crowdsourcing, David Brooks, Dissolution of the Soviet Union, diversification, diversified portfolio, en.wikipedia.org, financial innovation, financial intermediation, Flash crash, income inequality, index fund, invisible hand, London Whale, Long Term Capital Management, moral hazard, Northern Rock, passive investing, performance metric, Ponzi scheme, principal–agent problem, rent-seeking, Ronald Coase, shareholder value, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, Steve Jobs, the market place, The Wealth of Nations by Adam Smith, transaction costs, Upton Sinclair, value at risk, WikiLeaks

“The propensity to truck, barter or exchange one thing for another,” he wrote, “is common to all men.”29 But our ability to do so requires, at the least, that “transaction costs” be kept low. These are the costs involved in ensuring that the buyer gets the service he requires and that the supplier receives proper compensation. Where transaction costs are high, it is difficult to get markets to work. For example, lighthouses find it hard to charge passing ships for their service. Traditional economists had bundled these into a separate sort of product, known as “public goods,” where markets will fail and the goods must be purchased by the state. But as the Chicago economist Ronald Coase pointed out, the difference between the transaction costs involved in the provision of lighthouses and other goods is one of degree, not of quality. He noted that the first lighthouses were privately provided by the operators of nearby ports, and concluded that by dividing the world into “private goods,” where markets would regulate prices effectively, and “public goods,” where they would not, economists had posed the wrong question.30 The issue was not about whether there should be state or private provision, but how best to manage transaction costs so that the buyer and seller could easily strike a good deal.

It is hugely to society’s advantage that they do so, because the transaction cost of contracting for every element of performance rather than simply trusting one another is very high, particularly when the employee knows more about what he is up to, and how the contract can work to his advantage, than the employer. Yet these detailed, performance-based agreements are precisely the deals we strike with our top executives, who are “incented” through huge issues of shares, options, and bonuses, as if we otherwise didn’t trust them to do the job well. The predictable outcome is a legitimization of what to outsiders looks like outrageous greed. Trust is a central feature of any successful financial system. Well-justified trust keeps transaction costs low and allows the financial system to work. It is the oil that allows the engine to run without overheating and destroying itself.

Hence we have legislated to have the industry regulated. It doesn’t need to be. We could allow the charlatan to compete with the ethical drug producer, and individual patients could all ask to review the clinical studies on competing drugs before deciding whether to follow their doctor’s prescription. But the cost for each of us to find and to assess those studies would be huge. An economist would say that the “transaction costs” would be high.4 It is less costly to pass legislation to require that when a drug maker makes claims about a drug’s benefits and safety, those claims have passed a certain level of scrutiny. Some, of course, argue that we should regulate less. As we write this, the British government has a significant program to lessen what it terms the “burden” of regulation.5 Often regulations can seem foolish and trivial.


pages: 585 words: 165,304

Trust: The Social Virtue and the Creation of Prosperity by Francis Fukuyama

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barriers to entry, Berlin Wall, blue-collar work, business climate, capital controls, collective bargaining, corporate governance, deindustrialization, Deng Xiaoping, deskilling, double entry bookkeeping, equal pay for equal work, European colonialism, Francis Fukuyama: the end of history, Frederick Winslow Taylor, full employment, George Gilder, glass ceiling, global village, hiring and firing, industrial robot, Jane Jacobs, job satisfaction, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, labour market flexibility, labour mobility, land reform, low skilled workers, manufacturing employment, mittelstand, price mechanism, profit maximization, RAND corporation, rent-seeking, Ronald Coase, Silicon Valley, Steve Jobs, Steve Wozniak, The Death and Life of Great American Cities, The Nature of the Firm, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, transfer pricing, traveling salesman, union organizing

Coase’s answer to this puzzle, and the answer of most subsequent economists, was that although markets allocate goods efficiently, they often also entail substantial transaction costs. That is, market transactions entail costs of matching buyers and sellers, negotiating prices, and finalizing deals in the form of contracts. These costs made it more economical for a car company to acquire its suppliers outright rather than haggle with them repeatedly over price, quality, and delivery schedules for every part. Coase’s original thesis has been vastly elaborated, particularly by Oliver Williamson, into a broad theory of the modern corporation.12 In Williamson’s words, “The modern corporation is mainly to be understood as the product of a series of organizational innovations that have had the purpose and effect of economizing on transaction costs.”13 Transaction costs can be substantial, in turn, because human beings are not completely trustworthy.

But human beings are, in Williamson’s words, “opportunistic” and characterized by “bounded rationality” (meaning that they do not always make optimally rational decisions); integrated corporations are necessary because outside suppliers cannot be relied on to do what they contract to do.14 Firms integrate vertically, then, in order to reduce transaction costs. They continue to expand until the costs of large size begin to exceed the savings from these transaction costs. That is, large organizations suffer from diseconomies of scale: the free rider problem becomes more severe the larger the organization becomes;15 they are prone to agency costs, where the firm’s bureaucracy develops a stake in its own survival rather than profit maximization; and they suffer from information costs when managers lose track of what is happening in their own organizations. In Williamson’s view, the multidivisional corporation, which was pioneered by American corporations at the beginning of the twentieth century, was an innovative response to this problem that combined the transaction cost economies of integration with decentralized, independent profit centers.16 It should be clear, however, that the Japanese keiretsu is another innovative solution to the problem of scale.

In Williamson’s view, the multidivisional corporation, which was pioneered by American corporations at the beginning of the twentieth century, was an innovative response to this problem that combined the transaction cost economies of integration with decentralized, independent profit centers.16 It should be clear, however, that the Japanese keiretsu is another innovative solution to the problem of scale. The long-term relationships between keiretsu partners are a substitute for vertical integration, one that achieves similar efficiencies in terms of transaction cost savings. Toyota could have purchased outright one of its large subcontractors, Nippondenso, just as General Motors acquired Fisher Body in the 1920s. It has not done so, however, because purchase would not necessarily lower transaction costs. Toyota’s intimate relationship with Nippondenso allows it to participate in product and quality decisions, just as it would if the latter were a wholly owned subsidiary. Furthermore, the bonds of reciprocal obligation felt between the two companies give Toyota confidence that Nippondenso will continue to meet its needs reliably into the indefinite future.

The Concepts and Practice of Mathematical Finance by Mark S. Joshi

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Black-Scholes formula, Brownian motion, correlation coefficient, Credit Default Swap, delta neutral, discrete time, Emanuel Derman, implied volatility, incomplete markets, interest rate derivative, interest rate swap, London Interbank Offered Rate, martingale, millennium bug, quantitative trading / quantitative finance, short selling, stochastic process, stochastic volatility, the market place, time value of money, transaction costs, value at risk, volatility smile, yield curve, zero-coupon bond

A trading bank will typically have a team of research quantitative analysts working purely on the pricing 90 Practicalities of vanilla options in order to better understand these issues, to which we return in Chapter 18. 4.6 Transaction costs Although transaction costs are a reality, they tend not to be modelled explicitly when developing pricing models. There is a simple reason for this: transaction costs can never create arbitrages. In other words, if a price cannot be arbitraged in a world free of transaction costs, it cannot be arbitraged in a world with them either. The proof of this result is very simple. Suppose a price is arbitrageable in the world with transaction costs. Then we can set up a portfolio taking into account transaction costs at zero or negative cost today, which will be of non-negative and possibly positive value in the future. If we neglect to take into account transaction costs then the initial set-up cost of the portfolio will be even lower and thus still be negative or zero.

Whilst one can clearly not do this in the markets, when one is dealing in quantities of millions, which trading banks generally do, this is not so unreasonable the smallest unit one can hold is a millionth of the typical amount held, so any error is pretty small in comparison. 2.4.5 No transaction costs The fifth assumption is that there are no transaction costs. That is one can buy and sell assets without any costs. In the market, there are two typical ways to incur transaction costs. The first is just that doing something costs money. The second is that typically buy and sell prices differ slightly (or in the case of high street foreign exchange differ greatly.) This is called the bid-offer spread. The size of the bidoffer spread is closely related to liquidity, in a very liquid market it will be tiny but in less liquid markets it can be a substantial proportion of the asset's value. Taking 22 Pricing methodologies and arbitrage transaction costs into account is currently an active area of research; we will work in a world without transaction costs. Note that the bid-offer spread is how banks make money.

If we neglect to take into account transaction costs then the initial set-up cost of the portfolio will be even lower and thus still be negative or zero. The final value of the portfolio will however be at least as high as there will be no cash drain from any transaction costs during the portfolio's life. We therefore conclude that the portfolio is also an arbitrage portfolio in a world free of transaction costs. Thus the existence of arbitrage in the world with transaction costs implies arbitrage in a world free of them. A second reason they tend to be neglected is that hedging is carried out on a portfolio basis. This results in many transactions that would be necessary to hedge a single option, not being necessary because they cancel out with other positions. The precise transaction costs added by a single new trade are therefore a function of the existing positions, and could be effectively negative if a trade offsets existing ones. 4.7 Key points The buying and selling of vanilla options is really about the trading of volatility.

Mathematics for Finance: An Introduction to Financial Engineering by Marek Capinski, Tomasz Zastawniak

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Black-Scholes formula, Brownian motion, capital asset pricing model, cellular automata, delta neutral, discounted cash flows, discrete time, diversified portfolio, interest rate derivative, interest rate swap, locking in a profit, London Interbank Offered Rate, margin call, martingale, quantitative trading / quantitative finance, random walk, short selling, stochastic process, time value of money, transaction costs, value at risk, Wiener process, zero-coupon bond

Theorem 8.2 The expectation of the discounted payoff computed with respect to the riskneutral probability is equal to the present value of the contingent claim, (8.3) D(0) = E∗ (1 + r)−1 f (S(1)) . 176 Mathematics for Finance Proof This is an immediate consequence of (8.1): f (S u ) − f (S d ) (1 + u)f (S d ) − (1 + d)f (S u ) + u−d (u − d) (1 + r) u 1 (r − d)f (S ) (u − r)f (S d ) = + 1+r (u − d) u−d 1 p∗ f (S u ) + (1 − p∗ )f (S d ) = 1+r = E∗ (1 + r)−1 f (S(1)) , D(0) = as claimed. Exercise 8.3 Find the initial value of the portfolio replicating a call option if proportional transaction costs are incurred whenever the underlying stock is sold. (No transaction costs apply when the stock is bought.) Compare this value with the case free of such costs. Assume that S(0) = X = 100 dollars, u = 0.1, d = −0.1 and r = 0.05, admitting transaction costs at c = 2% (the seller receiving 98% of the stock value). Exercise 8.4 Let S(0) = 75 dollars and let u = 0.2 and d = −0.1. Suppose that you can borrow money at 12%, but the rate for deposits is lower at 8%. Find the values of the replicating portfolios for a put and a call.

In practice it is impossible to hedge in a perfect way by designing a single portfolio to be held for the whole period up to the exercise time T . The hedging portfolio will need to be modified whenever the variables affecting the option change with time. In a realistic case of non-zero transaction costs these modifications cannot be performed too frequently and some compromise strategy may be required. Nevertheless, here we shall only discuss hedging over a single short time interval, neglecting transaction costs. 9.1.1 Delta Hedging The value of a European call or put option as given by the Black–Scholes formula clearly depends on the price of the underlying asset. This can be seen in a slightly broader context. Consider a portfolio whose value depends on the current stock price S = S(0) and is hence denoted by V (S).

What will happen if the interest rate jumps to 15%? The examples above illustrate the variety of possible hedging strategies. The choice between them depends on individual aims and preferences. We have not touched upon questions related to transaction costs or long term hedging. Nor have we discussed the optimality of the choice of an additional derivative instrument. Portfolios based on three Greek parameters would require yet another derivative security as a component. They could provide comprehensive cover, though their performance might deteriorate if the variables remain unchanged. In addition, they might prove expensive if transaction costs were included. 9.2 Hedging Business Risk We begin by introducing an alternative measure of risk, related to an intuitive understanding of risk as the size and likelihood of a possible loss. 202 Mathematics for Finance 9.2.1 Value at Risk Let us present the basic idea using a simple example.


pages: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

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asset allocation, collateralized debt obligation, corporate governance, corporate social responsibility, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, estate planning, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, Flash crash, Hyman Minsky, income inequality, index fund, interest rate swap, invention of the wheel, market bubble, market clearing, mortgage debt, new economy, Occupy movement, passive investing, Ponzi scheme, principal–agent problem, profit motive, random walk, rent-seeking, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, statistical arbitrage, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam

In order to reduce pension contributions and enhance short-term earnings, corporate pension executives projected totally unrealistic high future returns. State and local government officials, pressed by labor unions for higher wages and pensions, not only did the same, but failed to provide financial disclosure that revealed—or even hinted at—the dire long-term financial consequences that are already beginning to emerge. The Decline in Unit Transaction Costs It wasn’t just the rise in institutional ownership that fueled the rise of speculation. Speculation was also fueled by the dramatic decline in transaction costs. Simply put, trading stocks got a whole lot cheaper. Taxes virtually disappeared as a limiting factor in stock sales. The lion’s share of the assets managed by these now-dominant, powerful investment institutions were in accounts managed for tax-deferred investors such as pension plans and thrift plans, and in tax-exempt accounts such as endowment funds.

Contents Foreword Acknowledgments About This Book Chapter 1: The Clash of the Cultures The Rise of Speculation High-Frequency Trading Mission Aborted Futures and Derivatives The Wall Street Casino How Speculation Overwhelmed Investment The Decline in Unit Transaction Costs Hedge Fund Managers and Other Speculators We Can’t Say We Weren’t Warned The Wisdom of John Maynard Keynes Speculation Will Crowd Out Investment Fixing the Social Contract Compensation Issues Creating Value versus Subtracting Value Restoring Balance in Our Investment Sector Tax Policies and Financial Transactions Develop Limits on Leverage, Transparency for Derivatives, and Stricter Punishments for Financial Crimes The Rules of the Game The Goal: Stewardship Capitalism Chapter 2: The Double-Agency Society and the Happy Conspiracy The Development of the Double-Agency Society Examining the Conflict Agency Costs and Managerial Behavior The Ownership Revolution Changing Leadership Renters and Owners The Creation of Corporate Value Time Horizons and the Sources of Investment Return “Short-Termism” and Managed Earnings The Failure of the Gatekeepers Conclusion Chapter 3: The Silence of the Funds Why Mutual Funds Are Passive Participants in Corporate Governance The Picture Begins to Change Reporting Proxy Votes Mobilizing Institutional Investors The Rights and Responsibilities of Ownership Acting Like Owners “The Proof of the Pudding” Executive Compensation How Did It Happen?

The Big Picture In Chapter 1, I begin with the ideas that culminated in the “Clash of the Cultures,” an essay I wrote for the Journal of Portfolio Management in the spring of 2011, itself a product of my lecture at Wall Street’s Museum of American Finance just a few months earlier. The essay focused on how a culture of short-term speculation came to dominate a culture of long-term investment. One example: In recent years, annual trading in stocks—necessarily creating, by reason of the transaction costs involved, negative value for traders—averaged some $33 trillion. But capital formation—that is, directing fresh investment capital to its highest and best uses, such as new businesses, new technology, medical breakthroughs, and modern plant and equipment for existing business—averaged some $250 billion. Put another way, speculation represented about 99.2 percent of the activities of our equity market system, with capital formation accounting for 0.8 percent.


pages: 512 words: 162,977

New Market Wizards: Conversations With America's Top Traders by Jack D. Schwager

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backtesting, Benoit Mandelbrot, Berlin Wall, Black-Scholes formula, butterfly effect, commodity trading advisor, Elliott wave, fixed income, full employment, implied volatility, interest rate swap, Louis Bachelier, margin call, market clearing, market fundamentalism, paper trading, pattern recognition, placebo effect, prediction markets, Ralph Nelson Elliott, random walk, risk tolerance, risk/return, Saturday Night Live, Sharpe ratio, the map is not the territory, transaction costs, War on Poverty

One day somebody will be standing next to you in the pit, the next day they’re gone. It happens all the time. I also learned a lot about Monroe Trout / 153 transaction costs. I’m able to estimate transaction costs fairly accurately on various types of trades. This information is essential in evaluating the potential performance of any trading model I might develop. Give me a practical example. Let’s take bonds. The average person off the floor might assume that the transaction costs beyond commissions is at least equal to the bid/ask spread, which in the bond market is one tick [$31.25]. In reality, if you have a good broker, it’s only about half a tick, because if he’s patient, most of the time he can get filled at the bid. If you have a bad broker, maybe it’s one tick. So the transaction cost in that case isn’t as high as you might think. Therefore, a T-bond trading system that you might discard because it has a small expected gain might actually be viable—assuming, of course, that you have good execution capabilities, as we do.

Although high leverage is one of the attributes of futures markets for traders, it should be emphasized that leverage is a twoedged sword. The undisciplined use of leverage is the single most important reason why most traders lose money in the futures markets. In generals, futures prices are no more volatile than the underlying cash prices or, for that matter, many stocks. The high-risk reputation of futures is largely a consequence of the leverage factor. 5. Low transaction costs—Futures markets provide very low transaction costs. For example, it is far less expensive for a stock portfolio manager to reduce market exposure by selling the equivalent dollar amount of stock index futures contracts than by selling individual stocks. 6. Ease of offset—A futures position can be offset at any time during market hours, providing prices are not locked at limit-up or limit-down. (Some futures markets specify daily maximum price changes.

Consequently, on balance, my trades had a positive expected return, regardless of my strategy. That fact alone could very well have represented 100 percent of my success. Is that, in fact, what you think? I think that the execution edge was probably the primary reason for my success as a floor trader. The major factor that whittles down small customer accounts is not that the small traders are so inevitably wrong, but simply that they can’t beat their own transaction costs. By transaction costs I mean not only commissions but also the skid in placing an order. As a pit trader, I was on the other side of that skid. As a former Ph.D. candidate in mathematics, did you miss the intellectual challenge in what you were doing? Initially, yes. But I eventually got into serious research on prices, and that was as tough a problem as anything I ever came across in academia. William Eckhardt / 107 Were any of the areas you studied in mathematics applicable to developing trading systems?

The Smartest Investment Book You'll Ever Read: The Simple, Stress-Free Way to Reach Your Investment Goals by Daniel R. Solin

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asset allocation, corporate governance, diversification, diversified portfolio, index fund, market fundamentalism, passive investing, prediction markets, random walk, risk tolerance, risk-adjusted returns, risk/return, transaction costs, Vanguard fund

These investors pour their money into mutual funds after periods of good performance, hoping for a repeat performance. They are often disappointed. Stated differently, Hyperactive Investors buy and sell stocks and/or mutual funds frequently. I ask you, what could be sillier than frequently buying and selling mutual funds? Mutual funds were originally conceived on the idea that small investors should not be buying and selling individual stocks frequently because transaction costs would eat up any potential profit. Instead, small investors should pool their money into a mutual fund, where a "professional" money manager buys and sells the stocks for them, in large blocks, 28 Your Broker or Advisor Is Keeping You from Being a Smart Investor with much lower commissions than an individual investor could get. In this way, the investor can "buy and hold" a good mutual fund, and the fund manager can indulge his or her illusive goal of beating the markets through stock picking and market timing.

. • The system often fails to measure risk, thereby exposing investors to portfolios that are far too risky, with terrible consequences. • Many hyperactive brokers and advisors in this system have successfully avoided being held to a fiduciary standard because they know they cannot meet that standard in their relationships with investors. 38 Your Broker or Advisor Is Keeping You from Being a Smart Investor In short, being a Hyperactive Investor is a fool's errand. It is a zero-sum game (or worse, when you consider transaction costs), except from the perspective of the hyperactive brokers and advisors. They make out just fine. Chapter 11 Brokers Aren't on Your Side It [is} a fundamental dishonesty, a fundamental problem that cuts to the core of the lack of integrity on Wall Street. -Eliot L. Spitzer, attorney general of New York. Interview on NOW with Bill Moyers, May 24, 2002 You need to have utmost trust, faith and confidence in your financial advisor and in the firm that employs him or her.

For example. as one prominent study by Patrick Bajari and John Kcainer noted. "lI] n 2000 and 2001. the least recommended stocks earned an average abnormal return of 13%. while the most highly recommended stocks earned average abnormal returns of -7%." Ouch! Even studies that demonstrate that there can be value in analyst recommendations note that, in order to take advantage of them. such heavy trading is required that the transaction costs incurred essentially offset the benefits obtained by relying on these recommendations. If this is true, it is difficult to understand what value these recommendations really have--even when they are correct. Finally. given the number of analyst recommendations. and the conflicting studies about their reliabililY. how do Hyperactive lnvesfOrs know which oncs have value and which ones don't?

The Darwin Economy: Liberty, Competition, and the Common Good by Robert H. Frank

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carbon footprint, carried interest, Cass Sunstein, clean water, congestion charging, corporate governance, deliberate practice, full employment, income inequality, invisible hand, Plutocrats, plutocrats, positional goods, profit motive, Ralph Nader, rent control, Richard Thaler, Ronald Coase, Ronald Reagan, sealed-bid auction, smart grid, The Nature of the Firm, The Wealth of Nations by Adam Smith, Thomas Malthus, transaction costs, trickle-down economics, ultimatum game, winner-take-all economy

Even if the buyer dealt with the most efficient suppliers in each instance, the number and complexity of the required contracts would make the ultimate price of the car prohibitively high. The whole process could be dramatically streamlined, he argued, by forming organizations in which employees simply did the bidding of supervisors. PERPETRATORS AND VICTIMS 91 In the wake of the 1937 paper’s publication, a new field in economics emerged and prospered. Called transaction cost economics, it tries to explain organizational forms and behavior as implicit or explicit consequences of attempts to economize on transaction costs.11 In the light of his intellectual history, there is no question that Coase was well aware of practical impediments that often make it prohibitively costly for private parties to negotiate agreements. His intended message simply cannot have been that government has no useful role to play in the regulation of activities that cause harm to others.

THE LIBERTARIAN’S OBJECTIONS RECONSIDERED 211 Libertarians might object that it violates their right to decide for themselves how much safety to buy. But defending that right means denying others the right to limit the amount of risk they permit themselves to take. Libertarians need to explain why the first right is more important to defend than the second. If rational libertarians would indeed have chosen to join the larger group that wanted safety regulation in a world with zero transaction costs, how can they then insist that safety regulation robs them of an essential right? The high transaction costs of the world we live in mean that one group or the other will not be able to get what it wants. What argument can libertarians offer to explain why wishes of the larger group should be discounted? How could a group that claims to celebrate freedom above all else argue for a result that people never would have endorsed in an environment in which everyone had complete freedom of choice?

DARWIN’S WEDGE 29 Still another economist suggested that the unwillingness to take context seriously might be rooted in the fact that doing so would undermine the celebrated invisible-hand narrative. This explanation may well account for the attitudes of at least some economists. But it’s not sufficient. The profession, after all, has incorporated numerous other forms of market failure into its arsenal of policy recommendations. Even the most ardent market enthusiasts, for example, are quick to concede a productive role for government intervention to curb pollution when transaction costs are high. A final possibility I consider is the one that strikes me as most plausible. In the more than thirty years I have been writing about positional concerns, the most frequent response of libertarians and others on the right has been to accuse me of trying to incite class warfare. They dismiss positional concerns for the same reason they dismiss the preferences of sadists. But bringing positional concerns into the conversation is nothing remotely like giving policy weight to the preferences of sadists.


pages: 416 words: 118,592

A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing by Burton G. Malkiel

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accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, Bernie Madoff, BRICs, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, fixed income, framing effect, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Long Term Capital Management, loss aversion, margin call, market bubble, mortgage tax deduction, new economy, Own Your Own Home, passive investing, pets.com, Ponzi scheme, price stability, profit maximization, publish or perish, purchasing power parity, RAND corporation, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, The Myth of the Rational Market, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond

If you ask me what this means, I cannot tell you, but I think the technician probably had the following in mind: “If the market does not go up or go down, it will remain unchanged.” Even the weather forecaster can do better than that. Obviously, I’m biased. This is not only a personal bias but a professional one as well. Technical analysis is anathema to much of the academic world. We love to pick on it. We have two main reasons: (1) after paying transactions costs and taxes, the method does not do better than a buy-and-hold strategy; and (2) it’s easy to pick on. And while it may seem a bit unfair, just remember that it’s your money we’re trying to save. Although the computer perhaps enhanced the standing of the technician for a time, and while charting services are widely available on the Internet, technology has ultimately proved to be the technician’s undoing.

It turns out that the correlation of past price movements with present and future price movements is very close to zero. Last week’s price change bears little relationship to the price change this week, and so forth. Whatever slight dependencies have been found between stock-price movements in different time periods are extremely small and economically insignificant. Although there is some short-term momentum in the stock market, as will be described more fully in chapter 11, any investor who pays transactions costs and taxes cannot benefit from it. Economists have also examined the technician’s thesis that there are often sequences of price changes in the same direction over several days (or several weeks or months). Stocks are likened to fullbacks who, once having gained some momentum, can be expected to carry on for a long gain. It turns out that this is simply not the case. Sometimes one gets positive price changes (rising prices) for several days in a row; but sometimes when you are flipping a fair coin you also get a long string of “heads” in a row, and you get sequences of positive (or negative) price changes no more frequently than you can expect random sequences of heads or tails in a row.

Conversely, when a stock drops on large volume, selling pressure is indicated and a sell signal is given. Again, the investor following such a system is likely to be disappointed in the results. The buy and sell signals generated by the strategy contain no information useful for predicting future price movements. As with all technical strategies, however, the investor is obliged to do a great deal of in-and-out trading, and thus his transactions costs and taxes are far in excess of those necessitated in a buy-and-hold strategy. After accounting for these costs, the investor does worse than he would by simply buying and holding a diversified group of stocks. Reading Chart Patterns Perhaps some of the more complicated chart patterns, such as those described in the preceding chapter, are able to reveal the future course of stock prices.


pages: 586 words: 159,901

Wall Street: How It Works And for Whom by Doug Henwood

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accounting loophole / creative accounting, affirmative action, Andrei Shleifer, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, borderless world, Bretton Woods, British Empire, capital asset pricing model, capital controls, central bank independence, corporate governance, correlation coefficient, correlation does not imply causation, credit crunch, currency manipulation / currency intervention, David Ricardo: comparative advantage, debt deflation, declining real wages, deindustrialization, dematerialisation, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, experimental subject, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, George Akerlof, George Gilder, hiring and firing, Hyman Minsky, implied volatility, index arbitrage, index fund, interest rate swap, Internet Archive, invisible hand, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, moral hazard, mortgage debt, mortgage tax deduction, oil shock, payday loans, pension reform, Plutocrats, plutocrats, price mechanism, price stability, prisoner's dilemma, profit maximization, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The Market for Lemons, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, transcontinental railway, women in the workforce, yield curve, zero-coupon bond

Conventional economics still treats the market as essentially self-regulating: the system, outside the firm, still works itself. But in reality there are substantial costs of time and money devoted to making the system work. Sellers must seek buyers, and buyers must weigh the competence and honesty of sellers. Transactions costs are far from trivial — as much as half U.S. GDP, according to one estimate cited by Coase (quoted in Williamson and Winter 1993, p. 63). Though Coase didn't make the point, the transaction cost argument for the existence of the firm can be applied to the provision of capital. Con- WALL STREET ventional theory assumes that entrepreneurs can raise capital for their projects effortlessly and costlessly, when in fact they cannot; even the most seasoned corporation has to pay commissions to the bankers underwriting its paper, and for less established and virginal ventures, capital can be expensive to raise, if it's available at all.

.), 259 Templeton, Sir John, 311 Thatcher, Margaret. 108. 311 Third Worid debt crisis, 110 political uses of, 294-295 development finance and capital flows, 110 stock markets, 15 inexplicability of returns, 125 TTiomas, Michael, 286 thrift campaigns, Keynes's denunciation of, 196; see also austerity thrifts (S&Ls), 81 crisis, 1980s, 86, 101 and early-1990s credit crunch, 158 Wall Street fleecing of, 180-181, 186 tobacco, 311 Tobias, Andrew, 81 Tobin, James, 143, 318-319; see also q ratio 371 WALL STREET Tompkins, Doug, 245 trade, merchandise, and currency trading, 42 traders vs. investors, 104-105 trading prowess, 32 trading strategies, 104-106 trading week, 127-135 transactions-cost economics, 248-251 financial applications, 249 transactions costs and efficient market theory, l64 estimate of, 249 international comparisons, 317 transactions taxes, 317-319 Treasury bonds. See bond markets Triad, 111 triumphalism, capitalist, 187 Trump, Donald, 100, 239 truth, Wall Street, 127 Turner, Philip, 108-110 Twentieth Century Fund, 144, 260, 293, 300, 319 uncertainty. SeensV. underconsumption, 208, 234 unemployment, 132, 200 union representatives on boards, 320 United Airlines, 299 United for a Fair Economy, 69 United Kingdom corporate structures, 252 inefficiently small firms, 298 United Nations Centre on Transnational Corporations, 111-112, 117 United Shareholders Association, 289 universities, 288 University of Chicago, 143 unproductive labor, 236 apologists for, 209-210 upscale liberals, 311 Useem, Michael, 290, 292-293 U.S.

.^ the technique of economics Charles Plosser (1984) listed some of the basic assumptions on which modern financial theory is based: Most of the fundamental contributions to financial economics, including portfolio theory, the Modigliani-Miller Theorem, efficient markets, and virtually all of the asset-pricing models, have been developed under the assumption of a perfect market by which I mean (1) no transaction costs, (2) complete and costless information, and (3) competition. As Plosser noted, "theorists, especially of the Keynesian variety, are quick to assume the existence of arbitrary constraints and/or market failures," such as "institutional and/or wage-price rigidities, nonmarket clearing, exogenously determined long-term contracts, and the money illusion, to which you may add your favorites." But, argued Plosser, we need pure models of market function so we may better understand the departures from purity.

The End of Power: From Boardrooms to Battlefields and Churches to States, Why Being in Charge Isn’t What It Used to Be by Moises Naim

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additive manufacturing, barriers to entry, Berlin Wall, bilateral investment treaty, business process, business process outsourcing, call centre, citizen journalism, Clayton Christensen, clean water, collapse of Lehman Brothers, collective bargaining, colonial rule, conceptual framework, corporate governance, crony capitalism, deskilling, disintermediation, don't be evil, failed state, Fall of the Berlin Wall, financial deregulation, Francis Fukuyama: the end of history, illegal immigration, immigration reform, income inequality, income per capita, intermodal, invisible hand, job-hopping, Joseph Schumpeter, Julian Assange, Kickstarter, Martin Wolf, megacity, Naomi Klein, Nate Silver, new economy, Northern Rock, Occupy movement, open borders, open economy, Peace of Westphalia, Plutocrats, plutocrats, price mechanism, price stability, private military company, profit maximization, Ronald Coase, Ronald Reagan, Silicon Valley, Skype, Steve Jobs, The Nature of the Firm, Thomas Malthus, too big to fail, trade route, transaction costs, Washington Consensus, WikiLeaks, World Values Survey

The propensity to operate through a vertically integrated firm is driven by the structure of the market of buyers and sellers active in the different stages of the industry and by the kinds of investments needed to enter the business. In short, transaction costs determine the contours, growth patterns, and, ultimately, the very nature of firms.21 Although Coase’s insight became an important underpinning of economics in general, its main initial impact was in the field of industrial organization, which focuses on factors that stimulate or hinder competition among firms. The idea that transaction costs determine the size and even the nature of an organization can be applied to many other fields beyond industry to explain why not just modern corporations but also government agencies, armies, and churches became large and centralized. In all such cases, it has been rational and efficient to do so. High transaction costs create strong incentives to bring critical activities controlled by others inside the organization, thereby growing it.

Earlier he had flirted with socialism, and he became intrigued by the similarities in organization between American and Soviet firms and, in particular, by the question of why large industry, where power was highly centralized, had emerged on both sides of the ideological divide.20 46 Coase’s explanation—which would help earn him the Nobel Prize in economics decades later—was both simple and revolutionary. He observed that modern firms faced numerous costs that were lower when the firm brought the functions in-house than they would have been when dealing at arms’ length with another enterprise. Included among such costs are those for drafting and enforcing sales contracts—expenses that Coase initially called “marketing costs” and later redubbed “transaction costs.” Specifically, transaction costs helped explain why some firms grew by vertically integrating—that is, by buying their suppliers or distributors— while others didn’t. Large oil producers, for example, prefer to own the refineries where their oil is processed, as this tends to be less risky and more efficient than relying on a commercial relationship with independent refiners whose actions the oil companies can’t control.

High transaction costs create strong incentives to bring critical activities controlled by others inside the organization, thereby growing it. And by the same token, the more the pattern of transaction costs made it rational for organizations to grow large by integrating vertically, the more daunting an obstacle this growth represented for new rivals trying to gain a foothold. It is harder for a new rival to challenge an existing company that also controls the main source of raw materials, for example, or has internalized the main distribution channels or retail chain. The same applies to situations in which one army has exclusive control over the procurement of its weapons and technology and a second army is forced to depend on another nation’s arms industry. Thus, the transaction costs that some organizations are able to minimize by “internalizing” or controlling the provider or the distributors constitute one more barrier to potential new rivals and a barrier to gaining power more generally—and scale boosted by vertical integration provides a high protective barrier for incumbents inasmuch as newer, smaller players have a lesser chance to compete and succeed.


pages: 383 words: 81,118

Matchmakers: The New Economics of Multisided Platforms by David S. Evans, Richard Schmalensee

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Airbnb, big-box store, business process, cashless society, Deng Xiaoping, if you build it, they will come, Internet Archive, invention of movable type, invention of the printing press, invention of the telegraph, invention of the telephone, Jean Tirole, Lyft, M-Pesa, market friction, market microstructure, mobile money, multi-sided market, Network effects, Productivity paradox, profit maximization, purchasing power parity, ride hailing / ride sharing, sharing economy, Silicon Valley, Snapchat, Steve Jobs, Tim Cook: Apple, transaction costs, two-sided market, Uber for X, Victor Gruen, winner-take-all economy

That’s the sort of problem that an important, but until recently overlooked, type of business sets out to solve by helping parties who have something valuable to exchange find each other, get together, and do a deal. Multisided Platforms In 1998, this important type of business didn’t have a name. That’s surprising, in retrospect. Many businesses had been built to reduce these sorts of market frictions, which economists tend to call transaction costs. Their basic business model had been around for thousands of years. But business schools didn’t teach classes on how to start or run businesses that help different parties get together to exchange value. Economists didn’t have a clue how these businesses worked. In fact, the companies that reduced these market frictions charged prices and adopted other strategies that economic textbooks insisted no sensible business would do.

Then smartphones and advances in the speed and reliability of wireless networks have put connected computing devices into the hands of almost two billion people around the world.20 More countries are getting wireless networks that can support Internet-connected devices, so that number will increase considerably in the coming years. The birth of the commercial Internet in the mid-1990s and mobile broadband in the early 2000s, combined with the earlier invention of personal computers and programming languages, has sent forth armies of multisided platforms working to reduce transaction costs of all sorts in most countries on the planet. Some stay within their own national borders. Others use the power of global connectivity to try to conquer the world. The pace has been frenetic for the last two decades and is quickening. The Internet and smartphones have turbocharged the ancient matchmaker business model. Whether turbocharged or not, the same economic principles for building, starting, and operating a multisided platform apply.

The core of this book in part II uses case studies of multisided platforms to provide a deeper understanding of the concepts that we’ve presented in this chapter. We focus on six critical issues that multisided platforms must address. The opportunity for a multisided platform ordinarily arises when frictions keep market participants from dealing with each other easily and directly. Entrepreneurs can identify opportunities for starting a matchmaker by looking for significant transaction costs that keep willing buyers and sellers apart and that a well-designed matchmaker can reduce. Multisided platforms have to secure critical mass in order to ignite. They have to solve the chicken-and-egg problem of getting both sides on board, in adequate numbers, to create value. If they don’t, they will implode. If they do, indirect network effects will generally fuel sustainable growth. This problem is so hard to solve that entrepreneurs need to make sure that the frictions they are trying to solve are substantial enough to persuade participants to join and to enable the matchmaker, possibly, to fund subsidies to one group of participants.

State-Building: Governance and World Order in the 21st Century by Francis Fukuyama

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Asian financial crisis, Berlin Wall, Bretton Woods, centre right, corporate governance, demand response, Doha Development Round, European colonialism, failed state, Fall of the Berlin Wall, Francis Fukuyama: the end of history, George Akerlof, Hernando de Soto, Nick Leeson, Potemkin village, price stability, principal–agent problem, rent-seeking, road to serfdom, Ronald Coase, structural adjustment programs, technology bubble, The Market for Lemons, The Nature of the Firm, transaction costs, Washington Consensus

For example, many of the new technologies of the later nineteenth century, such as railroads, coal-powered energy sources, steel, and heavy manufacturing, benefited from extensive economies of scale and thus encouraged centralization.4 By contrast, Malone, Yates et al. (1989), building on Coase’s thesis about the relationship between transaction costs and hierarchy, have speculated that with the advent of inexpensive information technology, transaction costs would fall across the board and hierarchies would increasingly give way to either markets or to more decentralized forms of organization in which cooperating units did not stand in a hierarchical relationship to one another. Information technology creating lower transaction costs has provided the theoretical justification for many firms to flatten their managerial hierarchies, outsource, or “virtualize” their structures. Long before the advent of the contemporary information revolution, Hayek (1945), following on von Mises (1981), pointed out that the growing technological complexity of modern economies dictated a higher degree of decentralized economic decision making.

Institutional Economics and the Theory of Organizations Economic theories about organizations1 begin with Ronald Coase’s (1937) theory of the firm, which established the basic For overviews of the intellectual history of the economists’s approach to organizational theory, see Furubotn and Richter (1997, chapter 8) and Moe (1984). 1 46 state-building distinction between markets and hierarchies and argued that certain resource allocation decisions were made within hierarchical organizations because of a need to economize on transaction costs. The costs of finding information about products and suppliers, negotiating contracts, monitoring performance, and litigating and enforcing contracts in decentralized markets often meant that it was more efficient to bring all of these activities within the boundaries of a single hierarchical organization that could make decisions on the basis of an authority relationship. Coase’s theory of the firm was actually not a theory of organizations but rather a theory of why the boundary between markets and organizations was drawn the way it was. Williamson (1975, 1985, 1993) used Coase’s transaction cost framework and filled in many of the details about why hierarchies were used in preference to markets.

Goals often emerge and evolve through complicated interactions between organizational players or are defined by the roles assigned to players in the organization—the so-called where you sit is where you stand rule (Allison 1971). Labor can be divided functionally in a variety of ways that necessarily favor one organizational goal over a another but never all simultaneously. Second, formal systems of monitoring and accountability, particularly in public administration, either entail very high transaction costs or are simply impossible because of the lack of specificity of the underlying activity. In these cases it is often more efficient to control agent behavior through informal norms, but control of agent behavior through norms has its drawbacks as well. An organization’s choice of formal or informal control mechanisms will depend on the particular circumstances it faces. Third, the appropriate degree of delegated discretion will vary according to the endogenous and exogenous conditions that an organization faces over time.


pages: 119 words: 10,356

Topics in Market Microstructure by Ilija I. Zovko

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Brownian motion, continuous double auction, correlation coefficient, financial intermediation, Gini coefficient, market design, market friction, market microstructure, Murray Gell-Mann, p-value, quantitative trading / quantitative finance, random walk, stochastic process, stochastic volatility, transaction costs

Variations in patience might be explained by a rationality-based explanation in terms of information arrival, or a behavioral-based explanation driven by emotional response, but in either case it suggests that patience is a key factor. These results have several practical implications. For market practitioners, understanding the spread and the market impact function is very useful for estimating transaction costs and for developing algorithms that minimize their effect. For regulators they suggest that it may be possible to make prices less volatile and lower transaction costs, if this is desired, by creating incentives for limit orders and disincentives for market orders. These scaling laws might also be used to detect anomalies, e.g. a higher than expected spread might be due to improper market maker behavior. This is part of a broader research program that might be somewhat humorously characterized as the “low-intelligence” approach: We begin with minimally intelligent agents to get a good benchmark of the effect of market institutions, and once this benchmark is wellunderstood, add more intelligence, moving toward market efficiency.

They note that the number of orders placed up to five quotes away from the market decay monotonically but do not attempt to estimate the distribution or examine orders placed further then five best quotes. Our analysis looks at the price placement of limit orders across a much wider range of prices. Since placing orders out of the market carries execution and adverse selection risk, our work is relevant in understanding the fundamental dilemma of limit order placement: execution certainty vs. transaction costs (see, e.g., Cohen, et al. (1981); Harris (1997); Harris and Hasbrouck (1996); Holden and Chakravarty (1995); Kumar and Seppi (1992); Lo, et al. (2002)). In addition to the above, our work relates to the literature on clustered volatility. It is well known that both asset prices and quotes display ARCH or GARCH effects (Engle (1982); Bollerslev (1986)), but the origins of these phenomena are not well understood.

The dots show the average predicted and actual value for each stock averaged over the full 21 month time period. The solid line is a regression; the dashed line is the diagonal, representing the model’s prediction with A = 1 and B = 0. spread, R2 = 0.76, so the model still explains most of the variance. 3.3 Average market impact Market impact is practically important because it is the dominant source of transaction costs for large trades, and conceptually important because it provides a convenient probe of the revealed supply and demand functions in the limit order book (see SM Section 3.5.7). When a market order of size ω arrives, if it removes all limit orders at the best bid or ask it will immediately change the midpoint price m ≡ (a + b)/2. We define the average market impact function φ in terms of the instantaneous logarithmic midpoint price shift∆ p conditioned on order size, φ(ω) = E[∆p|ω].∆ p is the difference between the price just before a market order arrives and the price just after it arrives (before any other events).


pages: 500 words: 145,005

Misbehaving: The Making of Behavioral Economics by Richard H. Thaler

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Albert Einstein, Amazon Mechanical Turk, Andrei Shleifer, Apple's 1984 Super Bowl advert, Atul Gawande, Berlin Wall, Bernie Madoff, Black-Scholes formula, capital asset pricing model, Cass Sunstein, Checklist Manifesto, choice architecture, clean water, cognitive dissonance, conceptual framework, constrained optimization, Daniel Kahneman / Amos Tversky, delayed gratification, diversification, diversified portfolio, Edward Glaeser, endowment effect, equity premium, Eugene Fama: efficient market hypothesis, experimental economics, Fall of the Berlin Wall, George Akerlof, hindsight bias, Home mortgage interest deduction, impulse control, index fund, invisible hand, Jean Tirole, John Nash: game theory, John von Neumann, late fees, law of one price, libertarian paternalism, Long Term Capital Management, loss aversion, market clearing, Mason jar, mental accounting, meta analysis, meta-analysis, More Guns, Less Crime, mortgage debt, Nash equilibrium, Nate Silver, New Journalism, nudge unit, payday loans, Ponzi scheme, presumed consent, pre–internet, principal–agent problem, prisoner's dilemma, profit maximization, random walk, randomized controlled trial, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Coase, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, technology bubble, The Chicago School, The Myth of the Rational Market, The Signal and the Noise by Nate Silver, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, transaction costs, ultimatum game, Walter Mischel

At this workshop, Lott was present and looking annoyed, so I hoped he was not packing a gun. His wife, Gertrude (also an economist), was in the crowd as well and asked a question about the mugs study. Couldn’t the low trading of the mugs be explained by transaction costs? I explained that the tokens experiment had ruled out this explanation—after all, the tokens had the same transaction costs as the mugs, and the tokens did trade as much as the theory predicted. She seemed satisfied, but then Lott jumped in to “help.” “Well,” he asked, “couldn’t we just call the endowment effect itself a transaction cost?” I was shocked by this comment; transaction costs are supposed to be the cost of doing a transaction—not the desire to do a transaction. If we are free to re-label preferences as “costs” at will so that behavior appears to be consistent with the standard theory, then the theory is both untestable and worthless.

To be considered for publication, however, proposed explanations must be falsifiable, at least in principle. A reader who claims that an alleged anomaly is actually the rational response to taxes should be willing to make some prediction based on that hypothesis; for example, the anomaly will not be observed in a country with no taxes, or for non-taxed agents, or in time periods before the relevant tax existed. Someone offering an explanation based on transaction costs might suggest an experimental test in which the transaction costs could be eliminated, and should be willing to predict that the effect will disappear in that environment. I wrote a column in every issue, that is, quarterly, for nearly four years. The articles were about ten to twelve published pages, short enough to make them a quick read, but long enough to give a fair amount of detail. Each article ended with a “Commentary” section in which I tried to explain the significance of the findings.

The reason this result is important for the law is that judges often decide who owns a certain right, and the Coase theorem says that if transaction costs are low, then what the judge decides won’t actually determine what economic activities will take place; the judge will just decide who has to pay. The article that includes this result, entitled “The Problem of Social Cost,” is one of the most cited economics articles of all time. The argument I have sketched up to this point crucially depends on the stated assumption that the costs involved in the two parties coming to an efficient economic agreement are small to nonexistent. Coase is upfront about this. He says: “This is, of course, a very unrealistic assumption.” Although many applications of the Coase theorem ignore Coase’s warning, we wanted to show that the result was wrong, even when it could be shown that transaction costs were essentially zero.

How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

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Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business process, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Nick Leeson, P = NP, pattern recognition, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

First, how do you decide what makes one trajectory better than another, and second, how do you find the best trajectory? Fortunately, there is mathematics ready-made for this setup. At each point in time, the stock portfolio has two costs associated with it: a risk cost and a market impact cost. The risk cost is the theoretical cost associated with holding a risky position that you do not want to be holding. The transaction cost is the cost associated with the market impact of the position’s changing through time. The total cost is the sum of the transaction costs and the risk cost appropriately adjusted by a risk aversion parameter, which controls for how urgently you want to reduce the risk. When you look at the problem this way, it naturally fits into the mathematical framework of the calculus of variations. This is a wellunderstood optimization problem whose solution is given by the EulerLagrange equation.

Integrating every step of the investment process across the same proprietary factors helps to ensure that the portfolio construction process fully exploits all detected investment opportunities and controls for all known risk exposures. Furthermore, with an integrated process, actual portfolio results can be used to evaluate security selection and provide input to the research process. Insights can also be eroded by transaction costs, but we hold several advantages in the trading arena. First, because of our disentangling JWPR007-Lindsey 274 May 28, 2007 15:46 h ow i b e cam e a quant approach, we can profit from multiple inefficiencies for each security that we trade. Second, with our integrated systems, transaction costs are estimated and fed back to the portfolio construction process, helping to ensure that only economical trades are made. Third, we were early advocates and users of low-cost electronic trading venues. Finally, we maintain strict capacity limits to ensure that our trading remains nimble and cost effective.

High information ratios require an edge, and the opportunity to diversify by applying that edge many times. Due to the fundamental law, quantitative active strategies tend to take many small bets as opposed to a few concentrated bets. The goal, based on this framework, is to deliver consistent performance. Beyond these basics, the book provided considerable guidance into how to build and test investment strategies, how to properly optimize portfolios, how to model and account for transactions costs, and how to analyze performance ex post. The book did not provide alpha ideas—as such, ideas only work if the market doesn’t already understand them. Active Portfolio Management has played an important role in legitimizing the science of investing. While the consistent investment performance of quantitative managers like Barclays Global Investors was critically important, the flow of institutional assets into quantitatively JWPR007-Lindsey 44 May 7, 2007 16:30 h ow i b e cam e a quant managed investments also required intellectual legitimacy, which Active Portfolio Management has helped provide.


pages: 331 words: 60,536

The Sovereign Individual: How to Survive and Thrive During the Collapse of the Welfare State by James Dale Davidson, Rees Mogg

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affirmative action, agricultural Revolution, bank run, barriers to entry, Berlin Wall, borderless world, British Empire, California gold rush, clean water, colonial rule, Columbine, compound rate of return, Danny Hillis, debt deflation, ending welfare as we know it, epigenetics, Fall of the Berlin Wall, falling living standards, feminist movement, financial independence, Francis Fukuyama: the end of history, full employment, George Gilder, Hernando de Soto, illegal immigration, income inequality, informal economy, information retrieval, Isaac Newton, Kevin Kelly, market clearing, Martin Wolf, Menlo Park, money: store of value / unit of account / medium of exchange, new economy, New Urbanism, offshore financial centre, Parkinson's law, pattern recognition, phenotype, price mechanism, profit maximization, rent-seeking, reserve currency, road to serfdom, Ronald Coase, school vouchers, seigniorage, Silicon Valley, spice trade, statistical model, telepresence, The Nature of the Firm, the scientific method, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, trade route, transaction costs, Turing machine, union organizing, very high income

Why do entrepreneurs hire employees, rather than placing every task that needs doing out to bid among independent contractors in the auction market? Nobel Prize-winning economist Ronald Coase helped launch a new direction in economics by asking some of these important questions. The answers he helped to frame hint at the revolutionary consequences of information technology for the structure of business. Coase argued that firms were an efficient way to overcome information deficits and high transaction costs.26 Information and Transaction Costs To see why, consider the obstacles you would have faced in trying to operate an industrial-era assembly line without a single firm to coordinate its activities. In principle, an automobile could have been produced without production being centralized under the oversight of a single firm. Economist Oliver Williamson, along with Coase, is another pioneer in developing the theory of the firm.

Microeconomics generally assumes that the price mechanism is the most effective means of coordinating resources for their most valued uses. As Putterman and Kroszner observe, this tends to imply that organizations like firms have no inherent "economic raison d'etre."27 In this sense, firms are mainly artifacts of information and transaction costs, which information technologies tend to reduce drastically. Therefore, the Information Age will tend to be the age of independent contractors without "jobs" with long-lasting "firms." As technology lowers transaction costs, the very process that will enable individuals to escape from domination by politicians will also prevent "rule by corporations." Corporations will compete with "virtual corporations" from across the globe to a degree that will disturb and threaten all but a few. Most corporations as institutions will be lucky to survive intensified competition as markets become more complete.

There is in these new media a foreshadowing of the intellectual and economic liberty that might undo all the authoritarian powers on earth." 2 Cyberspace, like the imaginary realm of Homer's gods, is a realm apart from the familiar terrestrial world of farm and factory. Yet its consequences will not be imaginary, but real. To a far greater extent than many now understand, the instantaneous sharing of information will be like a solvent dissolving large institutions. It will not only alter the logic of violence, as we have already explored; it will radically alter information and transaction costs that determine how businesses organize and the way the economy functions. We expect microprocessing to change the economic organization of the world. 144 "It is today possible, to a greater extent than at any time in the worlds' history, for a company to locate anywhere, to use resources from anywhere to produce a product that can be sold anywhere." MILTON FRIEDMAN THE TYRANNY OF PLACE The fact that the fading industrial era's first stab at conceiving the information economy is to think of it in terms of a gigantic public works project tells you how grounded our thinking is in the paradigms of the past.


pages: 257 words: 13,443

Statistical Arbitrage: Algorithmic Trading Insights and Techniques by Andrew Pole

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algorithmic trading, Benoit Mandelbrot, Chance favours the prepared mind, constrained optimization, Dava Sobel, Long Term Capital Management, Louis Pasteur, mandelbrot fractal, market clearing, market fundamentalism, merger arbitrage, pattern recognition, price discrimination, profit maximization, quantitative trading / quantitative finance, risk tolerance, Sharpe ratio, statistical arbitrage, statistical model, stochastic volatility, systematic trading, transaction costs

While the technicalities are important for understanding and analysis, the practical value for application in the late 1980s and early 1990s was minimal: Reversion was evident on such a large scale and over such a wide range of stocks that it was impossible not to make good returns except by deliberate bad practice! That rich environment has not existed for several years. As volatility in some industries declined—the utilities sector is a splendid example (Gatev, et al.)—raw standard deviation rules were rendered inadequate as the expected rate of return on a trade shrank below transaction costs. Implementing a minimum rate of return lower bound on trades solved that, and in later years provided a valuable risk management tool. 2.3 POPCORN PROCESS The trading rules exhibited thus far make the strong statement that a spread will systematically vary from substantially above the mean to substantially below the mean and so forth. The archetype of this pattern of temporal development is the sine wave.

The key to successfully exploiting predictions that are not very accurate is that the direction is forecast correctly somewhat better than 50 percent of the time (assuming that up and down forecasts 60 STATISTICAL ARBITRAGE are equally accurate).1 If a model makes correct directional forecasts (50 + )% of the time, then the net gain is (50 + ) − (50 − )% = 2% of the bets. This net gain can be realized if one can make a sufficient number of bets. The latter caveat is crucial because averages are reliable indicators of performance only in the aggregate. Guaranteeing that 2% of one’s bets is the net outcome of a strategy is not sufficient, by itself, to guarantee making a profit: Those bets must cover transaction costs. And remember, it is not the 1 The situation is actually more complicated in a manner that is advantageous to a fund manager. Symmetry on gains and losses makes for a simple presentation of the point that a small bias can drive a successful strategy; one can readily live with relative odds that would cause a physician nightmares. The practical outcome of a collection of bets is determined by the sum of the gains minus the sum of the losses.

Total up those small losses and discover the shamelessly omitted (oops, I mean inadvertently hidden in the detail) large cumulative loss over an extended period before the Batman surprise. So what have we truly gotten? A few periods of glee before inevitable catastrophe supplanted with prolonged, ulcer inducing negativity, despondency, despair, and (if you can stand the wait) possible vindication! It is still an uncertain game. Just different rules. There are many kinds of randomness. Structural Models 61 average transaction cost that must be covered by the net gain. It is the much larger total cost of all bets divided by the small percentage of net gain bets that must be covered. For example, if my model wins 51 percent of the time, then the net gain is 51 − 49 = 2 percent of bets. Thus, out of 100 bets (on average) 51 will be winners and 49 will be losers. I make net 2 winning bets for each 100 placed. Statistically guaranteed.


pages: 335 words: 94,657

The Bogleheads' Guide to Investing by Taylor Larimore, Michael Leboeuf, Mel Lindauer

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asset allocation, buy low sell high, corporate governance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, endowment effect, estate planning, financial independence, financial innovation, high net worth, index fund, late fees, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, market bubble, mental accounting, passive investing, random walk, risk tolerance, risk/return, Sharpe ratio, statistical model, transaction costs, Vanguard fund, yield curve

The SEC requires that fee and expense information be displayed in the first few pages of the prospectus. FEES NOT COVERED BY THE PROSPECTUS Now we come to the costs of mutual fund ownership we seldom find in the prospectus. Hidden Transaction Costs A mutual fund incurs a cost every time it buys or sells a security. Transaction costs, caused by fund turnover, include brokerage commissions, bid-offer spreads, and market impact costs. Together, they may easily exceed the expense ratio and other costs disclosed in the prospectus. Brokerage Commissions In a study titled, "Portfolio Transaction Costs at U.S. Equity Mutual Funds," researchers Jason Karceski, Miles Livingston, and Edward O'Neal found that the average brokerage commission cost for mutual fund managers was 0.38 percent of fund assets. Soft-Dollar Arrangements Some mutual fund companies have soft-dollar arrangements with their brokers.

It's estimated that the total of all costs in the U.S. equity market (not just mutual funds) is about $300 billion annually. We are talking about advisory fees, brokerage commissions, customer fees, legal fees, marketing expenditures, sales loads, securities processing expenses, and transaction costs. Not included in the $300 billion figure is the cost of taxes. We will discuss taxes in Chapters 10 and 11. FEES COVERED BY THE PROSPECTUS It's important that we understand the different mutual fund fees and expenses that are listed in every mutual fund prospectus. Later, we will investigate mutual fund transaction costs that are little known and seldom reported. Stephen Schutt, senior editor of TheStreet.com, writes: "Death by a thousand fees isn't going to show up in a quarterly fund statement." For this reason, we will go over them one by one here so that you will know what to look for, what to minimize, and what to avoid.

Richard Ferri, author of Protecting Your Wealth in Good Times and Bad: "When you are finished choosing a bond index fund, a total U.S. stock market index fund, and a broad international index fund, you will have a very simple, yet complete portfolio." Walter R. Good and Roy W. Hermansen, authors of Index Your Way to Investment Success: "Index funds save on management and marketing expenses, reduce transaction costs, defer capital gain, and control risk-and in the process, beat the vast majority of actively managed mutual funds!" Arthur Levitt, former chairman of the Securities Exchange Commission and author of Take on the Street: "The fund industry's dirty little secret: Most actively managed funds never do as well as their benchmark." Burton Malkiel, professor of economics, Princeton University and author of A Random Walk Down Wall Street: "Through the past thirty years more than two-thirds of professional portfolio managers have been outperformed by the unmanaged S&P 500 Index."


pages: 219 words: 15,438

The Essays of Warren Buffett: Lessons for Corporate America by Warren E. Buffett, Lawrence A. Cunningham

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compound rate of return, corporate governance, Dissolution of the Soviet Union, diversified portfolio, dividend-yielding stocks, fixed income, index fund, invisible hand, large denomination, low cost carrier, oil shock, passive investing, price stability, Ronald Reagan, the market place, transaction costs, Yogi Berra, zero-coupon bond

We do not believe that a NYSE listing will improve or diminish Berkshire's prospects for consistently selling at an appropriate price; the quality of our shareholders will produce a good result whatever the marketplace. But we do believe that the listing will reduce transaction costs for Berkshire's shareholders-and that is important. Though we want to attract shareholders who will stay around for a long time, we also want to minimize the costs incurred by shareholders when they enter or exit. In the long run, the aggregate pre-tax rewards to our owners will equal the business gains achieved by the company less the transaction costs imposed by the marketplace-that is, commissions charged by brokers plus the net realized spreads of 1997] THE ESSAYS OF WARREN BUFFETT 121 market-makers. Overall, we believe these transaction costs will be reduced materially by a NYSE listing. . . . [T]ransaction costs are very heavy for active stocks, often mounting to 10% or more of the earnings of a public company.

Cunningham All Rights Reserved Includes Previously Copyrighted Material Reprinted with Permission TABLE OF CONTENTS INTRODUCTION. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 PROLOGUE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 I. CORPORATE GOVERNANCE. . . . . . . . . . . . . . . . . . . . . . . . . . . . A. B. C. D. E. II. I. COMMON STOCK. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. A. B. C. D. E. F. IV. The Bane of Trading: Transaction Costs..... . . . . .. Attracting the Right Sort of Investor. . . . . . . . . . . . . .. Dividend Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. Stock Splits and Trading Activity Shareholder Strategies Berkshire's Recapitalization MERGERS AND ACQUISITIONS. . . . . . . . . . . . . . . . . . . . . . . .. A. B. C. D. E. V. 63 Mr. Market........................................ 63 Arbitrage.......................................... 66 Debunking Standard Dogma 72 "Value" Investing: A Redundancy................. 82 Intelligent Investing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 Cigar Butts and the Institutional Imperative 93 Junk Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Zero-Coupon Bonds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. 103 Preferred Stock 110 CORPORATE FINANCE AND INVESTING. . . . . . . . . . . . . . . .

The fashion of beta, according to Buffett, suffers from inattention to "a fundamental principle: It is better to be approximately right than precisely wrong." Long-term investment success depends not on studying betas and maintaining a diversified portfolio, but on recognizing that as an investor, one is the owner of a business. Reconfiguring a portfolio by buying and selling stocks to accommodate the desired beta-risk profile defeats long-term investment success. Such "flitting from flower to flower" imposes huge transaction costs in the forms of spreads, fees and commissions, not to mention taxes. Buffett jokes that calling someone who trades actively in the market an investor "is like calling someone who repeatedly engages in one-night stands a romantic." Investment knitting turns modern finance theory's folk wisdom on its head: instead of "don't put all your eggs in one basket," we get Mark Twain's advice from Pudd'nhead Wilson: "Put all your eggs in one basket-and watch that basket." 1997] THE ESSAYS OF WARREN BUFFETT 15 Buffett learned the art of investing from Ben Graham as a graduate student at Columbia Business School in the 1950s and later working at Graham-Newman.


pages: 345 words: 87,745

The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri

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asset allocation, backtesting, Bernie Madoff, capital asset pricing model, cognitive dissonance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, Long Term Capital Management, passive investing, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, too big to fail, transaction costs, Vanguard fund, yield curve

The following is Carhart’s conclusion: The evidence of the article suggests three important rules-of-thumb for wealth-maximizing mutual fund investors: (1) Avoid funds with persistently poor performance; (2) funds with high returns last year have higher-than-average expected returns next year, but not in the years thereafter; and (3) the investment costs of expense ratios, transaction costs, and load fees all have a direct, negative impact on performance. While the popular press will no doubt continue to glamorize the best-performance mutual fund managers, the mundane explanations of strategy and investment costs account for almost all of the important predictability in mutual fund returns. One caveat of Carhart’s study is transaction costs. His study was conducted with no penalty for the additional costs from sales loads or brokerage commissions. In addition, Carhart made no exception for funds closed to new investment. In the real world, these issues dilute portfolio returns and can eliminate any alpha derived from a mutual fund momentum trading strategy.

Assessments also tend to discourage incurring heavy investigative and transaction costs, including taxation of gains, in pursuit of strategies designed to beat the market through “timing” or “stock picking” in major central markets. On the other hand, these assessments have not prevented all intelligent and careful investors from including active management strategies in the investment programs for which they are responsible. Likewise, these assessments would not justify a legal rule that would bar fiduciaries from including active management strategies in investing funds for which they are responsible.6 Halbach elaborates on the cost of various strategies in relation to return, which points to a passive bias: “To the extent an investment strategy may demand extra management, tax and transaction costs or a departure from an efficiently diversified portfolio, or both, that strategy should be justifiable in terms of special circumstances or opportunities involved, or in terms of a realistically evaluated prospect of enhanced return.”7 The key words for active fund investors are the realistically evaluated prospect of enhanced return.

An interesting 1966 paper published by Sharpe in the Journal of Business evaluated the performance of 34 mutual funds over a period from 1954–1963 using the Sharpe ratio; the Treynor Ratio; and a third factor, fund expenses.12 Sharpe’s intent was to compare the three methods and perhaps determine which was better at determining skill among mutual fund managers. Sharpe found sufficient evidence that all three ratios had some predictability for selecting funds relative to each other, although no one method isolated funds that consistently outperformed the market as measured by the DJIA (Sharpe doesn’t disclose why he chose this limited market indicator when the more comprehensive S&P 500 existed). Sharpe acknowledged that the DJIA had no transaction cost or administrative expenses; however, he also noted that the fund returns were calculated without deducting their sales commission, which for most was 8.5 percent. Here are the results: The market as measured by the DJIA was less than 11 active funds and better than the remaining 23 funds. Basically, there was one winning fund for every two losing funds, a win-loss ratio of 1 to 2. The Sharpe Ratio for the Dow was 0.67 while the average ratio for the 34 funds was only 0.63.


pages: 490 words: 117,629

Unconventional Success: A Fundamental Approach to Personal Investment by David F. Swensen

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asset allocation, asset-backed security, capital controls, cognitive dissonance, corporate governance, diversification, diversified portfolio, fixed income, index fund, law of one price, Long Term Capital Management, market bubble, market clearing, market fundamentalism, passive investing, pez dispenser, price mechanism, profit maximization, profit motive, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Silicon Valley, Steve Ballmer, technology bubble, the market place, transaction costs, Vanguard fund, yield curve

Value-fund traders accommodate the market, buying what others want to sell and selling what others want to buy. From a transactions-cost perspective, value trumps growth. Size matters in transactions costs. Small-cap growth funds lead the pack in commissions with a charge of 0.41 percent of assets, well above the large-cap growth commission level of 0.25 percent of assets. The same phenomenon exists in the value arena, with small-cap value posting commissions of 0.26 percent of assets relative to the large-cap value level of 0.13 percent. Trading small-capitalization portfolios involves a significant level of costs. Index funds provide the exception to the mutual-fund rule of ridiculously high portfolio turnover and incredibly burdensome transactions costs. In 2002, index fund portfolio turnover amounted to a modest 7.7 percent, causing commissions to consume a mere 0.007 percent of assets.

If the stock in question performs well relative to the market, the overweighters win and the underweighters lose. If the stock performs poorly relative to the market, the overweighters lose and the underweighters win. Before considering transaction costs, active management appears to be a zero-sum game, a contest in which the winners’ gains exactly offset the losers’ losses. Unfortunately for active portfolio managers, investors incur significant costs in pursuit of market-beating strategies. Stock pickers pay commissions to trade and create market impact with buys and sells. Mutual-fund purchasers face the same market-related transactions costs in addition to management fees paid to advisory firms and distribution fees paid to brokerage firms. The leakage of fees from the system causes active management to turn into a negative-sum game in which the aggregate returns for active investors fall short of the aggregate returns for the market as a whole.

Turnover for both of the style indices clocked in substantially above the 23.4 percent rate posted by the plain vanilla Russell 2000. Passive investors who select Russell style-based indices lose a substantial share of the transactions-cost benefits of index-fund investing. The shortcomings of the Russell indices as vehicles for investment translate into shortcomings as benchmarks for performance measurement. Year-to-year changes in composition cause active managers to face a changing benchmark. Quite unfairly from the manager’s perspective, the index changes composition without facing the real-world performance drag of transactions costs. Counterbalancing (and likely overwhelming) the lack of a fair cost accounting, reconstitution arbitrage activity pulls in the opposite direction. By forcing prices up for index entrants prior to entry and forcing prices down for index exiters prior to exit, index-fund arbitrageurs slow the rabbit that active managers chase.


pages: 494 words: 142,285

The Future of Ideas: The Fate of the Commons in a Connected World by Lawrence Lessig

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AltaVista, Andy Kessler, barriers to entry, business process, Cass Sunstein, computer age, dark matter, disintermediation, Erik Brynjolfsson, George Gilder, Hacker Ethic, Hedy Lamarr / George Antheil, Howard Rheingold, Hush-A-Phone, HyperCard, hypertext link, Innovator's Dilemma, invention of hypertext, inventory management, invisible hand, Jean Tirole, Jeff Bezos, Joseph Schumpeter, linked data, Menlo Park, Network effects, new economy, packet switching, price mechanism, profit maximization, RAND corporation, rent control, rent-seeking, RFC: Request For Comment, Richard Stallman, Richard Thaler, Ronald Coase, Search for Extraterrestrial Intelligence, SETI@home, Silicon Valley, smart grid, software patent, spectrum auction, Steve Crocker, Steven Levy, Stewart Brand, Ted Nelson, Telecommunications Act of 1996, The Chicago School, transaction costs

First advanced by Edward Kitch, the prospect theory says there is good reason to hand out broad, strong patents because then others will know with whom they should negotiate if they want to build upon a certain innovation.91 This in turn will create incentives for people to invent, and as information is a by-product of invention, it will induce “progress” in the “useful arts.”92 The problem with this theory, however, is its very strong assumption (in some contexts, at least) that the parties will know enough to properly license the initial foundational invention, or that other issues won't muck up the incentives to license.93 Both limitations on the ability to license are what economists would call transaction costs.94 The transaction cost from ignorance is similar to the insight the founders of the Net had when they embraced an end-to-end architecture: rather than architecting a system of control from which changes could be negotiated, they were driven by humility to a system of noncontrol to induce many others to experiment with ways of using the technology that the experts wouldn't get.95 The transaction cost affecting incentives to license is in part a problem of ignorance, but in part the problem of strategic behavior that we've seen in many different contexts. It is the problem Christensen is discussing in The Innovator's Dilemma: the problem of nonneutral platforms that guided my review in chapter 4 of open code projects. My claim is not that these transaction costs are so high as to make patents unadvisable in the Internet context.

But because this research plan would not be protectable as intellectual property, the competitor might fear that the patent holder would appropriate the information for its own use, with no compensating benefit to the competitor. Even if these difficulties did not lead to bargaining breakdown, they would create transaction costs that reduced the cooperative surplus to be gained from a license and would thus deter at least some inventors and improvers from negotiating in the first instance. Transaction costs would be compounded by the likelihood that the would-be follow-on improver would likely have to negotiate licenses not simply with one owner of basic research but with many such owners. For example, in order to develop a commercial treatment for a genetic disease (particularly a polygenic disease), it may be necessary to have access to a large number of ESTs and SNPs, each conceivably patented by a different entity.

Scarcity is the nature of all valuable resources; but not all valuable resources are allocated by the government—at least, not in a free society. 14 Rather than a regime of licensing, Coase argued, spectrum should be allocated into property rights and sold to the highest bidder.15 A market for spectrum would better and more efficiently allocate spectrum than a system of government-granted licenses. History has been kinder to Coase than to the regulators of the early FCC. In 1991, he won a Nobel Prize for his work on transaction cost economics. And long before the Nobel committee recognized his genius, many policy makers in the United States came to believe that Coase's system was better than the FCC's. A market in spectrum would more efficiently allocate spectrum than any system controlled by the government. This is the debate I described at the start of the book. It is a debate between two regimes for controlling access to a resource—in this case, spectrum.

Stock Market Wizards: Interviews With America's Top Stock Traders by Jack D. Schwager

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Asian financial crisis, banking crisis, barriers to entry, Black-Scholes formula, commodity trading advisor, computer vision, East Village, financial independence, fixed income, implied volatility, index fund, Jeff Bezos, John von Neumann, locking in a profit, Long Term Capital Management, margin call, paper trading, passive investing, pattern recognition, random walk, risk tolerance, risk-adjusted returns, short selling, Silicon Valley, statistical arbitrage, the scientific method, transaction costs, Y2K

Even if you were somehow able to find one of the remaining inefficiencies without going through an extremely expensive, long-term research effort of the sort we've conducted over the past eleven years, you'd probably find that one such inefficiency wouldn't be enough to cover your transaction costs. As a result, the current barriers to entry in this field are very high. A firm like ours that has identified a couple dozen market inefficiencies in a given set of financial instruments may be able to make money even in the presence of transaction costs. In contrast, a new DAVID SHAW entrant into the field who has identified only one or two market inefficiencies would typically have a much harder time doing so. What gives you that edge? It's a subtle effect. A single inefficiency may not be sufficient to overcome transaction costs. When multiple inefficiencies happen to coincide, however, they may provide an opportunity to trade with a statistically expected profit that exceeds the associated transaction costs. Other things being equal, the more inefficiencies you can identify, the more trading opportunities you're likely to have.

Other things being equal, the more inefficiencies you can identify, the more trading opportunities you're likely to have. How could the use of multiple strategies, none of which independently yields a profit, be profitable? As a simple illustration, imagine that there are two strategies, each of which has an expected gain of $100 and a transaction cost of $110. Neither of these strategies could be applied profitably on its own. Further assume that the subset of trades in which both strategies provide signals in the same direction has an average profit of $180 and the same $110 transaction cost. Trading the subset could be highly profitable, even though each individual strategy is ineffective by itself. Of course, for Shaw's company, which trades scores of strategies in many related markets, the effect of strategy interdependencies is tremendously more complex.

Wouldn't arbitrage drive that opportunity away? Arbitrage will only eliminate opportunities where we both have the same costs of funds. If, however, your cost of funds is significantly higher or lower, then there will be an opportunity. In a more general sense, the markets might be priced very efficiently if everyone had the same costs of funds, received the same dividend, and had the same transaction costs. If, however, one set of investors is treated W I N - W I N INVESill very differently, and persistently treated differently, then it should be possible to set up a transaction that offers a consistent profit opportunity. Give me a specific example. Instead of IBM, say we're talking about an Italian computer company. Assume that because of tax withholding, U.S. investors receive only 70 cents on the dollar in dividends, whereas Italian investors receive the full dollar.


pages: 425 words: 122,223

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein

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Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, buy low sell high, capital asset pricing model, debt deflation, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, full employment, implied volatility, index arbitrage, index fund, interest rate swap, invisible hand, John von Neumann, Joseph Schumpeter, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, new economy, New Journalism, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, stochastic process, the market place, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, transfer pricing, zero-coupon bond

Efforts to do so—and regulation has come in many different forms—impair the efficiency with which financial assets perform the broad social function of serving as a store of value. Liquidity, low transaction costs, and the freedom of investors to act on information are essential to that function. ••• If individual investors had dominated the financial markets during the 1970s and 1980s, the revolution we have been describing would in all likelihood never have taken place; the ingenious journal articles would have stimulated more ingenious journal articles, but little change would have occurred on Wall Street. In any case, tax constraints and high transaction costs would have prevented individual investors from transforming their portfolios to accord with the new theories. Most individual investors work at the job only part-time and cannot undertake the long study and constant attention required by the application of innovative techniques.

Although the owners of a company that borrows money are in a riskier position than the owners of a debt-free company, the value of the company’s bonds and stock, taken as a totality, will still depend on the company’s overall expected earning power and the basic risks the company faces. That is the essence of Williams’s law of the Conservation of Investment Value. Under these conditions, and ignoring just for the moment transactions costs, taxes, and the possible lack of sufficient information, the market will place the same valuation on all companies with equal earning power and equal risk. No other outcome is possible when the market is functioning as Samuelson theorized that it should and as research into the efficiency of capital markets has demonstrated that it does. As people in Wall Street like to say, it sounds good in theory but does it work in practice?

If the only thing that matters is the fundamental earning power of the corporations’s underlying assets, why are all those corporate finance officers and their investment bankers spending so much time fine-tuning and modulating the firm’s financial structure? MM theory was admittedly an abstraction when it was originally presented. Like all economists, Modigliani and Miller tried to run their experiments with clean test tubes. In their antiseptic world there are no taxes, no transaction costs, information is freely available to everyone, growth is treated in simplified fashion, and corporations make investment decisions first and then worry about how to finance them. No one—least of all Modigliani and Miller—would claim that the real world looks like this. But by starting with immaculate laboratory equipment, they can test their hypotheses, analyze the consequences of their assumptions, and determine how closely their theory accords with the real world.


pages: 196 words: 57,974

Company: A Short History of a Revolutionary Idea by John Micklethwait, Adrian Wooldridge

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affirmative action, barriers to entry, Bonfire of the Vanities, borderless world, business process, Corn Laws, corporate governance, corporate social responsibility, credit crunch, crony capitalism, double entry bookkeeping, Etonian, hiring and firing, invisible hand, James Watt: steam engine, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, knowledge economy, knowledge worker, laissez-faire capitalism, manufacturing employment, market bubble, mittelstand, new economy, North Sea oil, race to the bottom, railway mania, Ronald Coase, Silicon Valley, six sigma, South Sea Bubble, Steve Jobs, Steve Wozniak, strikebreaker, The Nature of the Firm, The Wealth of Nations by Adam Smith, Thorstein Veblen, trade route, transaction costs, tulip mania, wage slave, William Shockley: the traitorous eight

That question was most succinctly answered back in 1937 by Ronald Coase, a young British economist. In an article called “The Nature of the Firm,” he argued that the main reason why a company exists (as opposed to individual buyers and sellers making ad hoc deals at every stage of production) is because it minimizes the transaction costs of coordinating a particular economic activity. Bring all the people in-house, and you reduce the costs of “negotiating and concluding a separate contract for each exchange transaction.” But the gains from reducing transaction costs that companies deliver have to be balanced against “hierarchy costs”—the costs of central managers ignoring dispersed information. In the nineteenth century, the gains to be had from integrating mass production with mass distribution were enormous—as Alfred Chandler, the doyen of business historians, puts it, the “visible hand of managerial direction” replaced “the invisible hand of market mechanisms.”

The most basic of these three works began as a lecture in 1932 to a group of Dundee students by a twenty-one-year-old economist just back from a tour of American industry. Five years later, Ronald Coase published his ideas in a paper in Economica called “The Nature of the Firm.” Coase tried to explain why the economy had moved beyond individuals selling goods and services to each other. The answer, he argued, had to do with the imperfections of the market and particularly to do with transaction costs—the costs sole traders might incur in getting the best deal and coordinating processes such as manufacturing and marketing. The history of the company since 1850 validated Coase’s point. General Motors, for instance, reaped enormous economies of scale by bundling together plenty of transactions that had previously been done independently. The costs of, say, trying to negotiate each bit of steel that was needed for a car would have been prohibitive.

At the heart of nearly all of them was the principle of miniaturization. In the last three decades of the twentieth century, the cost of computing processing power tumbled by 99.99 percent—or 35 percent a year.22 Computers thrust ever more power down the corporate hierarchy—to local area networks, to the desktop, and increasingly to outside the office altogether. Meanwhile, the Internet reduced transaction costs. By the end of the century, General Electric and Cisco were forcing their suppliers to bid for their business in on-line auctions; and eBay, the main independent on-line auction house, had 42 million users around the world. In the last three months of 2001, those eBay customers listed 126 million items and spent $2.7 billion. Previously, those transactions, if they had happened at all, would have involved thousands of intermediaries.

Remix: Making Art and Commerce Thrive in the Hybrid Economy by Lawrence Lessig

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Amazon Web Services, Andrew Keen, Benjamin Mako Hill, Berlin Wall, Bernie Sanders, Brewster Kahle, Cass Sunstein, collaborative editing, disintermediation, don't be evil, Erik Brynjolfsson, Internet Archive, invisible hand, Jeff Bezos, jimmy wales, Kevin Kelly, late fees, Netflix Prize, Network effects, new economy, optical character recognition, PageRank, recommendation engine, revision control, Richard Stallman, Ronald Coase, Saturday Night Live, SETI@home, sharing economy, Silicon Valley, Skype, slashdot, Steve Jobs, The Nature of the Firm, thinkpad, transaction costs, VA Linux

Why weren’t firms built like free markets? The answer was “transaction costs.” It cost money to go to the market: time, bargaining costs, costs of capital, etc. Coase reasoned that this cost would help explain the size of a firm. A firm would go 80706 i-xxiv 001-328 r4nk.indd 139 8/12/08 1:55:21 AM REMI X 140 to the market to obtain a product when doing so was cheaper than producing the product inside the firm. It would produce the product in house when the costs of the market were too high. Yochai Benkler summarizes the point: [P]eople use markets when the gains from doing so, net of transaction costs, exceed the gains from doing the same thing in a managed firm, net of the costs of organizing and managing a firm. Firms emerge when the opposite is true, and transaction costs can best be reduced by bringing an activity into a managed context that requires no individual transactions to allocate this resource or that effort.31 It follows from this insight that as transaction costs fall, all things being equal, the amount of stuff done inside a firm will fall as well.

Again, von Hippel: “the commercial attractiveness of innovations developed by users increased along with the strength of those users’ lead user characteristics.”13 Encouraging these “lead users” to innovate is thus a powerful way to push innovation at the firm.14 While hybrids will increase with the spread of the Net, I am not describing some special rule of economics that lives just in the virtual world. Indeed, to the extent that the hybrid is spreading the right to innovate, the dynamic is again following the very old principle I described above: shifting innovation out of the core of the corporation where transaction costs permit. The hybrid teaches us that this strategy will increase as technologies for reducing transaction costs proliferate. And conversely, it would be checked by changes that increase the transaction costs of the hybrid. Perceptions of Fairness Will in Part Mediate the Hybrid Relationship Between Sharing and Commercial Economies We are not far into the history of these hybrid economies. And early enthusiasm will no doubt soon give way to a more measured, 80706 i-xxiv 001-328 r4nk.indd 231 8/12/08 1:55:55 AM 232 REMI X perhaps skeptical view.

Firms emerge when the opposite is true, and transaction costs can best be reduced by bringing an activity into a managed context that requires no individual transactions to allocate this resource or that effort.31 It follows from this insight that as transaction costs fall, all things being equal, the amount of stuff done inside a firm will fall as well. The firm will outsource more. It will focus its internal work on the stuff it can do best (meaning more efficiently than the market). LEGO-ized innovation is simply the architectural instantiation of this economic point. Through the architecture that makes Web 2.0 possible—including what many have called Web services—the transaction costs of outsourcing functionality drop dramatically. Why set up a payment service—exposing yourself and your firm to the risk of fraud, for example—when you can simply contract with PayPal? Why run your own servers when a firm can really promise 24/7 service with its own?


pages: 375 words: 88,306

The Sharing Economy: The End of Employment and the Rise of Crowd-Based Capitalism by Arun Sundararajan

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3D printing, additive manufacturing, Airbnb, Amazon Mechanical Turk, autonomous vehicles, barriers to entry, bitcoin, blockchain, Burning Man, call centre, collaborative consumption, collaborative economy, collective bargaining, corporate social responsibility, cryptocurrency, David Graeber, distributed ledger, employer provided health coverage, Erik Brynjolfsson, ethereum blockchain, Frank Levy and Richard Murnane: The New Division of Labor, future of work, George Akerlof, gig economy, housing crisis, Howard Rheingold, Internet of things, inventory management, invisible hand, job automation, job-hopping, Kickstarter, knowledge worker, Kula ring, Lyft, megacity, minimum wage unemployment, moral hazard, Network effects, new economy, Oculus Rift, pattern recognition, peer-to-peer lending, profit motive, purchasing power parity, race to the bottom, recommendation engine, regulatory arbitrage, rent control, Richard Florida, ride hailing / ride sharing, Robert Gordon, Ronald Coase, Second Machine Age, self-driving car, sharing economy, Silicon Valley, smart contracts, Snapchat, social software, supply-chain management, TaskRabbit, The Nature of the Firm, total factor productivity, transaction costs, transportation-network company, two-sided market, Uber and Lyft, Uber for X, universal basic income, Zipcar

Think about your own experience owning a durable good like a car or a dining table. It provides value to you over an extended period of time. In a world with no “frictions,” that is, in a world where you could buy or sell instantaneously and without regard to transaction costs, you might freely adjust your ownership at any time to match your current needs, buying a Porsche when you feel like taking a drive down the beach, and then selling it and buying a minivan later that day to pick up your kids from soccer. In practice, of course, this isn’t possible because durable goods are “illiquid”—you can’t just simply buy and sell them instantly. There are significant and large transaction costs associated with buying and selling. As soon as you buy a car, it loses a lot of its value. Once Room&Board delivers that table to your home, its resale value is instantly a lot lower than the price you paid for it.

The second part of MYB’s argument is that progess in digital technologies will reduce asset specificity in many economic activities, thus moving the vertical line in the figure to the right, and shifting a set of economic activities to the market. Now, not everyone agreed with MYB’s unilateral prediction. Several years later Vijay Gurbaxani and Seungjin Whang acknowledged that “recent advances in IT have obviously introduced a great deal of operational efficiency in the market economy by providing more efficient market mechanisms and thus lowering the associated market transaction costs,” but they noted some additional tradeoffs.9 Apart from the “external coordination costs” associated with transacting through the market, there is a set of “internal coordination costs” that hierarchies bear. These grow as the organization scales; as the management structure gets more bloated, the interests and incentives of workers are increasingly misaligned or disconnected from the broader objectives of the firm.

The coin provides returns to early contributors—of human capital, of risky early participation, of effort publicizing the marketplace and facilitating critical mass—a new breed of purpose-driven investors. Value Creation and Capture in Decentralized Exchange There are a number of new forms of economic activity that new decentralized peer-to-peer marketplaces will facilitate simply because they lower transaction costs. Other decentralized systems, either independent or embedded in traditional privately owned corporations or markets, may emerge in contexts where there was previously insufficient trust for digital exchange, where the potential market was too small to attract private capital in the past, or where the blockchain lowers operating costs. Toward the end of the chapter, I’ll discuss some current examples.


pages: 209 words: 13,138

Empirical Market Microstructure: The Institutions, Economics and Econometrics of Securities Trading by Joel Hasbrouck

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barriers to entry, conceptual framework, correlation coefficient, discrete time, disintermediation, distributed generation, experimental economics, financial intermediation, index arbitrage, 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, short selling, statistical model, stochastic process, stochastic volatility, transaction costs, two-sided market, ultimatum game

In equity markets, for example, advance knowledge of an earnings surprise, takeover announcement, or similar event confers an obvious advantage. Similar events do not, however, characterize the government bond and foreign exchange markets. Models of these markets, therefore, must rely on a broader concept of private information. This important point has been stressed by Lyons (2001). 5.4.2 Fixed Transaction Costs Suppose that in addition to asymmetric information considerations, the dealer must pay a transaction cost c on each trade (as in the Roll model). The modification is straightforward. The ask and bid now are set to recover c as well as the information costs: A = E[V |Buy ] + c and B = E[V |Sell] − c. The ask quote sequence may still be expressed as a sequence of conditional expectations: Ak = E[V |k ] + c, where k is the information set that includes the direction of the kth trade.

V is less likely if the customer bought, reasons the dealer, because an informed customer who knew V = V would have sold. Furthermore ∂δ1 (Sell)/∂µ > 0. The dealer’s bid is set as B = E[V |Sell] = V (1 + µ) δ + V (1 − µ)(1 − δ) . 1 + µ(1 − 2δ) (5.6) The bid-ask spread is A−B = 4(1 − δ)δµ(V − V ) . 1 − (1 − 2δ)2 µ2 (5.7) In the symmetric case of δ = 1/2, A − B = (V − V )µ. In many situations the midpoint of the bid and ask is taken as a proxy for what the security is worth absent transaction costs. Here, the midpoint is equal to the unconditional expectation EV only in the symmetric case (δ = 1/2). More generally, the bid and ask are not set symmetrically about the efficient price. Exercise 5.1 As a modification to the basic model, take δ = 1/2 and suppose that immediately after V is drawn (as either V or V ), a broker is randomly drawn. The probability of an informed trader within broker b’s customer set is µb .

Also note that some limit orders will be unprofitable ex post. Consider the marginal limit order priced to sell at q = 2. If the size of the incoming order is in fact q = 2, the limit order is profitable: P(q = 2) > E[X |q = 2]. The limit order will also execute, however, if q = 8, in which case P(q = 2) < E[X |q = 8], the limit order incurs a loss. Finally, limq→0+ P(q) > µX = 5, that is, even a infinitesimal purchase will incur a transaction cost. Another way of putting this is that the bid-ask spread is positive even for arbitrarily small quantities. (In the competitive dealer model, in contrast, limq→0+ P(q) = limq→0− P(q) = µX .) The pricing schedule is sufficiently discriminatory that a ω considerably greater than µX is necessary before the customer will consider an even an infinitesimal purchase. DEPTH The relationship between the supply schedule and expectation revision functions is broadly similar to the empirical finding depicted in figure 13.1, with the latter lying below the former.


pages: 120 words: 39,637

The Little Book That Still Beats the Market by Joel Greenblatt

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backtesting, index fund, random walk, transaction costs

Timmy, with no investable funds that I know of, then fell asleep as I raced to the end, mentally rejiggering my retirement plan. Let me tell you this much: In the beginning, there were mutual funds, and that was good. But their sales fees and expenses were way too high. Then came no-load funds, which were better. They eliminated the sales fee, but were still burdened with management fees and with the tax and transactional burden that comes from active management. Then came “index funds,” which cut fees, taxes, and transaction costs to the bone. Very, very good. What Joel would have you consider, in effect, is an index-fund-plus, where the “plus” comes from including in your basket of stocks only good businesses selling at low valuations. And he has an easy way for you to find them. Not everyone can beat the averages, of course—by definition. But my guess is that patient people who follow Joel’s advice will beat them over time.

The study was biased because the database used in the study had been “cleaned up” and excluded companies that later went bankrupt, making the study results look better than they really were (a.k.a. survivorship bias). 3. The study included very small companies that couldn’t have been purchased at the prices listed in the database and uncovered companies too small for professionals to buy. 4. The study did not outperform the market by a significant amount after factoring in transaction costs. 5. The study picked stocks that were in some way “riskier” than the market, and that’s why performance was better. 6. The stock selection strategy was based on back-testing many different stock selection strategies until one was found that worked (a.k.a. data mining). 7. The stock selection strategies used to beat the market included knowledge gained from previous “market-beating” studies that was not available at the time the stock purchases were made in the study.

By using only this special database, it was possible to ensure that no look-ahead or survivorship bias took place. Further, the magic formula worked for both small-and large-capitalization stocks, provided returns far superior to the market averages, and achieved those returns while taking on much lower risk than the overall market (no matter how that risk was measured). Consequently, small size, high transaction costs, and added risk do not appear to be reasonable grounds for questioning the validity of the magic formula results. As for data mining and using academic research not available at the time of stock selection, this did not take place, either. In fact, the two factors used for the magic formula study were actually the first two factors tested. Simply, a high earnings yield combined with a high return on capital were the two factors we judged to be most important when analyzing a company before the magic formula study was conducted.


pages: 829 words: 186,976

The Signal and the Noise: Why So Many Predictions Fail-But Some Don't by Nate Silver

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airport security, availability heuristic, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, big-box store, Black Swan, Broken windows theory, Carmen Reinhart, Claude Shannon: information theory, Climategate, Climatic Research Unit, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, computer age, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, Daniel Kahneman / Amos Tversky, diversification, Donald Trump, Edmond Halley, Edward Lorenz: Chaos theory, en.wikipedia.org, equity premium, Eugene Fama: efficient market hypothesis, everywhere but in the productivity statistics, fear of failure, Fellow of the Royal Society, Freestyle chess, fudge factor, George Akerlof, haute cuisine, Henri Poincaré, high batting average, housing crisis, income per capita, index fund, Internet Archive, invention of the printing press, invisible hand, Isaac Newton, James Watt: steam engine, John Nash: game theory, John von Neumann, Kenneth Rogoff, knowledge economy, locking in a profit, Loma Prieta earthquake, market bubble, Mikhail Gorbachev, Moneyball by Michael Lewis explains big data, Monroe Doctrine, mortgage debt, Nate Silver, new economy, Norbert Wiener, PageRank, pattern recognition, pets.com, prediction markets, Productivity paradox, random walk, Richard Thaler, Robert Shiller, Robert Shiller, Rodney Brooks, Ronald Reagan, Saturday Night Live, savings glut, security theater, short selling, Skype, statistical model, Steven Pinker, The Great Moderation, The Market for Lemons, the scientific method, The Signal and the Noise by Nate Silver, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, transfer pricing, University of East Anglia, Watson beat the top human players on Jeopardy!, wikimedia commons

No investor can beat the stock market over the long run relative to his level of risk and accounting for his transaction costs. No investor can beat the stock market over the long run relative to his level of risk and accounting for his transaction costs, unless he has inside information. Few investors beat the stock market over the long run relative to their level of risk and accounting for their transaction costs, unless they have inside information. It is hard to tell how many investors beat the stock market over the long run, because the data is very noisy, but we know that most cannot relative to their level of risk, since trading produces no net excess return but entails transaction costs, so unless you have inside information, you are probably better off investing in an index fund.

During the 2000s, the stock market changed direction from day to day about 54 percent of the time, just the opposite of the pattern from earlier decades. Had the investor pursued his Manic Momentum strategy for ten years beginning in January 2000, his $10,000 investment would have been whittled down to $4,000 by the end of the decade even before considering transaction costs.40 If you do consider transaction costs, the investor would have had just $141 left over by the end of the decade, having lost almost 99 percent of his capital. In other words: do not try this stuff at home. Strategies like these resemble a high-stakes game of rock-paper-scissors at best,* and the high transaction costs they entail will deprive you of any profit and eat into much of your principal. As Fama and his professor had discovered, stock-market strategies that seem too good to be true usually are. Like the historical patterns on the frequency of earthquakes, stock market data seems to occupy a sort of purgatory wherein it is not quite random but also not quite predictable.

If you ignore dividends, inflation, and transaction costs, his $10,000 investment in 1976 would have been worth about $25,000 ten years later using the Manic Momentum strategy. By contrast, an investor who had adopted a simple buy-and-hold strategy during the same decade—buy $10,000 in stocks on January 2, 1976, and hold them for ten years, making no changes in the interim—would have only about $18,000 at the end of the period. Manic Momentum seems to have worked! Our investor, using a very basic strategy that exploited a simple statistical relationship in past market prices, substantially beat the market average, seeming to disprove the efficient-market hypothesis in the process. But there is a catch. We ignored this investor’s transaction costs. This makes an enormous difference. Suppose that the investor had pursued the Manic Momentum strategy as before but that each time he cashes into or out of the market, he paid his broker a commission of 0.25 percent.

Investment: A History by Norton Reamer, Jesse Downing

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Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, Brownian motion, buttonwood tree, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, moral hazard, mortgage debt, Network effects, new economy, Nick Leeson, Own Your Own Home, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve

Black-Scholes does make some unrealistic assumptions about dynamic hedging. First, it assumes that there are no transaction costs that would impede the constant trading required to maintain the hedge. Further, and perhaps even less realistically, there is an implicit assumption that markets follow a continuous pricing regime when they in fact follow a discontinuous one. That is to say, it is possible 236 Investment: A History for a stock price, for instance, to fall from $7.00 per share directly to $6.75, missing all the intermediary values, and thus the dynamic hedging required for a true no-arbitrage condition is difficult to achieve. It turns out, though, that these assumptions are not outrageously unrealistic, as markets are sufficiently liquid to keep transaction costs reasonably low and do not generally experience gaps of such substantial magnitude so as to wreak complete havoc on the idea of dynamic hedging.

Therefore, governments, monks, and wealthy individuals often made loans at high interest, with the government even at times forcing people to borrow in order to raise revenue. Contemporary Views of Usury Currently, credit markets now mostly operate free of religious criteria, and this has created more economically appropriate pricing of borrowing in today’s sophisticated markets. Overall, even though usury laws never entirely ruled out commercial lending, they did have substantial influence on the development of the financial system. In raising the transaction cost of lending and suppressing the growth of debt financing, usury implicitly encouraged equity financing and innovative business contracts and structures in societies that took strong stances against the practice.100 In recent decades, attitudes toward usurious interest rates seem to have changed completely—at times, it may appear that an insufficient premium and an unduly relaxed attitude is being taken toward higher-risk and lower-quality borrowers.

In effect, it was the other side of the coin: the first development of the modern corporate form generated the seeds of demand for capital, and the long-term effects of the Industrial Revolution produced the means of satisfying these capital demands. The third development was the construction of a means to connect empowered savers with these investment projects, which was accomplished through the emergence of public markets. The public market was, in the long term, the mechanism to join the two sides of the coin. Public markets offered liquidity, publicized value, broadcast availability, lowered transaction costs, and permitted investors to gain wide diversification with relative ease. Public markets, furthermore, aided in initiating the opportunity and need for regulation. The democratization of investment is not a finished project. Just as the political democratization of the eighteenth and nineteenth centuries is still playing out (it left key demographics still disenfranchised and has not yet spread to all corners of the world), the project of democratization of investment is incomplete.

Culture and Prosperity: The Truth About Markets - Why Some Nations Are Rich but Most Remain Poor by John Kay

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Albert Einstein, Asian financial crisis, Barry Marshall: ulcers, Berlin Wall, Big bang: deregulation of the City of London, California gold rush, complexity theory, computer age, constrained optimization, corporate governance, corporate social responsibility, correlation does not imply causation, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, Donald Trump, double entry bookkeeping, double helix, Edward Lloyd's coffeehouse, equity premium, Ernest Rutherford, European colonialism, experimental economics, Exxon Valdez, failed state, financial innovation, Francis Fukuyama: the end of history, George Akerlof, George Gilder, greed is good, haute couture, illegal immigration, income inequality, invention of the telephone, invention of the wheel, invisible hand, John Nash: game theory, John von Neumann, Kevin Kelly, knowledge economy, labour market flexibility, late capitalism, Long Term Capital Management, loss aversion, Mahatma Gandhi, market bubble, market clearing, market fundamentalism, means of production, Menlo Park, Mikhail Gorbachev, money: store of value / unit of account / medium of exchange, moral hazard, Naomi Klein, Nash equilibrium, new economy, oil shale / tar sands, oil shock, pets.com, popular electronics, price discrimination, price mechanism, prisoner's dilemma, profit maximization, purchasing power parity, QWERTY keyboard, Ralph Nader, RAND corporation, random walk, rent-seeking, risk tolerance, road to serfdom, Ronald Coase, Ronald Reagan, second-price auction, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, Steve Jobs, telemarketer, The Chicago School, The Death and Life of Great American Cities, The Market for Lemons, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, total factor productivity, transaction costs, tulip mania, urban decay, Washington Consensus, women in the workforce, yield curve, yield management

This distinction will, in chapter 21, explain why adaptive cooperators do better than rational, self-regarding maximizers. I described in the last chapter how neoclassical economics was enhanced both by game theory and by transactions costs economics. But neoclassical rationality assumptions were imposed on both. The transactions costs solution to the wilderness dilemma is that the economist should optimize within constraints. He should do just the amount of calculation needed to find the best strategy in the light of his knowledge that every second devoted to calculation increases the chances ofbeing caught by the bear. 18 Borrowing Herbert Simon's term (but for a very different concept), Oliver Williamson calls this optimization under constraints-bounded rationality. 19 In this vein, transactions costs economics often degenerates into a Panglossian view of the world: institutions that exist must be the solution to some constrained-optimization problem.

The Arrow-Debreu results are the culmination of a long tradition in economics that emphasizes supply and demand, perfectly competitive markets, and the search for market equilibrium, conducted by independent, self-regarding agents. Economic research since Arrow and Debreu has drawn game theory, transactions costs, and most recently behavioral economics into the mainstream of economic theory. In the Arrow-Debreu framework, interactions are anonymous and every market has many buyers and sellers. In game theory, the players are few and not anonymous. In the Arrow-Debreu framework, institutions do not exist or are dealt with in a reductionist way. Institutional, or transactions costs, economics recognizes that economic lives are lived in and through economic institutions. Behavioral economics contemplates alternative assumptions about motives and the nature of economic behavior. I will introduce game theory and institutional economics in the present chapter and take up behavioral economics in the chapter that follows.

Atomic Energy Commission-and the inspiration for Dr. Strangelove-before dying at the age of fifty-three. John Nash was author of the principal solution concept in game theory-the Nash equilibrium-but his productive career was ended by schizophrenia. His health partially restored, he was awarded the Nobel Prize in 1994. 21 Nash was played by Russell Crowe in an Oscar-winning film of his life, A Beautiful Mind. Institutional (or transactions cost) economics regards as its founder Ronald Coase,n a British economist who spent most of his career at the University of Chicago. His claim to fame rests mainly on two articles, published almost twenty-five years apart. The first was concerned with the theory of the firm. In the perfectly competitive world of Part III, firms played little or no role. There are many similar producers of every commodity.


pages: 523 words: 111,615

The Economics of Enough: How to Run the Economy as if the Future Matters by Diane Coyle

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accounting loophole / creative accounting, affirmative action, bank run, banking crisis, Berlin Wall, bonus culture, Branko Milanovic, BRICs, call centre, Cass Sunstein, central bank independence, collapse of Lehman Brothers, conceptual framework, corporate governance, correlation does not imply causation, Credit Default Swap, deindustrialization, demographic transition, Diane Coyle, disintermediation, Edward Glaeser, Eugene Fama: efficient market hypothesis, experimental economics, Fall of the Berlin Wall, Financial Instability Hypothesis, Francis Fukuyama: the end of history, George Akerlof, Gini coefficient, global supply chain, Gordon Gekko, greed is good, happiness index / gross national happiness, Hyman Minsky, If something cannot go on forever, it will stop, illegal immigration, income inequality, income per capita, invisible hand, Jane Jacobs, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, labour market flexibility, low skilled workers, market bubble, market design, market fundamentalism, megacity, Network effects, new economy, night-watchman state, Northern Rock, oil shock, principal–agent problem, profit motive, purchasing power parity, railway mania, rising living standards, Ronald Reagan, Silicon Valley, South Sea Bubble, Steven Pinker, The Design of Experiments, The Fortune at the Bottom of the Pyramid, The Market for Lemons, The Myth of the Rational Market, The Spirit Level, transaction costs, transfer pricing, tulip mania, ultimatum game, University of East Anglia, web application, web of trust, winner-take-all economy, World Values Survey

The radical reduction in those costs means companies are more efficient if decision-making is as decentralized as information. The work of institutional economists explains the structure of organizations in terms of transactions costs. Relationships are brought within an institution when the costs of a transaction in a market would be too high. Information makes up one important element of transaction costs, and by decreasing them so much the information revolution has thus contributed to a widespread crisis of governance.23 Another important transaction cost is created by distrust. The corrosion of trust in Western societies, described earlier, has increased transaction costs at the same time that reductions in information and communication costs have worked in the other direction. It isn’t at all clear what the combined implications for governance will be.

The right structures will take decisions out of the hands of centralized hierarchies. They will involve a more productive and thoughtful interplay between markets and governments than we’ve typically had in the past, one taking account of the dramatic technological and structural change in the economy. Markets and governments need each other to function well, and indeed often “fail” in the same contexts. The existence of transactions costs and information asymmetries present a challenge to any institutional framework. The work of the 2009 Nobel laureates Elinor Ostrom and Oliver Williamson focuses precisely on the way these aspects of reality shape different kinds of institutional response. The utterly transformed world of information, due to ICTs, is revolutionizing the governance of every economy, and we’re only partway through the revolution.

So, for instance, the key point about the economist’s assumption of rational “selfishness” is not that people really are utterly selfish or that they do formal calculations before purchasing everything, but rather that it’s entirely realistic to assume that people will act in their own self-interest on the basis of the information available to them. There is nothing in this that runs counter to human nature—on the contrary, it’s in the genes. And the assumption of rational self-interest forms the basis of a powerful way to analyze situations where people do appear to be acting counter to their own interests—it can help identify the information asymmetry or the transaction cost or the psychological trait that would explain the divergence between actual behavior and rational calculation. What’s more, there is much empirical evidence that in many practical situations people with all their cognitive limitations and inconsistencies nevertheless do make choices leading to exactly the outcomes predicted by textbook economic theory. One of the pioneers of this research was Vernon Smith.


pages: 411 words: 80,925

What's Mine Is Yours: How Collaborative Consumption Is Changing the Way We Live by Rachel Botsman, Roo Rogers

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Airbnb, barriers to entry, Bernie Madoff, bike sharing scheme, Buckminster Fuller, carbon footprint, Cass Sunstein, collaborative consumption, collaborative economy, Community Supported Agriculture, credit crunch, crowdsourcing, dematerialisation, disintermediation, en.wikipedia.org, experimental economics, George Akerlof, global village, Hugh Fearnley-Whittingstall, information retrieval, iterative process, Kevin Kelly, Kickstarter, late fees, Mark Zuckerberg, market design, Menlo Park, Network effects, new economy, new new economy, out of africa, Parkinson's law, peer-to-peer lending, Ponzi scheme, pre–internet, recommendation engine, RFID, Richard Stallman, ride hailing / ride sharing, Robert Shiller, Robert Shiller, Ronald Coase, Search for Extraterrestrial Intelligence, SETI@home, Simon Kuznets, Skype, slashdot, smart grid, South of Market, San Francisco, Stewart Brand, The Nature of the Firm, The Spirit Level, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thorstein Veblen, Torches of Freedom, transaction costs, traveling salesman, ultimatum game, Victor Gruen, web of trust, women in the workforce, Zipcar

Such exchanges have not been particularly efficient through off-line channels, but in the Internet age, redistribution is becoming a way of life. Collapse of “Transaction Costs” When we asked Beal which are the most commonly listed items on Freecycle, he explained that “there isn’t one particular thing” but instead massive categories of “inconvenient things” (old pianos, sofas, and televisions) and “unusual items” (disco balls, fish tanks, and even stuffed animals). These are the items that would have been a pain to lug to the dump (and sometimes you would even have to pay to dispose of them) or tricky to unload on a neighbor. The transaction costs to ensure they were kept in use, not in landfill, would have been high. In his paper “The Nature of the Firm,” economist and Nobel laureate Ronald Coase coined the term “transaction costs” to refer to the cost of making any form of exchange or participating in a market.3 If you go to the supermarket, for example, and buy some groceries, your costs are not just the price of the groceries but the energy, time, and effort required to write your list, travel to and from the store, wheel around your cart and choose your products, wait in the checkout line, and unpack and put away the groceries when you get back home.

In his paper “The Nature of the Firm,” economist and Nobel laureate Ronald Coase coined the term “transaction costs” to refer to the cost of making any form of exchange or participating in a market.3 If you go to the supermarket, for example, and buy some groceries, your costs are not just the price of the groceries but the energy, time, and effort required to write your list, travel to and from the store, wheel around your cart and choose your products, wait in the checkout line, and unpack and put away the groceries when you get back home. Your total “costs” are greater than the dollar number on your receipt. In the pre-Internet age, the transaction costs of coordinating groups of people with aligned wants and needs or even just similar interests were high, making the sharing of products tricky and inconvenient. Redistributing unwanted goods in and outside your immediate community was inefficient. Matching someone with something to give with another person who wanted that same item was not straightforward. Just think of what it took to find a new owner for a perfectly good desk you no longer wanted.

What Smith discovered in Topanga—and is now on a quest to make us all realize—is that coming up with ideas or getting people receptive to communal living is not the issue. The residents of Topanga had so many ideas that they had to decide where to start. The challenge the residents experienced was coordination. This barrier has historically prevented most people from attempting to “share nicely,” as the perceived effort and energy needed to make it work negate the value in return. The apparent transaction costs have been too high. They were happy to carpool, but how could they easily be aware of each other’s schedules? They wanted to share chores such as grocery shopping, but how would they know who wanted what and when? Meeting to decide these things would defeat the purpose of making life easier. And they didn’t want to create any kind of committee or nominate a leader to organize the effort, as that would be resorting back to the kind of centralized authority they were trying to avoid.


pages: 270 words: 79,180

The Middleman Economy: How Brokers, Agents, Dealers, and Everyday Matchmakers Create Value and Profit by Marina Krakovsky

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Affordable Care Act / Obamacare, Airbnb, Al Roth, Black Swan, buy low sell high, Credit Default Swap, cross-subsidies, crowdsourcing, disintermediation, diversified portfolio, experimental economics, George Akerlof, Goldman Sachs: Vampire Squid, income inequality, index fund, Jean Tirole, Lean Startup, Lyft, Mark Zuckerberg, market microstructure, Martin Wolf, McMansion, Menlo Park, moral hazard, multi-sided market, Network effects, patent troll, Paul Graham, Peter Thiel, pez dispenser, ride hailing / ride sharing, Sand Hill Road, sharing economy, Silicon Valley, social graph, supply-chain management, TaskRabbit, The Market for Lemons, too big to fail, trade route, transaction costs, two-sided market, Uber for X, ultimatum game, Y Combinator

Proponents of that idea, which has been called the “threatened intermediaries hypothesis,” began their argument with the premise that middlemen have traditionally been necessary to reduce the high transaction costs of the brick-and-mortar world. So far so good. But the rest of the argument was flawed: they reasoned that if the Internet reduced transaction costs, middlemen would become less necessary. The big flaw is to view all middlemen as providing just one service.18 But reducing transaction costs covers a large mix of services that don’t necessarily come in one bundle.19 If the Internet lowers transaction costs, it could actually create more demand for middlemen. After all, the Internet reduces costs for everyone—and when it reduces a middleman’s costs more than it does someone else’s, buyers and sellers prefer to keep doing business through the middleman.20 That’s why, despite the obsolescence of many travel agency jobs, for example, a certain class of travel agent is still thriving.21 Ellison Poe, owner of Poe Travel in Little Rock, Arkansas, is a perfect example, and after you meet her in a later chapter, you will understand why she says the Internet has had no downside whatsoever for her and why, on the contrary, it has been “a total pro, a great thing, a positive force in the world.”22 As some middlemen disappear, others will become more successful.

What kind of networks most benefit from the addition of a middleman? Which nodes should middlemen focus on connecting? How do they form those connections, and what can they do to strengthen them? In answering such questions, I contend that middlemen provide value by playing some combination of six roles and that the most successful middlemen are those who play those roles best.17 Each role solves a particular problem—reduces a specific friction, a specific transaction cost—that, without the middleman, would inhibit or prevent mutually beneficial deals: •The Bridge promotes trade by reducing physical, social, or temporal distance. •The Certifier separates the wheat from the chaff and gives buyers reassuring information about the seller’s underlying quality. •The Enforcer makes sure buyers and sellers put forth full effort, cooperate, and stay honest. •The Risk Bearer reduces fluctuations and other forms of uncertainty, especially for risk-averse trading partners.

A Course on Middlemen * * * The most admirable middlemen never got a formal education in being a middleman because no such classes exist. Yet there’s plenty of material for such an education because lots of social scientists have studied, from one angle or another, the questions of how middlemen provide value and profit from their roles between buyers and sellers. For example, economic theory has much to say about transaction-cost economics, two-sided markets, and intermediaries’ ability to reduce information asymmetries between buyers and sellers. In particular, game theory informs our understanding of repeated interactions, reputations, shirking and cheating, and third-party enforcement. Social psychology and experimental economics show how acting on behalf of others affects people’s behavior and impressions. And sociology offers insights into the ways the structures of social networks create opportunities for middlemen.


pages: 337 words: 89,075

Understanding Asset Allocation: An Intuitive Approach to Maximizing Your Portfolio by Victor A. Canto

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accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, buy low sell high, capital asset pricing model, commodity trading advisor, corporate governance, discounted cash flows, diversification, diversified portfolio, fixed income, frictionless, high net worth, index fund, inflation targeting, invisible hand, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, merger arbitrage, new economy, passive investing, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, statistical arbitrage, the market place, transaction costs, Y2K, yield curve

The argument in the pure-alpha strategy’s favor rests on hedge-fund managers’ ability to make leveraged investments as opposed to traditional asset allocations that do not normally allow for leveraged investments. Yet, when leverage is ruled out on theoretical grounds, whether one chooses an alpha strategy over an asset-allocation strategy is a matter of indifference because the two are equivalent. Transaction costs, however, tilt the balance in one strategy’s favor over the other. For small investors, the transaction costs of implementing a portable-alpha strategy with some market exposure may not be feasible. Most hedge funds have liquidity constraints, net worth conditions, and leverage requirements, all which combine to exclude many investors from pursuing a full fledged alpha strategy. The transaction-cost barrier alone keeps many investors in a pure asset-allocation strategy. This does not mean, however, alpha strategies cannot play a role in asset-allocation plans. By definition, a pure-alpha strategy has zero beta and is uncorrelated to a benchmark.

In spite of this, however, from the average investor’s perspective, the alpha strategy can be out of reach. Hedge funds require minimum investments. In addition, they have liquidity requirements and necessitate investors keep track of their market exposure (that is, long–short positions) to add market (beta) exposure. This is something individuals may not be willing to do or may not be able to do. The various transaction costs may in effect prevent most investors from pursuing alpha strategies. As wealth levels increase, however, investors may be able to amortize these transaction costs over their higher net worths and hire managers who can perform all the needed services. Some portable-alpha strategies may only be available to the wealthiest investors and larger pension plans. This does not rule out the role of pure-alpha strategies in a regular asset-allocation portfolio. As I have already mentioned, the pure-alpha strategy can be uncorrelated with the various asset classes and, in the context of risk reduction alone, can merit some exposure in a global asset-allocation portfolio.

In addition to this service, the firm also offers an assetallocation program with some fairly interesting characteristics. Largely due to the client base’s geographic location, the firm’s managers have tried to provide less U.S.-centric allocations than ones guided by market-capitalization weights. To this end, the firm’s strategy has been to reallocate some funds away from the U.S. and into other areas of the world, specifically the Pacific region. Transaction costs, taxes, and other considerations have dictated that portfolio allocations be revisited only once a year, with exceptions made for extraordinary events. Finally, the firm’s portfolio revisions are designed to take advantage of a changing economic environment; a top-down approach is used to tilt portfolios toward perceived changes in the macro environment. The firm’s benchmark selection, along with the tilts in the annual revision of asset allocations, generates a conservative portfolio, a balanced portfolio, and a growth portfolio.


pages: 389 words: 109,207

Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone

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Albert Einstein, anti-communist, asset allocation, Benoit Mandelbrot, Black-Scholes formula, Brownian motion, buy low sell high, capital asset pricing model, Claude Shannon: information theory, computer age, correlation coefficient, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John von Neumann, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, New Journalism, Norbert Wiener, offshore financial centre, publish or perish, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, short selling, speech recognition, statistical arbitrage, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, traveling salesman, value at risk, zero-coupon bond

Some economists hold that even though some people do have an informational edge, they are unable to profit from it. Transaction costs are often mentioned as a reason. The gains from inside information may be smaller than the commissions. It may also be that the arbitrageur is taking unacknowledged risks. What he believes to be a “sure thing” is not. The usual small profit comes at the expense of accepting a small risk of a catastrophic loss. And one way or another, no one beats the market in the long run. Kelly’s analysis raises doubts about this tidy conclusion. If the only limit to profit is the information rate of the private wire, then it is hard to see why transaction costs must always be larger than profits. With a sufficiently informative private wire, an investor could overcome costs and beat the market.

Shannon wondered about the statistical structure of the market’s random walk and whether information theory could provide useful insights. He mentions such diverse names as Bachelier, (Benjamin) Graham and (David) Dodd, (John) Magee, A. W. Jones, (Oskar) Morgenstern, and (Benoit) Mandelbrot. He considered margin trading and short-selling; stop-loss orders and the effects of market panics; capital gains taxes and transaction costs. Shannon graphs short interest in Litton Industries (shorted shares vs. price: the values jump all over with no evident pattern). He notes such success stories as Bernard Baruch, the Lone Wolf, who ran about $10,000 into a million in about ten years, and Hetty Green, the Witch of Wall Street, who ran a million into a hundred million in thirty years. Shannon once went into the office of MIT grad student Len Kleinrock to borrow a book.

It would be alarming to visit a great stock exchange and find the floor littered with worthless stock certificates. Try visiting a racetrack. Most wager tickets become worthless within minutes. It is folly to bet everything on a favorite (horse or stock). The only way to survive is through diversification. Someone who bets on every horse—or buys an index fund—will at least enjoy average returns, minus transaction costs. “Average” isn’t so hot at the racetrack, given those steep track takes. “Average” is pretty decent for stocks, something like 6 percent above the inflation rate. For a buy-and-hold investor, commissions and taxes are small. Shannon was more interested in above average returns. The only way to beat the market (of stocks or horse wagers) is by knowing something that other people don’t. The stock ticker is like the tote board.


pages: 819 words: 181,185

Derivatives Markets by David Goldenberg

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Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, financial innovation, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, law of one price, locking in a profit, London Interbank Offered Rate, Louis Bachelier, margin call, market microstructure, martingale, Norbert Wiener, price mechanism, random walk, reserve currency, risk/return, riskless arbitrage, Sharpe ratio, short selling, stochastic process, stochastic volatility, time value of money, transaction costs, volatility smile, Wiener process, Y2K, yield curve, zero-coupon bond

So, in addition to the eight basic natural strategies, we now have eight equivalent synthetic strategies. Further, the synthetic strategies are (economically) equivalent to their corresponding natural strategies. Therefore, except for transactions costs, they should have the same prices. Otherwise, there would be arbitrage opportunities. If there are transactions costs, then there could be infinitely more synthetic strategies that would not be arbitrage strategies if their execution prices differ by more than the transactions costs of executing the arbs, depending on by how much they differ. If the difference between the cost of executing the synthetic strategies and the cost of executing the natural strategies is less than the transaction costs involved, then these could be arbitrage strategies. In total, there are 16 no-arbitrage strategies described in Table 12.1, and a host of other potential arbitrage strategies.

If a bank borrows at one rate, LIBID3, in this case and lends at a higher rate, LIBOR3, then that has the appearance of an arbitrage strategy. However, there are transactions costs to the bank of arranging these transactions, and these costs can eat up the apparent arbitrage profits. What looks like arbitrage profits are just compensation for the services provided. 270 FORWARD CONTRACTS AND FUTURES CONTRACTS The same thing happens in many markets in which there is a bid-asked spread, and that includes most markets. The spread represents transactions costs and the dealer offering the ability to transact is just earning those transactions costs. Concept Check 10 The dealer would have to go out, at time T, into the spot market for 3-month Eurodollar time deposits and purchase it for the going spot price As shown in Chapter 5, section 5.8.1, he would still effectively pay the futures price he contracted at for the investment vehicle, due to his long ED futures position.

Or, we can buy the underlying commodity today and pay nothing today, fully financing it by issuing a zero-coupon bond with face value equal to the forward price Ft,T and maturity equal to the maturity of the natural forward contract. Either way, we get the same payoff at time T. The current costs are the same too. Zero in both cases. So we have matched up the natural instrument (a long forward position) with the synthetic instrument (a 100% leveraged position in the underlying commodity) exactly. To all intents and purposes, the natural position and the synthetic position are economically equivalent (we ignore transactions costs). What then is a long forward position? It is a 100% leveraged long position in the underlying commodity. That’s the economics. The difference between a fully paid for long position in the underlying commodity and a fully financed long position in the underlying commodity is the zero-coupon bond issuance. That’s what accounts for the –Ft,T component of the forward position, in the cash flow time line above.


pages: 280 words: 73,420

Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market Into a Casino by Jim McTague

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algorithmic trading, automated trading system, Bernie Madoff, Bernie Sanders, Bretton Woods, buttonwood tree, credit crunch, Credit Default Swap, financial innovation, Flash crash, High speed trading, housing crisis, index arbitrage, locking in a profit, Long Term Capital Management, margin call, market bubble, market fragmentation, market fundamentalism, naked short selling, pattern recognition, Ponzi scheme, quantitative trading / quantitative finance, Renaissance Technologies, Ronald Reagan, Sergey Aleynikov, short selling, Small Order Execution System, statistical arbitrage, technology bubble, transaction costs, Vanguard fund, Y2K

Source: CFTC and SEC The regulators had discussed the situation at length after the Flash Crash. There was a spirited debate whether or not to impose obligations on HFT firms in return for letting them charge investors slightly wider spreads. Transaction costs would rise, but investors would get a more orderly market. Theodore Weisberg, the president of Seaport Securities and someone who had been trading for more than 41 years, told Bloomberg television that trading in nickel increments instead of penny increments would be enough to attract dealers back to the equities markets. As a result, investor transaction costs would rise, but they’d be getting more stable markets in return, which was what long-term investors preferred. HFT firms were not the only source of concern in the joint report, however. One of its most damning indictments was aimed squarely at the “internalizers.”

Schapiro told Kaufman that the SEC was preparing to issue a “concept release” come January to request comments from the public on the wisdom of updating the regulations. Reacting to the news, Kaufman wrote to Schapiro, “There are at least two questions that must be posed—questions we must look to the markets’ regulators to answer. First, had these opaque, complex, increasingly sophisticated trading mechanisms been beneficial for retail investors, helping them to buy at the lowest possible price and sell at the highest praise with the lowest possible transaction costs, or have they left them as second-class investors, pushed aside by powerful trading companies able to take advantage of small but statistically and financially significant advantages? And second, do these high-tech practices and their ballooning daily volumes pose a systemic risk? To take just one example, is anyone examining the leverage these traders use in committing their capital in such huge daily volumes?

In 2000, Levitt’s SEC landed another huge blow on the chins of the market makers and specialists, demanding that all exchanges start pricing stocks in decimals by April 2001. That meant that the spreads they had charged would be squeezed from the old high of 12.5 cents to as low as a penny per share on the most heavily traded stock issues. It pushed many hangers on out of business. But the change was a bonanza for investors, big and small. By 2002, retail traders were reporting a 50% reduction in their transactions costs. Specialists at the NYSE remained a thorn in the side of many traders. The 1975 “Trade-Through Rule” remained in effect. The rule that required an exchange to send a customer’s order to a competing exchange if the competing exchange was posting had a better bid or asked price. The specialists at the NYSE and at the American Stock Exchange (AMEX) often posted better prices, especially for exchange-traded funds (ETFs), which were growing in popularity.


pages: 238 words: 73,824

Makers by Chris Anderson

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3D printing, Airbnb, Any sufficiently advanced technology is indistinguishable from magic, Apple II, autonomous vehicles, barriers to entry, Buckminster Fuller, Build a better mousetrap, business process, crowdsourcing, dark matter, David Ricardo: comparative advantage, death of newspapers, dematerialisation, Elon Musk, factory automation, Firefox, future of work, global supply chain, global village, industrial robot, interchangeable parts, Internet of things, inventory management, James Hargreaves, James Watt: steam engine, Jeff Bezos, job automation, Joseph Schumpeter, Kickstarter, Lean Startup, manufacturing employment, Mark Zuckerberg, means of production, Menlo Park, Network effects, profit maximization, race to the bottom, Richard Feynman, Richard Feynman, Ronald Coase, self-driving car, side project, Silicon Valley, Silicon Valley startup, Skype, slashdot, South of Market, San Francisco, spinning jenny, Startup school, stem cell, Steve Jobs, Steve Wozniak, Steven Levy, Stewart Brand, supply-chain management, The Nature of the Firm, The Wealth of Nations by Adam Smith, transaction costs, trickle-down economics, Whole Earth Catalog, X Prize, Y Combinator

His eventual answer, which he published in his landmark 1937 article “The Nature of the Firm,”33 was this: companies exist to minimize “transaction costs”—time, hassle, confusion, mistakes. When people share a purpose and have established roles, responsibilities, and modes of communication, it’s easy to make things happen. You simply turn to the person in the next cubicle and ask that individual to do his or her job. But in a passing comment in a 1990 interview, Bill Joy, one of the cofounders of Sun Microsystems, revealed a flaw in Coase’s model. “No matter who you are, most of the smartest people work for someone else,” he observed, stating what has now come to be known as “Joy’s Law.” His implication: for the sake of minimizing transaction costs, we don’t work with the best people. Instead, we work with whomever our company was able to hire.

But we certainly would have missed the cake maker, the graphics artist working for the Brazilian ad agency, the guy who runs the Italian ambulance radio company, the retired car-dealership owner, the Spaniard working for an energy company in the Canary Islands, and all the others who followed their passions into the project, even though their careers had taken them elsewhere. In short, because we don’t operate the company in a Coaseian model, we’ve got more and smarter people working for us. We minimize transaction costs with technology, not proximity. A social network is our common roof. Skype is the “next cubicle.” Our shared purpose is really shared, not dictated. Joy wins: The open-manufacturing model Joy’s Law and the new breed of companies and communities built on open-access Web principles turned Coase’s Law upside down. Now, working within a traditional monolithic company of the sort Coase had in mind often imposes higher transaction costs than running a project online. Why turn to the person who happens to be in the next office, who may or may not be the best person for the job, when it’s just as easy to turn to an online community member from a global marketplace of talent?

But it also needs to incorporate many of the skills of Web companies in creating and harnessing a community around its products that allow it to design new goods faster, better, cheaper. In short, it must be like the best hardware companies and the best software companies. Atoms and bits. Maryam Alavi, vice-dean of Emery University’s Goizueta Business School, argues that the only way firms can continue to have lower transaction costs than the open market is if they become more complex internally in order to respond to the increasingly complex external market. In the Aspen Institute’s “The Future of Work,” she explained that this was due to the “law of requisite variety” in systems theory, and she argued that a system must be as complex as the environment it is working within: “There are parts of the organization that are going to become more hierarchical because of the uncertainties that they deal with or don’t deal with.


pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

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Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, implied volatility, income inequality, index fund, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, Mark Zuckerberg, McMansion, mortgage debt, mortgage tax deduction, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

To see how little things have changed over the years, pick up a copy of a tract called Confusion de Confusiónes, written by a Sephardic Jew from Portugal named Joseph de la Vega and first published in 1688. De la Vega’s subject is the Amsterdam Stock Exchange, and in it he paints not only a landscape of familiar products but also a gallery of familiar behaviors. He observes “herding,” in which investors copy the behavior of others; overconfidence; overtrading, which still ends up costing investors today because of the excessive transaction costs they incur; and the “disposition effect,” in which people hold on to losing investments for far too long. That’s just in normal times. Occasionally, people really lose their heads. In the 2000s, the mania was for property; in the 1990s, it was for dot-com companies; in the mid-nineteenth century, it was for railways. Britain’s 1840s railway boom turned into a speculative bubble that ended up hitting the wallets of affluent investors, including Charles Darwin, John Stuart Mill, and the Brontë sisters.

These are investors who hold on to their positions for a matter of minutes, hours, or days. Their investment decisions tend to be based not on fundamental analysis of a company’s prospects, but on short-term price trends. They may be fast, critics say, but they are thoughtless.22 Yet the academic consensus also broadly supports the contention that high-frequency traders have helped bring down transaction costs. The British government’s lengthy 2012 investigation of automated trading found that liquidity had improved, bid-ask spreads had narrowed, and markets had become more efficient. Testimony delivered to the Securities and Exchange Commission in 2010 by George Sauter of Vanguard, a big fund manager, concluded that “high-frequency traders provide liquidity and ‘knit’ together our increasingly fragmented marketplace, resulting in tighter spreads that benefit all investors.”23 (Critics riposte that narrower spreads are illusory if the prices quoted are not the ones at which trades are actually executed.)

For example, it would be almost impossible to measure the aggregate costs and benefits of a fundamental innovation like a bank. Instead, they reckoned, a thought experiment—imagining what the world would look like without a particular innovation—might help.24 A world without HFTs is easy to imagine: the old world of “specialist” market makers and floor trading existed only a few years ago, so people remember it well. There is little obvious enthusiasm for returning to that model. Transaction costs were a lot higher. Big market makers used to charge 25–40 basis points to execute trades in a clunky process that involved an investor calling a broker, who got the stock ticker and went to a jobber on the floor to make the trade. Now the same thing is being done by an algorithm at 1–3 basis points. The very same arguments about unfair advantages were being put forward in different forms in the pre-HFT era.


pages: 336 words: 90,749

How to Fix Copyright by William Patry

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A Declaration of the Independence of Cyberspace, barriers to entry, big-box store, borderless world, business intelligence, citizen journalism, cloud computing, crowdsourcing, death of newspapers, en.wikipedia.org, facts on the ground, Frederick Winslow Taylor, George Akerlof, Gordon Gekko, haute cuisine, informal economy, invisible hand, Joseph Schumpeter, Kickstarter, knowledge economy, lone genius, means of production, new economy, road to serfdom, Ronald Coase, Ronald Reagan, semantic web, shareholder value, Silicon Valley, The Chicago School, The Wealth of Nations by Adam Smith, trade route, transaction costs, trickle-down economics, web application, winner-take-all economy

One-to-one negotiations will always be necessary for situations where we want copyright owners to control the individual use of their work, such as licensing the use of a novel or musical composition in a movie for “grand rights” (theater), or for use in advertisements. Statutory licensing is appropriate where we do not want users to bargain over the licensee fee (usually because the transaction costs are high relative to the license fee) but we do want them to pay. Collective administration is appropriate where, due to large transaction costs and the potential inequality of bargaining leverage by individual copyright owners, we want users to have to negotiate fees. The usual theoretical model today remains the exclusive rights. This model is becoming less useful given the large-scale, global nature of the Internet. But as much attention as unauthorized uses on the Internet receive, the largest problems facing authors today are not unauthorized uses but the obstacles put in the way of buyers willing to pay for access to or copies of the work.

At this rate, clearing the rights for the whole set of handbooks would take more than eight years.12 The EU report noted that in the case of books, the transaction costs for out-of-print books are normally higher than the cost of digitization, which is not inexpensive either.13 The Carnegie Mellon Library estimated that the total cost for clearing a book is $200 per book,14 a prohibitively high cost for a meaningful project THE LENGTH OF COPYRIGHT IS DAMAGING OUR CULTURAL HERITAGE 195 of any size. Moreover, after spending such fees, the end result is usually an inability to clear enough books to make the project live up to its goals. Other types of works fare just as badly: In the United Kingdom, an effort was made to digitize 2,900 posters. Only 270 posters were cleared, which was 19 percent. This 19 percent had transaction costs of 70,000 Euros (not including license fees) and took 88 working days.15 Where visual works are included within a book, finding the owners of those works is a nightmare.16 Funding for projects requires legal certainty; legal certainty requires considerable copyright expertise; considerable copyright expertise requires hiring lawyers; hiring lawyers requires paying lawyers.

For sound recordings, however, the court held there is no de minimis threshold; the copying of any amount is infringing.51 The result of this terrible decision has been an unwillingness of record companies to put out albums52 unless each and every sample is cleared. Producers of records must certify that all samples have been licensed when delivering the masters. Since previous hip-hop albums used hundreds (and sometimes thousands) of samples, licensing that number of samples is out of the question due to financial and transactional cost reasons. As a result, the creative process of hip-hop has changed.53 Here is an explanation by Public Enemy’s Chuck D and Hank Shocklee in interviews with Stay Free! Magazine: Stay Free!: When you were sampling from many different sources during the making of “It Takes a Nation,” were you at all worried about copyright clearance? Shocklee: No. Nobody did. At the time, it wasn’t even an issue.The only time copyright was an issue was if you actually took the entire rhythm of a song,....But we were taking a horn hit here, a guitar riff there, we might take a little speech, a kicking snare from somewhere else.


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Economists and the Powerful by Norbert Haring, Norbert H. Ring, Niall Douglas

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accounting loophole / creative accounting, Affordable Care Act / Obamacare, Albert Einstein, asset allocation, bank run, barriers to entry, Basel III, Bernie Madoff, British Empire, central bank independence, collective bargaining, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, diversified portfolio, financial deregulation, George Akerlof, illegal immigration, income inequality, inflation targeting, Jean Tirole, job satisfaction, Joseph Schumpeter, knowledge worker, labour market flexibility, law of one price, Long Term Capital Management, low skilled workers, market bubble, market clearing, market fundamentalism, means of production, minimum wage unemployment, moral hazard, new economy, obamacare, open economy, pension reform, Ponzi scheme, price stability, principal–agent problem, profit maximization, purchasing power parity, Renaissance Technologies, rolodex, Sergey Aleynikov, shareholder value, short selling, Steve Jobs, The Chicago School, the payments system, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, ultimatum game, union organizing, working-age population, World Values Survey

This makes it easy to answer the rhetorical question of Alchian and Demsetz concerning what distinguishes the relationship of employer and worker from the relationship between the grocer and the customer. The assumptions of complete information, negligible transaction costs, complete contracts and costless enforcement of contracts are even more unrealistic on the labor market than they are on many product markets. Those ugly market forces have to stay outside Only social exchange tends to engender feelings of personal obligations, gratitude, and trust; purely economic exchange as such does not. —Peter M. Blau, 1964 Employment relationships involve complex tasks that can rarely be specified in a complete contract. While the baker can easily make a new contract to sell bread with every customer, this is rarely feasible on the labor market due to high transaction costs. This is why employment relationships tend to be ongoing. Such long-term relationships help to solve the problem of incomplete information.

Moreover, how they view human beings and the free market says much about the field of economics in general. For example, all consumers have identical tastes and preferences (i.e. are identical clones), each is perfectly selfish and rational (i.e. is a robot), and each has perfect knowledge of all possible future market prices (i.e. is substantially omniscient), while all firms produce identical goods and services and make zero profit, and there are no transportation or transaction costs. Perhaps coincidentally, much of how globalization has been implemented and justified by economists during the past decades seems to assume that just such a worldview is true. Even from purely within the perspective of economics, the SMD assumptions exclude the possibility of increasing returns to scale. That is, mass production cannot be cheaper per unit than producing few units of the same good, which if true would make mass production uneconomical.

They have become so normal and ubiquitous that they seem without alternative, yet these practices brought about the latest financial crisis, and most of the other 124 systemic banking crises that economists of the IMF have counted between 1970 and 2007 (Laeven and Valencia 2008). According to one account, money creation by banks emerged as an aberration of deposit banking starting in the 1640s. Some English merchants deposited their gold with goldsmiths or other safe keepers. In order to economize on transaction costs, it was customary to transfer documents of possession rather than the physical gold. The deposit slips started to function as paper money, entirely backed by gold. Soon, the safe keepers had an idea – one that could be called either fraud or a smart invention. They could make money by multiplying the deposit slips they issued. As most gold would stay in their vaults for a long time without being requested by its current owners, they could lend out some MONEY IS POWER 75 of their customers’ gold and pocket the interest.


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The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

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asset allocation, backtesting, Bernie Madoff, Black Swan, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, passive investing, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, statistical model, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve

In short, traditional assets may have pricing issues similar to that existing in some alternative assets and often worse than alternative investments that concentrate on exchange traded derivatives. A quick historical example: Early on, equity derivatives were called more risky than the stocks they were based on because the futures contract reported higher historical volatility. The reason, we later discovered, was that individuals just traded in the derivatives markets because derivatives had lower transaction costs. Moreover, because of the lower transaction costs, the futures price would move even if the underlying stock index did not trade because of its higher transaction cost. No real difference in price, no difference in risk; it just looked so to the less educated observer. STOCK AND BOND INVESTMENT MEANS INVESTORS HAVE NO DERIVATIVES EXPOSURE Simply not true in today’s market. In fact, almost every investment into a firm’s equity or bond is also, if indirectly, an investment into derivatives.

Other markets and/or assets may require enlarged risk based factor models that capture an enlarged set of underlying risks and therefore expected returns. Small firms with few analysts following them, with less ability to raise capital, with a less diversified client base, limited legal support, and so on may be priced to reflect those risks. Many assets are simply not tradable or have high transaction costs (e.g., housing, commodities, employment contracts, or distressed debt). How they could or should be priced in a single-factor or even a multi-factor model framework was explored, but a solution was rarely found.9 Option Pricing Models and Growth of Futures Markets We have spent a great deal of time focusing on the equity markets. During this period of market innovation, considerable research also centered on direct arbitrage relationships.

Investment size restricts certain investors from taking advantage of more cost efficient asset A Brief History of Asset Allocation 15 classes (e.g., swaps may be the preferred form of accessing a particular asset class but many investors are limited to investing in exchange traded variants, which do not have the same statistical properties). As pointed out, the market is never efficient for everyone; that is, transaction costs differ, borrowing costs differ, taxation differs such that the actual after-tax return for individuals and institutions varies greatly. Finally, the ability to process and understand information and its consequences differs. The very unpredictable nature of risky asset pricing raises the issue of how best to manage that risk. Certainly, the Markowitz model based on estimates obtained from historical figures continues as a primary means by which individuals attempt to estimate portfolio risk; however, the 2007 and 2008 market collapse illustrated the fundamental flaw of the Markowitz diversification approach; that is, Murphy’s Law of Diversification—assets and markets only offer diversification benefits when you do not need them.


pages: 791 words: 85,159

Social Life of Information by John Seely Brown, Paul Duguid

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AltaVista, business process, Claude Shannon: information theory, computer age, cross-subsidies, disintermediation, double entry bookkeeping, Frank Gehry, frictionless, frictionless market, future of work, George Gilder, global village, Howard Rheingold, informal economy, information retrieval, invisible hand, Isaac Newton, Just-in-time delivery, Kevin Kelly, knowledge economy, knowledge worker, loose coupling, Marshall McLuhan, medical malpractice, moral hazard, Network effects, new economy, Productivity paradox, rolodex, Ronald Coase, shareholder value, Silicon Valley, Steve Jobs, Superbowl ad, Ted Nelson, telepresence, the medium is the message, The Nature of the Firm, The Wealth of Nations by Adam Smith, Thomas Malthus, transaction costs, Turing test, Vannevar Bush, Y2K

Microsoft continues to grow while other high-tech start-ups compete for the title of "fastest growing ever." 22 Downes and Mui draw on the theory of the firm proposed by the Nobel Prize-winning economist Ronald Coase. Coase developed the notion of transaction costs. These are the costs of using the marketplace, of searching, evaluating, contracting, and enforcing. When it is cheaper to do these as an organization than as an individual, organizations will form. Conversely, as transaction costs fall, this glue dissolves and firms and organizations break apart. Ultimately, the theory suggests, if transaction costs become low enough, there will be no formal organizations, but only individuals in market relations. And, Downes and Mui argue, information technology is relentlessly driving down these costs. Page 24 Though he produced elegant economic theory, Coase had strong empirical leanings. He developed his theory of transaction costs in the 1930s to bridge the gap between theoretical accounts of the marketplace and what he saw in the actual marketplaceparticularly when he traveled in the United States.

Notions of disintermediation and decentralization are features, for example, in the work of George Gilder or Kevin Kelly's (1997) writing on the "new economy." There are more "Ds" that could be added, such as Kevin Kelly's displacement and devolution. 22. Downes and Mui, 1998. 23. Coase, 1937. Coase's theory should be seen not so much as an attack on neoclassical individualism as an attempt to save it from itself. We return to transaction cost theory briefly in our discussion of the future of the firm in chapter 6. There we take a "knowledge based," rather than transaction cost, view of the firm. 24. Among the targets of early, landmark trust cases were Northern Securities (1911), Standard Oil (1911), and American Tobacco (1911). In November 1998, Philip Morris acquired several brands from the Ligget corporation. 25. The Economist, 13 December 1997. 26. Daniel, 1996, table 3.2. We take up this topic again in chapter 8. 27.

., 172 Sterne, Laurence, 24 Stewart, Thomas, 122 Stock, Brian, 192, 197 Storytelling, 106 108 Strassmann, Paul, 77, 79, 81 Strauss, Anselm, 190, 197 Suchman, Lucy, 119 Sun Microsystems, 87 Symantec, 59 T Tagore, Rabindrath, 136 Taylor, Frederick, 113 Technology integration into society, 86 81 taming of, 86 Telecommunications history of, 30, 87 89 modern trends in, 89 Tenner, Edward, 3 ThirdVoice.com, 182 3Com, 168 Time binding, 200 Times Mirror Newspapers, 178 Tocqueville, Alexis de, 196, 197 Toffler, Alvin, 18, 67, 69, 79 Total Quality Management, 145 Toulmin, Stephen, 107 Transaction costs, 23 24 Page 316 Trow, Martin, 217 Tunnel design, 2 4 TV University System (China), 25 TVI (tutored video instruction), 222 U USWeb/CKS, technology costs at, 82 V Varian, Hal, 171 Viewtron (Knight-Ridder), 178 Virtual Community, 190 Virtual University (California), 211, 212 W Wall Street Journal, Web presence of, 178 Wal-Mart, 29 Warrants documents as, 187 188 unreliability of, 188 189 Weizenbaum, Joseph, 35 WELL (Whole Earth 'Lectronic Link), 190 Wells, H.G., 84 Wellsprings of Knowledge, 122 Wenger, Etienne, 96, 126, 138, 141, 142 Western Union, 88 Whalen, Jack, 131, 133 Whyte, William, 152 Wilensky, Robert, 40, 41, 62 Williams, Raymond, 246 Wired, Web presence of, 178 Work practice cautions regarding, 114 115 collaborative, 104 106, 125 126 improvisation in, 108 109, 110 investigation of, 99 100, 102 109 lateral aspects of, 111 113 social aspects of, 102 103, 106 108 understanding of, 100 102 World Wide Web access and, 226 business plans on, 247 248 characteristics of, 201 economic importance of, 147 149 education on, 212, 225 227 mutability of, 198, 200 news on, 178 179 origins of, 147 services on, 37 structure and terminology of, 182 183 structure of page on, 202 205 Wren, Christopher, 191 X Xerox, 110, 142, 154 management of managers at, 78 79 and personal computers, 150 151, 157 160 Xerox PARC, 76, 150 151, 154, 155 157, 158 159, 190, 200, 244 and Apple Computer, 151, 157, 163, 166 Page 317 and paperless office, 176 177 reengineering of, 92 Z Zero-Knowledge Systems, 59 Zilog, 166 'zines, 193 Zuboff, Shoshona, 30 Page 319 About the Authors JOHN SEELEY BROWN is the Chief Scientist of Xerox Corporation and the Director of its famous Palo Alto Research Center (PARC).


pages: 330 words: 91,805

Peers Inc: How People and Platforms Are Inventing the Collaborative Economy and Reinventing Capitalism by Robin Chase

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3D printing, Airbnb, Amazon Web Services, Andy Kessler, banking crisis, barriers to entry, bitcoin, blockchain, Burning Man, business climate, call centre, car-free, cloud computing, collaborative consumption, collaborative economy, collective bargaining, congestion charging, crowdsourcing, cryptocurrency, decarbonisation, don't be evil, Elon Musk, en.wikipedia.org, ethereum blockchain, Ferguson, Missouri, Firefox, frictionless, Gini coefficient, hive mind, income inequality, index fund, informal economy, Internet of things, Jane Jacobs, Jeff Bezos, jimmy wales, job satisfaction, Kickstarter, Lean Startup, Lyft, means of production, megacity, Minecraft, minimum viable product, Network effects, new economy, Oculus Rift, openstreetmap, optical character recognition, pattern recognition, peer-to-peer lending, Richard Stallman, ride hailing / ride sharing, Ronald Coase, Ronald Reagan, Satoshi Nakamoto, Search for Extraterrestrial Intelligence, self-driving car, shareholder value, sharing economy, Silicon Valley, six sigma, Skype, smart cities, smart grid, Snapchat, sovereign wealth fund, Steve Crocker, Steve Jobs, Steven Levy, TaskRabbit, The Death and Life of Great American Cities, The Nature of the Firm, transaction costs, Turing test, Uber and Lyft, Zipcar

The logic for a very low transaction effort (and cost) was compelling from our business perspective as well: For Zipcar to work, we needed to be indifferent between eight 1-hour rentals and one 8-hour rental. Getting our transaction costs as close to zero as we could was absolutely necessary. When our fleet grew and I needed to hire a VP of operations with big-fleet experience, the candidates from the car rental industry would ask me, “So what’s Zipcar’s transaction cost?” At that time, almost all of our hard-won investment dollars were being poured into technology. Our development costs were huge. But the result was zero marginal cost for each transaction. “What is your transaction cost?” I’d prompt. I learned that in the rental industry the cost was between $8 and $12 per transaction! Yikes. No wonder they required a one-day minimum for every rental and extension. What was good for us was also exactly what the customer wanted. To make the transaction cost zero, to make sharing effortless, we needed technology that had several parts: 1.

The Internet has eliminated a key corporate competitive advantage. In 1937, in the influential essay “The Nature of the Firm,” British economist Ronald Coase wrote that the corporation was invented to do things that individuals and small companies couldn’t do. In particular, small companies would choose to become larger companies whenever it was cheaper to hire than to outsource. What would make hiring cheaper than outsourcing? Transaction costs (a term Coase invented). Finding, monitoring the quality of, and managing many discrete individuals was expensive. It was cheaper to hire them. But now the Internet has transformed that equation. Today, we see that the smartest companies and governments are using the Internet’s ability to facilitate collaboration by leveraging expertise, assets, and resources outside their sphere of control.

Employers could respond more rapidly to market forces; workers could diversify their income streams and transition from dying industries or boring jobs in an adaptive way that was much more in their control. The “job for life” that was the hallmark of corporate America in the 1950s has been gone for close to two generations. Way back in Chapter 1, I talked about the economist Ronald Coase and his work showing that companies grew bigger in order to avoid transaction costs grounded in lack of information. The corollary to this insight was his prediction that as markets become more efficient because of better information flow, companies will tend to get smaller and smaller. Our platforms are such places, where tiny little companies (often independent contractors) find each other and interact, together creating larger economic processes But in a genuinely efficient platform economy, in which assets and labor flow to the most productive uses, the job-for-life benefits package provided by private companies evaporates.


pages: 1,205 words: 308,891

Bourgeois Dignity: Why Economics Can't Explain the Modern World by Deirdre N. McCloskey

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Admiral Zheng, agricultural Revolution, Albert Einstein, BRICs, British Empire, butterfly effect, Carmen Reinhart, clockwork universe, computer age, Corn Laws, dark matter, David Ricardo: comparative advantage, Donald Trump, Edward Lorenz: Chaos theory, European colonialism, experimental economics, financial innovation, Fractional reserve banking, full employment, George Akerlof, germ theory of disease, Gini coefficient, greed is good, Howard Zinn, income per capita, interchangeable parts, invention of agriculture, invention of air conditioning, invention of writing, invisible hand, Isaac Newton, James Watt: steam engine, John Maynard Keynes: technological unemployment, John Snow's cholera map, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, means of production, Naomi Klein, New Economic Geography, New Urbanism, purchasing power parity, rent-seeking, road to serfdom, Robert Gordon, Ronald Coase, Ronald Reagan, Scientific racism, Scramble for Africa, Shenzhen was a fishing village, Simon Kuznets, Slavoj Žižek, spinning jenny, Steven Pinker, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, total factor productivity, transaction costs, tulip mania, union organizing, Upton Sinclair, urban renewal, V2 rocket, very high income, working poor, World Values Survey, Yogi Berra

As Weber put it, recall, “the impulse to acquisition, pursuit of gain, of money, of the greatest possible amount of money, . . . has been common to all sorts and conditions of men at all times and in all countries of the earth, wherever the objective possibility of it is or has been given.” What changed were “transaction costs,” in the phrase of the great economist Ronald Coase (1910- ), that is, the costs of getting together to make a deal — transportation costs, the costs of robbers on the highway or in the market, the costs of trust, the costs of insurance, the costs of using credit, the costs of getting coins and bills, the costs of negotiation, the costs of taboo, the costs of sneering at the bourgeoisie. All these make deals more expensive, and many of them are directly measurable. When such costs fall, “commercialization” takes place. What the economist and historian Douglass North got right (amongst a good deal that he got wrong) is that we should focus on the history of the transactions costs — about which there is ample documentation — and cease believing that there is something separately measurable “spreading” to make people and their taxing governments rich, called “commercialization” or “monetization” 234 (neither of which, by the way, are technical terms in economics, though they sound like they are).

North’s pioneering study of ocean freight rates from the seventeenth to the eighteenth century (North 1968) led him in the 1970s to ponder the evolution of what had in an economics influenced by Ronald Coase come to be called “transaction costs,” that is, the costs of doing business. Moving cotton from Savannah to Liverpool entails transportation costs, obviously. Less obviously — the point was made by Coase in all his work from the 1930s on — moving a piece of property from Mr. Jones to Ms. Brown entails transactioncosts, such as the cost of arriving at a satisfactory contract to do so and the cost of insuring against its failure. By North’s own account, in 1966 he had decided to switch from American to European economic history. With collaborators at Washington like Robert Paul Thomas, S. N. S. Cheung, Yoram Barzel, Barry Weingast, and John Wallis, North developed a story of the “rise of West” focusing on the gradual fall in such transaction costs. Since the 1980s, now at Washington University of St.

It is also what John Rawls was about in his later A Theory of Justice (1971) when he imagined a pre-natal veil of ignorance behind which we decide whether our society will have slavery or not. To the economist, the lower level, act utilitarianism has its charms. She points out that if the price of lumber is higher in England than in Sweden then shipping Swedish lumber from Norrland to London creates value, by the amount of the price difference less the transaction costs. An innovation in lumber manufacturing or organization can be seen as the same sort of alert arbitrage, buying an idea for lumber ships or steel saws low and selling it high. Again the gain in value is the price difference. Sven Svenson the Swedish lumber king is made better off, as is Jones the lumber merchant in London — and his employees and customers are made better off, too. True, if Sweden exports lumber some people are hurt.


pages: 443 words: 112,800

The Third Industrial Revolution: How Lateral Power Is Transforming Energy, the Economy, and the World by Jeremy Rifkin

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3D printing, additive manufacturing, Albert Einstein, barriers to entry, borderless world, carbon footprint, centre right, collaborative consumption, collaborative economy, Community Supported Agriculture, corporate governance, decarbonisation, distributed generation, en.wikipedia.org, energy security, energy transition, global supply chain, hydrogen economy, income inequality, informal economy, invisible hand, Isaac Newton, job automation, knowledge economy, manufacturing employment, marginal employment, Martin Wolf, Masdar, megacity, Mikhail Gorbachev, new economy, oil shale / tar sands, oil shock, open borders, peak oil, Ponzi scheme, post-oil, purchasing power parity, Ray Kurzweil, Ronald Reagan, Silicon Valley, Simon Kuznets, Skype, smart grid, smart meter, Spread Networks laid a new fibre optics cable between New York and Chicago, supply-chain management, the market place, The Wealth of Nations by Adam Smith, Thomas Malthus, too big to fail, transaction costs, trickle-down economics, urban planning, urban renewal, Yom Kippur War, Zipcar

In conventional, capitalist markets, profit is made at the margins of transaction costs. That is, at every step of the conversion process along the value chain the seller is marking up the cost to the buyer to realize a profit. The final price of the good or service to the end user reflects the markups. But TIR information and communication technologies dramatically shrink transaction costs across the supply chain in every industry and sector, and distributed renewable energies will soon do so as well. The new, green energy industries are improving performance and reducing costs at an ever-accelerating rate. And just as the generation and distribution of information is becoming nearly free, renewable energies will also. The sun and wind are available to everyone and are never used up. When the transaction costs for engaging in the new Third Industrial Revolution communications/energy system approach zero, it is no longer possible to maintain a margin, and the very notion of profit has to be re-thought.

When the transaction costs for engaging in the new Third Industrial Revolution communications/energy system approach zero, it is no longer possible to maintain a margin, and the very notion of profit has to be re-thought. That’s already happening with the communications component of the Third Industrial Revolution. The shrinking of transaction costs in the music business and publishing field with the emergence of music downloads, ebooks, and news blogs is wreaking havoc on these traditional industries. We can expect similar disruptive impacts with green energy, 3D manufacturing and other sectors. So how do businesses make profit when transaction costs shrink and margins disappear? In a near transaction-free economy, property still exists, but remains in the hands of the producer and is accessed by the consumer over a period of time. Why would anyone want to own anything in a world of continuous upgrades, where new product lines sweep in and out of the market in an instant?

The shrinking of distances and the annihilation of time, resulting from the convergence of coal- and steam-powered technology with print communications, sped up commercial activity at every stage of the supply chain, from the extraction and transport of coal and other ores to the factories, to the hurried transport of finished goods to wholesalers, distributors, and retailers. The dramatic increase in the flow of commerce was matched by the equally impressive decrease in transaction costs. This was achieved, in large measure, by dint of the new vertical economies of scale. Mass-producing products in giant, centralized factories reduced the cost per unit of production, allowing manufacturers to pass the savings along the entire supply chain to the end user. The mass production of cheap goods encouraged more consumption, which allowed more factories to produce greater volumes of goods at ever cheaper prices.


pages: 289 words: 113,211

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber

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affirmative action, Albert Einstein, asset allocation, backtesting, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commodity trading advisor, computer age, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, Jeff Bezos, London Interbank Offered Rate, Long Term Capital Management, loose coupling, margin call, market bubble, market design, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, new economy, Nick Leeson, oil shock, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, shareholder value, short selling, Silicon Valley, statistical arbitrage, The Market for Lemons, time value of money, too big to fail, transaction costs, tulip mania, uranium enrichment, yield curve, zero-coupon bond

We had adjusted our hedge gradually over the course of that Friday as we knew that a number of the largest portfolio insurance providers would be waiting until Monday to do so. This was in part for a technical reason—the models were only run once a day based on the market close—but could also be justified on efficiency grounds. Intraday adjustments can lead to unnecessary whipsawing and increase transaction costs as the market moves up and down. Even though Friday was not a normal day, many firms were locked into the next-day adjustment process and could not have made intraday adjustments, even though the market had declined by more than 70 points by midafternoon. We estimated that the overhang from LOR clients alone would be more than $5 billion, and while LOR was the market leader, the total overhang across all of the portfolio insurance purveyors could be double this amount.

THE AVALANCHE BURIES THE BUYERS Program traders and arbitrageurs take positions on the S&P contract trading in the futures pit while simultaneously taking opposite positions on the individual stocks that make up the S&P on the NYSE. When the S&P futures contract sells for less than the price of the basket of the individual stocks in the S&P, then the cash-futures arbitrageur buys the S&P and sends in orders to sell the individual stocks. If the price difference is greater than the transaction costs of doing this trade, then they make an almost certain profit. This trade effectively transfers the stock market activities of the futures pit to the individual stocks on the NYSE. That’s where things broke down in 1987, and broke down for a simple reason: Stocks are not as liquid as futures. The problem was that the traders in the S&P pit are mostly market makers, jammed together gesticulating and shouting out orders in hopes of scalping a few ticks.

THE PHYSICS OF THE MELTDOWN I spent the week chained to my desk, my eyes frozen on the Quotron screen as I struggled to maintain the hedges demanded of the portfolio insurance programs I ran. Prices were moving all over the place, swinging more violently minute by minute than they usually did in an entire day, and the spread required to buy or sell the S&P futures—still the most liquid instrument in the equity market—was a dollar or more, 20 times normal. I had to weigh the implications of holding off on a hedge adjustment on the one hand with the incredible transaction costs in executing in the market on the other. The huge volatility of the market broke down all but the most fundamental relationships between the market securities. The usual day-to-day world where investors cared about subtleties like corporate earnings or analyst forecasts dissolved as the energy of the market was turned up. All stocks moved together; if it was a stock, it was sold. The market hardly differentiated between domestic and foreign, small cap or large.


pages: 457 words: 128,838

The Age of Cryptocurrency: How Bitcoin and Digital Money Are Challenging the Global Economic Order by Paul Vigna, Michael J. Casey

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3D printing, Airbnb, altcoin, bank run, banking crisis, bitcoin, blockchain, Bretton Woods, California gold rush, capital controls, carbon footprint, clean water, collaborative economy, collapse of Lehman Brothers, Columbine, Credit Default Swap, cryptocurrency, David Graeber, disintermediation, Edward Snowden, Elon Musk, ethereum blockchain, fiat currency, financial innovation, Firefox, Flash crash, Fractional reserve banking, hacker house, Hernando de Soto, high net worth, informal economy, Internet of things, inventory management, Julian Assange, Kickstarter, Kuwabatake Sanjuro: assassination market, litecoin, Long Term Capital Management, Lyft, M-Pesa, Mark Zuckerberg, McMansion, means of production, Menlo Park, mobile money, money: store of value / unit of account / medium of exchange, Network effects, new economy, new new economy, Nixon shock, offshore financial centre, payday loans, peer-to-peer lending, pets.com, Ponzi scheme, prediction markets, price stability, profit motive, RAND corporation, regulatory arbitrage, rent-seeking, reserve currency, Robert Shiller, Robert Shiller, Satoshi Nakamoto, seigniorage, shareholder value, sharing economy, short selling, Silicon Valley, Silicon Valley startup, Skype, smart contracts, special drawing rights, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, supply-chain management, Ted Nelson, The Great Moderation, the market place, the payments system, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, tulip mania, Turing complete, Tyler Cowen: Great Stagnation, Uber and Lyft, underbanked, WikiLeaks, Y Combinator, Y2K, Zimmermann PGP

If the Afghani teen ever had any money, she had to transfer it into her father’s or brothers’ bank accounts, and that’s simply the way it is for most girls where she lives. In this sense, she was lucky—for many women from her background male family members block them from access to their funds and treat the money as their own. Ahmadi’s luck would change in early 2014. The Film Annex’s New York–based founder, Francesco Rulli, aware of the difficulty faced by women like Ahmadi and frustrated by the transaction costs he incurred in sending relatively small amounts of money around the world, implemented a sweeping change to the Film Annex’s payment system. He would pay his bloggers in bitcoin, the digital currency that had seemed to come out of nowhere in 2013, with a small, fiercely dedicated band of tech-minded, libertarian-leaning digital utopians acting as its standard-bearers, and swearing to anybody who’d listen that it was going to change the world.

The right to privacy and the need to re-empower individuals didn’t factor in this—then again, they had never done so. The race for an e-commerce fix would be won by the same payments model run by big banks like those with which Chaum was negotiating. In other words, they ended up having no use for him. With the aid of new Web-site security solutions and third-party ratings to give consumers confidence, the infrastructure of the credit-card payment networks, with the intermediaries and transaction costs that went with it, was just bolted onto that of the Internet. Some alternatives, such as PayPal, would create a bridge for those retailers with no means of accepting card payments, but over time most would simply migrate to cards. It would provide an enormous jolt of new business for the two big bank-issued card associations, Visa and MasterCard. The banks that owned them—both card companies were at that time controlled by different consortia of banks—would enjoy a huge rush of new revenue through their payment processing and revolving-credit businesses

Also like bitcoin and other cryptocurrencies, Rosen’s project ran off a permanent ledger of transactions and allowed for the digital dollar to be cut into smaller pieces so that commerce could occur in whatever denomination was required. Citi’s e-cash was in this sense a disruptive, disintermediating, peer-to-peer currency. It wouldn’t need the extensive network of communications that underpins credit-card payments, so transaction costs would be kept low, providing gains for both consumers and businesses and making micropayments viable. But this is not to say Rosen wanted to cut banks out from the system as, say, Satoshi Nakamoto did. Far from it. Banks would sit at the heart of his system, reflecting a deep-felt view that he’d developed on the theory of money by reading the likes of Milton Friedman and the nineteenth-century financial journalist Walter Bagehot.


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The Fissured Workplace by David Weil

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accounting loophole / creative accounting, affirmative action, Affordable Care Act / Obamacare, banking crisis, barriers to entry, business process, call centre, Carmen Reinhart, Cass Sunstein, Clayton Christensen, clean water, collective bargaining, corporate governance, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, declining real wages, employer provided health coverage, Frank Levy and Richard Murnane: The New Division of Labor, George Akerlof, global supply chain, global value chain, hiring and firing, income inequality, intermodal, inventory management, Jane Jacobs, Kenneth Rogoff, law of one price, loss aversion, low skilled workers, minimum wage unemployment, moral hazard, Network effects, new economy, occupational segregation, performance metric, pre–internet, price discrimination, principal–agent problem, Rana Plaza, Richard Florida, Richard Thaler, Ronald Coase, shareholder value, Silicon Valley, statistical model, Steve Jobs, supply-chain management, The Death and Life of Great American Cities, The Nature of the Firm, transaction costs, ultimatum game, union organizing, women in the workforce, Y2K, yield management

In a world where the costs of transactions between parties may be significant, many activities become located within the walls of a firm.6 A&P’s model of getting food from producers to a consumer’s kitchen lowered costs relative to a long chain of market transactions from producers to wholesale distributors to retail stores. Oliver Williamson built on the Coasian framework to develop a formal theory of transaction cost economics, viewing the primary purpose and impact of organizations as economizing on transaction costs in the course of producing complicated products and services. In the transaction cost framework pioneered by Williamson, business organizations that make up an industry are neither simply production processes combining capital, labor, and material to produce goods for the market (as traditional economics would lead one to believe) nor organizations untethered from economic forces and able to configure themselves as they wish (as often implied by popular business gurus or some management academics).

A&P’s size in fact led fretful congressional leaders to pass the Robinson-Patman Act of 1936, which prohibited chain stores from receiving better pricing than smaller retailers. 6. See Coase (1937). 7. Williamson notes, “I submit that the modern corporation is mainly to be understood as the product of a series of organizational innovations that have had the purpose and effect of economizing on transaction costs” (1985, 273). 8. One problem with the transaction cost approach is that such costs are not directly observed and are difficult to define, making it challenging to test the theory in practice. The property rights framework provides a more formal way of modeling the consequence of incomplete contracts on how markets and organizations solve coordination problems. See, for example, Grossman and Hart (1986) and O. Hart and Moore (1990). 9.

Over time, competitive forces acting on individual decision makers within organizations pursuing their own objectives lead some functions to end up being done internally, others through various types of relationships (partnerships, franchise agreements, other forms of contracting), and still others through market transactions.7 Property rights (or efficient contracts) theorists in the 1980s pushed Coase’s and Williamson’s questions on the drivers of firm boundaries by asking why parties could not undertake more activities via market relationships by writing contracts that would solve the types of problems that created high transaction costs.8 Market transactions would be sufficient if two parties could write a “complete contract” that captured the private benefits and costs of two parties (whether business/business, buyer/supplier, or employer/employee) covering all exigencies. But that is often not possible for a variety of reasons. The vagaries and uncertainties of life mean that writing a contract that covers all possible outcomes is simply not possible.


pages: 313 words: 34,042

Tools for Computational Finance by Rüdiger Seydel

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bioinformatics, Black-Scholes formula, Brownian motion, continuous integration, discrete time, implied volatility, incomplete markets, interest rate swap, linear programming, London Interbank Offered Rate, mandelbrot fractal, martingale, random walk, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process, zero-coupon bond

Intrinsic value of a call with exercise price K (payoff function) The Payoff Function At time t = T , the holder of a European call option will check the current price S = ST of the underlying asset. The holder will exercise the call (buy 1.1 Options 3 the stock for the strike price K), when S > K. For then the holder can immediately sell the asset for the spot price S and makes a gain of S − K per share. In this situation the value of the option is V = S − K. (This reasoning ignores transaction costs.) In case S < K the holder will not exercise, since then the asset can be purchased on the market for the cheaper price S. In this case the option is worthless, V = 0. In summary, the value V (S, T ) of a call option at expiration date T is given by 0 in case ST ≤ K (option expires worthless) V (ST , T ) = ST − K in case ST > K (option is exercised) Hence V (ST , T ) = max{ST − K, 0}. Considered for all possible prices St > 0, max{St − K, 0} is a function of St .

Intrinsic value of a put with exercise price K (payoff function) 4 Chapter 1 Modeling Tools for Financial Options The curves in the payoff diagrams of Figures 1.1, 1.2 show the option values from the perspective of the holder. The profit is not shown. For an illustration of the profit, the initial costs paid when buying the option at t = t0 must be subtracted. The initial costs basically consist of the premium and the transaction costs. Since both are paid upfront, they are multiplied by er(T −t0 ) to take account of the time value; r is the continuously compounded interest rate. Substracting this amount leads to shifting the curves in Figures 1.1, 1.2 down. The resulting profit diagram shows a negative profit for some range of S-values, which of course means a loss, see Figure 1.3. V K K S Fig. 1.3. Profit diagram of a put The payoff function for an American call is (St −K)+ and for an American put (K − St )+ for any t ≤ T .

Definition 1.1 (Black-Scholes equation) 1 ∂V ∂2V ∂V + σ 2 S 2 2 + rS − rV = 0 ∂t 2 ∂S ∂S (1.2) The equation (1.2) is a partial differential equation for the value function V (S, t) of options. This equation may serve as symbol of the market model. But what are the assumptions leading to the Black-Scholes equation? Assumptions 1.2 (model of the market) (a) The market is frictionless. This means that there are no transaction costs (fees or taxes), the interest rates for borrowing and lending money are equal, all parties have immediate access to any information, and all securities and credits are available at any time and in any size. Consequently, all variables are perfectly divisible —that is, may take any real number. Further, individual trading will not influence the price. (b) There are no arbitrage opportunities.


pages: 379 words: 113,656

Six Degrees: The Science of a Connected Age by Duncan J. Watts

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Berlin Wall, Bretton Woods, business process, corporate governance, Drosophila, Erdős number, experimental subject, Frank Gehry, Geoffrey West, Santa Fe Institute, invisible hand, Long Term Capital Management, market bubble, Milgram experiment, Murray Gell-Mann, Network effects, new economy, Norbert Wiener, Paul Erdős, rolodex, Ronald Coase, Silicon Valley, supply-chain management, The Nature of the Firm, The Wealth of Nations by Adam Smith, Toyota Production System, transaction costs, transcontinental railway, Y2K

The second Toyota paradox: How delaying decisions can make better cars faster. Sloan Management Review, 36(3), 43–51 (1995). Markets and Hierarchies The original text—and still one of the greatest—on industrial organization is Smith, A. The Wealth of Nations (University of Chicago Press, Chicago, 1976). A precursor to Coase’s theory of transaction costs was Frank Knight’s claim that firms exist to reduce uncertainty: Knight, F. H. Risk, Uncertainty, and Profit (London School of Economics and Political Science, London, 1933). And Ronald Coase’s original argument of transaction costs as the basis for the firm is explicated in Coase, R. The nature of the firm. Economica, n.s., 4 (November 1937). Several decades later, Coase is still trying to get his ideas accepted by mainstream economics. His latest attempt is Coase, R. The Nature of the Firm (Oxford University Press, Oxford, 1991).

Nevertheless, because many firms after the Industrial Revolution were actually organized in just this way, the consensus of economic theory for much of the last century has been that the optimal form of industrial organization, and, by association, the internal architecture of a business firm, is a hierarchy. To cut a (very) long story short, the most generally agreed-upon economic theory of industrial organization essentially divides the world between hierarchies and markets. Firms, it claims, exist because markets in the real world suffer from a set of imperfections that the Nobel Prize–winning economist Ronald Coase called transaction costs. If everyone could discover, draw up, and enforce market-based contracts with everyone else (if we could all be independent contractors, for example), then the immense flexibility of market forces would effectively eliminate the need for firms entirely. But in the real world, as we have already seen in a number of contexts, information is costly to discover and hard to process. Furthermore, any agreement between two parties, even if it seems like a good idea at the time, is subject to uncertainty about future conditions and unexpected eventualities.

Inside a firm, in other words, markets cease to operate, and the skills, resources, and time of its employees are coordinated through a strict authority structure. Although Coase himself never specified what this authority structure should look like, the consensus of subsequent economic theory is that it should be a hierarchy. Markets, meanwhile, continue to operate between firms, where the boundary between firm and market is a trade-off between the coordination cost of conducting a particular function within the firm and the transaction cost of striking an external contract. If the relationship between two firms ever becomes so specialized that one is effectively in a position to manipulate the other, the problem is assumed to be resolved by a merger or an acquisition. Hence, firms grow by the process of vertical integration: one hierarchy effectively gets absorbed into another, generating a larger, vertically integrated hierarchy.

Frugal Innovation: How to Do Better With Less by Jaideep Prabhu Navi Radjou

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3D printing, additive manufacturing, Affordable Care Act / Obamacare, Airbnb, Albert Einstein, barriers to entry, Baxter: Rethink Robotics, Bretton Woods, business climate, business process, call centre, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, cloud computing, collaborative consumption, collaborative economy, connected car, corporate social responsibility, crowdsourcing, Elon Musk, financial innovation, global supply chain, income inequality, industrial robot, Internet of things, job satisfaction, Khan Academy, Kickstarter, late fees, Lean Startup, low cost carrier, M-Pesa, Mahatma Gandhi, megacity, minimum viable product, more computing power than Apollo, new economy, payday loans, peer-to-peer lending, Peter H. Diamandis: Planetary Resources, precision agriculture, race to the bottom, reshoring, ride hailing / ride sharing, risk tolerance, Ronald Coase, self-driving car, shareholder value, sharing economy, Silicon Valley, Silicon Valley startup, six sigma, smart grid, smart meter, software as a service, Steve Jobs, supply-chain management, TaskRabbit, The Fortune at the Bottom of the Pyramid, The Nature of the Firm, transaction costs, unbanked and underbanked, underbanked, women in the workforce, X Prize, yield management, Zipcar

This bottom-up approach is creating the horizontal economy. In a 1937 essay, Ronald Coase, a Nobel Prize-winning economist, argued that the reason Western economies are organised vertically – like a pyramid with a few large producers at the top and millions of passive consumers at the bottom – is because of transaction costs (the intangible costs associated with search, bargaining, decision-making and enforcement).5 But with the explosion of the internet, mobile technologies and social media – think of the 1.3 billion interconnected Facebook users – these transaction costs have all but disappeared in many sectors. This has allowed a horizontal economy to emerge in the US, western Europe and Japan. The foundations of a new, self-sustaining commercial system are now being laid. The building blocks of the horizontal economy include the following.

Together, they reduced carbon emissions by 42 million tonnes and redirected 48 million tonnes of waste from landfills for reuse, reducing costs or generating income of more than £3 billion. The NISP has helped Michelin, a tyre manufacturer, reduce its landfill waste by 97% within just 3 years, 18 months ahead of schedule. It estimates that every tonne of carbon dioxide saved costs members merely around $1. This is a far more cost-effective approach than, say, carbon trading, with its high transaction cost. The OECD declared the NISP to be a game-changer in waste management. Its model is being replicated in 20 countries worldwide. Sharing waste is only half the story Companies can also share underused assets and resources. FLOOW2 is a business-to-business marketplace that enables companies to share and exchange under-utilised equipment, services, skills and knowledge. By tightly integrating their supply chains, companies can keep their fixed assets fully utilised and also save on costly raw materials and energy.

Index 3D printers 18, 47–9, 50, 128, 132, 134, 152, 166 3D printing 9, 47–9, 50, 51, 52, 132, 151–2, 206 4D revolution 53–4 A Accor 172–6 Accountable Care Solutions 211 Active Health Management 211 adaptability 90, 154 additive manufacturing 47–9 ADEO Group 127, 128 advertising 24, 61–3, 71–2 aerosols 95, 96 Aetna 32, 208–13, 213, 215 Affinnova 31, 141 affordability 3, 82, 136, 153, 161, 172, 194, 216 in emerging markets 4, 56, 120, 198, 206 health-care innovations 202–3 and quality 1, 3, 9, 12, 75, 120–1, 198, 206 affordances 120–1 Africa 40, 56, 146, 161, 164, 197 financial services 198, 201 IBM in 200–2 innovation potential 200–2 as market 12, 169, 197–8, 199 ageing populations 109, 194 ageing workforce 13, 29, 49, 153 agility 26, 41, 69, 75, 143, 169–70 in innovation 21, 27, 33–4, 42–3, 72, 154, 167, 173, 176, 206 in manufacturing 44–5, 49, 52 Akerman, Dave 136 Air Liquide 205–7 air pollution 74, 78, 187, 200 Airbnb 10, 17, 85, 136, 140, 163, 173, 175 aircraft 68, 149 parts 48–9, 49, 121, 151–2 airlines 60, 121 Alteryx 32 Amazon 46, 60–1, 150 Amelio, Gil 68–9 AmEx (American Express) 161–2, 167, 215 Amgen 45 Anderson, Chris 18 Android operating system 130, 172 AOL 42 Apple 17, 24, 68–9, 71, 99, 150, 155, 172 Apple TV 62 apps 99, 106, 107, 108, 111–12, 124–5, 148 Arduino 135 Ariely, Dan 132 Arla Foods 37 artists 88, 93 ASDA 158–9, 159 Asia 161, 164, 200 aspirations 88–9, 119–20, 198 assets digitising 65–6 flexing see flexing assets reusing 92–3 sharing 159–61, 167 AT&T 21 ATMI 88 Auchan 13, 126, 128, 215 austerity 5, 6–7, 23 Australia 5, 62, 146, 200 Autodesk 48, 92, 132, 196–7 Automatic 131 automation 49–50 Avon 146 AXA 116 Ayed, Anne-Christine 75, 76 B B Corps (Benefit Corporations) 82 B2B (business-to-business) sectors 25–6, 34, 57, 142, 161, 175, 212 B2C (business-to-consumer) companies 25, 34, 212 Badrinath, Vivek 174 BAE Systems 48–9 Ban, Shigeru 93 Bangladesh 66 Bank of America 155 banking services 13, 17, 57, 161–2, 198 see also financial services Banner Health Network 210 Banzi, Massimo 135 Barber, Michael 181 Barclays 100, 115, 117, 215 Barry, Mike 183–4, 187 Bayer 66–7 Bazin, Sébastien 173 BBVA 125 Béhar, Yves 110 Belgium 103 Benefit Corporations (B Corps) 82 Benelux countries 7, 103 Benetton 67 Benoît, Paul 89 Berg 89 Bergh, Chip 122–3 Bertolini, Mark 208–9, 212, 213, 217 BHAGs (“big, hairy audacious” goals) 90–1, 158–9, 179, 191–2 Biasiotta, Bruno 123 big data 32–3, 117, 150 big-box retailers 9, 18, 137 “bigger is better” 2, 8, 14–15, 104 biomimetics (or biomimicry) 84 Birol, Jacques 163–4 BlaBlaCar 10, 85, 163 Blanchard, David 94, 96 Bloomberg, Michael 18, 79, 133 BMI (business model innovation) 192 BMW 47, 62–3, 86 BNP Paribas 168–9 Boeing 92, 144 Bolland, Marc 180–1, 186 Bontha, Ven 59 Booz & Company (now Strategy&) 6, 22, 23, 28, 171 Bosch 156 Boston Consulting Group 55, 64, 116, 145, 217 Botsman, Rachel 10 bottom-of-pyramid (BOP) customers 161, 203, 207 Bouygues Immobilier 90 BP 169 BPS (by-product synergy) 159 Brabeck-Letmathe, Peter 44, 78 brand ambassadors 143, 145 brand loyalty 46, 100, 204, 215 branding 15, 108, 119–20, 156 brands 1, 71, 139, 141, 143, 154, 165–6, 215 “conversations” with 129, 131–2 working together 154, 156–7 Braungart, Michael 82 Brazil 40, 74, 102, 146, 188, 199 emerging market 4, 12, 38, 146, 197, 199 Bretton Woods Conference (1944) 104 Brin, Sergey 63 BringBee 85 Bross, Matt 37–8, 171 Brown, Tim 121 Brusson, Nicolas 163 BT 37–8, 171 BTG (British Technology Group) 171 budgeting, personal 124–5 budgets 6–7, 36, 42 Buffett, Warren 138 buildings 196–7 bureaucracy 36, 63–4, 65, 70, 165, 169, 173, 182 business, primary purpose of 14 business model innovation (BMI) 192 business models 2, 34, 38, 80, 118, 205, 216, 217 changing 190–3, 213 business opportunities 36, 188–9, 190 business process re-engineering 192 business strategy 34 business-to-business see B2B business-to-consumer see B2C by-product synergy (BPS) 159 C C2C (cradle-to-cradle) design 75, 77, 82, 84, 97 Cacciotti, Jerry 22, 23 CAD (computer-aided design) 47, 65, 132, 165 California 79, 99 Calmes, Stéphane 127, 128 Camp, Garrett 163 Canada 5, 102 cannibalisation conundrum 15, 117–18 capital costs 45 car insurance 116 car sharing 10, 17, 85, 86, 108, 123, 163 car-related services 62–3, 116 Caravan Shop 89 carbon emissions 102, 103, 196 reducing 78–9, 106–7, 159, 160, 174 stabilising 184, 186 carbon footprint 94, 100, 102, 156, 184, 186 Carrefour 121–2, 157, 174 cars 89, 92, 116, 119–20, 144, 155, 156 electric 47, 86, 172 emissions 47, 106–7 fuel consumption 47, 106–7 fuel efficiency 8, 12, 24, 47, 78, 131, 197 low-cost 2–4 personalisation 129–30 related services 62–3 standards for 78–9 see also BMW; Ford; Nissan; Renault; Tesla; Toyota Caterpillar 31, 55 CellScope 110 Cemex 59 centralisation 9, 44, 51 CEOs 34, 40, 168, 203–5, 204 certification, sustainability 84 Chaparral Steel 159 chemical industry 33, 58, 66–7 chemical usage, reducing 79 Cheshire, Ian 185–6 Chesky, Brian 163 Chevron 170 China 44, 83, 102, 144, 213, 216 air pollution 187, 200 emerging market 4, 38, 169, 197, 205 innovation in 169, 200 mobile phones 198 R&D 40, 188, 206 selling into 187–8 shifting production from 55, 56 Christchurch (New Zealand) 93 Chrysler 166 circular economy 9, 76–7, 80–4, 159–60, 195–6 “Circular Economy 100” 76–7, 86 circular supply chains 193 Cisco 17, 29, 65, 110 CISL (University of Cambridge Institute for Sustainability Leadership) 158–9 cities 107, 153 Citigroup 161 climate change 8, 100 closed-loop products 86, 91, 185, 192–3 cloud computing 60, 61, 157, 169 CMF-A car platform 4–5, 198–9 CNC (computer numerical control) cutters 128, 134, 152 co-branding 143 co-creation 126–9, 202–3, 206–7 see also collaboration; horizontal economy; prosumers co-distribution 143 co-marketing 143 co-operation 64–5, 69, 70–1 co-opetition 158–9 Coase, Ronald 133 Coca-Cola 57, 62, 142, 154 “cold chains” 57 CoLearnr 114 Collaborating Centre on Sustainable Consumption and Production (CSCP) 193–4 collaboration 76, 114, 138–9, 176, 211, 217–18 cross-functional 36–8, 39, 71–2 see also hyper-collaboration; TechShop collaborative consumption see sharing economy collaborative manufacturing 50–1 collective buying platforms 137 Commonwealth Fund 110 communities of customers 129, 131, 132–3 local 52, 57, 146, 206–7 commuting 131 competition 22, 27, 102, 189 competitive advantage 15–16, 80, 195 competitors 19, 26, 148, 149–50, 172, 215 emerging markets 16, 205–6, 216 engaging 158–9, 167 frugal 16–18, 26, 216 complexity 24, 64 components 3, 67 computer numerical control see CNC computer-aided design (CAD) 47, 65, 132, 165 Comstock, Beth 40–1, 149, 150, 151, 170 concentration 96 Concept Lab 211 concept testing 25, 31, 72, 191 Cone, Carol 7 congestion 108, 201 constraints 4–5, 22, 34, 36, 42, 207, 217 consumer behaviour 3, 6, 97, 98–101 shaping xix, 99–101, 105–9, 125 Consumer Empowerment Index 103 consumer spending 103 consumers 8, 27, 37, 97, 105 developed-world 2, 7, 9, 102 dissatisfaction 130–1 empowerment 22, 105, 106 environmental awareness 101–2, 105 frugal 197–200 of the future 193–4 innovative ideas from 50–1 with particular needs 194–5 power 102–4, 139 social experience 139 and sustainability 95, 97, 101–4 trust of 143 young 16, 85, 86, 122, 124, 131 see also customers; prosumers consumption 85, 101–6, 115, 124, 193 continuous processing 44–5, 47, 50 Cook, Scott 19 core, focusing on 68–9 Cornillon, Paul 37 Corporate Home Exchange 175 corporate leaders 122–4, 180–1, 203–5 corporate social responsibility see CSR Cortese, Amy 138 cost effectiveness 12, 34, 149, 164, 172, 188, 190, 191 consumer energy use 53 customisation 67 health care 202 innovation 21, 173 micro-factories 52 Costco 18 costs 3D printers 48 capital costs 45 development costs 22, 36 distribution costs 54, 55, 96 electricity generation 104 energy costs 161, 190 environmental costs 11 fuel costs 121 of good-enough approach 27 health-care costs 13, 109 innovation costs 168, 171 inventory costs 54 life-cycle costs 12, 24, 196 maintenance costs 48–9, 66 manufacturing costs 47, 48, 52 operating costs 45, 215 production costs 9, 83 raw materials 153, 161, 190 reducing 11, 46, 47, 60, 84, 89, 160, 167, 200 resource costs 78, 203 shipping costs 55, 59 supply chain 58, 84 transaction costs 133 wage costs 48 Coughlin, Bill 167 Coursera 61, 112 Coye, Molly 202 cradle-to-cradle see C2C design creativity 88, 94, 128, 130, 135, 163–4, 199 in organisations 63–4, 70, 71 credit culture 115–16 CRM (customer relationship management) systems 59, 157 cross-functional collaboration 36–8, 39, 71–2 crowdfunding 17, 48, 132, 137–9, 152 crowdsourcing 28–9, 50–1, 126, 140, 143, 152, 202 platforms 142, 150–1, 151, 152 CSCP (Collaborating Centre on Sustainable Consumption and Production) 193–4 CSR (corporate social responsibility) 77, 82, 94, 161 culture, organisational see organisational culture “culture of simplification” 170 curiosity 153–4 customer behaviour see consumer behaviour customer experience, enhancing 75 customer feedback 31–2, 33, 72, 152, 170, 192 customer immersion labs 31–2 customer loyalty 28, 68, 77, 80, 124, 129, 131–2, 215 customer needs 37, 58, 90, 139–40, 170, 192, 206 changing 28, 38, 51, 127, 150, 168, 205 diversity 38, 46, 51 R&D disconnect from 26, 38 customer preferences 58, 67, 75 customer relationship management see CRM customer satisfaction 65, 128, 130–1 customer service 25–6, 127–8, 147 customer visits 18, 20, 128 customers 19, 27, 46, 76, 148, 205 alienating 24–6 behaviour see consumer behaviour bottom-of-pyramid 12–13, 161, 203, 207 communities of 129, 131, 132–3 cost-conscious 3, 6, 7, 22, 26, 156, 189, 215 dreams 140–1 eco-awareness 22, 26, 54, 75, 78, 93, 156, 195–6, 215 in emerging markets 200 engaging with 20–1, 24–6, 27–33, 34, 35, 38–9, 42–3, 115, 128, 170 as experts 146 focus on 19–21, 43, 62, 157–8, 204 goodwill of 84 motivation for change 117 multiple roles 143–6 needs see customer needs outsourcing to 143 participation 128–9 profligate 115–16 R&D and 27–8, 31–2, 38, 43 rewards for 147–8 shared 156–8 used to motivate employees 205–7 young 16, 85, 86, 122, 124, 131 see also consumers; prosumers customisation 9, 46, 47, 48, 51–2, 57–8, 67, 72 CVS Health 7 D D2D Fund 162 Dacia 2–4, 156, 179 Dannon 141 Danone 66, 141, 184, 186 Darchis, François 205–6, 207 DARPA (Defence Advanced Research Projects Agency) 49 Darukhanavala, P.P.

Mathematical Finance: Core Theory, Problems and Statistical Algorithms by Nikolai Dokuchaev

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Black-Scholes formula, Brownian motion, buy low sell high, discrete time, fixed income, implied volatility, incomplete markets, martingale, random walk, short selling, stochastic process, stochastic volatility, transaction costs, volatility smile, Wiener process, zero-coupon bond

Let the initial wealth be X0=1. Let a self-financing strategy be such that the number of stock shares at the initial time be γ0=1/2. Find γ1, X1, X2, βi, i=0, 1, 2 for the constantly rebalanced portfolio. Solve Problems 3.11 and 3.12. Problem 3.63 (Make your own model). Introduce a reasonable version of the discrete time market model that takes into account transaction costs (a brokerage fee), and derive the equation for the wealth evolution for self-financing strategy here. (Hint: transaction costs may be per transaction, or may be proportional to the size of transaction or may be of a mixed type.) Discrete time market: arbitrage and completeness Solve Problem 3.29. Problem 3.64 Prove that an equivalent risk-neutral probability measure does not exist for Problem 3.29. Problem 3.65 Let a market model be such that ρt≡ρ, where ρ is non-random and such that given, {ξt} are independent, and let there exist for all t.

Definition 3.2 We say that the strategy is self-financing if Xt+1−Xt=γt(St+1−St), t=0, 1,…. (3.2) It follows from (3.2) that (3.3) Here X0>0 is the initial wealth at time t=0. For example, for the trivial risk-free strategy, when γt≡0, the corresponding total wealth is Xt≡X0. © 2007 Nikolai Dokuchaev Discrete Time Market Models 25 Note that these definitions present a simplification of the real market situation, because transaction costs, bid and ask gap, possible taxes and dividends, interest rate for borrowing, etc., are not taken into account. 3.3 A discrete time bond-stock market model A more realistic model of the market with non-zero interest rate for borrowing can be described via the following bond—stock model. We introduce a model of a market, consisting of the risk-free bond or bank account with price Bt and the risky stock with the price St, t=0, 1, 2,….

For instance, as far as we know, there are no examples of complete discrete time markets with N>1. Some special effects can be found for N→+∞ (such as strategies that converge to arbitrage). Note also that the most widely used results in practice for optimal portfolio selection are obtained for the case of single-period multi-stock markets, i.e., with T=1 and N>1 (Markowitz mean-variance setting). • Transaction costs (brokerage fees), bid-ask gap, gap between lending and borrowing rate, taxes, and dividends, can be included in the condition of self-investment. • Additional constraint can be imposed on the admissible strategies (for instance, we can consider only strategies without short positions, i.e., with γt≥0). • In fact, we addressed only the so-called ‘small investor’ setting, when the stock prices are not affected by any strategy.


pages: 130 words: 11,880

Optimization Methods in Finance by Gerard Cornuejols, Reha Tutuncu

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asset allocation, call centre, constrained optimization, correlation coefficient, diversification, finite state, fixed income, frictionless, frictionless market, index fund, linear programming, Long Term Capital Management, passive investing, Sharpe ratio, transaction costs, value at risk, Y2K

This is not a restrictive assumption either–we can always reformulate the problem in this way via a change of numeraire. We assume that proportional transaction costs are paid on asset purchases and sales and denote them with αil and βil for sales and purchases, respectively, for asset i and period l. We assume that αil ’s and βil ’s are all known at the beginning of period 0, although they can vary from period to period and from asset to asset. Transaction costs are paid from the investor’s cash account and therefore, we have the following balance equation for the cash account: xl0 = xl−1 + 0 n X (1 − αi )Pil sli − i=1 n X (1 + βi )Pil bli , l = 1, . . . , L. i=1 This balance condition indicates that the cash available at the beginning of period l is the sum of last period’s cash holdings and the proceeds from sales (discounted by transaction costs) minus the cost of new purchases. For technical reasons, we will replace the equation above with an inequality, effectively allowing the investor “burn” some of her cash if she wishes to: xl0 ≤ xl−1 + 0 n X (1 − αi )Pil sli − i=1 n X (1 + βi )Pil bli , l = 1, . . . , L.

In [1], Bawa, Brown, and Klein argue that using estimates of the unknown expected returns and covariances leads to an estimation risk in portfolio choice, and that methods for optimal selection of portfolios must take this risk into account. Furthermore, the optimal solution is sensitive to perturbations in these input parameters—a small change in the estimate of the return or the variance may lead to a large change in the corresponding solution, see, for example, [8, 9]. This attribute is unfavorable since the modeler may want to periodically rebalance the portfolio based on new data and may incur significant transaction costs to do so. Furthermore, using point estimates of the expected return and covariance parameters do not respond to the needs of a conservative investor who does not necessarily trust these estimates and would be more comfortable choosing a portfolio that will perform well under a number of different scenarios. Of course, such an investor cannot expect to get better performance on some of the more likely scenarios, but will have insurance for more extreme cases.


pages: 580 words: 168,476

The Price of Inequality: How Today's Divided Society Endangers Our Future by Joseph E. Stiglitz

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affirmative action, Affordable Care Act / Obamacare, airline deregulation, Andrei Shleifer, banking crisis, barriers to entry, Basel III, battle of ideas, Berlin Wall, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collapse of Lehman Brothers, collective bargaining, colonial rule, corporate governance, Credit Default Swap, Daniel Kahneman / Amos Tversky, Dava Sobel, declining real wages, deskilling, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, Flash crash, framing effect, full employment, George Akerlof, Gini coefficient, income inequality, income per capita, indoor plumbing, inflation targeting, invisible hand, John Harrison: Longitude, John Maynard Keynes: Economic Possibilities for our Grandchildren, Kenneth Rogoff, labour market flexibility, London Interbank Offered Rate, lone genius, low skilled workers, Mark Zuckerberg, market bubble, market fundamentalism, medical bankruptcy, microcredit, moral hazard, mortgage tax deduction, obamacare, offshore financial centre, paper trading, patent troll, payday loans, price stability, profit maximization, profit motive, purchasing power parity, race to the bottom, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, Simon Kuznets, spectrum auction, Steve Jobs, technology bubble, The Chicago School, The Fortune at the Bottom of the Pyramid, The Myth of the Rational Market, The Spirit Level, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transaction costs, trickle-down economics, ultimatum game, uranium enrichment, very high income, We are the 99%, women in the workforce

For if they had succeeded, America’s elderly would have been in an even worse position than they are today: those who had put their money in the stock market would have seen much of their retirement wealth gone; those who put their money in safe T-bills would be struggling to survive, as the Fed pushes interest rates down to near-zero levels. But even before the crisis, it should have been obvious that privatization was a bad deal for most Americans. We noted before that Social Security is more efficient than private providers of annuities. Private insurance companies have much higher transactions costs. In fact, that was the whole point of privatization: for the elderly, transactions costs are a bad thing; but for the financial sector, they are a good thing. That’s their income. That’s what they live off of. Their hope was to get a slice of the hundreds of billions of dollars65 that people put every year into their Social Security accounts.66 Liberalization/deregulation initiatives have had as mixed a record as those of privatization—with the most notorious being financial sector deregulation and capital market liberalization.

One role of government is to rebalance the scales of justice—and in the case of the BP disaster, it did, but very gently, and in the end, it became clear that many of the victims were likely to receive compensation that was but a fraction of what they suffered.4 Ronald Coase, a Chicago Nobel Prize–winning economist, explained how different ways of assigning property rights were equally efficient for addressing externalities, or at least would be in a hypothetical world with no transactions costs.5 In a room with smokers and nonsmokers, one could assign the “air rights” to the smokers, and if the nonsmokers valued clean air more than the smokers valued smoking, they could bribe the smokers not to smoke. But one could alternatively assign the air rights to the nonsmokers. In that case, smokers could bribe the nonsmokers to allow them to smoke so long as they valued the right to smoke more than the nonsmokers valued clean air. In a world of transactions costs—the real world, where, for instance, it costs money to collect money from one group to pay another—one assignment can be much more efficient than the other.6 But more to the point, there can be large distributive consequences of alternative assignments.

Now it’s blaming these programs for the country’s fiscal difficulties. In its most hopeful scenarios, the Right would privatize both services. Privatization, of course, is based on yet another myth: that government-run programs must be inefficient, and privatization accordingly must be better. In fact, as we noted in chapter 6, the transaction costs of Social Security and Medicare are much, much lower than those of private-sector firms providing comparable services. This should not come as a surprise. The objective of the private sector is to make profits—for private companies, transactions costs are a good thing; the difference between what they take in and what they pay out is what they want to maximize.31 The gap between revenues and expenditures for public programs does create problems over the long run. In the case of Social Security, the gap is probably relatively small, with a high degree of uncertainty.


pages: 467 words: 154,960

Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael W. Covel

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Albert Einstein, asset allocation, Atul Gawande, backtesting, Bernie Madoff, Black Swan, buy low sell high, capital asset pricing model, Clayton Christensen, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, fiat currency, fixed income, game design, hindsight bias, housing crisis, index fund, Isaac Newton, John Nash: game theory, linear programming, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, mental accounting, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Renaissance Technologies, Richard Feynman, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, systematic trading, the scientific method, Thomas L Friedman, too big to fail, transaction costs, upwardly mobile, value at risk, Vanguard fund, volatility arbitrage, William of Occam

Trading gamma rays, at around one cycle per 10–20 seconds, requires a lot of expensive instrumentation, whereas you can trade visible light ‘by eye.’ I don’t know of even one short-term trader, however, who claims to show a profit at these frequencies. In general, higher-frequency trading succumbs to declining profit potential against nondeclining transaction costs. You might consider trading a chart with a long enough time scale that transaction costs are a minor factor— something like a daily price chart, going back a year or two.” 375 C He’s barely rated a mention in the nation’s most important newspapers, but pay close attention to what Institutional Investor wrote about him… “Jim Simons [president of Renaissance Technologies and operator of the Medallion Fund] may very well be the best money manager on earth.”

The real question is: Do they make more money than they would investing in a blind index fund that mimics the performance of the market as a whole? Most academic financial experts believe in some form of the random-walk theory and consider technical analysis almost indistinguishable from a pseudoscience whose predictions are either worthless or, at best, so barely discernibly better than chance as to be unexploitable because of transaction costs.”12 Markets aren’t chaotic, just as the seasons follow a series of predictable trends, so does price action. Stocks are like everything else in the world: They move in trends, and trends tend to persist. Jonathan Hoenig Portfolio Manager, Capitalistpig Hedge Fund LLC This is the view of technical analysis held by most people who know of technical analysis—that it is some form of mysterious chart reading technique, such as astrology.

Ed Seykota takes Odean’s thought a step further in poking holes in fundamental analysis:4 “While fundamental analysis may help you understand how things work, it does not tell you when, or how much. Also, by the time a fundamental case presents, the move may already be over. Just around the recent high in the Live Cattle market, the fundamental reasons included Chinese Buying, Mad Cow Disease, and The Atkins’ Diet.”5 Trend followers control what they know they can control. They know they can choose a certain level of risk. They know they can measure volatility. They understand the transaction costs associated with trading. However, there is still plenty they know they do not know, so in the face of uncertainty, what do they do? They swing the bat. Their ability to decide is core to their trading philosophy—that is their swinging the bat. Their decision-making skills might seem not worthy of much discussion, but the philosophical framework of their decision making is critical to understanding how they trade successfully.


pages: 607 words: 133,452

Against Intellectual Monopoly by Michele Boldrin, David K. Levine

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accounting loophole / creative accounting, agricultural Revolution, barriers to entry, cognitive bias, David Ricardo: comparative advantage, Dean Kamen, Donald Trump, double entry bookkeeping, en.wikipedia.org, Ernest Rutherford, experimental economics, financial innovation, informal economy, interchangeable parts, invention of radio, invention of the printing press, invisible hand, James Watt: steam engine, Jean Tirole, John Harrison: Longitude, Joseph Schumpeter, linear programming, market bubble, market design, mutually assured destruction, Nash equilibrium, new economy, open economy, pirate software, placebo effect, price discrimination, profit maximization, rent-seeking, Richard Stallman, Silicon Valley, Skype, slashdot, software patent, the market place, total factor productivity, trade liberalization, transaction costs, Y2K

Selling our labor is not tantamount to selling our house, which is why even renting it – that is, becoming an employee – is quite complicated and subject to a variety of regulations and transaction costs. The transaction costs implied by slavery are socially damaging, as they imply violation of privacy and of essential civil liberties. Hence, they are commonly rejected on economic, not just moral, grounds. Moreover, there is no economic reason to allow slavery. With well-functioning markets, renting labor is a good substitute for owning it. And so we allow the rental of labor but not its permanent sale. For intellectual property, the reverse is the socially beneficial arrangement: allow the permanent sale but ban the rental. Again, this is efficient because it minimizes transaction costs. For, with intellectual property, possession belongs to the buyer and not to the seller. If you sell me a copy of an idea, I now have that idea embodied either in me or in an object I own.

If you and I, as owners of bakeries, get together and sign a contract agreeing to limit the number of loaves of bread we will sell, P1: PDX head margin: 1/2 gutter margin: 7/8 CUUS245-10 cuus245 978 0 521 87928 6 May 8, 2008 14:11 254 Against Intellectual Monopoly not only will the courts not enforce that contract, but we will be subject to criminal prosecution as well. The same is true if the same contract is entered into by a bakery and, say, a client restaurant or even a private citizen. Second, economists recognize the important element of transaction costs in determining which contracts should be enforced. “Possession is nine-tenths of the law” is a truth in economics as well as in common parlance. Take the case of slavery. Why should people not be allowed to sign private contracts binding them to slavery? In fact economists have consistently argued against slavery – during the nineteenth century David Ricardo and John Stuart Mill engaged in a heated public debate with literary luminaries such as Charles Dickens, with the economists opposing slavery and the literary giants arguing in favor.28 The fact is that our labor cannot be separated from ourselves.

Without government grants of monopoly or enforcement of monopolistic contracts, innovators by virtue of their first-mover advantage will generally have some monopoly power. There are government policies that can be used to combat even this ephemeral monopoly. For example, at the lesser end, trade secrecy, digital rights management, and encryption could be eliminated by a law requiring the publication of detailed information about an innovation as a condition of doing business. Of course, the transaction costs are probably large, as the definition of innovation would suddenly become blurred, and legal challenges could be mounted with relative ease. Nevertheless, the idea is certainly practical. For example, to sell computer software, the seller would be required to make available the source code; to sell a drug, the manufacturer would have to publish the chemical formula. This latter example may convince you that, along certain dimensions, such a proposal is scarcely radical – to sell a drug now, the chemical formula must be published – pharmaceutical companies are not allowed trade secrecy over their products.


pages: 879 words: 233,093

The Empathic Civilization: The Race to Global Consciousness in a World in Crisis by Jeremy Rifkin

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agricultural Revolution, Albert Einstein, back-to-the-land, British Empire, carbon footprint, collaborative economy, death of newspapers, delayed gratification, distributed generation, en.wikipedia.org, energy security, feminist movement, global village, hydrogen economy, illegal immigration, income inequality, income per capita, interchangeable parts, Internet Archive, invention of movable type, invention of the steam engine, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, labour mobility, Mahatma Gandhi, Marshall McLuhan, means of production, megacity, meta analysis, meta-analysis, Milgram experiment, new economy, New Urbanism, Norbert Wiener, out of africa, Peace of Westphalia, peak oil, planetary scale, Simon Kuznets, Skype, smart grid, smart meter, supply-chain management, surplus humans, the medium is the message, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, transaction costs, upwardly mobile, uranium enrichment, working poor, World Values Survey

In pure networks, providers and users replace sellers and buyers, and access to the use of goods in extended time segments substitutes for the physical exchange of the goods. Transaction costs and margins also come into play in the shift from market-exchange models to network models. In a market exchange economy, sellers make profit on their margins, and margins are dependent on transaction costs. But in most industries, margins are continuing to go down, mainly because of the introduction of new information, communications, and production technologies and new energy-saving technologies, as well as new methods of organization that are reducing their transaction costs. When transaction costs approach zero, margins virtually disappear, and market exchanges are no longer viable ways of conducting business. Book publishing is a case in point.

At each stage of the process, the seller is marking up the cost to the buyer to reflect his or her transaction costs. Now an increasing number of publishers—especially of textbooks and research books, which require continuous updating—are bypassing all of the intermediate steps in publishing a physical book and the transaction costs involved at each stage of the process. While Encyclopaedia Britannica still charges $1,395 for its thirty-two-volume set of books, the company sells far fewer physical books. Instead, the company puts the book contents on the World Wide Web, where information can be updated and accessed continuously. Users now pay a subscription fee to access the information over an extended period of time. Encyclopaedia Britannica eliminates virtually all of the remaining transaction costs of getting the information to its subscribers.

Creating a shared identity was also essential to making viable an unobstructed national market. Before there was an England, France, Germany, and Italy, what existed was a thousand different stories and traditions being lived out in little hamlets, nestled in valleys and on mountainsides across the continent. Each story was passed on in a separate language or at least in a distinct dialect. A myriad of local languages, customs, and regulations for conducting commerce kept the transaction costs high for producing and trading goods and services over a wide geographic terrain. Suppressing or even eliminating pockets of cultural diversity was an essential step in creating an efficient and seamless national market. Creating a single homogenized national myth required the often ruthless destruction or subordination of all the local stories and traditions that existed for centuries of European history.


pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

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Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, Bretton Woods, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, New Journalism, oil shock, p-value, passive investing, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, systematic trading, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond

Small-growth stocks—the proverbial lottery tickets—had the lowest average returns. Table 3.1 shows that, on paper, momentum strategies fared even better than value, and short-term reversal strategies did even better. It is no coincidence that we find the highest gross returns in small-cap stocks and in high-turnover strategies such as short-term reversal and medium-term momentum. Recall that the numbers here exclude transaction costs, which would be substantial for these strategies. Incorporating trading costs would eat seriously into these paper gains. Ghayur et al. (2010) estimate that—net of costs—value and momentum strategies earned similar long-run returns. Others estimate that the double-digit gross returns of the short-term reversal strategy would have been negative after costs. For evidence on the long-run stability of these relations, Figure 3.5 plots decade average returns over time.

The capital asset pricing model (CAPM), originated by Sharpe, Lintner, Mossin, and Treynor, was the profession’s first answer and, for a long time, the principal one [1]. The CAPM can be based on various sets of assumptions. I will not derive it formally here but show one traditional set of assumptions (that can later be relaxed):• one-period world (this implies a constant investment opportunity set and constant risk premia over time); • access to unlimited riskless borrowing/lending and tradable risky assets; • no taxes or transaction costs (i.e., frictionless markets); • investors are rational mean variance optimizers (only caring about means and covariances can be motivated by normally distributed asset returns or by a quadratic utility function); and • investors have homogeneous expectations (all agree about asset means and covariances; all investors see the same picture). These assumptions ensure that every investor holds the same portfolio of risky assets, combining it with some amount, positive or negative, of the riskless asset (this latter amount depends on the specific risk aversion of a given investor).

End-customers assess an arbitrageur’s ability by studying performance track records; and widening mispricing normally implies deteriorating performance for the arbitrageur. To compound the arbitrageurs’ problems when they are facing losses, creditors may make margin calls if leverage is employed, stop-loss rules or risk managers can require position reductions, and vanishing liquidity may reinforce the downward spiral. All these considerations push arbitrageurs toward short time horizons and constrain their position sizes. There are also transaction costs and model uncertainty to consider. Trading costs on leveraged strategies can be significant. Barring remarkable hubris, no arbitrageur can be completely confident that his model or view is correct. One important implication for long-horizon institutional investors is that when they delegate asset management, external managers may not inherit the ultimate investor’s long horizon. Principal–agent problems shorten horizons from both sides, a phenomenon that can make the long-horizon investor lose his natural edge.


pages: 701 words: 199,010

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

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affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, labour mobility, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, mortgage debt, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

Traders quickly pick up on even proprietary factors. Their risk models are often similar, as are their transaction cost models. The optimization process traders use to create portfolios (which accounts for transaction costs) leads to professional quant portfolios that are concentrated in a few hundred similar stocks. Many of those stocks likely appear many times across many portfolios. These concentrated portfolios moved a lot in August. Hedge fund quant factors moved between 10 and 20 standard deviations from historical norms.21 Standard quant factors also moved by unusual amounts in August, two to three standard deviations from historical norms. Crowding among quants happens for several reasons, but the transaction costs model was of primary importance, as it caused us to trade similar securities at each point in time.

The hedge wasn’t a perfect one, because LTCM’s short position was on the whole index, and the basket was only a subset of Japanese stocks. So LTCM made a total return stock swap with another bank. The bank paid LTCM the return on the basket of the other stocks in the JASDAQ and LTCM paid the bank 30 basis points. The resulting trade had zero risk and essentially no profit or loss, apart from transaction costs and the 30 basis-point financing cost. Then LTCM borrowed the Japanese stocks from themselves and shorted them while also buying the associated cheap warrants. This innovative financing scheme let LTCM borrow nonborrowable stocks and take advantage of an arbitrage opportunity. They called it index art. LTCM's portfolio consisted mainly of fixed-income trades with a smaller fraction in equity-related trades.1 The firm tended to group trades into two broad themes: relative value trades and convergence trades.

This was the average for Merrill Lynch, Morgan Stanley, Goldman Sachs, Lehman Brothers, Citi, Deutsche Bank, UBS, J.P. Morgan, and Bear Stearns. 20. The calculation is simple. Suppose the loans were completed at $100, for a total of 100 $1 loans. Each house costs $1. Now suppose all housing prices drop by x% in value and p% default. Freddie is stuck with the underlying collateral: the houses of those who default. Forget any transaction costs associated with this and just focus on the portfolio’s mark-to-market value. Freddie will have losses of $100 x · p. To figure out the size of x that forces Freddie into bankruptcy, find the x such that $100 · x · p = Shareholder Equity. The critical x is given by . This is an illustrative example, using approximations. In the real world, only mortgages issued in 2006 would have dropped by the full 27%.


pages: 296 words: 87,299

Portfolios of the poor: how the world's poor live on $2 a day by Daryl Collins, Jonathan Morduch, Stuart Rutherford

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Cass Sunstein, clean water, failed state, financial innovation, financial intermediation, income per capita, informal economy, job automation, M-Pesa, mental accounting, microcredit, moral hazard, profit motive, purchasing power parity, RAND corporation, randomized controlled trial, The Fortune at the Bottom of the Pyramid, transaction costs

Or save at 4 percent per year, when another institution will give you 134 THE PRICE OF MONEY 6 percent? Economic theory places price at the absolute center of financial decision-making. The cost of financial services is important for the poor, too, but it is more difficult to understand how these services are priced. Modern rich-country providers have made huge strides in reducing “transaction costs”—the costs of using an instrument other than the financial cost of the funds used. But transaction costs for poor people usually remain high. They may include the time taken to stand in a long queue, the emotional cost of having to deal with unhelpful, stone-faced tellers, the cost of the bus ride to reach the bank, or the sheer number of lenders who must be persuaded to part with their money before a usefully large sum can be amassed. In the case of some informal transactions, there may be obligations to the lender other than repaying the loan along with interest—to work for some days at a low wage, for example.

India, for example, had 35 micro health insurance schemes running in 2006, under this partner-agent model, with nearly 900,000 policyholders.23 The diaries show us why microfinance institutions are good at the retail end of this partnership. Their regular contact with clients in their own slums and villages allows them to break up the loan repayments into more manageable pieces. The installments then become small and frequent enough to suit the cash flows of poor households (while not driving transaction costs too high). The same principles apply to collecting insurance premiums. Given all of the other elements of designing a workable insurance product, it is easy to overlook the important role of a convenient payment plan. This chapter has demonstrated the importance of payment systems for the poor households we came to know. Translating that understanding into product design is a key to launching new products for the poor.

While this structure can perhaps be viewed as a kind of distributive justice (profits are made from those with, rather than those without, the money available), it is one of the reasons why moneylenders remain restricted in scale and limited to poor and 152 THE PRICE OF MONEY high-risk markets: since they do not reward “good” clients who have capital, they are likely to attract “bad” and cash-strapped clients disproportionately. Third, most informal interest-bearing loans are troublesome to arrange, in spite of their price. So there is an additional transaction cost that is not reliably priced for every borrower or perhaps even for the same borrower over time. Poor households care about price, but they also care about convenience and flexibility and are willing to pay for those features. They are also happy to pay for reliability of the sort that Jyothi provides, and they are agreeably surprised when they find reliability combined with a relatively low price, as they do, increasingly, at microfinance institutions.


pages: 318 words: 87,570

Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street Are Destroying Investor Confidence and Your Portfolio by Sal Arnuk, Joseph Saluzzi

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algorithmic trading, automated trading system, Bernie Madoff, buttonwood tree, 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

• And if you are an agency broker, like we are, there’s a reason why some big brokerage firm salesmen offer their VWAP algo for free! It’s because their firm has a way to make money by disadvantaging your orders all day long. Our markets today are not about executing your trade and investment ideas in a way that is beneficial to you. It is about how dozens of HFT computers touch and manipulate your order so they can make money from your ideas—without you even knowing. Explicitly, your transaction costs may have come down. Your commissions have declined, and spreads have narrowed. You think you’re happy. Implicitly, you pay more for the stocks you buy or you receive less from those you sell. As a result, your assets, whether they are managed by you or by institutions, are slowly, but steadily, being whittled away. The purpose of this chapter is to explain how and why the stock market has become an insanely complex mess of for-profit exchanges and dark pools.

Or was it to fulfill grander visions of a more competitive marketplace? In a June 2000 press release, Levitt said, “As the securities markets become more global, with many stocks traded in multiple jurisdictions, the U.S. securities markets must adopt the international convention of decimal pricing to remain competitive. The overall benefits of decimal pricing are likely to be significant. Investors may benefit from lower transaction costs due to narrower spreads, and prices will be easier to understand. It is time for the U.S. securities markets to make this change.”6 No doubt Levitt was trying to tilt the playing field toward the individual investor and away from the mutual fund industry. Even though mutual funds represent the retail investor, Levitt apparently thought they had too much power. In his 2002 book, Take on the Street, he attacked the mutual fund industry on its fees and performance.

Typically, dark pool fees are lower to attract more flow. Many dark pools, however, are filled with predatory traders, who are electronically hiding out so that they can watch for institutional algo footprints, to take advantage of these orders. See Chapter 8, “Heart of Darkness,” for more about adverse selection issues with dark pools. Institutional investors may think they are lowering their transaction costs because their brokers are supplying algos at a commission rate of a fraction of a penny per share. The real cost of a trade, however, is what you don’t see. In our Instinet days, we referred to this as the transaction iceberg. Routers that have the goal to maximize economics due to the maker/taker model are a good reason why these implicit costs are so high. In a comment letter to the SEC on March 4, 2010, Morgan Stanley explained:22 The real, underlying problem that needs to be addressed is the conduct of market participants...The economic incentives that exist in the market to reduce execution costs inevitably lead to a race for cheaper execution alternatives.


pages: 385 words: 111,807

A Pelican Introduction Economics: A User's Guide by Ha-Joon Chang

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Affordable Care Act / Obamacare, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, banks create money, Berlin Wall, bilateral investment treaty, borderless world, Bretton Woods, British Empire, call centre, capital controls, central bank independence, collateralized debt obligation, colonial rule, Corn Laws, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, discovery of the americas, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, Fall of the Berlin Wall, falling living standards, financial deregulation, financial innovation, Francis Fukuyama: the end of history, Frederick Winslow Taylor, full employment, George Akerlof, Gini coefficient, global value chain, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, Haber-Bosch Process, happiness index / gross national happiness, high net worth, income inequality, income per capita, interchangeable parts, interest rate swap, inventory management, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, knowledge economy, laissez-faire capitalism, land reform, manufacturing employment, Mark Zuckerberg, market clearing, market fundamentalism, Martin Wolf, means of production, Mexican peso crisis / tequila crisis, Northern Rock, obamacare, offshore financial centre, oil shock, open borders, post-industrial society, precariat, principal–agent problem, profit maximization, profit motive, purchasing power parity, quantitative easing, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, savings glut, Scramble for Africa, shareholder value, Silicon Valley, Simon Kuznets, sovereign wealth fund, spinning jenny, structural adjustment programs, The Great Moderation, The Market for Lemons, The Spirit Level, The Wealth of Nations by Adam Smith, Thorstein Veblen, trade liberalization, transaction costs, transfer pricing, trickle-down economics, Washington Consensus, working-age population, World Values Survey

The main point of departure from the OIE was that the NIE analysed how institutions emerge out of deliberate choices by individuals.24 The key concept in the NIE is that of transaction cost. In Neoclassical economics, the only cost is the cost of production (costs of material, wages, etc.). However, the NIE emphasizes that there are also costs of organizing our economic activities. Some define transaction cost rather narrowly as the cost involved in market exchange itself – finding out about alternative products (‘shopping around’), spending time and money actually doing the shopping and sometimes bargaining for better prices. Others define it more broadly as the ‘cost of running the economic system’, which includes the cost of conducting market exchange but also the cost involved in enforcing the contract after the exchange is over. So, in this broader definition, transaction cost includes the cost of policing against thefts, running the court system and even monitoring workers in factories so that they put in the maximum possible amount of labour service specified in their contract.

Another big problem was that some members of the school went overboard in emphasizing the social nature of individuals and effectively adopted a structural determinism. Social institutions and the structure they create were everything; individuals were seen as being totally determined by the society they live in – ‘there is no such thing as an individual’, infamously declared Clarence Ayres, who dominated the (declining) Institutionalist school in the US in the early post-Second World War period. Transaction costs and institutions: the rise of the New Institutional Economics From the 1980s, a group of economists with Neoclassical and Austrian leanings – led by Douglass North, Ronald Coase and Oliver Williamson – started a new school of institutional economics, known as the New Institutional Economics (NIE).23 By calling themselves institutional economists, the New Institutionalist economists made it clear that they were not typical Neoclassical economists, who looked at only individuals but not the institutions that affect their behaviour.

So, in this broader definition, transaction cost includes the cost of policing against thefts, running the court system and even monitoring workers in factories so that they put in the maximum possible amount of labour service specified in their contract. Institutions are not just constraints: contributions and limitations of the New Institutional Economics Deploying the concept of transaction cost, the NIE has developed a wide range of interesting theories and case studies. One prominent example is the question as to why, in a supposedly ‘market’ economy, so many economic activities are conducted within firms. The (simplified) answer is that market transactions are often very costly due to the high cost of information and contract enforcement. In such cases, it would be much more efficient if things were done through hierarchical commands within the firm. Another example is the analysis of the impacts of the exact nature of property rights (the rules on what owners can do with which kinds of property) on patterns of investments, choice of production technologies, and other economic decisions.


pages: 368 words: 32,950

How the City Really Works: The Definitive Guide to Money and Investing in London's Square Mile by Alexander Davidson

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accounting loophole / creative accounting, algorithmic trading, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, Big bang: deregulation of the City of London, capital asset pricing model, central bank independence, corporate governance, Credit Default Swap, dematerialisation, discounted cash flows, diversified portfolio, double entry bookkeeping, Edward Lloyd's coffeehouse, Elliott wave, Exxon Valdez, forensic accounting, global reserve currency, high net worth, index fund, inflation targeting, interest rate derivative, interest rate swap, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Nick Leeson, North Sea oil, Northern Rock, pension reform, Piper Alpha, price stability, purchasing power parity, Real Time Gross Settlement, reserve currency, shareholder value, short selling, The Wealth of Nations by Adam Smith, transaction costs, value at risk, yield curve, zero-coupon bond

. ________________________ SHARE TRADING VENUES AND EXCHANGES 137  The London Stock Exchange perspective At the 2007 convention of the Federation of European Securities Exchanges, Clara Furse, chief executive of the LSE, said it was worth examining Project Turquoise’s claims that it would be able to significantly reduce exchange fees and that its mutual ownership structure was right and even superior. On exchange fees, Furse noted that the average cost of buying a UK equity is around £6.50 per £1,000 traded, of which the exchange fee is 4 pence, or little more than half of 1 per cent of the total transaction cost. Clearing and settlement come to 2 pence, commissions an average of 85 pence, market impact approximately 60 pence and, unique to the UK, stamp duty is £5. Even if investors avoided stamp duty by trading contracts for difference (rather than the cash equities), the fee charged by the LSE was likely to be less than 3 per cent of total transaction cost, Furse told the convention. ‘So even if were to offer our services for free this would only reduce the cost of trading to the investor by 4 pence per thousand pounds traded.’ Furse told the convention delegates that it was only seven years ago that the LSE demutualised.

It expresses this return as equal to the riskfree rate of return plus the product of the equity risk premium and the stock’s beta. The beta measures the sensitivity of a share price to movements in the general stock market. The CAPM stipulates that the market does not reward investors for taking unsystematic (company-specific) risk because it can be eliminated through diversification. The model is theoretical and is based on various assumptions, including no taxes or transaction costs. Share buyers require a higher return than debt providers to compensate for the risk, and for the fact that the company must give priority to debt repayment over paying dividends. The cost of debt, the other part of WACC, is more transparent. It is commonly estimated as the redemption yield on the company’s bonds, and interest rates on loans and overdrafts. DCF has proved itself a flexible tool in the hands of analysts wishing to create valuations sometimes out of thin air but it has lost credibility since the market crash of March 2000.The problem has been more about how DCF is used than with the underlying concept.

The premium consists of both intrinsic and time value, both of which can change constantly. These are factors used in the Black–Scholes model, which was developed in 1973 and is widely used in financial markets for valuing options. Other factors used in the model are volatility, the underlying stock price, and the risk-free rate of return. But Black–Scholes makes key assumptions that are not always tenable, including a constant risk-free interest rate, continuous trading and no transaction costs. Equity options tend to come in the standard contract size of 1,000 shares. To find the cost of an option contract, multiply the option price by 1,000. If a call option is priced at 70p, it will cost £700 per contract. The contract size may _______________________________ DERIVATIVES FOR RETAIL INVESTORS 71  vary if the underlying company is involved in a capital restructuring such as a rights issue.


pages: 300 words: 77,787

Investing Demystified: How to Invest Without Speculation and Sleepless Nights by Lars Kroijer

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Andrei Shleifer, asset allocation, asset-backed security, Bernie Madoff, bitcoin, Black Swan, BRICs, Carmen Reinhart, cleantech, compound rate of return, credit crunch, diversification, diversified portfolio, equity premium, estate planning, fixed income, high net worth, implied volatility, index fund, invisible hand, Kenneth Rogoff, market bubble, passive investing, pattern recognition, prediction markets, risk tolerance, risk/return, Robert Shiller, Robert Shiller, sovereign wealth fund, too big to fail, transaction costs, Vanguard fund, yield curve, zero-coupon bond

Using the Case-Shiller index as a proxy for residential property investments since 1890 we can compare the returns of the housing market to an investment over the same time period in short-term US government bonds (see Figure 9.1). The first thing to note is that over the past century we would have done far better investing in US government bonds than in residential property. It is of course easy to criticise analysis like this for not correctly incorporating rental income (or the ownership benefit of not paying rent), maintenance and improvement costs, transaction costs, insurance costs, and transaction and on-going tax. Or not being international. I would agree that it is hard to claim that these things are an overly exact science, but this index questions the premise that property investments are necessarily a huge profit centre. Figure 9.1 Inflation adjusted Case-Shiller House Price index versus short-term US government debt However, we can also see why property was such a hot investment in the years before the sub-prime crisis (see Figure 9.2).

While there are certain indices that suggest that art has been a great investment,8 they suffer from a few shortcomings. For one, the studies often focus on segments of the art world that have been successful, suggesting selection bias, and are typically not easily replicable, so gaining exposure to them is not feasible. Also, many indices and the past performance of collectibles ignore the large transactional costs, insurance and storage costs. When you include all of these costs the return from collectibles is far less obvious, and you should not include them in the financial part of your portfolio. There are, of course, non-economic reasons for buying collectibles. On top of the hope for a financial return, investors in a painting could derive great value from looking at it or reading a first edition book.

While there is a small cost saving to doing so this means you are responsible for ensuring that the maturity profile of your bonds is in line with your target on average time to maturity as it naturally changes with time. For most people it is worth paying the cheap product providers’ small costs so that everything is taken care of for you. Trading is expensive and pulling the trigger can be nerve wracking Trading is expensive and one of the main reasons many investors underperform, but by changing allocations when you are trading securities you will be able to save money on transaction costs. Some product providers offer combined products with fixed weightings between bonds and equities. While they have the same issues outlined here they also have the huge advantage of large natural flows from customers and have lower costs as a result. If you find a product that suits your profile this added advantage is worth noting. When rebalancing your portfolio also consider your ticket size.


pages: 272 words: 19,172

Hedge Fund Market Wizards by Jack D. Schwager

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asset-backed security, backtesting, banking crisis, barriers to entry, Bernie Madoff, Black-Scholes formula, British Empire, Claude Shannon: information theory, cloud computing, collateralized debt obligation, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, family office, financial independence, fixed income, Flash crash, hindsight bias, implied volatility, index fund, James Dyson, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, quantitative easing, quantitative trading / quantitative finance, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve

Whereas most traders would be selling to cut their exposure when a market was breaking sharply, you would more likely be a buyer and have lots of liquidity. That’s right, as long as there wasn’t a bearish shift in the fundamentals as well. Do you ever run into situations where size is an issue? No, because we make sure that we do not run into the problem of size being an issue. We know our transaction costs very well, and we know how long it takes for us to get in and out of positions. We will limit our position size to assure that we can get out reasonably quickly and to keep our transaction costs small relative to the expected alpha of the trades in that market. Is there a limitation as to how large you can allow the fund to grow? Yes, we have been closed for several years. But even if you are closed, in a year like 2010, your assets can grow dramatically just from profits. We returned profits.

Most hedge funds end up having size-related difficulties managing much smaller sums. There are two major differences between us and most other hedge funds. Most hedge funds trade fewer markets, and they trade much more actively. We trade virtually every liquid market in the world, so the amount we have committed to any single market is small relative to our total equity. We also change our positions slowly. As you know, transaction costs are a function of the amount you have to move in a given time frame. Therefore, we have considerably more capacity than managers who trade fewer markets and turn their positions over more quickly. What is your turnover rate per market, per year? It depends what you mean by turnover rate. If you are defining turnover as moving from net long to net short rather than changes in magnitude, then the average time length is about 12 to 18 months.

Overtrading and listening to tips. Do losing periods cause any emotional strain? How do you handle it? Yes, periods of poor performance are difficult. I generally handle it by focusing very hard on improving the trading system. How would you summarize the trading rules you live by? Look where others don’t. Adjust position sizes to overall risk to target a particular volatility. Pay careful attention to transaction costs. Any final words? When I was in my teens, my highly insightful father was somehow able to instill in me the discipline of objectively evaluating your own progress. That lesson, more than anything else, has been critical to my success. Woodriff’s views, confirmed by his long-term success, provide four important insights about trading systems: 1. It is possible to find systems that are neither trend following nor countertrend that work better than either of those more common approaches (judging by the comparison of Woodriff’s return/risk to the return/risk of the universe of systematic traders). 2.


pages: 423 words: 149,033

The fortune at the bottom of the pyramid by C. K. Prahalad

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barriers to entry, business process, call centre, cashless society, clean water, collective bargaining, corporate social responsibility, deskilling, disintermediation, farmers can use mobile phones to check market prices, financial intermediation, Hernando de Soto, hiring and firing, income inequality, late fees, Mahatma Gandhi, market fragmentation, microcredit, new economy, profit motive, purchasing power parity, rent-seeking, shareholder value, The Fortune at the Bottom of the Pyramid, time value of money, transaction costs, working poor

The use of information technology to build a network can create a powerful motivation to be part of the system. The farmers know the difference between the old system and the system introduced by the ITC eChoupal. It is more than just a win in terms of savings. It provides a social basis for becoming an insider. 3. The ICICI-supported SHGs take it one step further. They start with understanding the rationale for the contacting system: how and why it reduces transaction costs and therefore reduces the cost of capital as well as increases access to capital. Further, governance cannot be just between ICICI and the individual. By creating a collective commitment to accountability to contracting conditions, SHGs continually reinforce in the local community the benefits of being within the system. Ultimately, the goal in development is to bring as many people as possible to enjoy the benefits of an inclusive market.

Ownership and the transfer of ownership must be enforced. Under such a system, assets can become capital. Investors will seek the best opportunities. TGC is the capacity of a society to guarantee transparency in the process of economic transactions and the ability to enforce commercial contracts. This is about reducing uncertainty as to ownership and transfer of ownership. Transparency in the process reduces transaction costs. Clearly developed laws, transparent microregulations, social norms, and timely and uniform enforcement are all part of TGC. My argument is that TGC is more important than laws that are not enforced. BOP consumers live in a wide variety of countries with varying degrees of TGC. Consider the spectrum: 1. Countries that are arbitrary and authoritarian. Laws do not exist and the laws that do exist are not enforced.

The dependence on the informal sector was as high as 58% for households with assets lower than Rs. 5,000.”13 In other words, a majority of the extremely poor are reliant on extortionist money lenders for living capital. Yet formal financial intermediaries, such as commercial banks, typically do not serve poor households. The reasons include the high cost of small transactions, the lack of traditional collateral, geographic isolation, and simple social prejudice. “According to Mahajan,14 the transaction costs of savings in formal institutions were as high as 10% for the rural poor. This was because of the small average size of transactions and distance of the branches from the villages.” Even those institutions that provide financial services to the poor are limited in scale. With more than 400 million poor people and participation rates in formal institutions around 30%, demand far outstrips supply.


pages: 407 words: 114,478

The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein

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asset allocation, Bretton Woods, British Empire, buy low sell high, carried interest, corporate governance, cuban missile crisis, Daniel Kahneman / Amos Tversky, Dava Sobel, diversification, diversified portfolio, Edmond Halley, equity premium, estate planning, Eugene Fama: efficient market hypothesis, financial independence, financial innovation, fixed income, German hyperinflation, high net worth, hindsight bias, Hyman Minsky, index fund, invention of the telegraph, Isaac Newton, John Harrison: Longitude, Long Term Capital Management, loss aversion, market bubble, mental accounting, mortgage debt, new economy, pattern recognition, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, transaction costs, Vanguard fund, yield curve

In those years when small caps have done well, indexing them has also done well. For example, for the years 1992–1994, this Fund ranked in the 13th percentile of the Morningstar small-cap category, and, for the three years ending August 2001, in the 29th percentile. If survivorship bias were taken into account, it would almost certainly have had even higher rankings. Even if it is possible for active managers to successfully pick small stocks, transactional costs in this arena are much higher than with large stocks, so any gains from stock picking will be more than offset by the costs of trading small stocks. • “Active managers do better than index funds in down markets.” This is flat-out wrong—they certainly do not. For example, from January 1973 to September 1974, according to Lipper Inc., the average domestic stock fund lost 47.9%, versus a loss of 42.6% for the S&P 500.

He tabulated the change in investor expectations as follows: The first thing that leaps out of this table is that the average investor thinks that he will best the market by about 2%. While some investors may accomplish this, it is, of course, mathematically impossible for the average investor to do so. As we’ve already discussed, the average investor must, of necessity, obtain the market return, minus expenses and transaction costs. Even the most casual observer of human nature should not be surprised by this paradox—people tend to be overconfident. Overconfidence likely has some survival advantage in a state of nature, but not in the world of finance. Consider the following: • In one study, 81% of new business owners thought that they had a good chance of succeeding, but that only 39% of their peers did. • In another study, 82% of young U.S. drivers considered themselves in the top 30% of their group in terms of safety.

At the end of each year, calculate it.1 If your math skills aren’t up to the task, it’s well worth paying your accountant to do it. Don’t Become a Whale Wealthy investors should realize that they are the cash cows of the investment industry and that most of the exclusive investment vehicles available to them—separate accounts, hedge funds, limited partnerships, and the like—are designed to bleed them with commissions, transactional costs, and other fees. “Whales” are eagerly courted with impressive descriptions of sophisticated research, trading, and tax strategies. Don’t be fooled. Remember that the largest investment pools in the nation—the pension funds—are unable to beat the market, so it is unlikely that the investor with $10 million or even $1 billion will be able to do so. My advice to the very wealthy? Swallow your pride and make that 800 call to a mutual fund specializing in low-cost index funds.


pages: 416 words: 39,022

Asset and Risk Management: Risk Oriented Finance by Louis Esch, Robert Kieffer, Thierry Lopez

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asset allocation, Brownian motion, business continuity plan, business process, capital asset pricing model, computer age, corporate governance, discrete time, diversified portfolio, implied volatility, index fund, interest rate derivative, iterative process, P = NP, p-value, random walk, risk/return, shareholder value, statistical model, stochastic process, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

With this notation, the return on the portfolio takes the following form: N RP ,t = Xj Rj t j =1 Note The relations set out above assume, of course, that the number of each of the securities in the portfolio remains unchanged during the period in question. Even if this condition is satisfied, the proportions Xj will be dependent on t through the prices. If therefore one wishes to consider a portfolio that has identical proportions at two given different moments, the nj must be altered in consequence. This is very difficult to imagine in practice, because of transaction costs and other factors, and we will not take account of it in future. Instead, our reasoning shall be followed as though the proportions remained unchanged. As for an isolated security, when one considers a return estimated on the basis of several returns relating to the same duration but from different periods, one uses the arithmetical mean instead of the geometric mean, which gives: = 1 RP ,t 12 t=1 = 1 Xj Rj t 12 t=1 j =1 12 RP ,1 month N 12 = N Xj j =1 1 Rj t 12 t=1 12 Therefore, according to what was stated above:4 RP ,1 month = N Xj Rj,1 month .

The economic conditions that define an efficient market are: • The economic agents involved on the market behave rationally; they use the available information coherently and aim to maximise the expected utility of their wealth. • The information is available simultaneously to all investors and the reaction of the investors to the information is instantaneous. • The information is available free of charge. • There are no transaction costs or taxes on the market. • The market in question is completely liquid. It is obvious that these conditions can never be all strictly satisfied in a real market. This therefore raises the question of knowing whether the differences are significant and whether they will have the effect of invalidating the efficiency hypothesis. This question is addressed in the following paragraphs, and the analysis is carried out at three levels according to the accessibility of information.

Their origin may be: • Speculative bubbles, in which the rate of a security differs significantly and for a long time from its intrinsic value before eventually coming back to its intrinsic value, without movements of the market economic variables as an explanation for the difference. • Irrational behaviour by certain investors. These various elements, although removed from the efficiency hypothesis, do not, however, bring it into question. In addition, the profit to investors wishing to benefit from them will frequently be lost in transaction costs. 3.1.2.6 Conclusion We quote P. Gillet in conclusion of this analysis. Financial market efficiency appears to be all of the following: an intellectual abstraction, a myth and an objective. The intellectual abstraction. Revealed by researchers, the theory of financial market efficiency calls into question a number of practices currently used by the financial market professionals, such as technical analysis. (. . .)


pages: 606 words: 157,120

To Save Everything, Click Here: The Folly of Technological Solutionism by Evgeny Morozov

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3D printing, algorithmic trading, Amazon Mechanical Turk, Andrew Keen, augmented reality, Automated Insights, Berlin Wall, big data - Walmart - Pop Tarts, Buckminster Fuller, call centre, carbon footprint, Cass Sunstein, choice architecture, citizen journalism, cloud computing, cognitive bias, crowdsourcing, data acquisition, Dava Sobel, disintermediation, East Village, en.wikipedia.org, Fall of the Berlin Wall, Filter Bubble, Firefox, Francis Fukuyama: the end of history, frictionless, future of journalism, game design, Gary Taubes, Google Glasses, illegal immigration, income inequality, invention of the printing press, Jane Jacobs, Jean Tirole, Jeff Bezos, jimmy wales, Julian Assange, Kevin Kelly, Kickstarter, license plate recognition, lone genius, Louis Pasteur, Mark Zuckerberg, market fundamentalism, Marshall McLuhan, Narrative Science, Nicholas Carr, packet switching, PageRank, Paul Graham, Peter Singer: altruism, Peter Thiel, pets.com, placebo effect, pre–internet, Ray Kurzweil, recommendation engine, Richard Thaler, Ronald Coase, Rosa Parks, self-driving car, Silicon Valley, Silicon Valley ideology, Silicon Valley startup, Skype, Slavoj Žižek, smart meter, social graph, social web, stakhanovite, Steve Jobs, Steven Levy, Stuxnet, technoutopianism, the built environment, The Chicago School, The Death and Life of Great American Cities, the medium is the message, The Nature of the Firm, the scientific method, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, transaction costs, urban decay, urban planning, urban sprawl, Vannevar Bush, WikiLeaks

Shirky’s veneration of Ronald Coase’s theory of the firm—and its accompanying discourse on transaction costs—may seem harder to dismiss, not least because Coase is a Nobel Prize–winning economist. References to Coase pop up regularly in the work of our Internet theorists; in addition to Clay Shirky, Yochai Benkler also draws heavily on Coase to discuss the open-source movement. There is nothing wrong with Coase’s theories per se; in the business context, they offer remarkably useful explanations and have even helped spawn a new branch of economics. But here is the problem: thinking of a Californian start-up in terms of transaction costs is much easier than pulling the same trick for, say, the Iranian society. While it seems noncontroversial to conclude that cheaper digital technologies might indeed lower most so-called transaction costs in Iran, that insight doesn’t really say much, for unless we know something about Iran’s culture, history, and politics, we know nothing about the contexts in which all these costs have supposedly fallen.

Take Clay Shirky’s Here Comes Everybody, which enjoys a cult status in geek circles as a seemingly original argument about the falling costs of collaboration. For much of his theoretical apparatus, Shirky draws on two sources: Susanne Lohmann’s explanation of the 1989 protests in East Germany by means of rational-choice theory (from which Shirky borrows the notion of information cascades) and Ronald Coase’s theory of the firm (from which Shirky borrows the notion of transaction costs). Alas, neither of them is an unambiguously good or neutral guide to understanding digital technologies once we liberate ourselves from Internet-centrism. Like most scholars in the rational-choice tradition, Lohmann—whom Shirky misidentifies as a historian (she’s a political scientist)—doesn’t explain collective action of East Germany by attending to historical and cultural factors or tracing the emergence of new attitudes or ideologies.

While it seems noncontroversial to conclude that cheaper digital technologies might indeed lower most so-called transaction costs in Iran, that insight doesn’t really say much, for unless we know something about Iran’s culture, history, and politics, we know nothing about the contexts in which all these costs have supposedly fallen. Who are the relevant actors? What are the relevant transactions? In the absence of such knowledge about Iran, the natural reflex is to opt for the simplest possible model: imagine a two-way split between the government and the dissidents and then think through how their own transaction costs may have fallen thanks to “the Internet.” This seems like a rather perfunctory way of talking about a rather complex subject. Cue Don Tapscott, a popular Internet pundit, proclaiming that “the Internet not only drops transaction and collaboration costs in business—it also drops the cost of collaboration in dissent, rebellion and even in insurrection.” Okay—but is no one else in these countries collaborating or engaging in transactions?


pages: 179 words: 43,441

The Fourth Industrial Revolution by Klaus Schwab

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3D printing, additive manufacturing, Airbnb, Amazon Mechanical Turk, Amazon Web Services, augmented reality, autonomous vehicles, barriers to entry, Baxter: Rethink Robotics, bitcoin, blockchain, Buckminster Fuller, call centre, clean water, collaborative consumption, conceptual framework, continuous integration, crowdsourcing, disintermediation, distributed ledger, Edward Snowden, Elon Musk, epigenetics, Erik Brynjolfsson, future of work, global value chain, Google Glasses, income inequality, Internet Archive, Internet of things, invention of the steam engine, job automation, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, life extension, Lyft, megacity, meta analysis, meta-analysis, more computing power than Apollo, mutually assured destruction, Narrative Science, Network effects, Nicholas Carr, personalized medicine, precariat, precision agriculture, Productivity paradox, race to the bottom, randomized controlled trial, reshoring, RFID, rising living standards, Second Machine Age, secular stagnation, self-driving car, sharing economy, Silicon Valley, smart cities, smart contracts, software as a service, Stephen Hawking, Steve Jobs, Steven Levy, Stuxnet, The Spirit Level, total factor productivity, transaction costs, Uber and Lyft, Watson beat the top human players on Jeopardy!, WikiLeaks, winner-take-all economy, women in the workforce, working-age population, Y Combinator, Zipcar

P2P (peer-to-peer) platforms are now dismantling barriers to entry and lowering costs. In the investment business, new “robo-advisory” algorithms and their corresponding apps provide advisory services and portfolio tools at a fraction of the old transaction cost – 0.5% instead of the traditional 2%, thereby threatening a whole segment of the current financial industry. The industry is also aware that blockchain will soon revolutionize the way it operates because its possible applications in finance have the opportunity to reduce settlement and transaction costs by up to $20 billion and transform the way the industry works. The shared database technology can streamline such varied activities as the storage of clients’ accounts, cross-border payments, and the clearing and settling of trades, as well as products and services that do not exist yet, such as smart futures contracts that self-execute without a trader (e.g. a credit derivative that pays out automatically when a country or company defaults).

Shift 17: The Sharing Economy The tipping point: Globally more trips/journeys via car sharing than in private cars By 2025: 67% of respondents expected this tipping point to have occurred The common understanding of this phenomenon is the usually technology-enabled ability for entities (individuals or organizations) to share the use of a physical good/asset, or share/provide a service, at a level that was not nearly as efficient or perhaps even possible before. This sharing of goods or services is commonly possible through online marketplaces, mobile apps/location services or other technology-enabled platforms. These have reduced the transaction costs and friction in the system to a point where it is an economic gain for all involved, divided in much finer increments. Well-known examples of the sharing economy exist in the transportation sector. Zipcar provides one method for people to share use of a vehicle for shorter periods of time and more reasonably than traditional rental car companies. RelayRides provides a platform to locate and borrow someone’s personal vehicle for a period of time.


pages: 328 words: 92,317

Machinery of Freedom: A Guide to Radical Capitalism by David Friedman

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back-to-the-land, Fractional reserve banking, hiring and firing, jitney, laissez-faire capitalism, Machinery of Freedom by David Friedman, means of production, rent control, road to serfdom, Ronald Coase, Ronald Reagan, Stewart Brand, The Wealth of Nations by Adam Smith, transaction costs, urban renewal, Vernor Vinge, Whole Earth Catalog

If the right is more valuable to me than to you, I should be able to make some offer that you will accept. This insight leads us to the Coase Theorem, named after Ronald Coase, the economist whose ideas are largely responsible for this part of the chapter. The Coase Theorem states that any initial definition of property rights will lead to an efficient outcome, provided that transaction costs are zero. The condition — zero transaction costs — is as important as the theorem. Suppose we start with a definition of property rights that forbids trespassing photons; anyone may forbid me from making a light that he can see. The right to decide whether or not I turn on the lights in my house is worth more to me than to my neighbors, so in principle I should be able to buy their permission. The problem is that there are a lot of people living within sight of my house.

The size of the public is so enormous that a unanimous contract is virtually impossible, especially since one secret supporter of a foreign power could prevent the whole deal. Buying up most of the land affected by national defense might be less difficult than negotiating a unanimous contract among 200 million people, but hardly easy. The land must be purchased before sellers realize what is going on and increase their price. Raising enough money to buy the United States would be a hard project to keep secret. In addition, the transaction costs would be substantial — about $100 billion in realtor commissions for all the fixed property in the United States. There is one favorable factor to help offset these difficulties. The cost of a minimal national defense is only about $20 billion to $40 billion a year. The value to those protected is several hundred billion dollars a year. National defense is thus a public good worth about ten times what it costs; this may make it easier, although not easy, to devise some noncoercive way of financing it.

The right to control the air a foot over a piece of land is worth more to the owner than to anyone else, so ownership of land usually includes ownership of the space immediately above it. The second is that, since the proper composition of bundles of rights will often be uncertain and may change over time, they should be defined in a way that makes it as easy as possible to trade rights. Property rights should be defined in a way that minimizes the transaction costs of likely transactions. One of the questions to be decided is how to bundle the rights; another and closely related question is what the rights are that we are bundling. Does my right to forbid intense lights and sounds from my property mean that I can forbid my neighbor from testing lasers and nuclear weapons — and holding loud parties — or only that I can collect damages afterwards? The answer has been suggested in an earlier discussion.


pages: 274 words: 93,758

Phishing for Phools: The Economics of Manipulation and Deception by George A. Akerlof, Robert J. Shiller, Stanley B Resor Professor Of Economics Robert J Shiller

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Andrei Shleifer, asset-backed security, Bernie Madoff, Capital in the Twenty-First Century by Thomas Piketty, collapse of Lehman Brothers, Credit Default Swap, Daniel Kahneman / Amos Tversky, dark matter, David Brooks, en.wikipedia.org, endowment effect, equity premium, financial intermediation, full employment, George Akerlof, greed is good, income per capita, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, Kenneth Rogoff, late fees, loss aversion, Menlo Park, mental accounting, Milgram experiment, moral hazard, new economy, payday loans, Ponzi scheme, profit motive, Ralph Nader, randomized controlled trial, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, Silicon Valley, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, theory of mind, Thorstein Veblen, too big to fail, transaction costs, Unsafe at Any Speed, Upton Sinclair, Vanguard fund, wage slave

Producers have been just as inventive in getting us to feel we need what is produced as they have been in filling the needs that we really have. No one wants to go to bed at night worried about the bills. Yet most people do.19 One source of our angst about those bills comes from rip-offs: as consumers we are especially prone to pay too much when we step outside of our comfort zone to make the rare, expensive purchase.20 In some 30 percent of home sales to new buyers, total—buyer plus seller—transaction costs, remarkably, are more than half of the down payment that the buyer puts into the deal.21 Auto salesmen, as we shall see, have developed their own elaborate techniques to sell us more car than we really want; and also to get us to pay too much. Nobody wants to be ripped off. Yet we are, even in the most carefully considered purchases of our lives. Financial and Macroeconomic Instability. Phishing for phools in financial markets is the leading cause of the financial crises that lead to the deepest recessions.

Homebuyers, then, are vulnerable to buying the wrong house, but there is also another source of rip-off that is not shown on TV: the closing costs. Once an offer has been accepted, the deadline to arrange the necessary financing is short: the seller is waiting anxiously for verification that the buyer can come up with the money, as promised. This makes the homebuyer, who is inexperienced, and whose focus also has previously been elsewhere, especially vulnerable to rip-off. Usually, when we think of the transaction costs for the transfer of a house, we think of the real estate fees. In one sample of home purchases (involving Federal Housing Administration mortgages), the standard 6 percent was still the modal fee: paid by 29 percent of sellers. Some 47 percent did pay less; but, remarkably, 24 percent somehow managed to pay more.12 Framed as 6 percent, these fees seem fairly small: it’s like the sales tax on a bottle of Tylenol at the local CVS.

We can’t say for sure, but note that these fees are much lower in other countries; and people there do not seem to be complaining about bad service.15 But those payments to the real estate dealer are not the end of the transaction fees. In a large sample of Federal Housing Administration loans, additional closing costs were on average approximately a further 4.4 percent of the value of the mortgage.16 Put together with the payments to the real estate agent, that means that the transaction costs, for those 10-percent-down first-time homebuyers are about as large as all the money that they themselves are bringing to the table. Those additional fees for closing come in many different forms. The bulk of them are for two purposes: for exchange of title, and for initiating the mortgage. And here, in the charges for initiating the mortgage, a careful study shows a remarkable example of rip-off, which went on for years until it was, finally, outlawed in the DoddFrank Financial Reform Act of 2010.17 We will look at this rip-off in some detail, because we have some remarkable information regarding just how large it had been.


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Exponential Organizations: Why New Organizations Are Ten Times Better, Faster, and Cheaper Than Yours (And What to Do About It) by Salim Ismail, Yuri van Geest

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23andMe, 3D printing, Airbnb, Amazon Mechanical Turk, Amazon Web Services, augmented reality, autonomous vehicles, Baxter: Rethink Robotics, bioinformatics, bitcoin, Black Swan, blockchain, Burning Man, business intelligence, business process, call centre, chief data officer, Clayton Christensen, clean water, cloud computing, cognitive bias, collaborative consumption, collaborative economy, corporate social responsibility, cross-subsidies, crowdsourcing, cryptocurrency, dark matter, Dean Kamen, dematerialisation, discounted cash flows, distributed ledger, Edward Snowden, Elon Musk, en.wikipedia.org, ethereum blockchain, Galaxy Zoo, game design, Google Glasses, Google Hangouts, Google X / Alphabet X, gravity well, hiring and firing, Hyperloop, industrial robot, Innovator's Dilemma, Internet of things, Iridium satellite, Isaac Newton, Jeff Bezos, Kevin Kelly, Kickstarter, knowledge worker, Kodak vs Instagram, Law of Accelerating Returns, Lean Startup, life extension, loose coupling, loss aversion, Lyft, Mark Zuckerberg, market design, means of production, minimum viable product, natural language processing, Netflix Prize, Network effects, new economy, Oculus Rift, offshore financial centre, p-value, PageRank, pattern recognition, Paul Graham, Peter H. Diamandis: Planetary Resources, Peter Thiel, prediction markets, profit motive, publish or perish, Ray Kurzweil, recommendation engine, RFID, ride hailing / ride sharing, risk tolerance, Ronald Coase, Second Machine Age, self-driving car, sharing economy, Silicon Valley, skunkworks, Skype, smart contracts, Snapchat, social software, software is eating the world, speech recognition, stealth mode startup, Stephen Hawking, Steve Jobs, subscription business, supply-chain management, TaskRabbit, telepresence, telepresence robot, Tony Hsieh, transaction costs, Tyler Cowen: Great Stagnation, urban planning, WikiLeaks, winner-take-all economy, X Prize, Y Combinator

Smaller Beats Bigger (aka Size Does Matter, Just not the Way You Think) Ronald Coase won the 1991 Nobel Prize in Economics for his theory that larger companies do better because they aggregate assets under one roof and, as a result, enjoy lower transaction costs. Two decades later, the reach delivered by the information revolution has negated the need to aggregate assets in the first place. For decades, scale and size have been desirable traits in an enterprise. A bigger company could do more, the argument went, because it could leverage economies of scale and negotiate from strength. That’s one reason why, for generations, business schools and consulting firms have focused on the management and organization of extremely large companies. And Wall Street has gotten rich trading the stock of giant companies, which often merge to create even more gigantic organizations. All that is changing. In The Start-up of You, Reid Hoffman shows that transaction costs are no longer an advantage and that each individual can (and should) manage himself or herself as a business.

As enterprises grow more exponential, it is our belief that they will become distributed, decentralized platforms leveraging communities with open APIs. We also believe they will operate with a balanced mix of open and protected data, encouraging constant and disruptive innovation at their edges. In the same way that Internet communications have seen costs drop to near zero, we expect to see internal organizational and transactions costs also fall to near zero as we increasingly information-enable and distribute our organizational structures. Ultimately, in the face of such low transaction costs, we anticipate what we’re calling a Cambrian Explosion in organizational design—everything from community-based structures to virtual organizations (see Ethereum) that will be small, nimble and extensible. It is also becoming increasingly clear that, like the Internet, the ExO paradigm is not just for business.


pages: 209 words: 89,619

The Precariat: The New Dangerous Class by Guy Standing

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8-hour work day, banking crisis, barriers to entry, Bertrand Russell: In Praise of Idleness, call centre, Cass Sunstein, centre right, collective bargaining, corporate governance, crony capitalism, deindustrialization, deskilling, fear of failure, full employment, hiring and firing, Honoré de Balzac, housing crisis, illegal immigration, immigration reform, income inequality, labour market flexibility, labour mobility, land reform, libertarian paternalism, low skilled workers, lump of labour, marginal employment, Mark Zuckerberg, means of production, mini-job, moral hazard, Naomi Klein, nudge unit, pensions crisis, placebo effect, post-industrial society, precariat, presumed consent, quantitative easing, remote working, rent-seeking, Richard Thaler, rising living standards, Ronald Coase, Ronald Reagan, science of happiness, shareholder value, Silicon Valley, The Market for Lemons, The Nature of the Firm, The Spirit Level, Tobin tax, transaction costs, universal basic income, unpaid internship, winner-take-all economy, working poor, working-age population, young professional

The owners could be out tomorrow, along with their management teams and the nods-andhandshakes that make up informal bargains about how labour is done, how payments should be honoured and how people are treated in moments of need. In 1937, Ronald Coase set out a theory that was to earn him a Nobel Prize in Economics. He argued that firms, with their hierarchies, were superior to atomised markets made up solely of individuals; they reduced the transaction costs of doing business, one reason being that they fostered long-term relationships based on trust. This reasoning has collapsed. Now that opportunistic buyers can amass vast funds and take over even well-run companies, there is less incentive to form trust relationships inside firms. Everything becomes contingent and open to re-negotiation. 30 THE PRECARIAT For years academic journals were full of articles on national ‘varieties of capitalism’.

They have multiple ‘workplaces’ – employment exchanges, benefit offices, job-search training offices – and have to indulge in a lot of work-for-labour – filling in forms, queuing, commuting to employment exchanges, commuting in search of jobs, commuting to job training and so on. It can be a full-time job being unemployed, and it involves flexibility, since people must be on call almost all the time. What politicians call idleness may be no more than being on the end of the phone, chewing nails nervously hoping for a call. The precarity trap A labour market based on precarious labour produces high transaction costs for those on the margins. These costs include the time it takes to apply for benefits if they become unemployed, the lack of income in that period, the time and costs associated with searching for jobs, the time and cost in learning new labour routines, and the time and cost involved in adjusting activities outside jobs to accommodate the demands of new temporary jobs. The total may be substantial by comparison with expected earnings.

If our woman is fortunate, she may obtain state benefits with which to pay off some of the debts and gain some financial relief. But then suppose she is offered another temporary low-paying job. She hesitates. Some benefits might continue for a while, under rules to help ‘make work pay’ and reduce the WHY THE PRECARIAT IS GROWING 49 standard ‘poverty trap’. But she knows that when the job ends she will once again face daunting transaction costs. The reality is that she cannot afford to take the job because, in addition to the cost in lost benefits while the job lasts, there is the cost of getting back on benefits. That is the precarity trap. The precarity trap is intensified by the erosion of community support. While being in and out of temporary low-wage jobs does not build up entitlement to state or enterprise benefits, the person exhausts the ability to call on benefits provided by family and friends in times of need.


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The Wisdom of Crowds by James Surowiecki

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AltaVista, Andrei Shleifer, asset allocation, Cass Sunstein, Daniel Kahneman / Amos Tversky, experimental economics, Frederick Winslow Taylor, George Akerlof, Howard Rheingold, I think there is a world market for maybe five computers, interchangeable parts, Jeff Bezos, Joseph Schumpeter, knowledge economy, lone genius, Long Term Capital Management, market bubble, market clearing, market design, moral hazard, new economy, offshore financial centre, Picturephone, prediction markets, profit maximization, Richard Feynman, Richard Feynman, Richard Feynman: Challenger O-ring, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, The Nature of the Firm, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Toyota Production System, transaction costs, ultimatum game, Yogi Berra

The problem with the “outsource everything” model, Coase saw, was that setting up and monitoring all those different deals and contracts takes a lot of time and effort. It takes work to find the right people, and to haggle with them over how much you’ll pay them. It takes work to ensure that everyone’s doing what they promised they would do. And it takes work to make sure, after everything’s done, that everyone gets what’s coming to them. These are all what Coase called “transaction costs,” which include “search and information costs, bargaining and decision costs, policing and enforcement costs.” A well-run company reduces these costs. If your e-mail goes on the fritz, it’s easier and faster to call the office tech guy instead of some outside company. And it’s often smarter for a company to hire full-time employees who are always available to work than it is to go hunting for talented people every time a new project arises.

But the company thinks its chances of publishing interesting books are better if it leaves the door open to lots of different writers, and so it’s willing to endure the hassle of having to sign each book on a case-by-case basis. (It’s also a hassle for writers, of course, who have to write and sell books on a case-by-case basis. One way publishers and authors try to reduce the hassle, which is to say, reduce transaction costs, is by signing multibook deals.) Although companies typically don’t think of it in this way, what they’re really wrestling with when they think about outsourcing is the costs and benefits of collective action. Doing things in-house means, in some sense, cutting themselves off from a host of diverse alternatives, any of which could help them do business better. It means limiting the amount of information they get, because it means limiting the number of information sources they have access to.

This model allows people to be handpicked for their diverse abilities (planning, safecracking, explosives, etc.), so that the group can have exactly what it needs for the job. And the one-off nature of the project ensures that everyone on the team has an incentive to perform well. The problems with this model, though, are precisely those that Ronald Coase had in mind when he talked about transaction costs. It takes a lot of work to put the group together. It’s difficult to ensure that people are working in the group’s interest and not their own. And when there’s a lack of trust between the members of the group (which isn’t surprising given that they don’t really know each other), considerable energy is wasted trying to determine each other’s bona fides. (Of course, jewel thieves face a hurdle that normal businessmen don’t: they can’t rely on contracts to make people commit to their responsibilities.)


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Platform Revolution: How Networked Markets Are Transforming the Economy--And How to Make Them Work for You by Sangeet Paul Choudary, Marshall W. van Alstyne, Geoffrey G. Parker

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3D printing, Affordable Care Act / Obamacare, Airbnb, Amazon Mechanical Turk, Amazon Web Services, Andrei Shleifer, Apple's 1984 Super Bowl advert, autonomous vehicles, barriers to entry, big data - Walmart - Pop Tarts, bitcoin, blockchain, business process, buy low sell high, chief data officer, clean water, cloud computing, connected car, corporate governance, crowdsourcing, data acquisition, data is the new oil, discounted cash flows, disintermediation, Edward Glaeser, Elon Musk, en.wikipedia.org, Erik Brynjolfsson, financial innovation, Haber-Bosch Process, High speed trading, Internet of things, inventory management, invisible hand, Jean Tirole, Jeff Bezos, jimmy wales, Khan Academy, Kickstarter, Lean Startup, Lyft, market design, multi-sided market, Network effects, new economy, payday loans, peer-to-peer lending, Peter Thiel, pets.com, pre–internet, price mechanism, recommendation engine, RFID, Richard Stallman, ride hailing / ride sharing, Ronald Coase, Satoshi Nakamoto, self-driving car, shareholder value, sharing economy, side project, Silicon Valley, Skype, smart contracts, smart grid, Snapchat, software is eating the world, Steve Jobs, TaskRabbit, The Chicago School, the payments system, Tim Cook: Apple, transaction costs, two-sided market, Uber and Lyft, Uber for X, winner-take-all economy, Zipcar

Before the rise of the platform, it might have been possible to loan something to a family member, close friend, or neighbor, but much harder to loan to a stranger. This is because it would be difficult to trust that your home would be left in good shape (Airbnb), your car would be returned undamaged (RelayRides), or your lawnmower would come back (NeighborGoods). The effort necessary to individually verify credit- and trustworthiness is an example of the high transaction costs that used to prevent exchange. By providing default insurance contracts and reputation systems to encourage good behavior, platforms dramatically lower transaction costs and create new markets as new producers start producing for the first time. Platforms beat pipelines by using data-based tools to create community feedback loops. We’ve seen how the Kindle platform relies on reactions from the community of readers to determine which books will be widely read and which will not.

THE INCUMBENTS FIGHT BACK: PIPELINES BECOMING PLATFORMS Platform businesses, then, are disrupting the traditional business landscape in a number of ways—not only by displacing some of the world’s biggest incumbent firms, but also by transforming familiar business processes like value creation and consumer behavior as well as altering the structure of major industries. What can incumbents do to respond? Are entrenched companies that operate familiar pipeline businesses doomed to capitulate as platforms reshape and ultimately take over their industries? Not necessarily. But if incumbents hope to fight the forces of platform disruption, they’ll need to reevaluate their existing business models. For example, they’ll need to scrutinize all their transaction costs—that is, the money they spend on processes such as marketing, sales, product delivery, and customer service—and imagine how those costs might be reduced or eliminated in a more seamlessly connected world. They’ll also need to examine the entire universe of individuals and organizations they currently interact with and envision new ways of networking them so as to create new forms of value.14 They’ll need to ask questions such as: • Which processes that we currently manage in-house can be delegated to outside partners, whether suppliers or customers?

Core developers are responsible for basic platform capabilities. Airbnb provides an infrastructure that allows guests and hosts to interact with each other using system resources, including the search capabilities and data services that allow guests to find attractive properties as well as the payment mechanisms necessary to conclude a transaction. In addition, Airbnb manages behind-the-scenes functions that reduce transaction costs for guests and hosts. For example, the platform provides default insurance contracts for both parties, protecting guests in the event of accident or crime and protecting hosts from negligent guest behavior (though, as we’ll discuss in chapter 11, this insurance coverage is not without its shortcomings). It also verifies the identity of participants in order to make its reputation system a meaningful measure of user behavior.


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The Market for Force: The Consequences of Privatizing Security by Deborah D. Avant

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barriers to entry, corporate social responsibility, failed state, hiring and firing, interchangeable parts, Mikhail Gorbachev, Peace of Westphalia, private military company, profit motive, RAND corporation, rent-seeking, rolodex, the market place, The Nature of the Firm, trade route, transaction costs

Though contemporary mercenaries attempt to distinguish themselves from the lawless “guns for hire” that ran riot over Africa during the Cold War, their consortium with arms manufacturers, mineral exploiters, and Africa’s authoritarian governments and warlords sustains the militarization of Africa.13 This poses “a mortal danger to 7 Oliver Williamson, “Public and Private Bureaucracies: a Transaction Cost Economic Perspective,” Journal of Law, Economics, and Organization Vol. 15, No. 1 (1999), p. 320. 8 Abdel-Fatau Musah and J. Kayode Fayemi, “Introduction,” in Mercenaries: an African Security Dilemma (London: Pluto, 2000) p. 4. 9 Communication from James Fennell, head of the Africa division of DSL, 29 November 2000. 10 Ken Silverstein, “Privatizing War: How Affairs of State are Outsourced to Corporations Beyond Public Control,” The Nation, 28 July 1997; Musah and Fayemi, Mercenaries. 11 Ken Silverstein, Private Warriors (New York: Verso, 2000), p. 143. 12 Ibid., p. xvii. 13 Musah and Fayemi, “Africa: In Search of Security,” in Mercenaries, pp. 23–25.

The privatization of sovereign tasks should be a less efficient means to collective ends, reducing functional control and/or changing political control. Building on the Hobbesian supposition that life is “nasty, brutish, and short” in anarchy, economic institutionalists focus on the importance of the state for the control of violence. North, Levi, Olson and others suggest that state monopoly over violence is necessary to move out of anarchy and into a situation where productive activity can take place.18 Transaction cost economics further develops this logic, suggesting that a state can best control violence if it organizes internally to create public bureaucracies. 19 Williamson argues that just as hierarchies are some- times preferable to markets there are conditions under which public bureaucracies are preferable to private firms. In general, contracts are problematic when uncertainty and bounded rationality occur together, because they make it costly or impossible to identify future contingen- cies and specify how to handle them in a contract. 20 Also, when there are few competitors and they are opportunistic, contracts become risky and expensive. 21 States, on the other hand, have mechanisms for aggregating interests via procedures people have agreed to and thus promote convergent expectations. 22 States also contain mechanisms by which authority to 18 See Douglass North, Structure and Change in Economic History (New York: W.W.

Only by contracting with a “specialist in violence” can people can move beyond the trade-off between peace and prosperity. If the specialists in violence become governments, coercion can be used in productive ways. Robert Bates, Avner Greif, and Smita Singh, “Organizing Violence,” Journal of Conflict Resolution Vol. 46, No. 5 (October 2002): 599–629. 19 Oliver Williamson, “Public and Private Bureaucracies: A Transaction Cost Economics Perspective,” Journal of Law, Economics and Organization, Vol. 15, No. 1 (1999). 20 See Oliver Williamson, Markets and Hierarchies: Analysis and Anti-Trust Implications (New York: Free Press, 1975). See also, R. H. Coase, “The Nature of the Firm,” Economica Vol. 4, No. 16 (November 1937); H. A. Simon, Administrative Behavior (New York: Macmillan 1961); A. A. Alchian and H. Demsetz, “Production, Information Costs, and Economic Organization,” American Economic Review Vol. 62 (December 1972). 21 Williamson, Markets and Hierarchies, pp. 8–10. 22 In such a complex market, bureaucracies facilitate adaptive decision making that can respond to change.


pages: 363 words: 28,546

Portfolio Design: A Modern Approach to Asset Allocation by R. Marston

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asset allocation, Bretton Woods, capital asset pricing model, capital controls, carried interest, commodity trading advisor, correlation coefficient, diversification, diversified portfolio, equity premium, Eugene Fama: efficient market hypothesis, family office, financial innovation, fixed income, German hyperinflation, high net worth, hiring and firing, housing crisis, income per capita, index fund, inventory management, Long Term Capital Management, mortgage debt, passive investing, purchasing power parity, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sharpe ratio, Silicon Valley, superstar cities, transaction costs, Vanguard fund

This compares with an excess return for the year as a whole of 0.375 percent per month. So it is the month of January which is the key to the small-cap premium. This January effect has also seemed to diminish more recently. Since 1981, the small cap premium in January has diminished from 5.27 percent per month to 1.74 percent per month. That’s still a hefty premium for a one month return, though transaction costs in the small-cap space may be large enough to prevent abnormal returns for investors seeking to exploit this premium. This chapter will not focus on the January effect per se since this is not a book about short-term trading strategies. Instead, we will ask whether the small-cap premium continues to exist and, if so, how this should influence P1: a/b c03 P2: c/d QC: e/f JWBT412-Marston T1: g December 8, 2010 17:27 Printer: Courier Westford Small-Cap Stocks 43 portfolio allocations.

That’s because currency futures contracts are fairly priced. In the long run, there is little profit or loss from selling currencies in the forward market (which an investor would do in order to hedge the currency risk). A policy of selling French francs to hedge the currency exposure on French stock investments, for example, made an average profit of minus 0.7 percent per year between 1979 and June 2009 ignoring transactions costs. The same policy applied to Deutschemarks made an average profit of only +0.5 percent per year.10 It should not be surprising that returns are so small, since consistently high profits would be soon eliminated by additional speculators joining in the game. A more surprising result is shown in Table 5.4. Currency hedging does not have much impact on risk. Table 5.4 compares the standard deviations of the country indexes when the stock returns are hedged and when they are left un-hedged.

American investors find investing in ADRs very convenient compared with investing in shares in foreign stock markets. Investors do not have to worry about foreign currency transactions and custody remains in the United States. To what extent is the American investor getting true foreign diversification by investing in ADRs? First, it’s important to recognize that arbitrage will ensure that the returns on ADRs and on the underlying foreign stocks are identical except for transactions costs. Second, there are now almost 3000 ADRs available in the U.S. market for firms from virtually every country that has an active stock market, so it’s possible to invest in a wide variety of foreign stocks through ADRs. To examine pricing of ADRs, consider first the case of liquid stocks that are widely traded by investors. If traders notice price discrepancies between the prices of ADRs and the underlying stocks, they will immediately jump on the opportunity to make an arbitrage (or riskless) profit.


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The Zero Marginal Cost Society: The Internet of Things, the Collaborative Commons, and the Eclipse of Capitalism by Jeremy Rifkin

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3D printing, additive manufacturing, Airbnb, autonomous vehicles, back-to-the-land, big-box store, bioinformatics, bitcoin, business process, Chris Urmson, clean water, cleantech, cloud computing, collaborative consumption, collaborative economy, Community Supported Agriculture, computer vision, crowdsourcing, demographic transition, distributed generation, en.wikipedia.org, Frederick Winslow Taylor, global supply chain, global village, Hacker Ethic, industrial robot, informal economy, intermodal, Internet of things, invisible hand, Isaac Newton, James Watt: steam engine, job automation, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, Julian Assange, Kickstarter, knowledge worker, labour mobility, Mahatma Gandhi, manufacturing employment, Mark Zuckerberg, market design, means of production, meta analysis, meta-analysis, natural language processing, new economy, New Urbanism, nuclear winter, Occupy movement, oil shale / tar sands, pattern recognition, peer-to-peer lending, personalized medicine, phenotype, planetary scale, price discrimination, profit motive, RAND corporation, randomized controlled trial, Ray Kurzweil, RFID, Richard Stallman, risk/return, Ronald Coase, search inside the book, self-driving car, shareholder value, sharing economy, Silicon Valley, Skype, smart cities, smart grid, smart meter, social web, software as a service, spectrum auction, Steve Jobs, Stewart Brand, the built environment, The Nature of the Firm, The Structural Transformation of the Public Sphere, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, too big to fail, transaction costs, urban planning, Watson beat the top human players on Jeopardy!, web application, Whole Earth Catalog, Whole Earth Review, WikiLeaks, working poor, Zipcar

In a market-exchange economy, profit is made at the margins. For example, as an author, I sell my intellectual work product to a publisher in return for an advance and future royalties on my book. The book then goes through several hands on the way to the end buyer, including an outside copyeditor, compositor, printer, as well as wholesalers, distributors, and retailers. Each party in this process is marking up the transaction costs to include a profit margin large enough to justify their participation. But what if the marginal cost of producing and distributing a book plummeted to near zero? In fact, it’s already happening. A growing number of authors are writing books and making them available at a very small price, or even for free, on the Internet—bypassing publishers, editors, printers, wholesalers, distributors, and retailers.

The fixed costs of bringing online a distributed IoT infrastructure, while considerable, are far less than those required to build out and maintain the more centralized technology platforms of the First and Second Industrial Revolutions. While fixed costs are less, the Internet of Things also brings down the marginal cost of communication, energy, and logistics in the production and distribution of goods and services. By eliminating virtually all of the remaining middlemen who mark up the transaction costs at every stage of the value chain, small- and medium-sized enterprises—especially cooperatives and other nonprofit businesses—and billions of prosumers can share their goods and services directly with one another on the Collaborative Commons—at near zero marginal cost. The reduction in both fixed and marginal costs dramatically reduces the entry costs of creating new businesses in distributed peer-to-peer networks.

With print, commercial “trust” was sealed in written accounts accompanied by personal signatures. The convergence of print and renewable energies had the effect of democratizing both literacy and power, posing a formidable challenge to the hierarchical organization of feudal life. The synergies created by the print revolution and wind and water power, along with steady improvements in road and river transport, sped up exchange and decreased transaction costs, making possible trade in larger regional markets. The new communication/energy matrix not only shortened distances and quickened time, bringing diverse people together in joint economic pursuits after centuries of isolation, but in so doing, also encouraged a new openness to others and the beginning of a more cosmopolitan frame of mind. Centuries of provincialism and xenophobia that had stultified life began to melt away and a new sense of possibility seized the human imagination.


pages: 442 words: 39,064

Why Stock Markets Crash: Critical Events in Complex Financial Systems by Didier Sornette

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Asian financial crisis, asset allocation, Berlin Wall, Bretton Woods, Brownian motion, capital asset pricing model, capital controls, continuous double auction, currency peg, Deng Xiaoping, discrete time, diversified portfolio, Elliott wave, Erdős number, experimental economics, financial innovation, floating exchange rates, frictionless, frictionless market, full employment, global village, implied volatility, index fund, invisible hand, John von Neumann, joint-stock company, law of one price, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, market design, market fundamentalism, mental accounting, moral hazard, Network effects, new economy, oil shock, open economy, pattern recognition, Paul Erdős, quantitative trading / quantitative finance, random walk, risk/return, Ronald Reagan, Schrödinger's Cat, short selling, Silicon Valley, South Sea Bubble, statistical model, stochastic process, Tacoma Narrows Bridge, technological singularity, The Coming Technological Singularity, The Wealth of Nations by Adam Smith, Tobin tax, total factor productivity, transaction costs, tulip mania, VA Linux, Y2K, yield curve

Let us consider the limit where only Bt t and Bt t − 1 are nonzero and the natural waiting time between transactions is approximately equal to the correlation time taken as the time unit, again equal to five minutes in this exercise. The point is that you don’t want to trade too much, otherwise you will have to pay for significant transaction costs. The average return over one correlation time that you will make using this strategy is of the order of the typical amplitude of the return over these five minutes, say 003% (to account for imperfections in the prediction skills, we take a somewhat more conservative measure than the scale of 004% over one minute used before). Over a day, this gives an average gain of 059%, which accrues to 435% per year when return is reinvested, or 150% without reinvestment! Such small correlations would lead to substantial profits if transaction costs and other friction phenomena like slippage did not exist (slippage refers to the fact that market orders are not always executed at the order price due to limited liquidity and finite human execution time).

Such small correlations would lead to substantial profits if transaction costs and other friction phenomena like slippage did not exist (slippage refers to the fact that market orders are not always executed at the order price due to limited liquidity and finite human execution time). It is clear that a transaction cost as small as 003%, or $3 per $10000 invested is enough to destroy the expected gain of this strategy. The conundrum is that you cannot trade at a slower rate in order to reduce the transaction costs because, if you do so, you lose your prediction skill based on correlations only present within a five minute time 38 chapter 2 horizon. We can conclude that the residual correlations are those little enough not to be profitable by strategies such as those described above due to “imperfect” market conditions. In other words, the liquidity and efficiency of markets control the degree of correlation that is compatible with a near absence of arbitrage opportunity. THE EFFICIENT MARKET HYPOTHESIS AND THE RANDOM WALK Such observations have been made for a long time.

Assuming the validity of the no-arbitrage condition together with rational expectations amounts to postulating that a fraction of the population of traders behave in such a way that prices tend to reflect available information and that risk is adequately and approximately fairly remunerated. In order to understand the specific manners with which this is attained would require a level of modeling not yet available at present and whose achievement is at the heart of a very active domain of research that we only glimpsed in chapter 4. As we pointed out in chapter 2, the existence of transaction costs and other imperfections of the market should not be used as an excuse for disregarding the no-arbitrage condition but rather should be constructively invoked to study its impacts on the models. In other words, these market imperfections are considered as second-order effects. Existence of Rational Agents Mainstream finance and economic modeling add a second overarching organizing principle, namely that investors and economic agents are rational.


pages: 295 words: 66,824

A Mathematician Plays the Stock Market by John Allen Paulos

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Benoit Mandelbrot, Black-Scholes formula, Brownian motion, business climate, butterfly effect, capital asset pricing model, correlation coefficient, correlation does not imply causation, Daniel Kahneman / Amos Tversky, diversified portfolio, Donald Trump, double entry bookkeeping, Elliott wave, endowment effect, Erdős number, Eugene Fama: efficient market hypothesis, four colour theorem, George Gilder, global village, greed is good, index fund, invisible hand, Isaac Newton, John Nash: game theory, Long Term Capital Management, loss aversion, Louis Bachelier, mandelbrot fractal, margin call, mental accounting, Nash equilibrium, Network effects, passive investing, Paul Erdős, Ponzi scheme, price anchoring, Ralph Nelson Elliott, random walk, Richard Thaler, Robert Shiller, Robert Shiller, short selling, six sigma, Stephen Hawking, transaction costs, ultimatum game, Vanguard fund, Yogi Berra

Again, poorly understood behavioral factors seem to be involved. Technical Strategies and Blackjack Most academic financial experts believe in some form of the random-walk theory and consider technical analysis almost indistinguishable from a pseudoscience whose predictions are either worthless or, at best, so barely discernibly better than chance as to be unexploitable because of transaction costs. I’ve always leaned toward this view, but I’ll reserve my more nuanced judgment for later in the book. In the meantime, I’d like to point out a parallel between market strategies such as technical analysis in one of its many forms and blackjack strategies. (There are, of course, great differences too.) Blackjack is the only casino game of chance whose outcomes depend on past outcomes. In roulette, the previous spins of the wheel have no effect on future spins.

Through the actions of this investing horde the market rapidly responds to the new information, efficiently adjusting prices to reflect it. Opportunities to make an excess profit by utilizing technical rules or fundamental analyses, so the story continues, disappear before they can be fully exploited, and investors who pursue them will see their excess profits shrink to zero, especially after taking into account brokers’ fees and other transaction costs. Once again, it’s not that subscribers to technical or fundamental analysis won’t make money; they generally will. They just won’t make more than, say, the S&P 500. (That exploitable opportunities tend to gradually disappear is a general phenomenon that occurs throughout economics and in a variety of fields. Consider an argument about baseball put forward by Steven Jay Gould in his book Full House: The Spread of Excellence from Plato to Darwin.

An expectation of a regression to the mean is not the whole story, of course, but there are dozens of studies suggesting that value investing, generally over a three-to-five year period, does result in better rates of return than, say, growth investing. It’s important to remember, however, that the size of the effect varies with the study (not surprisingly, some studies find zero or a negative effect), transaction costs can eat up some or all of it, and competing investors tend to shrink it over time. In chapter 6 I’ll consider the notion of risk in general, but there is a particular sort of risk that may be relevant to value stocks. Invoking the truism that higher risks bring greater returns even in an efficient market, some have argued that value companies are risky because they’re so colorless and easily ignored that their stock prices must be lower to compensate!


pages: 193 words: 63,618

The Fair Trade Scandal: Marketing Poverty to Benefit the Rich by Ndongo Sylla

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British Empire, carbon footprint, corporate social responsibility, David Ricardo: comparative advantage, deglobalization, Doha Development Round, Food sovereignty, global value chain, illegal immigration, income inequality, income per capita, invisible hand, Joseph Schumpeter, labour mobility, land reform, market fundamentalism, means of production, Mont Pelerin Society, Naomi Klein, non-tariff barriers, offshore financial centre, open economy, Plutocrats, plutocrats, price mechanism, purchasing power parity, Ronald Reagan, Scientific racism, structural adjustment programs, The Wealth of Nations by Adam Smith, trade liberalization, transaction costs, transatlantic slave trade, trickle-down economics, Washington Consensus

But this is in all likelihood only possible if FT producers pay ‘unfair’ and ‘unsustainable’ prices to the rest of the economy, or if a significant growth in global productivity occurs in the nations in question. However, the first assumption is not acceptable for a movement concerned with sustainable working conditions, whereas the second is simply a parameter beyond the scope of the movement. The second answer consists in reducing transaction costs. Here again there are macroeconomic and institutional considerations that curb the determination and the margin for manoeuvre of producer organisations. Indeed, the level of transaction costs is influenced by the economic development level reached by countries. Generally speaking, they are higher among poor countries than among rich ones (World Bank, 2010b and its Logistics Performance Index). The third answer is that cost reduction can finally refer to achieving economies of scale in production (improving technical efficiency as opposed to allocative efficiency).

Fallacies around efficiency When a theory is filled with contradictions, these generally take the form of ‘residual categories’, in other words notions or concepts that are inconsistent a priori, or even contradictory, in relation to its fundamental axioms (Alexander, 1987). The notion of ‘efficiency’ enjoys such a status in the paradigm of ‘sustainable social economy’ in its FT version. Indeed, in the book written by the two co-founders of Fairtrade, numerous sections advocate in favour of the increased efficiency of producers in the South. For instance, one can read: Fair Trade should suggest a market structure that reduces transaction costs as much as possible. Inefficiency leads to higher costs, and therefore, loss of markets. (Roozen and van der Hoff, 2002: 245) Fair Trade does not encourage inefficient production by suggesting a protected market. (Roozen and van der Hoff, 2002: 247) Or again: Fair Trade is full-fledged trade and must therefore adapt to the key components of the market as a whole: efficiency and quality, financial 88 Sylla T02779 01 text 88 28/11/2013 13:04 the free market as a solution to poverty flexibility and the use of appropriate techniques are the guarantees of an environmentally sound production model and of long-term economic policy.


pages: 700 words: 201,953

The Social Life of Money by Nigel Dodd

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accounting loophole / creative accounting, bank run, banking crisis, banks create money, Bernie Madoff, bitcoin, blockchain, borderless world, Bretton Woods, BRICs, capital controls, cashless society, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, computer age, conceptual framework, credit crunch, cross-subsidies, David Graeber, debt deflation, dematerialisation, disintermediation, eurozone crisis, fiat currency, financial innovation, Financial Instability Hypothesis, financial repression, floating exchange rates, Fractional reserve banking, German hyperinflation, Goldman Sachs: Vampire Squid, Hyman Minsky, illegal immigration, informal economy, interest rate swap, Isaac Newton, John Maynard Keynes: Economic Possibilities for our Grandchildren, joint-stock company, Joseph Schumpeter, Kula ring, laissez-faire capitalism, land reform, late capitalism, liquidity trap, litecoin, London Interbank Offered Rate, M-Pesa, Marshall McLuhan, means of production, mental accounting, microcredit, mobile money, money: store of value / unit of account / medium of exchange, mortgage debt, new economy, Nixon shock, Occupy movement, offshore financial centre, paradox of thrift, payday loans, Peace of Westphalia, peer-to-peer lending, Ponzi scheme, post scarcity, postnationalism / post nation state, predatory finance, price mechanism, price stability, quantitative easing, quantitative trading / quantitative finance, remote working, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Satoshi Nakamoto, Scientific racism, seigniorage, Skype, Slavoj Žižek, South Sea Bubble, sovereign wealth fund, special drawing rights, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transaction costs, Wave and Pay, WikiLeaks, Wolfgang Streeck, yield curve, zero-coupon bond

According to Ingham, there is a logical fallacy at the heart of the evolutionary theory of money because it cannot explain why all agents choose a particular asset as “money.” The problem, he argues, comes down to Menger’s adherence to an untenable methodological individualism, with each agent trying to reduce transaction costs in isolation, both from each other and, more importantly, an overarching institutional authority: “To state the sociologically obvious: the advantages of money for the individual presuppose the existence of money as an institution in which its ‘moneyness’ is established” (Ingham 2004b: 23, original italics). Orléan sees the issue slightly differently, arguing that whereas the emphasis on reducing transactions costs is an advantage of Menger’s model, “what the instrumentalist approach has never been able successfully to demonstrate is that money is an essential requirement for the existence of a market economy” (Orléan 2013: 51).

By design, the euro entailed breaking up the relationship between money and political authority by assigning the task of monetary creation to a central bank that would be rigorously independent (Goodhart 1998: 425). This method is meant to treat money as if it were a commodity: a creature of the market, not of sovereignty, law, or society. According to Goodhart, the euro’s design was informed by the theory of “optimal currency areas,” in which it is assumed—consistent with Menger’s theory—that money’s spatial domain can evolve on the basis of the progressive minimization of transaction costs (Goodhart 1998: 419). If Menger’s theory has been discredited by historical evidence that contradicts it, what explains its enduring appeal to economists? For one thing, the theory seems elegant and simple. As Goodhart notes, although the idea that money is a social or political artifact might be better supported by the empirical data, such a viewpoint “is somewhat woolly and socio-logical” (Goodhart 2008: 301), and does not lend itself easily to mathematical modeling.

This coping mechanism is now performed by public institutions, such as central banks (Harvey 2010a: 81). 12 There are hints of functionalist explanation in Marx’s argument at this stage, particularly when he says that credit money “takes root spontaneously in the function of money as the means of payment” (Marx 1982: 224)—as if the need for credit money was enough, historically, to bring about its emergence. As Harvey notes, the credit monies Marx refers to originated as private bills of exchange that had two key advantages: their supply adjusted quickly to changes in commodity production (unlike ordinary money, credit notes disappear from circulation once they are paid off), and they helped to reduce transaction costs (Harvey 2006: 245–46). 13 Gold, in turn, was the main constituent of international means of payment, or world money. When gold functions in this way, Marx said, money reverts to its “primitive” form (Marx 2009: 202). 14 Peter Schlemihl is the main character in Adelbert von Chamisso’s novel, Peter Schlemihls wundersame Geschichte (1814) (von Chamisso 2008), who sells his shadow to the devil in exchange for an endless supply of gold.


pages: 545 words: 137,789

How Markets Fail: The Logic of Economic Calamities by John Cassidy

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Albert Einstein, Andrei Shleifer, anti-communist, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black-Scholes formula, Bretton Woods, British Empire, capital asset pricing model, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, global supply chain, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, laissez-faire capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Network effects, Nick Leeson, Northern Rock, paradox of thrift, Ponzi scheme, price discrimination, price stability, principal–agent problem, profit maximization, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, unorthodox policies, value at risk, Vanguard fund

In his 1960 article, he acknowledged that when an activity inflicted harm on many different people, getting all the interested parties to agree on an efficient solution might be difficult and costly. Economists refer to the costs of negotiation as transaction costs: in his Nobel lecture, Coase acknowledged that the theorem named after him applied only when these were negligible. “I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transactions costs,” he said. And he went on: “[I]t does not imply, when transaction costs are positive, that government action . . . could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do.”

Such a simplistic mindset makes it impossible for people to discuss in a responsible way the relative merits of different tax systems. Instead, we Pigovians acknowledge: (1) There will be some government spending; (2) This spending will be funded with taxes; (3) Government should use the least bad taxes it has available. In fact, Pigovian taxes are not only least bad—they are good. They correct market failures when transaction costs are too high to expect the forces of the Coase theorem to fix the problem. An alternative method of dealing with global warming is for the government to impose a cap on total carbon emissions. A variant of this idea, which the Obama administration is pursuing, is to distribute a limited number of “emission rights,” which can be traded in a secondary market. “Cap and trade” schemes of this type have already been used successfully to reduce emissions of sulfur dioxide and nitrogen oxide, which cause acid rain, and they form the basis of the Kyoto Protocol, the international climate change treaty, from which the United States withdrew in 2001.


pages: 382 words: 120,064

Bank 3.0: Why Banking Is No Longer Somewhere You Go but Something You Do by Brett King

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3D printing, additive manufacturing, Albert Einstein, Amazon Web Services, Any sufficiently advanced technology is indistinguishable from magic, asset-backed security, augmented reality, barriers to entry, bitcoin, bounce rate, business intelligence, business process, business process outsourcing, call centre, capital controls, citizen journalism, Clayton Christensen, cloud computing, credit crunch, crowdsourcing, disintermediation, en.wikipedia.org, George Gilder, Google Glasses, high net worth, I think there is a world market for maybe five computers, Infrastructure as a Service, invention of the printing press, Jeff Bezos, jimmy wales, London Interbank Offered Rate, M-Pesa, Mark Zuckerberg, mass affluent, microcredit, mobile money, more computing power than Apollo, Northern Rock, Occupy movement, optical character recognition, performance metric, platform as a service, QWERTY keyboard, Ray Kurzweil, recommendation engine, RFID, risk tolerance, self-driving car, Skype, speech recognition, stem cell, telepresence, Tim Cook: Apple, transaction costs, underbanked, web application

A lack of formal financial services infrastructure and activity limits market exchanges, increases risk, and limits opportunities to save. Without formal financial services, households rely on informal services that are associated with high transaction costs. Thus increasing access to formal financial services for the majority of households in developing countries remains an important policy goal for institutions such as the United Nations, the World Bank and IMF. It has also been recognised that even for those with bank accounts, physical distances to branches or points of financial service add significantly to transactions costs. Mainstream financial institutions generally shy away from developing economies because of the premise that low-income populations do not save and are bad borrowers. However, the microfinance revolution effectively shattered these myths by demonstrating that when poor households have access to financial services, not only do they save, they also have high repayment rates and low default rates when they borrow.

Finally, HTML5 allows developers to embed links to specific web pages into specific parts of an app, a technique that can be particularly useful for promotions and advertising. To date, this “deep linking” has not been easy to do in native apps. Of course, HTML5 won’t be a silver bullet that eliminates all the downsides to native apps in a single stroke. Although HTML5 will reduce developers’ dependence on app stores, which typically take a commission of between 10 and 30 per cent, they will still incur some marketing, distribution and transaction costs. The benefits of cross-platform speed to market, along with lower distribution costs, mean that the likes of Facebook will be championing HTML5 as an alternative app experience. The restrictions will be around native mobile function and feature access. That will likely be solved by mobile browsers that have the native plug-ins. So how long does the App Store have? Maybe another two to three years of dominance.

In October 2011, iZettle raised $11m in a Series A financing deal, supporting its growth plans.16 iZettle is based in Sweden. But there are other competitors also, including the likes of iCarte, Erply, iMag, and others looking to enable NFC in the same way. Dwolla Unlike Square and PayPal, Dwolla works completely independently of the existing payment networks beyond cash-in and cash-out functionality. Dwolla’s main strategy is to attack the current transaction costs of moving money around. If a transaction is under $10, the transfer (or payment) is free, if over $10, there is a capped $0.25 fee. Dwolla has around 70,000 customers today (including 5000 merchants or retailers17) and it already processes around $1m a day through its network. Dwolla argues that its network is safer for consumers and merchants alike because it doesn’t send sensitive credit card details across the network—just a secure ID and the transaction details.


pages: 424 words: 115,035