transaction costs

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pages: 1,164 words: 309,327

Trading and Exchanges: Market Microstructure for Practitioners by Larry Harris

active measures, Andrei Shleifer, asset allocation, automated trading system, barriers to entry, Bernie Madoff, business cycle, buttonwood tree, buy and hold, compound rate of return, computerized trading, corporate governance, correlation coefficient, data acquisition, diversified portfolio, fault tolerance, financial innovation, financial intermediation, fixed income, floating exchange rates, High speed trading, index arbitrage, index fund, information asymmetry, information retrieval, interest rate swap, invention of the telegraph, job automation, law of one price, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market clearing, market design, market fragmentation, market friction, market microstructure, money market fund, Myron Scholes, Nick Leeson, open economy, passive investing, pattern recognition, Ponzi scheme, post-materialism, price discovery process, price discrimination, principal–agent problem, profit motive, race to the bottom, random walk, rent-seeking, risk tolerance, risk-adjusted returns, selection bias, shareholder value, short selling, Small Order Execution System, speech recognition, statistical arbitrage, statistical model, survivorship bias, the market place, transaction costs, two-sided market, winner-take-all economy, yield curve, zero-coupon bond, zero-sum game

Accordingly, they try to trade more or less aggressively if, on a per unit basis, their missed trade opportunity costs are respectively greater or less than their transaction costs. Traders who are concerned about this issue should estimate their marginal transaction costs from the costs of executing the last trades that fill their orders. 21.7 TRANSACTION COST PREDICTION Traders need to predict transaction costs in order to evaluate active trading strategies. To this end, traders develop, estimate, and use transaction cost prediction models. Most transaction cost prediction analyses use explicit and implicit information to predict transaction costs. 21.7.1 Explicit Information About Future Transaction Costs Explicit information about future transaction costs consists of the contractual information about commissions and trading fees enumerated above.

We then consider how traders use information about past transaction costs to predict future transaction costs. 21.1 TRANSACTION COST COMPONENTS Defining and measuring exactly what we mean by the term “transaction costs” is difficult. This entire book is about understanding what transaction costs are, where they come from, and how to measure them. We explore these questions in detail throughout this book. For our present purpose, transaction costs include all costs associated with trading. These costs include explicit costs, implicit costs, and missed trade opportunity costs. Explicit transaction costs are all costs that a cost accountant would easily identify. These costs include commissions paid to brokers, fees paid to exchanges, and taxes paid to government. Explicit transaction costs also include any resources that traders devote to the trading process.

In chapter 22, we consider why superior selection/composition performance is difficult to achieve and even more difficult to predict. 21 Liquidity and Transaction Cost measurement Traders pay attention to their transaction costs because transaction costs make implementation of their trading strategies expensive. Transaction costs are most important to traders who trade frequently or who trade large sizes. For most active traders, transaction costs are the most significant determinants of their total returns. Speculators who perform poorly usually do so because their transaction costs exceed the values of their trading strategies. Traders measure their transaction costs to evaluate how well they and their brokers have implemented their trading strategies. Traders must evaluate implementation in order to manage it effectively.


pages: 504 words: 139,137

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

activist fund / activist shareholder / activist investor, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, money market fund, mortgage debt, Myron Scholes, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stocks for the long run, stocks for the long term, survivorship bias, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

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

algorithmic trading, automated trading system, backtesting, commoditize, computerized trading, 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, money market fund, 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

algorithmic trading, asset allocation, automated trading system, backtesting, Black Swan, Brownian motion, business continuity plan, buy and hold, compound rate of return, Edward Thorp, Elliott wave, endowment effect, fixed income, general-purpose programming language, index fund, John Markoff, Long Term Capital Management, loss aversion, p-value, paper trading, price discovery process, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Ray Kurzweil, Renaissance Technologies, risk-adjusted returns, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, systematic trading, transaction costs

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: 313 words: 95,077

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

Andrew Keen, Berlin Wall, bioinformatics, Brewster Kahle, c2.com, Charles Lindbergh, 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, Joi Ito, Kuiper Belt, liberation theology, Mahatma Gandhi, means of production, Merlin Mann, Metcalfe’s law, Nash equilibrium, Network effects, Nicholas Carr, Picturephone, place-making, Pluto: dwarf planet, prediction markets, price mechanism, prisoner's dilemma, profit motive, Richard Stallman, Robert Metcalfe, 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, Vilfredo Pareto, 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: 354 words: 26,550

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

algorithmic trading, asset allocation, asset-backed security, automated trading system, backtesting, Black Swan, Brownian motion, business cycle, business process, buy and hold, capital asset pricing model, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, computerized trading, diversification, equity premium, fault tolerance, financial intermediation, fixed income, high net worth, implied volatility, index arbitrage, information asymmetry, interest rate swap, inventory management, law of one price, Long Term Capital Management, Louis Bachelier, margin call, market friction, market microstructure, martingale, Myron Scholes, 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, zero-sum game

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: 356 words: 103,944

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

affirmative action, Asian financial crisis, bank run, banking crisis, bilateral investment treaty, borderless world, Bretton Woods, British Empire, business cycle, 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, endogenous growth, 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, industrial cluster, information asymmetry, joint-stock company, Kenneth Rogoff, land reform, liberal capitalism, light touch regulation, Long Term Capital Management, low skilled workers, margin call, market bubble, market fundamentalism, Martin Wolf, mass immigration, 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, Paul Samuelson, 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.


High-Frequency Trading by David Easley, Marcos López de Prado, Maureen O'Hara

algorithmic trading, asset allocation, backtesting, Brownian motion, capital asset pricing model, computer vision, continuous double auction, dark matter, discrete time, finite state, fixed income, Flash crash, High speed trading, index arbitrage, information asymmetry, interest rate swap, latency arbitrage, margin call, market design, market fragmentation, market fundamentalism, market microstructure, martingale, natural language processing, offshore financial centre, pattern recognition, price discovery process, price discrimination, price stability, quantitative trading / quantitative finance, random walk, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, Tobin tax, transaction costs, two-sided market, yield curve

For example, they can be used as impact minimisers, but when excessive HFT activity is detected they can update minimum crossing quantities and limit prices quickly, to protect the order from being gamed or otherwise exploited. Specific examples of constructing and using HFT signals are given later, after a brief discussion of the effect of adaptive algorithms on transaction cost. ALGORITHMS AND TRANSACTION COST In this section we discuss transaction cost at the client order level. Although this is not a high-frequency view of the trading process, we want to understand the general properties of price impact and also provide evidence that high-frequency signals reduce the total transaction cost. 28 i i i i i i “Easley” — 2013/10/8 — 11:31 — page 29 — #49 i i EXECUTION STRATEGIES IN EQUITY MARKETS Figure 2.2 Average arrival slippage by participation rate Arrival slippage (bp) 10 5 0 0 5 10 15 Participation rate (%) 20 25 Fully filled client orders of at least 1,000 shares and duration of at least one minute were used.

Monitoring market conditions for high toxicity can be particularly beneficial for LF traders. In the US flash crash, the Waddell and Reed trader would surely have been well advised to defer trading rather than to sell, as they did, in a market experiencing historically high toxicity levels. Choice #3: join the herd Trade with volume bursts, such as at the opening and closing of the session, when your footprint is harder to detect. Transaction costs now largely consist of price impact costs, and astute LF traders must use transaction cost analysis products that are predictive, rather than simply reactive. Naive trading strategies are simply bait for predatory algorithms. 15 i i i i i i “Easley” — 2013/10/8 — 11:31 — page 16 — #36 i i HIGH-FREQUENCY TRADING Choice #4: Use “smart brokers”, who specialise in searching for liquidity and avoiding footprints As we have seen, HFT algorithms can easily detect when there is a human in the trading room, and take advantage.

By summing over 185 i i i i i i “Easley” — 2013/10/8 — 11:31 — page 186 — #206 i i HIGH-FREQUENCY TRADING all child orders, we can thus measure the effect of the temporary component on overall trading costs. To be more precise, we extend the classic Perold (1988) “implementation shortfall” approach to decompose ex post transaction costs into various components, one of which accounts for the trading costs associated with transitory pricing errors. Because trading cost analysis is often performed on an institution’s daily trading, we first illustrate our transaction cost measurement approach at a daily frequency. However, our methods are much more precise when more disaggregated trading data are available. Using detailed information on the intra-day child order executions from a larger institutional parent order, we show how the transitory price component evolves with trading on a minute-by-minute basis, and we show how this transitory price component contributes to overall implementation shortfall.


pages: 346 words: 97,330

Ghost Work: How to Stop Silicon Valley From Building a New Global Underclass by Mary L. Gray, Siddharth Suri

Affordable Care Act / Obamacare, Amazon Mechanical Turk, augmented reality, autonomous vehicles, barriers to entry, basic income, big-box store, bitcoin, blue-collar work, business process, business process outsourcing, call centre, Capital in the Twenty-First Century by Thomas Piketty, cloud computing, collaborative consumption, collective bargaining, computer vision, corporate social responsibility, crowdsourcing, data is the new oil, deindustrialization, deskilling, don't be evil, Donald Trump, Elon Musk, employer provided health coverage, en.wikipedia.org, equal pay for equal work, Erik Brynjolfsson, financial independence, Frank Levy and Richard Murnane: The New Division of Labor, future of work, gig economy, glass ceiling, global supply chain, hiring and firing, ImageNet competition, industrial robot, informal economy, information asymmetry, Jeff Bezos, job automation, knowledge economy, low skilled workers, low-wage service sector, market friction, Mars Rover, natural language processing, new economy, passive income, pattern recognition, post-materialism, post-work, race to the bottom, Rana Plaza, recommendation engine, ride hailing / ride sharing, Ronald Coase, Second Machine Age, sentiment analysis, sharing economy, Shoshana Zuboff, side project, Silicon Valley, Silicon Valley startup, Skype, software as a service, speech recognition, spinning jenny, Stephen Hawking, The Future of Employment, The Nature of the Firm, transaction costs, two-sided market, union organizing, universal basic income, Vilfredo Pareto, women in the workforce, Works Progress Administration, Y Combinator

See benefits; wages computers access to, 85, 122, 236 n26 algorithmic cruelty in, 67–69, 85–91 as executors of code, xiv–xv humans as, 39, 51–53, 54, 57 limitations of, 170–71, 231 n41 outsourcing, rise of, 54–56 consumer action, 193–94 content moderation, ix, x–xii, xxi, 19, 183 Contingent and Alternative Employment Arrangements, xxiv contingent work, xxii, xxiv, 8, 44, 46, 51, 53–55, 58–61 contract (temporary) work Amazon.com hiring of, 1–2 classification of, 57–63, 144–47 vs full-time work, 45–50, 159–60, 172–73, 185, 187–88 reliance on, 39 transaction costs, 68–69 See also on-demand employment corporate culture, transaction costs, 73 corporate firewalls, 16–21 cost-of-living allowance (COLA), 47 costs/expenses of employees, 39, 54 hiring, 32 outsourcing and, 55 platform fees, 144–47 shared workspaces, 180–81 social consequences, 68–69 transaction costs. see transaction costs up-front costs for workers, 108 See also double bottom line Craigslist, 4, 27, 32 creativity dependence on, xii, 31, 147, 170–71, 192 humans vs CPUs, xiv, 176, 231 n41 LeadGenius, 22 need for, 21, 161, 177–78 CrowdFlower, xv, 13, 34–35, 144–45 crowdsourcing.

So the humans, on both sides of the market, are left with the task of resolving these complexities at their own expense, though the workers bear the heavier brunt of these costs. The Cost of Doing Business At the heart of the on-demand economy is the premise that relying on ghost work cuts transaction costs and, therefore, boosts profits. Transaction costs are those expenses associated with managing the production and exchange of goods or services. Nobel laureate Ronald Coase, a key contributor to modern economic theory, popularized the notion of transaction costs, though he did not coin the phrase itself. His seminal 1937 article “The Nature of the Firm” was published only two years after Wagner passed the National Labor Relations Act. In it, Coase argued that businesses had to coordinate their operations, such as finding, hiring, and training workers, to reduce market frictions.

For all the claims that ghost work can combine algorithms, artificial intelligence, and platform interfaces to replace the company’s function as “the entrepreneur-coordinator, who directs production,”3 there is evidence to the contrary. The transaction costs of ghost work don’t melt away. Instead they are shifted to the shoulders of requesters and workers. Requesters must juggle all the management that typically comes with scoping a new project and handing it to a new employee. They spend extra time and energy explaining tasks that they thought needed no explication once converted to code and relayed via APIs. Workers pay a disproportionately higher price: they lose their time, even their paychecks, with no opportunity to appeal any mistreatment. Many of the transaction costs passed on to requesters mirror those shouldered by workers. Each hurdle faced demonstrates that ghost work isn’t working smoothly for anyone involved. REQUESTING WORK: TRANSACTION COSTS The most commonly reported requester difficulty occurred in the process of matching a worker to a task.


Capital Ideas Evolving by Peter L. Bernstein

Albert Einstein, algorithmic trading, Andrei Shleifer, asset allocation, business cycle, buy and hold, buy low sell high, capital asset pricing model, commodity trading advisor, computerized trading, creative destruction, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, diversification, diversified portfolio, endowment effect, equity premium, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, high net worth, hiring and firing, index fund, invisible hand, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, market bubble, mental accounting, money market fund, Myron Scholes, paper trading, passive investing, Paul Samuelson, price anchoring, price stability, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical model, survivorship bias, systematic trading, technology bubble, The Wealth of Nations by Adam Smith, transaction costs, yield curve, Yogi Berra, zero-sum game

Then came the jumbo crash of October 19, 1987, when stock prices fell over 20 percent in one day, and portfolio insurance crashed along with the market. But that was then. In contrast to Capital Ideas, this book is almost completely about the implementation of theory and only incidentally about the development of new theory. * Just incidentally, in relation to how transactions costs on October 19 nearly buried portfolio insurance, Bob Merton has pointed out to me the wonderful paradox that there would be no Black-Scholes-Merton option pricing model without transactions costs. Transactions costs make the replicating portfolio impractical and options irreplaceable. bern_a03fpref.qxd xii 3/23/07 8:43 AM Page xii PREFACE It is interesting to note that this process is not unique to finance. E. Han Kim of the Ross School of Business at the University of Michigan and two colleagues recently authored a study of papers published in major economics journals over the last thirty-five years that had received more than 500 citations as of June 2006.1 In reviewing the content of these papers, Kim and his coauthors find that “In the early 1970s, 77 percent of the most highly cited papers were theoretical, while only 11 percent [were] empirical.

Investors using portfolio insurance did fare better than uninsured investors, but their outcome was far from what they had been led to expect. The difficulty of executing transactions was overwhelming as panic transformed the whole market-making process into a disaster area. Because of the practical difficulties, especially the transactions costs of managing a replicating portfolio, investors are better off trading in a derivative instrument such as an option or a futures contract, if it is available. As Merton explains, “Black-Scholes has value because of the existence of transaction costs!” If there were no transactions costs to anyone, puts and calls would be useless, portfolio insurance would have been a glorious success, and Black, Scholes, and Merton would have had to find other ways to spend their time—and would they have won a Nobel anyway? In reality, institutions efficiently produce options and other contingent claims and sell them to investors who desire the payoff patterns of the replicating portfolio at low cost.

To Merton, these markets are the crown jewels of the whole system, because derivative instruments have greatly expanded opportunities for risk sharing, have lowered transactions costs, and have reduced information and agency costs. bern_c04.qxd 54 3/23/07 9:02 AM Page 54 THE THEORETICIANS The bad news in this story is that we cannot trade without incurring the cost of producers who, in effect, do the replicating executions for us. But the good news is that competition is constantly forcing the institutions in the capital markets to seek ways of lowering transactions costs. Thus, institutional change is providing huge benefits to investors over what those investors would face without the miracles of technology and competition. For example, the Plexus Group, specialists in the analysis of transactions costs, anticipates a dramatic reduction in the cost of trading from the mergers between purely electronic exchanges like Instinet and traditional security markets with f loor brokers, like the New York Stock Exchange or NASDAQ.


pages: 369 words: 128,349

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

3Com Palm IPO, Andrei Shleifer, asset allocation, buy and hold, capital asset pricing model, correlation coefficient, cross-subsidies, Daniel Kahneman / Amos Tversky, diversified portfolio, endowment effect, fixed income, index arbitrage, index fund, information asymmetry, liberal capitalism, locking in a profit, Long Term Capital Management, loss aversion, margin call, market friction, market microstructure, mental accounting, merger arbitrage, Myron Scholes, new economy, prediction markets, price stability, profit motive, random walk, Richard Thaler, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, survivorship bias, 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: 350 words: 103,988

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

"Robert Solow", accounting loophole / creative accounting, Albert Einstein, Alvin Roth, Andrei Shleifer, Anton Chekhov, Asian financial crisis, congestion charging, corporate governance, corporate raider, 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, information asymmetry, invisible hand, Isaac Newton, job-hopping, John Harrison: Longitude, John von Neumann, Kenneth Arrow, land reform, lone genius, manufacturing employment, market clearing, market design, market friction, market microstructure, means of production, Network effects, new economy, offshore financial centre, ought to be enough for anybody, 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: 443 words: 51,804

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

algorithmic trading, asset allocation, automated trading system, backtesting, Black-Scholes formula, Brownian motion, business process, buy and hold, 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: 220 words: 73,451

Democratizing innovation by Eric von Hippel

additive manufacturing, correlation coefficient, Debian, disruptive innovation, hacker house, informal economy, information asymmetry, inventory management, iterative process, James Watt: steam engine, knowledge economy, longitudinal study, 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.


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

addicted to oil, asset allocation, backtesting, Black-Scholes formula, Bretton Woods, business cycle, buy and hold, 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, dogs of the Dow, equity premium, Eugene Fama: efficient market hypothesis, Everybody Ought to Be Rich, 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, Myron Scholes, new economy, oil shock, passive investing, Paul Samuelson, popular capitalism, 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, stocks for the long run, survivorship bias, 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.


pages: 678 words: 216,204

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

affirmative action, barriers to entry, bioinformatics, Brownian motion, call centre, Cass Sunstein, centre right, clean water, commoditize, dark matter, desegregation, East Village, fear of failure, Firefox, game design, George Gilder, hiring and firing, Howard Rheingold, informal economy, information asymmetry, invention of radio, Isaac Newton, iterative process, Jean Tirole, jimmy wales, John Markoff, Kenneth Arrow, longitudinal study, market bubble, market clearing, Marshall McLuhan, Mitch Kapor, New Journalism, optical character recognition, pattern recognition, peer-to-peer, 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, Vilfredo Pareto

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.


pages: 345 words: 86,394

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

Albert Einstein, asset allocation, beat the dealer, Black-Scholes formula, Brownian motion, butterfly effect, buy and hold, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, lateral thinking, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, 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

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, Pareto efficiency, 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: 504 words: 126,835

The Innovation Illusion: How So Little Is Created by So Many Working So Hard by Fredrik Erixon, Bjorn Weigel

"Robert Solow", Airbnb, Albert Einstein, American ideology, asset allocation, autonomous vehicles, barriers to entry, Basel III, Bernie Madoff, bitcoin, Black Swan, blockchain, BRICs, Burning Man, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Cass Sunstein, Clayton Christensen, Colonization of Mars, commoditize, corporate governance, corporate social responsibility, creative destruction, crony capitalism, dark matter, David Graeber, David Ricardo: comparative advantage, discounted cash flows, distributed ledger, Donald Trump, Elon Musk, Erik Brynjolfsson, fear of failure, first square of the chessboard / second half of the chessboard, Francis Fukuyama: the end of history, George Gilder, global supply chain, global value chain, Google Glasses, Google X / Alphabet X, Gordon Gekko, high net worth, hiring and firing, Hyman Minsky, income inequality, income per capita, index fund, industrial robot, Internet of things, Jeff Bezos, job automation, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, joint-stock company, Joseph Schumpeter, Just-in-time delivery, Kevin Kelly, knowledge economy, laissez-faire capitalism, Lyft, manufacturing employment, Mark Zuckerberg, market design, Martin Wolf, mass affluent, means of production, Mont Pelerin Society, Network effects, new economy, offshore financial centre, pensions crisis, Peter Thiel, Potemkin village, price mechanism, principal–agent problem, Productivity paradox, QWERTY keyboard, RAND corporation, Ray Kurzweil, rent-seeking, risk tolerance, risk/return, Robert Gordon, Ronald Coase, Ronald Reagan, savings glut, Second Machine Age, secular stagnation, Silicon Valley, Silicon Valley startup, Skype, sovereign wealth fund, Steve Ballmer, Steve Jobs, Steve Wozniak, technological singularity, telemarketer, The Chicago School, The Future of Employment, The Nature of the Firm, The Rise and Fall of American Growth, The Wealth of Nations by Adam Smith, too big to fail, total factor productivity, transaction costs, transportation-network company, tulip mania, Tyler Cowen: Great Stagnation, uber lyft, University of East Anglia, unpaid internship, Vanguard fund, Yogi Berra

When the entrepreneur can no longer manage the firm efficiently by relying only on entrepreneurial spirit, complexity typically overwhelms the company. Internal transaction costs suck the energy out of business development and value creation. Matters of less importance, and not what makes or breaks firms, begin to occupy them instead. When firms grow big, internal rent-seekers are empowered. So the good news is that the size of the firm is not predetermined, but it depends on how managers balance internal and external transaction costs. That balance does not just change because “business men will be constantly experimenting, controlling more or less.”19 It also determines whether companies can thrive, let alone survive. Companies go out of business when internal transaction costs get too high. Companies with internal transaction costs that are too high are companies that have lost their entrepreneurial spirit and allowed excessive managerialism.

Firms, after all, are complex social constructs, permeated with operational slack and inefficiencies that a perfectly functioning market could root out. Companies are hardly seamlessly connected and easily managed entities as described in glossy corporate presentations. Companies that fail often do so because internal transaction costs are too high. Yet firms also exist because of high market-transaction costs. And, in a way, the higher they are, the better it is to have companies, because the transaction costs partly set the value of a firm. Firms, if you want to be provocative, exist because markets fail, at least in a theoretical way. And the greater the failure, the more space there is for an upward valuation of companies. Coase put it slightly more dryly: “The main reason why it is profitable to establish a firm would seem to be that there is a cost of using the price mechanism.”18 A successful firm can bank on the value of its unique combination of ideas, management, capital, and labor – or of what it has that cannot easily be reproduced by the market, or copied by another firm.

As companies grew bigger, global, and fragmented they changed their habits but not their character. They still operate, for want of a better word, on “the Coasean principle,” the source code of corporate behavior that we introduced in the previous chapter. The beauty of globalization was that it cut market transaction costs – and, as a consequence, allowed for a reorganization of production. That change also created new conditions for how companies balance internal and external transaction costs. Companies could contract away a larger part of production because falling trade and transmission costs also cut market transaction costs. What is more, they could now define and bundle their core assets in new ways, and change their strategies for how to make money. Globalization, then, helped companies to “marketize” their supply and value chains, and benefit from taking selected parts of them out of their own organizations.


pages: 297 words: 84,009

Big Business: A Love Letter to an American Anti-Hero by Tyler Cowen

23andMe, Affordable Care Act / Obamacare, augmented reality, barriers to entry, Bernie Sanders, bitcoin, blockchain, Bretton Woods, cloud computing, cognitive dissonance, corporate governance, corporate social responsibility, correlation coefficient, creative destruction, crony capitalism, cryptocurrency, dark matter, David Brooks, David Graeber, don't be evil, Donald Trump, Elon Musk, employer provided health coverage, experimental economics, Filter Bubble, financial innovation, financial intermediation, global reserve currency, global supply chain, Google Glasses, income inequality, Internet of things, invisible hand, Jeff Bezos, late fees, Mark Zuckerberg, mobile money, money market fund, mortgage debt, Network effects, new economy, Nicholas Carr, obamacare, offshore financial centre, passive investing, payday loans, peer-to-peer lending, Peter Thiel, pre–internet, price discrimination, profit maximization, profit motive, RAND corporation, rent-seeking, reserve currency, ride hailing / ride sharing, risk tolerance, Ronald Coase, shareholder value, Silicon Valley, Silicon Valley startup, Skype, Snapchat, Social Responsibility of Business Is to Increase Its Profits, Steve Jobs, The Nature of the Firm, Tim Cook: Apple, too big to fail, transaction costs, Tyler Cowen: Great Stagnation, ultimatum game, WikiLeaks, women in the workforce, World Values Survey, Y Combinator

Prospective workers have such opinions, as do prospective CEOs, financial journalists, government officials, voters, commentators on social media, and just about everyone else. But you also can pick up on some significant hints of the fourth feature of how I view corporations, especially in chapter 3, on CEO pay, and in the chapter on finance.2 Still, I wish to push back against the focus on transactions costs in explaining modern business activity. If firms were mainly about lowering transactions costs, they would be loved much more than is the case. Firms do have low enough transactions costs to get the job done, at least compared with the other feasible alternatives. That said, firms do not have especially low or favorable transactions costs, and so we are frustrated with them often, including in our roles as employees. Unless we are working in a very small enterprise, we so often hate the bureaucracies in the companies we work in (even if we enforce comparable bureaucratic strictures when on the other side of the relationship).

While I have learned a great deal from the writings of Coase and Williamson, my final position is influenced more heavily by Commons, Kreps (the corporation as carrier of reputation), and Rotemberg.   2.   You might be tempted to suggest that viewing companies as carriers of social and legal reputation ultimately boils down to transaction-costs-minimizing theories of the firm. To be sure, the firm as a carrier of reputation does minimize transaction costs to some extent, but it also increases transaction costs by making the firm more of a target. I would say the carrier-of-reputation element is not fundamentally a choice a firm makes at the margin, resulting in minimal transaction costs, but rather part of what a firm is required to be (with room for adjustment at the margins), and in this regard it still differs significantly from the Coase and Williamson models. SELECTED BIBLIOGRAPHY Adelino, Manuel, Antoinette Schoar, and Felipe Severino. 2017.

This research has laid the groundwork for the most fundamental ideas about corporations in economic thought, but while it contains numerous grains of truth, it doesn’t describe my own perspective very well. I agree that sometimes corporations reduce transactions costs, but they don’t always, and I am not sure they do on average. Ask yourself a simple question. Let’s say you want to buy a work computer for your desk. Which method involves lower transactions costs: going online with Amazon (or driving to Best Buy) or trying to get an order for a new computer through your company’s purchasing department? Of course, it depends on the company in question, but most of us already know the likely answer. A lot of markets today involve very, very low transactions costs. The purchasing department may get you a better price if they buy in bulk, but dealing with them probably is more of a pain. Their priorities are not your priorities, paperwork and approval may be required, and your company is probably somewhat or maybe even deeply bureaucratic, especially if it has more than fifty or a hundred employees.


pages: 242 words: 68,019

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

"Robert Solow", Ada Lovelace, Albert Einstein, Arthur Eddington, assortative mating, business cycle, Claude Shannon: information theory, David Ricardo: comparative advantage, Douglas Hofstadter, Everything should be made as simple as possible, frictionless, frictionless market, George Akerlof, Gödel, Escher, Bach, income inequality, income per capita, industrial cluster, information asymmetry, invention of the telegraph, invisible hand, Isaac Newton, James Watt: steam engine, Jane Jacobs, job satisfaction, John von Neumann, Joi Ito, New Economic Geography, Norbert Wiener, p-value, Paul Samuelson, phenotype, price mechanism, Richard Florida, Ronald Coase, Rubik’s Cube, 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: 517 words: 139,477

Stocks for the Long Run 5/E: the Definitive Guide to Financial Market Returns & Long-Term Investment Strategies by Jeremy Siegel

Asian financial crisis, asset allocation, backtesting, banking crisis, Black-Scholes formula, break the buck, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, capital asset pricing model, carried interest, central bank independence, cognitive dissonance, compound rate of return, computer age, computerized trading, corporate governance, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Deng Xiaoping, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Financial Instability Hypothesis, fixed income, Flash crash, forward guidance, fundamental attribution error, housing crisis, Hyman Minsky, implied volatility, income inequality, index arbitrage, index fund, indoor plumbing, inflation targeting, invention of the printing press, Isaac Newton, joint-stock company, London Interbank Offered Rate, Long Term Capital Management, loss aversion, market bubble, mental accounting, money market fund, mortgage debt, Myron Scholes, new economy, Northern Rock, oil shock, passive investing, Paul Samuelson, Peter Thiel, Ponzi scheme, prediction markets, price anchoring, price stability, purchasing power parity, quantitative easing, random walk, Richard Thaler, risk tolerance, risk/return, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, stocks for the long run, survivorship bias, technology bubble, The Great Moderation, the payments system, The Wisdom of Crowds, transaction costs, tulip mania, Tyler Cowen: Great Stagnation, Vanguard fund

But there have been changes in the economy and financial markets that may raise the P/E ratio in the future. These changes include a decrease in the cost of investing in equity indexes, a lower discount rate, and an increase in knowledge about the advantages of equity versus fixed-income investments. A Fall in Transaction Costs Chapter 5 confirmed that the real return on equity as measured by stock indexes was between 6 and 7 percent after inflation over the past two centuries. But over the nineteenth century and the early part of the twentieth century, it was extremely difficult, if not impossible, for an investor to replicate these stock returns because of transactions costs. Charles Jones of Columbia University has documented the decline in stock trading costs over the last century.18 These costs include both the fees paid to brokers and the bid-asked spread, or the difference between the buying and selling price for stocks.

His analysis shows that the average one-way 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 in 2002, and even lower today. The fall in transaction costs implies that the price of obtaining and maintaining a diversified portfolio of common stocks, which is necessary to replicate index returns, could have easily cost investors from 1 to 2 percent per year over much of the nineteenth and early twentieth centuries. Because of these costs, investors in earlier years were less diversified and assumed more risk than implied by stock indexes. Alternatively, if investors attempted to buy all the stocks to replicate a broad-based index, their real returns could have been as low as 5 percent per year after deducting transaction costs. If the required real return on equity for investors is only 5 percent, then a P/E ratio of 20, corresponding to an earnings yield of 5 percent, will produce that return for today’s investors.19 Lower Real Returns on Fixed-Income Assets We have noted that the real returns on fixed-income assets have fallen dramatically over the past decade.

As noted earlier, the timing strategy had its biggest success avoiding the 1929-to-1932 crash. If that period is excluded, the returns of the timing strategy are 68 basis points per year behind the holding strategy, although the timing strategy has lower risk. TABLE 20-1 Annualized Returns of Timing and Holding Strategies, 1886–2012 Moreover, if the transaction costs of implementing the timing strategy are included in the calculations, the excess returns over the whole period, including the 1929-to-1932 Great Crash, more than vanish. Transaction costs include brokerage costs and bid-asked spreads, as well as the capital gains tax incurred when stocks are sold, and are assumed to be on average half a percent when buying or selling the market. This number probably underestimates such costs, especially in the earlier years, but likely overstates these costs in more recent years.


pages: 275 words: 84,980

Before Babylon, Beyond Bitcoin: From Money That We Understand to Money That Understands Us (Perspectives) by David Birch

agricultural Revolution, Airbnb, bank run, banks create money, bitcoin, blockchain, Bretton Woods, British Empire, Broken windows theory, Burning Man, business cycle, capital controls, cashless society, Clayton Christensen, clockwork universe, creative destruction, credit crunch, cross-subsidies, crowdsourcing, cryptocurrency, David Graeber, dematerialisation, Diane Coyle, disruptive innovation, distributed ledger, double entry bookkeeping, Ethereum, ethereum blockchain, facts on the ground, fault tolerance, fiat currency, financial exclusion, financial innovation, financial intermediation, floating exchange rates, Fractional reserve banking, index card, informal economy, Internet of things, invention of the printing press, invention of the telegraph, invention of the telephone, invisible hand, Irish bank strikes, Isaac Newton, Jane Jacobs, Kenneth Rogoff, knowledge economy, Kuwabatake Sanjuro: assassination market, large denomination, M-Pesa, market clearing, market fundamentalism, Marshall McLuhan, Martin Wolf, mobile money, money: store of value / unit of account / medium of exchange, new economy, Northern Rock, Pingit, prediction markets, price stability, QR code, quantitative easing, railway mania, Ralph Waldo Emerson, Real Time Gross Settlement, reserve currency, Satoshi Nakamoto, seigniorage, Silicon Valley, smart contracts, social graph, special drawing rights, technoutopianism, the payments system, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, tulip mania, wage slave, Washington Consensus, wikimedia commons

In chapter 14 I suggested that in the future all money will be local, belonging to the community in which it is used; it’s just that ‘community’ will mean something different in the connected world. Whether the community is Totnes or the Chinese diaspora or World of Warcraft won’t matter, but the shared desire to minimize transaction costs for ‘us’ at the possible expense of transactions costs with ‘them’ will. Since the overwhelming majority of retail transactions are local, most people’s transactions most of the time will be in their local currency, with minimal transaction costs. A small number of transactions will be in ‘foreign’ currencies (i.e. someone else’s local currency). From this perspective, the widespread view that ‘alternative’ money can work in isolated local environments but not at scale is wrong, because both locality and globalization will mean something different in the networked world and there’s no reason why interconnection between local money of one form or another (via markets) cannot operate globally.

It is interesting to reflect on Buiter’s position that it is only the high-denomination notes that should be abolished. He says that as a ‘concession to the poor’ we should keep a limited number of low-denomination notes and coins in circulation, but this doesn’t seem right to me. Cash isn’t a concession to the poor: it forces them to pay higher transaction costs than their better-off neighbours. And if the amount of cash falls, then the cost of the whole infrastructure of ATMs and cash registers, armoured vans and night safes will fall on the poor, thus further raising their transaction costs. It is clear, then, that cash plays a major role in facilitating crime, so cashlessness ought to tackle crime in useful ways: at least by making it more expensive, even if it is unable to eliminate it. But what if – rather than traditional money-related crimes such as fraud and counterfeiting – the primary problem created by electronic money will be in its use to support other kinds of crime?

More than 700 of Swindon’s 1,000 retailers adopted Mondex, which was an impressive testament to the team effort behind the launch. By and large, the retailers seemed positive (Leighton 2014). The shops and pubs didn’t particularly want to mess around with change or take bags of coins to the bank for deposit. Many of the retailers were enthusiastic because there was no transaction charge and for some of them the costs of cash handling and management were high for non-transaction cost reasons. I can remember talking to a hairdresser who was keen to get rid of cash because it was dirty and she had to keep washing her hands, a baker who was worried about staff ‘shrinkage’, and so on. But while ‘from a retailer’s point of view it’s very good’, news-stand manager Richard Jackson said, ‘less than one per cent of my actual customers use it’. As he went on to explain, ‘Lots of people get confused about what it actually is, they think it’s a Switch card or a credit card’ (Whittaker 1996).


Trade Your Way to Financial Freedom by van K. Tharp

asset allocation, backtesting, Bretton Woods, buy and hold, capital asset pricing model, commodity trading advisor, compound rate of return, computer age, distributed generation, diversification, dogs of the Dow, Elliott wave, high net worth, index fund, locking in a profit, margin call, market fundamentalism, passive income, prediction markets, price stability, random walk, reserve currency, risk tolerance, Ronald Reagan, Sharpe ratio, short selling, transaction costs

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 because market professionals have developed a system to make sure they profit no matter what you do with your account. Transaction costs are a major part of doing business. Market makers get the benefit of the bid-ask spread. Your brokerage firm gets its commissions. And should you invest in any sort of fund, they get paid a fee based on the size of your investment. In fact, I often see systems that over a number of years produce profits that are not much bigger than the transaction costs they generate. For example, my active trading system generated a 30 percent return in 2004 after transaction costs, but the transaction costs were still about 20 percent of the initial account value. Thus, I got 60 percent of the total profit, while my broker got 40 percent in transaction costs.

These abnormally large price changes over a short period of time are what make trend following work, and you see them all the time. Is Trend Following for Everyone? Trend following is probably one of the easiest techniques for the new trader or investor to understand and use. The longer term the indicators, the less that total transaction costs will affect profits. Short-term models tend to have difficulty overcoming the costs of many transactions. Costs include not only commissions but also slippage on the trades. The fewer trades you make, provided you have the patience for it, the less you spend in transaction costs and the easier it is for you to make a profit. There are numerous examples where trend following is not appropriate. Floor traders who are scalping ticks are not likely to use a trend-following concept. Hedging investors may find it more risky to hedge their risk by using trend-following indicators than by choosing some form of passive economic hedge approach.

Thus, I got 60 percent of the total profit, while my broker got 40 percent 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 because your cost per trade is very high. I often see systems that over a number of years produce profits that are not much bigger than the transaction costs they generate. Losing much less money when you abort a trade is probably an exciting prospect to most of you. However, the worst thing a trader can do is miss a major move. Consequently, you must be willing to get right back in the position should it again give you a signal. Many people cannot tolerate three to five losses in a row, which this strategy will regularly produce. However, let’s say that each exit produces a loss of only $100.


pages: 356 words: 51,419

The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns by John C. Bogle

asset allocation, backtesting, buy and hold, creative destruction, diversification, diversified portfolio, financial intermediation, fixed income, index fund, invention of the wheel, Isaac Newton, new economy, passive investing, Paul Samuelson, random walk, risk tolerance, risk-adjusted returns, Sharpe ratio, stocks for the long run, survivorship bias, transaction costs, Upton Sinclair, Vanguard fund, William of Occam, yield management, zero-sum game

There is no net gain to fund shareholders as a group. In fact, they incur a loss equal to the transaction costs they pay to those “Helpers” that Warren Buffett warned us about in Chapter 1. Investors pay far too little attention to the costs of investing. It’s especially easy to underrate their importance under today’s three conditions: (1) when stock market returns have been high (since 1980, stock returns have averaged 11.5 percent per year, and the average fund has provided a nontrivial—but clearly inadequate—return of 10.1 percent); (2) when investors focus on short-term returns, ignoring the truly confiscatory impact of costs over an investment lifetime; and (3) when so many costs are hidden from view (portfolio transaction costs, the largely unrecognized impact of front-end sales changes, and taxes incurred on fund distributions from capital gains, often realized unnecessarily).

Hard as it is to imagine, from 1945 to 1965 the annual turnover rate of equity funds averaged just 16 percent, an average holding period of six years for the average stock in a fund portfolio. This huge increase in turnover and its attendant transaction costs have ill-served fund investors. But the baneful impact of excessive taxes that funds have passed through to their investors have made a bad situation worse. This pattern of tax inefficiency for active managers seems destined to continue as long as (1) stocks rise and (2) fund managers continue their pattern of hyperactive trading. Let’s be clear: In an earlier era, most fund managers focused on long-term investment. Now they are too often focused on short-term speculation. The traditional index fund follows precisely the opposite policy—buying and holding “forever.” Its annual portfolio turnover has run in the range of 3 percent, resulting in transaction costs that are somewhere between infinitesimal and zero. Bring on the data!

They pick funds based on the recent performance superiority—or even the long-term superiority—of a fund manager, and often hire advisers to help them achieve the same goal (Warren Buffett’s “Helpers,” described in the next chapter). But as I explain in Chapter 12, the advisers do it with even less success. Oblivious of the toll taken by costs, too many fund investors willingly pay heavy sales loads and incur excessive fund fees and expenses, and are unknowingly subjected to the substantial but undisclosed transaction costs incurred by funds as a result of their hyperactive portfolio turnover. Fund investors are confident that they can consistently select superior fund managers. They are wrong. Mutual fund investors are confident that they can easily select superior fund managers. They are wrong. Contrarily, for those who invest and then drop out of the game and never pay a single unnecessary cost, the odds in favor of success are awesome.


pages: 453 words: 111,010

Licence to be Bad by Jonathan Aldred

"Robert Solow", Affordable Care Act / Obamacare, Albert Einstein, availability heuristic, Ayatollah Khomeini, Benoit Mandelbrot, Berlin Wall, Black Swan, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Cass Sunstein, clean water, cognitive dissonance, corporate governance, correlation does not imply causation, cuban missile crisis, Daniel Kahneman / Amos Tversky, Donald Trump, Douglas Engelbart, Douglas Engelbart, Edward Snowden, Fall of the Berlin Wall, falling living standards, feminist movement, framing effect, Frederick Winslow Taylor, From Mathematics to the Technologies of Life and Death, full employment, George Akerlof, glass ceiling, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Isaac Newton, Jeff Bezos, John Nash: game theory, John von Neumann, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, meta analysis, meta-analysis, Mont Pelerin Society, mutually assured destruction, Myron Scholes, Nash equilibrium, Norbert Wiener, nudge unit, obamacare, offshore financial centre, Pareto efficiency, Paul Samuelson, plutocrats, Plutocrats, positional goods, profit maximization, profit motive, race to the bottom, RAND corporation, rent-seeking, Richard Thaler, ride hailing / ride sharing, risk tolerance, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, Skype, Social Responsibility of Business Is to Increase Its Profits, spectrum auction, The Nature of the Firm, The Wealth of Nations by Adam Smith, transaction costs, trickle-down economics, Vilfredo Pareto, wealth creators, zero-sum game

Finally, once a deal has been done, there are costs involved in monitoring the outcome to be sure that the other party has stuck to the agreement. And if they haven’t, there are further costs in trying to enforce the deal, perhaps through the courts. Transaction costs imply that the thing being argued over may not go to the individual, firm or organization which values it the most. This is because transaction costs often prevent deals being done, even when the deal is beneficial to all parties. If, for any of the parties involved, the overall transaction costs involved in arranging and enforcing a deal exceed the expected benefits from doing so, then the deal will not happen. But if a deal beneficial to all parties does not happen, then the outcome is in a sense wasteful: it wastes an opportunity to make all parties better off.

By the 1970s most Chicago lawyers and economists had begun to accept that the Coase Theorem does not hold in the real world because of the ubiquity of transaction costs. Instead, they saw the theorem in utopian terms. In an ideal world, a Posnerian Wonderland, everyone would have unlimited opportunities to do deals for mutual benefit. Accordingly, the project of Chicago law-and-economics was to reshape the real world into this Wonderland as far as possible. First, legal impediments to deal-making should be stripped away. Even if the deal involves selling a baby, the law should not in general intervene because that would prevent valuable gains from trade. Second, if the courts become involved as a result of transaction costs preventing parties from making deals, the courts should simply bring about, by judicial decree, the wealth-enhancing deals that the parties would have made in an ideal world without transaction costs. This was dubbed the ‘mimic the market’ approach to judicial decision-making.

No one seems sure, but an important part of the answer is that even great thinkers often focus on solving what with hindsight turn out to be yesterday’s problems. Coase was preoccupied with how previous economists had analysed problems such as pollution. The standard analysis assumed there were no transaction costs but nevertheless called for government intervention. Coase wanted to show that in this strictly blackboard world of zero transaction costs, government intervention would be unnecessary because the polluter and pollutee would make a deal. So, given Coase’s backward-looking gaze, his starting point of a zero transaction cost world made sense. But it helped entrench a disastrous misinterpretation of his ideas by future generations. By the 1970s Coase had begun to refer tentatively to such a misinterpretation, but he did not shout loudly enough and was drowned out by influential Chicago voices including Becker, Friedman and Stigler.


Governing the Commons: The Evolution of Institutions for Collective Action by Elinor Ostrom

agricultural Revolution, clean water, Gödel, Escher, Bach, land tenure, Pareto efficiency, principal–agent problem, prisoner's dilemma, profit maximization, RAND corporation, The Nature of the Firm, transaction costs

A theory of self-organiza­ tion and self-governance of smaller units within larger political systems must overtly take the activities of surrounding political systems into ac­ count in explaining behavior and outcomes. To distinguish between the successful and unsuccessful instances of self-organization to solve CPR problems, one must take account of how the strategies of external actors affect the costs and benefits of CPR appropriators. A third problem with current theories relates to the way that information and transactions costs are assumed away. To assume that complete in­ formation is freely available and that transactions costs can be ignored does not generate theoretical explanations that can be used in a setting where information is scant, potentially biased, and expensive to obtain and where most transactions are costly.2 Why individuals monitor each other's rule conformance would be difficult to explain using the assumption of com­ plete information. To summarize the foregoing discussion, there are three problems with the current theories of collective action that reduce their usefulness for providing a foundation for policy analysis of institutional change in small­ er-scale CPRs.

Assuming independent action does not push the analyst to ask if individuals take into account the effects of their actions on the choices made by others. Assum­ 190 191 1 the need to reflect the incremental, self-transforming nature of institu­ tional change, 2 the importance of the characteristics of external political regimes in an analysis of how internal variables affect levels of collective provision of rules, and 3 the need to include information and transaction costs. Governing the commons A framework for analysis of CPRs ing zero-cost monitoring does not push the analyst to examine cost and effectiveness for various monitoring rules. Assuming fixed structure does not push the analyst to examine whether or not and how individuals change their own rules and how the surrounding political regime enhances or inhibits institutional change. Frameworks that relate whole families of models together also provide an important part of the theoretical foundation for policy analysis, because they point to the set of variables and the types of relationships among variables that need to be examined in conducting any theoretical or empi­ rical study of a particular type of phenomenon.

The theoretical enterprise requires social scientists to engage in model-building,1° but not theoretical inquiry to that specific level of discourse. We need to appreciate the analytical power that can be derived from the prior in­ tellectual efforts of important contributors such as Hobbes, Montesquieu, Madison, Hamilton, Tocqueville, and many others.21 Con­ temporary studies in the theory of public and social choice, the economics of transactions costs, the new institutional economics, law and economics, game theory, and many related fields22 are making important contributions that need to be carried forward in theoretically informed empirical in­ quiries in both laboratory and field settings. 216 Notes 1. REFLECTIONS ON THE COMMONS 1 Attributed to Merrill M. Flood and Melvin Dresher and formalized by Albert W. Tucker (R. Campbell 1985, p. 3), the game is described (Luce and Raiffa 1957, p. 95) as follows: "Two suspects are taken into custody and separated.


pages: 585 words: 165,304

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

barriers to entry, Berlin Wall, blue-collar work, business climate, business cycle, capital controls, collective bargaining, corporate governance, corporate raider, creative destruction, 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, Gunnar Myrdal, hiring and firing, industrial robot, Jane Jacobs, job satisfaction, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Arrow, land reform, liberal capitalism, liberation theology, 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.


pages: 571 words: 105,054

Advances in Financial Machine Learning by Marcos Lopez de Prado

algorithmic trading, Amazon Web Services, asset allocation, backtesting, bioinformatics, Brownian motion, business process, Claude Shannon: information theory, cloud computing, complexity theory, correlation coefficient, correlation does not imply causation, diversification, diversified portfolio, en.wikipedia.org, fixed income, Flash crash, G4S, implied volatility, information asymmetry, latency arbitrage, margin call, market fragmentation, market microstructure, martingale, NP-complete, P = NP, p-value, paper trading, pattern recognition, performance metric, profit maximization, quantitative trading / quantitative finance, RAND corporation, random walk, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, Silicon Valley, smart cities, smart meter, statistical arbitrage, statistical model, stochastic process, survivorship bias, transaction costs, traveling salesman

At a particular horizon h = 1, …, H, we have a forecasted mean μh, a forecasted variance Vh and a forecasted transaction cost function τh[ω]. This means that, given a trading trajectory ω, we can compute a vector of expected investment returns r, as where τ[ω] can adopt any functional form. Without loss of generality, consider the following: , for h = 2, …, H ω*n is the initial allocation to instrument n, n = 1, …, N τ[ω] is an Hx1 vector of transaction costs. In words, the transaction costs associated with each asset are the sum of the square roots of the changes in capital allocations, re-scaled by an asset-specific factor Ch = {cn, h}n = 1, …, N that changes with h. Thus, Ch is an Nx1 vector that determines the relative transaction cost across assets. The Sharpe Ratio (Chapter 14) associated with r can be computed as (μh being net of the risk-free rate) 21.4 The Problem We would like to compute the optimal trading trajectory that solves the problem This problem attempts to compute a global dynamic optimum, in contrast to the static optimum derived by mean-variance optimizers (see Chapter 16).

Look-ahead bias: Using information that was not public at the moment the simulated decision would have been made. Be certain about the timestamp for each data point. Take into account release dates, distribution delays, and backfill corrections. Storytelling: Making up a story ex-post to justify some random pattern. Data mining and data snooping: Training the model on the testing set. Transaction costs: Simulating transaction costs is hard because the only way to be certain about that cost would have been to interact with the trading book (i.e., to do the actual trade). Outliers: Basing a strategy on a few extreme outcomes that may never happen again as observed in the past. Shorting: Taking a short position on cash products requires finding a lender. The cost of lending and the amount available is generally unknown, and depends on relations, inventory, relative demand, etc.

The Sharpe Ratio (Chapter 14) associated with r can be computed as (μh being net of the risk-free rate) 21.4 The Problem We would like to compute the optimal trading trajectory that solves the problem This problem attempts to compute a global dynamic optimum, in contrast to the static optimum derived by mean-variance optimizers (see Chapter 16). Note that non-continuous transaction costs are embedded in r. Compared to standard portfolio optimization applications, this is not a convex (quadratic) programming problem for at least three reasons: (1) Returns are not identically distributed, because μh and Vh change with h. (2) Transaction costs τh[ω] are non-continuous and changing with h. (3) The objective function SR[r] is not convex. Next, we will show how to calculate solutions without making use of any analytical property of the objective function (hence the generalized nature of this approach). 21.5 An Integer Optimization Approach The generality of this problem makes it intractable to standard convex optimization techniques.


pages: 140 words: 91,067

Money, Real Quick: The Story of M-PESA by Tonny K. Omwansa, Nicholas P. Sullivan, The Guardian

BRICs, business process, business process outsourcing, call centre, cashless society, cloud computing, creative destruction, crowdsourcing, delayed gratification, dematerialisation, disruptive innovation, financial exclusion, financial innovation, financial intermediation, income per capita, Kibera, Kickstarter, M-Pesa, microcredit, mobile money, Network effects, new economy, reserve currency, Silicon Valley, software as a service, transaction costs

Cash is the enemy of governments, which must replace ripped notes by printing and distributing new currency; it is the enemy of bill payers, who must waste half days queuing to pay water and electric bills, or getting bank checks to pay school tuitions; it is the enemy of businesses, which have no easy and verifiable way to offer credit to customers or pay suppliers in advance, or to pay their workers in cash, which restricts them to doing business in small geographic circles. But cash is the most formidable enemy of the poor. Cash is difficult to store and certainly to save; and the transaction costs are prohibitive. That’s why, in many parts of the developing world, the idea of interest on savings is irrelevant; people often pay as much as 30% to get others to safely store money for them. That is a lower transaction cost than the alternative, which might mean seeing the money disappear altogether. The poor depend on cash but it is the enemy; the poor have little money but lead complex financial lives; the poor have low cash balances but move large amounts of cash every day, week and month. The many conundrums of the poor and cash have been increasingly well documented in recent years through in-depth financial diaries, notably in Portfolios of the Poor.

And the stamp to send the letter wasn’t free! The combination of increased transfers and lower transactions costs, along with instantaneous communications, translated into more money in the village, which of course has sparked local economies. As M-PESA remittances redistribute money from urban to rural areas, savings are more productively allocated across households, families and businesses. Instead of shopping in the market town where they once got cash, women now withdraw cash from agents in their villages and spend it there. Increased cash from remittances allows farmers to hire more casual labor, which in turn keeps more money circulating in the village in a virtuous circle: More money in circulation with lower transaction costs means more transactions and less seepage of money outside the community. In the past, money in a village was basically tucked in a mattress, or some equivalent.

.” - David Mataen, Columnist, The Daily Nation Two-and-a-half billion adults in the world don’t have bank accounts, but about half of these unbanked have mobile phones. Many of those phones are being used to, send, receive and save money. People who first used a phone five or 10 years ago and never had a bank account are now transferring money by phone. In countries where money means cash and cash typically moves by bus or post, the move to mobile is reducing transaction costs, and increasing the velocity and productivity of money. For the banked, mobile money provides superior speed, convenience and safety. For the unbanked, mobile money forms the beginning of a shadow banking system. For everyone, cash is the enemy—expensive to print, hard to store and move. Dematerializing money is good for people rich and poor, businesses, and governments. Mobile money, e-money, e-float, e-wallets, mobile banking, however you characterize it, is not just a cool app.


pages: 206 words: 70,924

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

"Robert Solow", Albert Einstein, Bayesian statistics, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, 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 Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, Myron Scholes, Paul Samuelson, 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, Thales and the olive presses, Thales of Miletus, 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: 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

activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, asset allocation, Atul Gawande, backtesting, beat the dealer, Black Swan, business cycle, butter production in bangladesh, buy and hold, 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, Edward Thorp, Eugene Fama: efficient market hypothesis, forensic accounting, hindsight bias, intangible asset, 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, survivorship bias, 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: 402 words: 110,972

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

AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, business cycle, butter production in bangladesh, butterfly effect, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, creative destruction, 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, fixed income, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, intangible asset, Internet Archive, John Nash: game theory, Kenneth Arrow, 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, Metcalfe’s law, moral hazard, mutually assured destruction, Myron Scholes, natural language processing, negative equity, 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, risk tolerance, risk-adjusted returns, risk/return, Robert Metcalfe, Ronald Reagan, Rubik’s Cube, 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, your tax dollars at work

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: 321

Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

algorithmic trading, asset allocation, automated trading system, backtesting, barriers to entry, business cycle, buy and hold, capital asset pricing model, constrained optimization, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial intermediation, Flash crash, implied volatility, index arbitrage, index fund, intangible asset, iterative process, Long Term Capital Management, loss aversion, market design, market microstructure, merger arbitrage, natural language processing, passive investing, pattern recognition, performance metric, popular capitalism, prediction markets, price discovery process, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, selection bias, sentiment analysis, shareholder value, Sharpe ratio, short selling, Silicon Valley, speech recognition, statistical arbitrage, statistical model, stochastic process, survivorship bias, systematic trading, text mining, transaction costs, Vanguard fund, yield curve

Combining many diverse alphas results in a stronger, more informed prediction that is more likely to overcome transaction costs and other trading constraints. A diverse alpha pool requires diverse ideas, methods, and data, resulting in alphas with a wide range of turnover profiles. To put it another way: there is diversity in alpha turnover. Alphas with different horizons are likely taking into account different types of information, and this may result in lower correlations. When alphas are combined in a single strategy, the alphas’ opposing trades “cross.” Consider an alpha that is looking to buy 200 shares of IBM and is combined with another that has a contrarian view and suggests selling 300 shares of IBM. Assuming both alphas have equal weights of 1, the resulting combined alpha will sell 100 IBM shares. Two hundred shares of IBM “cross” and no transaction costs are incurred; the trade never goes out to the market and is therefore cost-­ free.

The Sharpe ratio is a measure of the risk-adjusted returns (returns/ volatility). It can be treated as a proxy for the predictive ability of a model. The higher the Sharpe ratio, the more reliable the alpha tends to be. Turnover is a measure of the volume of trading required to reach the alpha’s desired positions over the simulation period. Each trade in or out of a position carries transaction costs (fees and spread costs). If the turnover number is high – for example, over 40% – the transaction costs may eradicate some or all of the PnL that the alpha generated during simulation. The other performance metrics and their uses in evaluating alpha performance are discussed in more detail in the WebSim user guides and in videos in the educational section of the website. In addition to the aggregate performance metrics, WebSim data visualization charts and graphs help to confirm that an alpha has an acceptable distribution of positions and returns across equities grouped by capitalization, industry, or sector.

There are different ways to do this mapping, but the simplest is to assume the prediction strength of an alpha is the dollar position taken by the trading strategy. One issue with this mapping method is that alphas often will not map to good strategies on their own because they are designed to predict returns, not to make profitable trades net of costs. One way to address this issue is by charging reduced transaction costs in the simulation. Once the simulation has been constructed, some useful measurements that can be taken are: •• Information ratio. The mean of the alpha’s returns divided by the standard deviation of the returns, this measures how consistently the alpha makes good predictions. Combining the information ratio with the length of the observation period can help us determine our level of confidence that the alpha is better than random noise.


pages: 515 words: 126,820

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

Airbnb, altcoin, asset-backed security, autonomous vehicles, barriers to entry, bitcoin, blockchain, Blythe Masters, Bretton Woods, business process, buy and hold, Capital in the Twenty-First Century by Thomas Piketty, carbon footprint, clean water, cloud computing, cognitive dissonance, commoditize, corporate governance, corporate social responsibility, creative destruction, Credit Default Swap, crowdsourcing, cryptocurrency, disintermediation, disruptive innovation, distributed ledger, Donald Trump, double entry bookkeeping, Edward Snowden, Elon Musk, Erik Brynjolfsson, Ethereum, 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, information asymmetry, intangible asset, interest rate swap, Internet of things, Jeff Bezos, jimmy wales, Kickstarter, knowledge worker, Kodak vs Instagram, Lean Startup, litecoin, Lyft, M-Pesa, Marc Andreessen, Mark Zuckerberg, Marshall McLuhan, means of production, microcredit, mobile money, money market fund, Network effects, new economy, Oculus Rift, off grid, pattern recognition, peer-to-peer, peer-to-peer lending, peer-to-peer model, performance metric, Peter Thiel, planetary scale, Ponzi scheme, prediction markets, price mechanism, Productivity paradox, QR code, 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 intelligence, social software, standardized shipping container, 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, uber lyft, unbanked and underbanked, underbanked, unorthodox policies, wealth creators, 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.


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

Black-Scholes formula, Brownian motion, correlation coefficient, Credit Default Swap, delta neutral, discrete time, Emanuel Derman, fixed income, 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.


pages: 200 words: 54,897

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

bank run, barriers to entry, bash_history, Bernie Madoff, computerized markets, computerized trading, Flash crash, housing crisis, index fund, locking in a profit, London Whale, market microstructure, merger arbitrage, prediction markets, price discovery process, Sergey Aleynikov, Spread Networks laid a new fibre optics cable between New York and Chicago, transaction costs, zero day

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.”


Risk Management in Trading by Davis Edwards

asset allocation, asset-backed security, backtesting, Black-Scholes formula, Brownian motion, business cycle, computerized trading, correlation coefficient, Credit Default Swap, discrete time, diversified portfolio, fixed income, implied volatility, intangible asset, interest rate swap, iterative process, John Meriwether, London Whale, Long Term Capital Management, margin call, Myron Scholes, Nick Leeson, p-value, paper trading, pattern recognition, random walk, risk tolerance, risk/return, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, statistical model, stochastic process, systematic trading, time value of money, transaction costs, value at risk, Wiener process, zero-coupon bond

It is common for reallife problems that did not show up in historical testing to appear when trading is attempted in real life. TRANSACTION COSTS AND SLIPPAGE Models of trading strategies rarely work as well in practice as they do in simulation. A common reason for underperformance is the inability to get an execution at the desired market price. The root problem is that the market price is typically a historical price (perhaps the price of a recent transaction). 102 TABLE 4.1 RISK MANAGEMENT IN TRADING Transaction Costs and Slippage Type of Problem Description Bad Market Price If the market price was set by a mistake, made under duress, or news has just been released, the previous market price may not represent the market view as to a fair price. In other words, it is not always possible to transact at that price. Transaction Costs Immediate transactions (market orders) are typically made against the best limit order available at the time of the execution.

To reduce the risk of selecting bad strategies, traders typically try to quantify testing in several ways. For example, in addition to just looking at profits, traders might examine: ■ ■ ■ ■ ■ ■ ■ What percentage of trades is expected to be profitable? Does this percentage vary over time or is it stable? What is the expected return on each trade? Has this been declining over time or holding steady? How quickly should a trade make money on average? How sensitive are profits to transaction costs? If transaction costs are higher than expected, does this make the strategy unprofitable? Are losses randomly distributed or correlated? What kind of losses can be expected, on average, once a month? What is the worst case scenario for a drawdown? (A drawdown is a peak to trough decline in profitability). Typically, traders will look for strategies that have good performance and a consistent trading profile.

The purpose of this step is to identify and address issues that might not be found during historical testing. Simulating and testing the strategy as it would be executed once actual trading begins allows the strategy developer to identify implementation problems. For example, with historical testing, pricing data already exists. Backtesting and Trade Forensics 101 KEY CONCEPT: TRANSACTIONS COSTS AND TIMING Two items that are hard to model from historical data are the costs associated with making trades and timing of when market data arrives. Transaction Costs. Many strategies look profitable in simulation because no trades have occurred to bring prices back to equilibrium. The only way to fully determine if a price represents a transaction opportunity is to find someone willing to transact at that price during actual trading. Timing of Data. Trading strategies need to use data that is available at the time of trading.


Beat the Market by Edward Thorp

beat the dealer, buy and hold, compound rate of return, Edward Thorp, margin call, Paul Samuelson, RAND corporation, short selling, transaction costs

In Figure E.1, showing the average monthly percentage change for our sample, we see that listed warrants tend to fall faster as expiration approaches. Figures E.2, E.3, and E.4 show the average monthly percentage change for various hedged positions. 205 Figure E.1. Percentage gain from shorting warrant and covering in one month assuming 100% margin and no transaction costs. Figure E.2. Percentage gain for a 1 to 1 hedge held for one month, assuming 100% margin and no transaction costs. Figure E.3. Percentage gain for 2 to 1 hedge held for one month, assuming 100% margin and no transaction costs. Figure E.4. Percentage gain from 3 to 1 hedge held for one month, assuming 100% margin and no transaction costs. REFERENCES [1] [2] [3] [4] [5] [6] Bladen, Ashby, Techniques for Investing in Convertible Bonds. Salomon Bros. and Hutzler, New York, 1966. A leading practitioner’s view of convertible bond premiums. Cootner, Paul, editor, The Random Character of Stock Market Prices.

To protect the warrant holder’s original rights, for each 100 warrants he holds he is allowed to buy, after the stock dividend, 102 shares of common; one warrant buys 1.02 new shares, still for $25. An anti-dilution provision to thus adjust the warrant’s terms after stock splits and dividends was made for the protection of the Sperry warrant holders when the warrants were issued. * Commissions are not a factor because some traders have virtually no transaction costs and are ready to exploit such opportunities. 24 There was another 2% stock dividend on September 28, 1961. The warrant was adjusted so that after the dividend one warrant plus $25 bought 1.02 times as many shares as before this second dividend. Since it could buy 1.02 shares before this second dividend, it became the right to buy 1.02 x 1.02 = 1.0404 shares after the dividend. In practice this was rounded off to 1.03 shares.

Eighteen months before expiration, warrants of hypothetical company X are at 3 and the common is at 6. Exercise price is 10. Warrants are sold short and common is purchased at these prices, with the plan of liquidating the entire position just before expiration. Initial margin of 3 for the warrant and 5 for the common are assumed. Gains from intermediate decisions or from reinvesting profits are ignored, as are transactions costs. as roughly equal to the short-sale proceeds of about $300. (This happens, for instance, if the common at expiration is unchanged in price.) We have put up $300 initial margin for the 100 warrants short at 3. For 100 common long at 6, we ned $420 if initial margin is 70%, for a total original investment of $720. We realize a 42% profit on the $720 in 18 months. This is 28% per annum. Chapter 7 shows that this annual rate of return has been typical of the basic system.


pages: 416 words: 118,592

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

accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, backtesting, beat the dealer, Bernie Madoff, BRICs, butter production in bangladesh, buy and hold, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dogs of the Dow, Edward Thorp, 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, money market fund, mortgage tax deduction, new economy, Own Your Own Home, passive investing, Paul Samuelson, 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, stocks for the long run, survivorship bias, The Myth of the Rational Market, the rule of 72, 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: 474 words: 120,801

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

additive manufacturing, barriers to entry, Berlin Wall, bilateral investment treaty, business cycle, 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, creative destruction, crony capitalism, deskilling, disintermediation, disruptive innovation, 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, intangible asset, intermodal, invisible hand, job-hopping, Joseph Schumpeter, Julian Assange, Kickstarter, liberation theology, Martin Wolf, mega-rich, 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, zero-sum game

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 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.


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

Black-Scholes formula, Brownian motion, capital asset pricing model, cellular automata, delta neutral, discounted cash flows, discrete time, diversified portfolio, fixed income, 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: 358 words: 104,664

Capital Without Borders by Brooke Harrington

banking crisis, Big bang: deregulation of the City of London, British Empire, capital controls, Capital in the Twenty-First Century by Thomas Piketty, complexity theory, corporate governance, corporate social responsibility, diversified portfolio, estate planning, eurozone crisis, family office, financial innovation, ghettoisation, haute couture, high net worth, income inequality, information asymmetry, Joan Didion, job satisfaction, joint-stock company, Joseph Schumpeter, liberal capitalism, mega-rich, mobile money, offshore financial centre, race to the bottom, regulatory arbitrage, Robert Shiller, Robert Shiller, South Sea Bubble, the market place, Thorstein Veblen, transaction costs, upwardly mobile, wealth creators, web of trust, Westphalian system, Wolfgang Streeck, zero-sum game

For instance, wealth managers can direct their clients’ assets to “dark pool” investment funds—a private trading system in which prices are invisible to the public and participation is by invitation only—and hedge funds, which are limited by law to accept as investors only those with a net worth of $5 million or more.77 These private investment opportunities are lightly regulated, particularly in offshore jurisdictions. This offers privacy for the transaction participants and lower transaction costs compared to the open market, providing more room for profit.78 This last point is crucial, and often overlooked: one way to get rich and stay that way is to keep transaction costs to a minimum. As the well-known American mutual fund manager Bill Miller is known for saying, “Lowest average cost wins.”79 That is, the way to make the most money—to “win”—isn’t just by earning the highest returns but also by minimizing costs. This is consistent with the observations of the Nobel Prize–winning political theorist Douglass North, who argued that transaction costs are the most significant determinant of wealth (and poverty) worldwide.80 Figure 5.1. The “perpetual-motion machine” of wealth inequality.

For many clients from civil-law jurisdictions, this combination of traits would seem to make the foundation a best-of-both-worlds proposition. As Parvita—a Mauritius practitioner—put it, “The foundation is dressed like a corporation yet has the soul of a trust.” However, foundations do have four significant downsides compared to trusts. For one thing, there is greater administrative complexity and thus higher transaction costs, which create a drain on the wealth held in the structure. Much like corporations, foundations are required to establish bylaws and articles, to create regular financial statements for the managing council to review, and to provide for audits.138 Second, in many jurisdictions, foundations are subject to taxation, and transfers of assets into noncharitable foundations can be taxed.139 Third, as a legal person that owns assets, foundations can be sued and go bankrupt.140 This is in contrast to a trust arrangement, in which there is no legal personality, but only a “natural person” (the fiduciary) who holds only partial ownership rights; this makes it difficult to access the trust assets through lawsuits.

During this time, many commercial enterprises were organized through trusts; these were known as “deed of settlement” firms.146 By the mid-nineteenth century, corporations were once again made widely available, and by the twentieth century they had become the dominant form of organization for manufacturing and trading. However, a succession of further corporate crises, particularly in the past thirty years, has attracted even more regulatory attention to firms, again restricting their management and activities.147 This certainly has not eliminated the use of firms or the occurrence of fraud, but it has raised the transaction costs attached to corporate profits. The form remains popular for three reasons. First, it is universally recognized: unlike the trust, which is a product of England’s unique ecclesiastical equity courts and their rulings based on moral right, the corporation was created by statute law, which exists worldwide.148 This has made corporations an excellent vehicle for global trading, as exemplified by the multinational corporation.


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

carbon footprint, carried interest, Cass Sunstein, clean water, congestion charging, corporate governance, deliberate practice, full employment, income inequality, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Paul Samuelson, 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.


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

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, information asymmetry, liberal world order, Live Aid, Nick Leeson, Pareto efficiency, 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, Westphalian system

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: 332 words: 81,289

Smarter Investing by Tim Hale

Albert Einstein, asset allocation, buy and hold, buy low sell high, capital asset pricing model, collapse of Lehman Brothers, corporate governance, credit crunch, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, eurozone crisis, fiat currency, financial independence, financial innovation, fixed income, full employment, implied volatility, index fund, information asymmetry, Isaac Newton, John Meriwether, Long Term Capital Management, Northern Rock, passive investing, Ponzi scheme, purchasing power parity, quantitative easing, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, technology bubble, the rule of 72, time value of money, transaction costs, Vanguard fund, women in the workforce, zero-sum game

Active managers invariably claim that their market-beating approach will work better in less-efficient markets, such as small company stocks or small overseas equity markets, as they theoretically have the ability to exploit these inefficiencies. However, always remember that even in markets where information is deemed to be less than perfect, if the anomalies cannot be exploited to exceed the transaction costs involved with investing in them, then active management for you or me is worthless. Transaction costs are significantly higher in smaller, less efficient, markets, negating much of the benefit. Remember that they are still playing in a zero-sum game, but with higher costs. What does the research tell us? The reality is that research suggests that few investors outperform the market portfolio consistently over time, especially after transaction costs and taxes are taken into account. The magnitude and consistency of this research, from a wide number of angles, supports this emphatically. Let us look at the case more closely.

Here are some of the ways in which tracking error occurs. Replication methods affect tracking error The way in which the investment manager chooses to copy the index is important. There are three common methods that are used. Full replication: As its name suggests, each company in the index is purchased by the fund. This would give you zero tracking error in a world where transaction costs are zero, but it is not the world we live in. Inevitably, transaction costs will create some tracking error. In addition, smaller funds may suffer from having to buy odd lots of stock that cannot be split as the amount being purchased is too small. Corporate actions and dividend payments also create activity that may generate tracking error. Sampling (or partial replication): In this case, the manager takes the view that the cost of creating and maintaining a portfolio with all the securities in the index is greater than the tracking error risk of holding only some of the securities.

First, though, consider the following logical argument that immediately puts the active manager’s case on the back foot, with the probabilities favouring a passive (index) approach. Passive investors will beat the majority of active investors As we have discovered in the zero-sum game above, all investors are the market. So, the average investor will generate the market return before fees, transaction costs and taxes. In the real world these costs cannot be avoided so the average active investor must inevitably be below the market by the amount of these costs. If index funds have lower costs than the average active investor, which is most often the case, then they will beat the average active manager by the difference between these costs. Index funds will thus beat the majority of active funds over the long run.


pages: 383 words: 81,118

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

Airbnb, Alvin Roth, big-box store, business process, cashless society, Chuck Templeton: OpenTable:, creative destruction, Deng Xiaoping, disruptive innovation, if you build it, they will come, information asymmetry, Internet Archive, invention of movable type, invention of the printing press, invention of the telegraph, invention of the telephone, Jean Tirole, John Markoff, Lyft, M-Pesa, market friction, market microstructure, mobile money, multi-sided market, Network effects, Productivity paradox, profit maximization, purchasing power parity, QR code, ride hailing / ride sharing, sharing economy, Silicon Valley, Snapchat, Steve Jobs, Tim Cook: Apple, transaction costs, two-sided market, Uber for X, uber lyft, ubercab, 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.


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

activist fund / activist shareholder / activist investor, Admiral Zheng, banking crisis, Basel III, Bernie Madoff, Black Swan, buy and hold, centralized clearinghouse, clean water, computerized trading, 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, fixed income, Flash crash, income inequality, index fund, information asymmetry, invisible hand, Kenneth Arrow, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, moral hazard, Myron Scholes, Northern Rock, passive investing, performance metric, Ponzi scheme, post-work, 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: 339 words: 109,331

The Clash of the Cultures by John C. Bogle

asset allocation, buy and hold, collateralized debt obligation, commoditize, 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, money market fund, mortgage debt, new economy, Occupy movement, passive investing, Paul Samuelson, Ponzi scheme, post-work, 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, survivorship bias, The Wealth of Nations by Adam Smith, transaction costs, Vanguard fund, William of Occam, zero-sum game

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.


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

asset allocation, buy and hold, corporate governance, diversification, diversified portfolio, index fund, market fundamentalism, money market fund, Myron Scholes, passive investing, prediction markets, random walk, risk tolerance, risk-adjusted returns, risk/return, transaction costs, Vanguard fund, zero-sum game

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?


pages: 586 words: 159,901

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

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, affirmative action, Andrei Shleifer, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, borderless world, Bretton Woods, British Empire, business cycle, capital asset pricing model, capital controls, central bank independence, computerized trading, corporate governance, corporate raider, 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, information asymmetry, interest rate swap, Internet Archive, invisible hand, Irwin Jacobs, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liberal capitalism, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, oil shock, Paul Samuelson, payday loans, pension reform, plutocrats, Plutocrats, price mechanism, price stability, prisoner's dilemma, profit maximization, publication bias, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, selection bias, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, 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.


pages: 512 words: 162,977

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

backtesting, beat the dealer, Benoit Mandelbrot, Berlin Wall, Black-Scholes formula, butterfly effect, buy and hold, commodity trading advisor, computerized trading, Edward Thorp, Elliott wave, fixed income, full employment, implied volatility, interest rate swap, Louis Bachelier, margin call, market clearing, market fundamentalism, money market fund, 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?


pages: 246 words: 116

Tyler Cowen-Discover Your Inner Economist Use Incentives to Fall in Love, Survive Your Next Meeting, and Motivate Your Dentist-Plume (2008) by Unknown

airport security, Andrei Shleifer, big-box store, British Empire, business cycle, cognitive dissonance, cross-subsidies, fundamental attribution error, George Santayana, haute cuisine, market clearing, microcredit, money market fund, pattern recognition, Ralph Nader, Stephen Hawking, The Wealth of Nations by Adam Smith, trade route, transaction costs

MAR K E T S N EVE ReO V E R or offer all options, if only because of economic and legal constraints. Economists refer to "transaction costs" and "fixed costs." Most of these constraints are weakening over time, and thus we witness an intensifying proliferation of markets, including those cited above. That places a greater burden on our faculties of self-control. Transaction costs reflect the difficulty of bringing together buyers and sellers and getting them to agree on terms. For instance, I continue to look for an extra copy of the CD The Kampala Sound, a collection of top Ugandan tunes from the 1960s. The Web fails me, and even Original Music, the issuer, claims to have no back copies. But finding a seller may just be a matter of time. The Internet is causing transaction costs to fall to ever-lower levels. FedEx, fax machines, credit bureaus, eBay buyer ratings, and cheaper air travel all make it easier to cut deals and move the goods.

The idea, which started on the Internet, allows a small number of buyers to get in touch with the willing but regionally dispersed artistic suppliers. This is now possible because transaction costs have fallen. Avoiding the Seven Deadly Sins (or Not) I 177 Some of today's newest and most innovative markets exist in online computer games. In these "synthetic worlds" it is possible to buy, sell, lend, own property, or for that matter steal. Rewards depend upon performance, and the game prizes are convertible into real-world cash. It has been estimated that all the synthetic economies put together, with about 10 million players, are in value terms about equal to the size of the economies of Bosnia and Herzegovina. Ten years ago, these games did not exist. The "fixed costs" idea-another limit on markets-is a little more difficult to define than transaction costs, but we all understand it intuitively through our Inner Economist.

The "fixed costs" idea-another limit on markets-is a little more difficult to define than transaction costs, but we all understand it intuitively through our Inner Economist. Fixed costs are the reason why we don't see many walk-in, quirky bohemian bookshops in rural Nebraska. There just aren't enough buyers to cover the basic expenses of operation. But like transaction costs, fixed costs have been falling rapidly, and for many of the same reasons. Even though more markets are possible than ever before, our legislators have decided that there should not be markets in everything. Laws curtail voluntary exchange in ecstasy, sexual intercourse, kidneys for transplant, betting on numbers, and many supposed cures for cancer. It is very difficult to find the best unpasteurized French cheeses in the United States; the FDA has decided they are not good for us. Of course, many of these markets proceed with or without legal support. Prostitutes advertise freely in the Yellow Pages; the police usually tolerate the practice as long as the neighbors do not complain.


pages: 500 words: 145,005

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

"Robert Solow", 3Com Palm IPO, Albert Einstein, Alvin Roth, Amazon Mechanical Turk, Andrei Shleifer, Apple's 1984 Super Bowl advert, Atul Gawande, Berlin Wall, Bernie Madoff, Black-Scholes formula, business cycle, 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, information asymmetry, invisible hand, Jean Tirole, John Nash: game theory, John von Neumann, Kenneth Arrow, Kickstarter, late fees, law of one price, libertarian paternalism, Long Term Capital Management, loss aversion, market clearing, Mason jar, mental accounting, meta analysis, meta-analysis, money market fund, More Guns, Less Crime, mortgage debt, Myron Scholes, Nash equilibrium, Nate Silver, New Journalism, nudge unit, Paul Samuelson, 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, Stanford marshmallow experiment, statistical model, Steve Jobs, Supply of New York City Cabdrivers, 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, Vilfredo Pareto, Walter Mischel, zero-sum game

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

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 cycle, business process, butter production in bangladesh, buy and hold, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, commoditize, computerized markets, corporate governance, correlation coefficient, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Donald Knuth, Edward Thorp, 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, Myron Scholes, Nick Leeson, P = NP, pattern recognition, Paul Samuelson, 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 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: 425 words: 122,223

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

"Robert Solow", Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, corporate raider, 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, Kenneth Arrow, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, money market fund, Myron Scholes, new economy, New Journalism, Paul Samuelson, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, stochastic process, Thales and the olive presses, 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, zero-sum game

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: 490 words: 117,629

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

asset allocation, asset-backed security, buy and hold, 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, money market fund, passive investing, Paul Samuelson, pez dispenser, price mechanism, profit maximization, profit motive, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, shareholder value, Silicon Valley, Steve Ballmer, stocks for the long run, survivorship bias, technology bubble, the market place, transaction costs, Vanguard fund, yield curve, zero-sum game

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.


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

Asian financial crisis, banking crisis, barriers to entry, beat the dealer, Black-Scholes formula, commodity trading advisor, computer vision, East Village, Edward Thorp, financial independence, fixed income, implied volatility, index fund, Jeff Bezos, John Meriwether, John von Neumann, locking in a profit, Long Term Capital Management, margin call, money market fund, Myron Scholes, 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: 257 words: 13,443

Statistical Arbitrage: Algorithmic Trading Insights and Techniques by Andrew Pole

algorithmic trading, Benoit Mandelbrot, constrained optimization, Dava Sobel, George Santayana, 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

asset allocation, buy and hold, 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, money market fund, passive investing, Paul Samuelson, random walk, risk tolerance, risk/return, Sharpe ratio, statistical model, stocks for the long run, survivorship bias, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

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: 345 words: 87,745

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

asset allocation, backtesting, Bernie Madoff, buy and hold, 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, intangible asset, Long Term Capital Management, money market fund, passive investing, Paul Samuelson, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve, zero-sum game

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: 219 words: 15,438

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

buy and hold, compound rate of return, corporate governance, Dissolution of the Soviet Union, diversified portfolio, dividend-yielding stocks, fixed income, George Santayana, index fund, intangible asset, invisible hand, large denomination, low cost airline, 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.


No Slack: The Financial Lives of Low-Income Americans by Michael S. Barr

active measures, asset allocation, Bayesian statistics, business cycle, Cass Sunstein, conceptual framework, Daniel Kahneman / Amos Tversky, financial exclusion, financial innovation, Home mortgage interest deduction, income inequality, information asymmetry, labor-force participation, late fees, London Interbank Offered Rate, loss aversion, market friction, mental accounting, Milgram experiment, mobile money, money market fund, mortgage debt, mortgage tax deduction, New Urbanism, p-value, payday loans, race to the bottom, regulatory arbitrage, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, the payments system, transaction costs, unbanked and underbanked, underbanked

See also Payment cards Electronic Transfer Account program, 85, 109–10 Elliehausen, Gregory, 173 Employment patterns, correlations: bank account ownership, 30; bankruptcy filings, 185; in financial transactions costs model, 61; saving behaviors, 40; shortterm credit usage, 66–67, 147 Employment patterns, survey sample, 28 Equity measures, home ownership, 159, 161 Evans, David, 92 Faris, Robert, 137 Fay, Scott, 182–83, 192 Federal Deposit Insurance Corporation (FDIC), 86, 91–92, 141–42, 145, 274 Federal Reserve Board, 85–86, 144–45 Fees, financial services: as access barrier, 2–7, 30–32, 77–80, 84; annual outlays, 55, 67–75; credit cards, 143–44, 269–71; market-consumer bias conflicts, 252–53, 266; payday lending, 49, 136; payment cards, 85, 89–90, 94, 102–03, 106–7; refund anticipation loans, 140, 210–11; savings impact, 24; tax preparation, 204–05, 206, 210. See also Financial transactions, costs model; Home mortgages, pricing; Interest rates; Overdrafts Financial education, policy proposals, 16, 282.

See Hardship correlations Financial Management Service, banking policy proposals, 50–51 Financial slack, welfare-enhancing effects, 1–7, 14–16 Financial system participation, overview: asset holdings, 42–43; banked/ 12864-14_Index.indd 291 291 unbanked status, 28–32; choice constraints, 1–7, 22–24, 25–26, 51–52; debt patterns, 43–49; income receipt methods, 34–36; payment card preferences, 32–34; policy implications, 8, 14–19, 38–42, 50–51, 280–86; research needs, 24–25; saving behaviors, 38–42; survey data summarized, 8–14; survey methodology, 7, 26–28 Financial transactions, costs model: literature review, 57–58; nonpecuniary costs, 8–9, 75–76; outlay estimates, 8, 67–75, 79; policy implications, 78–80; short-term credit data, 65–67; survey methodology, 59–60; transaction services data, 61–65. See also Fees, financial services Florida, pawnshop regulation, 140 Gan, Li, 183 Garnishment regulation, electronic benefit programs, 87 Geographic access model, banking services: overview, 9–10, 115–17; data ­descriptions, 119–21; estimation results, 122–31; ­methodology, 117–19 Gold seal approach, banking behavior, 272–73 Gross, David, 183 Hardship correlations: overview of survey data, 37–38, 46, 48; alternative financial services usage, 149–51; bank account ownership, 56; bankruptcy filings, ­180–81, 192, 194–96; in financial transactions costs model, 76–77 Hausman test, interpretation validity, 183 Home mortgages, bankruptcy filers, 189 Home mortgages, behaviorally informed regulation: broker incentives, 176, ­265–66; disclosure policies, 175–76, 257–61; Dodd-Frank Act provisions, 266–67; ­opt-out systems, 261–65 Home mortgages, pricing: overview, 10–12, 156–58, 175–76; broker-related patterns, 165, 173–75; creditworthiness measures, 162–63; fees, 166, 168–69, 172; interest rates, 163, 165–66, 167–69; owner demographics, 159–62; policy implications, 175–76, 285; 3/23/12 11:58 AM 292 race-related patterns, 166–75; summary of characteristics, 164, 168–71 Home ownership, survey overview, 42–43 H&R Block, 141 Hurst, Erik, 173, 182–83, 192 Income levels, correlations: asset holdings, 43, 49; bank account ownership, 30, 56; bankruptcy filings, 185–87, 193–94; in financial transactions costs model, 55, 60–61, 68–77; in geographic access model, 119; home ownership, 159, 161–62; in payment card choice model, 102–03; saving behaviors, 40–41, ­271–72; short-term credit usage, 147 Income levels, survey sample, 28 Income receipt methods, 34–36, 64 Institutional power element, human behavior, 250–52 Interest rates: broker correlations, 156, 157, 173–75, 266; market-consumer bias conflicts, 252–53; pawnshop regulation, 139–40; payday loan regulation, 137, 138; race-related patterns, 157, 167–72, 173, 265; refund anticipation loans, 140–41, 142 Jackson, Howell, 173 Keys, Benjamin, 181 Knowledge and attitudes, financial activity correlations, 150–51, 196–99 Knowledge element, human behavior, 249–50 Koehler, Derek, 247 Laibson, David, 223 Life insurance, 42, 146 Lifeline banking programs, 54 Loading methods, payment card preferences, 99, 102 Loss aversion explanation, overwithholding, portfolio allocation model, 224, 234–36 Mann, Ronald, 183–84 Marital status, correlations: bankruptcy filings, 184, 185; home ownership, 159; short-term credit usage, 147 Marital status, survey sample, 28 Market bias dimension, in behaviorally informed policymaking model: over- 12864-14_Index.indd 292 index view, 252–57, 281–82; credit cards, 267–70; home mortgages, 257–66; ­savings programs, 272–73 Market-structure theory, bankruptcy filings, 183 Medical expenses: bankruptcy filers, 180–81, 189, 194–95; mortgage payment delays, 163; occurrence statistics, 37–38, 149; payday lending, 46–47; saving behaviors, 41, 42 Mental accounting: as human behavior element, 248–49; in overwithholding model, 223, 234–35 Michigan, payday lending regulation, 138 Milgram, Stanley, 247 Military personnel, payday lending regulation, 137 Minnesota, rent-to-own regulation, 142 Mobile payment systems, 92–93 Money orders, 37, 57, 65 Mortgages, home.

No slack too often means that small problems can escalate rapidly and undermine the fragile financial stability of these households. Unfortunately, families often have only limited access to the sound financial products that could help them generate financial slack. In fact, higher-cost financial services can reduce the slack available to households. For example, many lowwage individuals see their take-home pay reduced by the high transaction costs they face when using check-cashing services to obtain their income. Moreover, inadequate access to financial services—such as direct deposit to a bank account or its functional equivalent—can contribute to taxpayers’ using refund anticipation loans and expensive check-cashing services that diminish the value of the earned-income tax credit. Limited access to mainstream financial services can also hinder the ability of low-income families to save.


pages: 494 words: 142,285

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

AltaVista, Andy Kessler, barriers to entry, business process, Cass Sunstein, commoditize, computer age, creative destruction, dark matter, disintermediation, disruptive innovation, Donald Davies, 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, Kenneth Arrow, Larry Wall, Leonard Kleinrock, linked data, Marc Andreessen, Menlo Park, Mitch Kapor, Network effects, new economy, packet switching, peer-to-peer, peer-to-peer model, price mechanism, profit maximization, RAND corporation, rent control, rent-seeking, RFC: Request For Comment, Richard Stallman, Richard Thaler, Robert Bork, 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, zero-sum game

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.


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

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, creative destruction, 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, Norman Macrae, offshore financial centre, Parkinson's law, pattern recognition, phenotype, price mechanism, profit maximization, rent-seeking, reserve currency, road to serfdom, Ronald Coase, Sam Peltzman, 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, Vilfredo Pareto

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: 482 words: 121,672

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

accounting loophole / creative accounting, Albert Einstein, asset allocation, asset-backed security, beat the dealer, Bernie Madoff, bitcoin, butter production in bangladesh, buttonwood tree, buy and hold, capital asset pricing model, compound rate of return, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Detroit bankruptcy, diversification, diversified portfolio, dogs of the Dow, Edward Thorp, Elliott wave, Eugene Fama: efficient market hypothesis, experimental subject, feminist movement, financial innovation, financial repression, fixed income, framing effect, George Santayana, hindsight bias, Home mortgage interest deduction, index fund, invisible hand, Isaac Newton, Long Term Capital Management, loss aversion, margin call, market bubble, money market fund, mortgage tax deduction, new economy, Own Your Own Home, passive investing, Paul Samuelson, 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, stocks for the long run, survivorship bias, the rule of 72, The Wisdom of Crowds, transaction costs, Vanguard fund, zero-coupon bond, zero-sum game

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.

The results reveal that past movements in stock prices cannot be used reliably to foretell future movements. The stock market has little, if any, memory. While the market does exhibit some momentum from time to time, it does not occur dependably, and there is not enough persistence in stock prices to make trend-following strategies consistently profitable. 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: 491 words: 77,650

Humans as a Service: The Promise and Perils of Work in the Gig Economy by Jeremias Prassl

3D printing, Affordable Care Act / Obamacare, Airbnb, Amazon Mechanical Turk, Andrei Shleifer, autonomous vehicles, barriers to entry, call centre, cashless society, Clayton Christensen, collaborative consumption, collaborative economy, collective bargaining, creative destruction, crowdsourcing, disruptive innovation, Donald Trump, Erik Brynjolfsson, full employment, future of work, George Akerlof, gig economy, global supply chain, hiring and firing, income inequality, information asymmetry, invisible hand, Jeff Bezos, job automation, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, Kickstarter, low skilled workers, Lyft, Mahatma Gandhi, Mark Zuckerberg, market friction, means of production, moral hazard, Network effects, new economy, obamacare, pattern recognition, platform as a service, Productivity paradox, race to the bottom, regulatory arbitrage, remote working, ride hailing / ride sharing, Robert Gordon, Ronald Coase, Rosa Parks, Second Machine Age, secular stagnation, self-driving car, shareholder value, sharing economy, Silicon Valley, Silicon Valley ideology, Simon Singh, software as a service, Steve Jobs, TaskRabbit, The Future of Employment, The Market for Lemons, The Nature of the Firm, The Rise and Fall of American Growth, transaction costs, transportation-network company, Travis Kalanick, two tier labour market, two-sided market, Uber and Lyft, Uber for X, uber lyft, union organizing, working-age population

Regulatory Arbitrage Professor Julia Tomassetti is highly critical of the suggestion that platforms’ primary value creation is achieved through better matching and lower transaction cost: ‘What happens when we actually subject the Uber narra- tive to scrutiny under Coasian theory? It does not hold up. From the Coasian perspective, Uber does not write the epitaph of the firm.’32 Platforms, she argues, speak the language of markets—but they operate like old- fashioned employers, relying on technology to exercise tight control over their workforce. Tomassetti doesn’t deny that gig-economy platforms have dramatically lowered transaction cost in comparison with established competitors. Lowering transaction cost alone, however, cannot account for platforms’ phenomenal valuations and claims to disruptive innovation: there is, despite all claims to the contrary, little that is genuinely novel as far as platforms’ production pro- cesses are concerned.

The platform economy, breathless futurologists assure us, is the future of work: with ‘freelancing [as] the new normal’,12 it will fundamentally reshape the organization of businesses, the economy, and our working lives. Not everyone agrees. Frank Kalman, editor of Talent Economy magazine, is ‘not buying it’.13 The gig economy, he argues, represents a tiny fraction of our labour markets, goes against the grain of corporate work culture, and imposes a host of hidden coordination and transaction costs on traditional businesses. In short, ‘gig work is likely to remain a small part of the overall labor force, both from an economic perspective and a cultural, performance and man- agement perspective’.14 How big, then, is the gig economy? Depending on where we look, we are faced with wildly different numbers—especially when trying to deter- mine what proportion of the overall workforce are engaged in the gig economy.15 Very little, some argue: economists Lawrence Katz of Harvard University and Alan Krueger of Princeton University, for example, esti- mated in 2016 that a mere 0.5 per cent of the US workforce worked for on-demand platforms—that is, no more than 800,000 workers.16 US Senator Mark Warner, meanwhile, cites a much larger (if hardly credible) range of estimates: ‘I've seen it range from 3 million to 53 million.’17 The truth lies somewhere in between those extremes.

In an open-market transaction with an independent entrepreneur, consumers would have to spend significant amounts of time and effort to find out information about the service provider’s background and experi- ence, control the quality of the work, and negotiate prices. This is the real value of digital work intermediation: gig-economy operators also provide information about how reliable a worker is, take care of invoicing and pay- ments, and provide a (digital) infrastructure within which the entire exchange can take place. With transaction cost so drastically reduced, the narrative continues, the traditional firm as described by Ronald Coase becomes obsolete; instead, we move into a hybrid world between markets and hierarchies. According to Coase’s theory of the firm, companies exist because the control exercised by an entrepreneur-coordinator over her workforce and other factors of pro- duction is much cheaper than the cost involved in going out to the market and haggling over each individual transaction.31 On the other hand, once an app has taken all of the hassle out of such transactions, Coase’s entrepreneur will no longer need to strike long-term bargains with workers, let alone invest in assets; she can replace her workforce with an external crowd, ready to complete individual tasks as and when required.


pages: 290 words: 76,216

What's Wrong with Economics? by Robert Skidelsky

"Robert Solow", additive manufacturing, agricultural Revolution, Black Swan, Bretton Woods, business cycle, Cass Sunstein, central bank independence, cognitive bias, conceptual framework, Corn Laws, corporate social responsibility, correlation does not imply causation, creative destruction, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, disruptive innovation, Donald Trump, full employment, George Akerlof, George Santayana, global supply chain, global village, Gunnar Myrdal, happiness index / gross national happiness, hindsight bias, Hyman Minsky, income inequality, index fund, inflation targeting, information asymmetry, Internet Archive, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, Joseph Schumpeter, Kenneth Arrow, knowledge economy, labour market flexibility, loss aversion, Mark Zuckerberg, market clearing, market friction, market fundamentalism, Martin Wolf, means of production, moral hazard, paradox of thrift, Pareto efficiency, Paul Samuelson, Philip Mirowski, precariat, price anchoring, principal–agent problem, rent-seeking, Richard Thaler, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, shareholder value, Silicon Valley, Simon Kuznets, survivorship bias, technoutopianism, The Chicago School, The Market for Lemons, The Nature of the Firm, the scientific method, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, Thomas Malthus, Thorstein Veblen, transaction costs, transfer pricing, Vilfredo Pareto, Washington Consensus, Wolfgang Streeck, zero-sum game

Today they comprise the orthodox microeconomics of institutions. Why do firms exist? Coase’s answer is that they exist to reduce the costs to individuals of doing business separately. His argument is that people organise production in firms when the transaction costs of coordinating production through market exchange are greater than internalising them within the firm. The costs of transacting in markets include discovering relevant prices, negotiating and writing enforceable contracts, and haggling about the division of the surplus.4 What gives rise to transaction costs is incomplete information about relevant prices and the costs of monitoring and enforcing good performance. It is because production has a time-element that production transactions are not typically like those which take place in a fruit and vegetable market, where both buyer and seller know the prices of all the products.

Rather than presupposing the direction of causality and performing a revisionist exercise to provide a semi-coherent interpretation of apparently disconfirming facts, such as Becker and Murphy’s theory of rational addiction, ontological enquiry should be a normal part of economic practice.21 That is, in attempting to answer any given problem, economists should think seriously about the structures and elements involved, and whether or when reduction to a lower level adds or subtracts from explanatory power. 8 INSTITUTIONAL ECONOMICS The nature of the firm is not simply a minimizer of transaction costs, but a kind of protective enclave from the potentially volatile and sometimes destructive, ravaging speculation of a competitive market. Geoffrey Hodgson, Economics and Institutions Anglo-American thinkers of the Enlightenment had an intense suspicion of institutions, which they saw as impediments to the flowering of individual liberty. The economists shared this attitude and perpetuated it.

So the assumption of profit maximisation can be retained: in setting up firms owners (shareholders) cede technical authority to managers to maximise profits on their behalf. Though somewhat of an intruder on the map of individual maximisation, the firm fulfils the neoclassical criterion of rational choice. The economic historian Douglass North (1920–2015) received a Nobel prize for using the theory of transaction costs to explain the institutional innovations which led to economic growth in the eighteenth century. The institution ‘is an arrangement between economic units which defines and specifies the ways by which they can cooperate and compete’.5 Economic institutions, like products, are innovated when the gains from the innovation exceed the costs of innovating. North then goes on to explain how the modernisation of property rights in Britain set it on its growth path, by making it profitable for ‘improving’ landlords to capture the profits of their improvements, thus equalising the private and social rates of return.


pages: 375 words: 88,306

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

additive manufacturing, Airbnb, AltaVista, Amazon Mechanical Turk, autonomous vehicles, barriers to entry, basic income, bitcoin, blockchain, Burning Man, call centre, collaborative consumption, collaborative economy, collective bargaining, commoditize, corporate social responsibility, cryptocurrency, David Graeber, distributed ledger, employer provided health coverage, Erik Brynjolfsson, Ethereum, ethereum blockchain, Frank Levy and Richard Murnane: The New Division of Labor, future of work, George Akerlof, gig economy, housing crisis, Howard Rheingold, information asymmetry, Internet of things, inventory management, invisible hand, job automation, job-hopping, Kickstarter, knowledge worker, Kula ring, Lyft, Marc Andreessen, megacity, minimum wage unemployment, moral hazard, moral panic, Network effects, new economy, Oculus Rift, pattern recognition, peer-to-peer, peer-to-peer lending, peer-to-peer model, peer-to-peer rental, 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, Ross Ulbricht, 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, uber lyft, 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.


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

"Robert Solow", airport security, availability heuristic, Bayesian statistics, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, big-box store, Black Swan, Broken windows theory, business cycle, buy and hold, 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, global pandemic, haute cuisine, Henri Poincaré, high batting average, housing crisis, income per capita, index fund, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), 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, Laplace demon, locking in a profit, Loma Prieta earthquake, market bubble, Mikhail Gorbachev, Moneyball by Michael Lewis explains big data, Monroe Doctrine, mortgage debt, Nate Silver, negative equity, new economy, Norbert Wiener, PageRank, pattern recognition, pets.com, Pierre-Simon Laplace, 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 Bayes, 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.


file:///C:/Documents%20and%... by vpavan

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, asset allocation, Berlin Wall, business cycle, buttonwood tree, buy and hold, corporate governance, corporate raider, disintermediation, diversification, diversified portfolio, Donald Trump, estate planning, fixed income, index fund, intangible asset, interest rate swap, margin call, money market fund, Myron Scholes, new economy, price discovery process, profit motive, risk tolerance, shareholder value, short selling, Silicon Valley, Small Order Execution System, Steve Jobs, stocks for the long run, stocks for the long term, technology bubble, transaction costs, Vanguard fund, women in the workforce, zero-coupon bond, éminence grise

But it's there. Both cases— the cost of not finding the best match for your order and the cost exacted by the exchange and its various middlemen who handle your trade— are called transaction costs. They are costs over which you have little control. But that is changing. Transaction costs are the cause of much debate and controversy today, and the root of an immense struggle pitting the NYSE against Nasdaq; both established exchanges against new electronic networks; large investment banking firms against the exchanges; and small investors against institutional investors. In this chapter, you'll learn all about transaction costs and how they affect you. You'll also learn about recent structural changes in the stock markets, some of which have been revolutionary, that affect trading costs. I'll explain the differences between the NYSE and Nasdaq; the role of middlemen, such as NYSE specialists and Nasdaq market-makers; and the importance of newfangled systems called electronic communication networks, or ECNs.

For the year ended December 30, 2001, 47 percent of domestic stock funds did not perform as well as the S&P 500, according to Morningstar, even though the S&P lost 13.4 percent. And 2001 was one of the better years for managed funds. For years, experts have debated whether index funds are superior to managed funds. Index-fund proponents argue that actively managed funds waste money by paying higher salaries for top-flight analysts and stock pickers to put together a winning portfolio. They also incur higher transaction costs because they engage in frequent trading. But after all that, most managed funds still can't beat the passive index funds. On the other hand, managed-fund backers say that index funds don't always perform better, such as in the twelve months following the March 2000 technology bust. And managed-fund aficionados say index funds are, well, boring. When the market is booming, they mimic but never outshine the indices.

It found that the lower the turnover, the better the performance, because turnover drives up trading costs, such as brokerage commissions, and trading costs reduce results. So why do managers persist with their frenetic buying and selling? Because they are convinced that they can add value by outsmarting the market on a day-to-day basis rather than buying and holding for the long term. "Short-term speculation is what they're doing," gripes Vanguard founder Bogle. "All this thrashing around hits investors with higher transaction costs and higher taxes, but no observable improvement in fund performance." Too many fund managers also buy stocks when they think the market is about to move up and sell when they believe the market is getting ready to swoon. In other words, they try to time the market, a strategy most experts warn is a foolish attempt at achieving the impossible. No one is smart enough to time the market's ups and downs.


pages: 119 words: 10,356

Topics in Market Microstructure by Ilija I. Zovko

Brownian motion, computerized trading, continuous double auction, correlation coefficient, financial intermediation, Gini coefficient, information asymmetry, 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: 196 words: 57,974

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

affirmative action, barriers to entry, Bonfire of the Vanities, borderless world, business process, Charles Lindbergh, Corn Laws, corporate governance, corporate raider, corporate social responsibility, creative destruction, credit crunch, crony capitalism, double entry bookkeeping, Etonian, hiring and firing, industrial cluster, 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.


pages: 209 words: 13,138

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

Alvin Roth, barriers to entry, business cycle, conceptual framework, correlation coefficient, discrete time, disintermediation, distributed generation, experimental economics, financial intermediation, index arbitrage, information asymmetry, interest rate swap, inventory management, market clearing, market design, market friction, market microstructure, martingale, price discovery process, price discrimination, quantitative trading / quantitative finance, random walk, Richard Thaler, second-price auction, selection bias, short selling, statistical model, stochastic process, stochastic volatility, transaction costs, two-sided market, ultimatum game, zero-sum game

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: 436 words: 76

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

"Robert Solow", Albert Einstein, Asian financial crisis, Barry Marshall: ulcers, Berlin Wall, Big bang: deregulation of the City of London, business cycle, 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, Gunnar Myrdal, haute couture, illegal immigration, income inequality, industrial cluster, information asymmetry, intangible asset, invention of the telephone, invention of the wheel, invisible hand, John Meriwether, John Nash: game theory, John von Neumann, Kenneth Arrow, Kevin Kelly, knowledge economy, light touch regulation, 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, Myron Scholes, Naomi Klein, Nash equilibrium, new economy, oil shale / tar sands, oil shock, Pareto efficiency, Paul Samuelson, 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, Right to Buy, 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 Market for Lemons, The Nature of the Firm, the new new thing, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, total factor productivity, transaction costs, tulip mania, urban decay, Vilfredo Pareto, 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.


Order Without Design: How Markets Shape Cities by Alain Bertaud

autonomous vehicles, call centre, colonial rule, congestion charging, creative destruction, cross-subsidies, Deng Xiaoping, discounted cash flows, Donald Trump, Edward Glaeser, en.wikipedia.org, extreme commuting, garden city movement, Google Earth, Jane Jacobs, job satisfaction, Joseph Schumpeter, land tenure, manufacturing employment, market design, market fragmentation, megacity, new economy, New Urbanism, openstreetmap, Pearl River Delta, price mechanism, rent control, Right to Buy, Ronald Coase, self-driving car, Silicon Valley, special economic zone, the built environment, trade route, transaction costs, transit-oriented development, trickle-down economics, urban planning, urban sprawl, zero-sum game

Attention should be given to the supply side, including the elasticity of land supply, the productivity of the real estate industries, and the reduction of transaction costs imposed on building permits and property title transfers. Planners Can Influence Consumption by Using Markets, Not by Imposing Norms Clearly separating markets from design in the development of cities does not mean that planners should just passively monitor markets. For instance, planners should certainly be concerned by very low housing consumption among lower-income households and should act to increase it. However, they should be aware that the way to increase housing consumption is better achieved through market mechanisms (e.g., increasing supply or lowering transactions costs) rather than through regulatory design (e.g., fixing by law a minimum floor area or lot area or the rent per apartment).

The use of spreadsheets soon became common in all sectors of the economy, but the spillover occurred first in large cities, spreading from MIT in Cambridge, Massachusetts, where it was originally invented. Knowledge spillovers are responsible for agglomeration economies (i.e., economies that increase productivity due to the rapid dissemination of new ideas because of large numbers of workers in close contact).2 Agglomeration economies also result from a lowering of transaction costs in larger cities because of the proximity of competing suppliers and consumers. Economic literature linking the wealth of cities to spatial concentration is quite abundant and is no longer controversial in academic circles. National accounts show that the output share of large cities is always much higher than their share of the national population. The 2009 World Bank Development Report “Reshaping Economic Geography,” and the report of the Commission on Growth and Development “Urbanization and Growth” (published the same year) exhaustively summarize and document the theoretical and empirical arguments justifying the economic advantage provided by the spatial concentration of economic activities in large cities.

If we agree that consumption is a market issue, then planners could consider several possible solutions based on market mechanisms that would increase consumption. For instance, planners could increase the supply of developed land by increasing the speed of transport so that more land could be opened for development; they could lower the cost of construction by increasing the productivity of the building industry or by decreasing the transactions costs linked to building permits and land acquisition. Planners could also use a demand side approach, stimulating demand by increasing access to mortgage credit or even by indirectly causing an increase in salaries by opening the city to outside investments in manufacturing or services. All these measures are likely to contribute to an increase in housing consumption per household. Incidentally, the Chinese government took all these steps in the period of reform starting in the late 1990s, resulting in a nine-fold increase in urban housing consumption from 1978 to 2015!!


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

Amazon Web Services, Andrew Keen, Benjamin Mako Hill, Berlin Wall, Bernie Sanders, Brewster Kahle, Cass Sunstein, collaborative editing, commoditize, disintermediation, don't be evil, Erik Brynjolfsson, Internet Archive, invisible hand, Jeff Bezos, jimmy wales, Joi Ito, Kevin Kelly, Larry Wall, late fees, Mark Shuttleworth, Netflix Prize, Network effects, new economy, optical character recognition, PageRank, peer-to-peer, 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, yellow journalism

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: 819 words: 181,185

Derivatives Markets by David Goldenberg

Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, correlation coefficient, 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, Myron Scholes, Norbert Wiener, Paul Samuelson, 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, yield curve, zero-coupon bond, zero-sum game

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. 12.2 THE COVERED CALL HEDGING STRATEGY We can also use European P-C Parity to generate some not-so-basic hedging strategies as indicated in Table 12.2.

The LIBOR3, LIBID3 spread is typically 0.125%. 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. 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: 1,202 words: 424,886

Stigum's Money Market, 4E by Marcia Stigum, Anthony Crescenzi

accounting loophole / creative accounting, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Black-Scholes formula, Brownian motion, business climate, buy and hold, capital controls, central bank independence, centralized clearinghouse, corporate governance, credit crunch, Credit Default Swap, currency manipulation / currency intervention, David Ricardo: comparative advantage, disintermediation, distributed generation, diversification, diversified portfolio, financial innovation, financial intermediation, fixed income, full employment, high net worth, implied volatility, income per capita, intangible asset, interest rate derivative, interest rate swap, large denomination, locking in a profit, London Interbank Offered Rate, margin call, market bubble, market clearing, market fundamentalism, money market fund, mortgage debt, Myron Scholes, offshore financial centre, paper trading, pension reform, Ponzi scheme, price mechanism, price stability, profit motive, Real Time Gross Settlement, reserve currency, risk tolerance, risk/return, seigniorage, shareholder value, short selling, technology bubble, the payments system, too big to fail, transaction costs, two-sided market, value at risk, volatility smile, yield curve, zero-coupon bond, zero-sum game

Since the arb is so obvious, there is rarely money to be made either in stripping or in reconstituting bonds. In a study, Sack found that the arbitrage opportunities between coupon-bearing Treasury securities and the reconstitutable portfolio of STRIPS is limited and that most of the price differences likely fall within the range of transaction costs. The study found that, under the typical transaction cost (a bid-offer spread of about of a point), only about 15% of the study’s 57,084 observations presented a stripping arbitrage opportunity. The actual profit potential may be smaller than that because the actual transaction costs could be greater than is apparent. This results from slight differences in the taxation of these instruments, although this seems to have a trivial effect. The coupon interest of conventional Treasury securities is taxed, along with a portion of the anticipated capital gains or losses on the security.

However, if a dealer reasons that, as a core position, she is always going to have $200 million of 5-years, $200 million of 3-years, then for a portion of that it makes sense for her to put on a duration-weighted hedge using swaps. The dealer might put on a 5-year swap for maybe $100 million and then let that 5-year become a 4-year and then a 3-year, and then maybe get rid of it. This approach reduces not only spread (basis) risk, but transaction costs as well. Every time a dealer shorts a Treasury and then has to buy it back, she loses as much as a 32nd. For a shop that maintains ongoing positions in MTNs, a cheaper way (from the point of view of transaction costs) to hedge that core position may be to book an interest rate: be the payer of fixed and receiver of floating to hedge fixed-rate MTNs. MTNs VERSUS CORPORATE BONDS In the beginning and in its purest form, the MTN market dealt in unsecured, fixed-rate, medium-term paper, typically sold on a continuous basis by several dealers who acted on an agency basis.

Buying securities and rolling them involves more work than some people sometimes care to do or have time for, and having a bank or broker do the job may involve high transaction costs. Also, for some instruments, yields on small denominations are lower than those on large denominations. Finally, an investor with limited funds can’t easily reduce risk by diversifying: by buying a mix of different names or instruments. None of these difficulties exists for mutual funds such as money funds, which pool the resources of many investors. Because such a fund handles large sums of money, high minimum denominations pose no problem. FIGURE 26.1 Assets of mutual funds, January 1984–August 2000 (in billions of dollars) Transaction costs in terms of both money and time spent per dollar invested are minuscule compared to the costs that small investors incur.


pages: 348 words: 97,277

The Truth Machine: The Blockchain and the Future of Everything by Paul Vigna, Michael J. Casey

3D printing, additive manufacturing, Airbnb, altcoin, Amazon Web Services, barriers to entry, basic income, Berlin Wall, Bernie Madoff, bitcoin, blockchain, blood diamonds, Blythe Masters, business process, buy and hold, carbon footprint, cashless society, cloud computing, computer age, computerized trading, conceptual framework, Credit Default Swap, crowdsourcing, cryptocurrency, cyber-physical system, dematerialisation, disintermediation, distributed ledger, Donald Trump, double entry bookkeeping, Edward Snowden, Elon Musk, Ethereum, ethereum blockchain, failed state, fault tolerance, fiat currency, financial innovation, financial intermediation, global supply chain, Hernando de Soto, hive mind, informal economy, intangible asset, Internet of things, Joi Ito, Kickstarter, linked data, litecoin, longitudinal study, Lyft, M-Pesa, Marc Andreessen, market clearing, mobile money, money: store of value / unit of account / medium of exchange, Network effects, off grid, pets.com, prediction markets, pre–internet, price mechanism, profit maximization, profit motive, ransomware, rent-seeking, RFID, ride hailing / ride sharing, Ross Ulbricht, Satoshi Nakamoto, self-driving car, sharing economy, Silicon Valley, smart contracts, smart meter, Snapchat, social web, software is eating the world, supply-chain management, Ted Nelson, the market place, too big to fail, trade route, transaction costs, Travis Kalanick, Turing complete, Uber and Lyft, uber lyft, unbanked and underbanked, underbanked, universal basic income, web of trust, zero-sum game

All of them charge fees. The more files and pages that need hosting, the more they charge. All these solutions worked for those who could afford them. But, inevitably, the added transaction costs translated into barriers to entry that helped the largest incumbents ward off competitors, limiting innovation and denying billions of financially excluded people the opportunity to fully exploit the Internet’s many possibilities for advancement. It’s how we’ve ended up with Internet monopolies. Those with first-mover advantages have not only enjoyed the benefits of network effects; they’ve been indirectly protected by the hefty transaction costs that competitors face in trying to grow to the same scale. In a very tangible way, then, the high cost of trust management has fed the economic conditions that allow the likes of Amazon, Netflix, Google, and Facebook to keep squashing competitors.

It was another jury-rigged solution that meant that the banking system, the centralized ledger-keeping solution with which society had solved the double-spend problem for five hundred years, would be awkwardly bolted onto the ostensibly decentralized Internet as its core trust infrastructure. With customers now sufficiently confident they wouldn’t be defrauded, an explosion in online shopping ensued. But the gatekeeping moneymen now added costs and inefficiencies to the system. The result was high per-transaction costs that made it too expensive, for example, to sustain micropayments—extremely low payments, maybe as little as pennies, that otherwise promised to open up a whole new world of online business models. That nixed a dream of early Internet visionaries, who saw that idea feeding into a global marketplace where software, storage, media content, and processing power would be bought and sold in fractional amounts to maximize efficiency.

He raised $5 million, partially with tokens, to launch a startup called Lykke, whose mission, he says, is to “build a matching engine that can offer a fair market price across any digital coin, whatever its nature.” Confident that the scaling problems of blockchains will be resolved one way or another, he is convinced that open data and middleman-free blockchain-based asset markets will trend toward zero transaction costs for cross-trading in all securitized digital assets. He plans to deploy into that efficient market setting a network of high-speed, computerized trading machines. Much like Wall Street bond traders, these will “make markets” to bring financial liquidity to every countervailing pair of tokens—buying some here and selling others there—so that if anyone wants to trade 100 BATs for a third of a Jackson Pollock, they can be assured of a reasonable market price.


pages: 374 words: 97,288

The End of Ownership: Personal Property in the Digital Economy by Aaron Perzanowski, Jason Schultz

3D printing, Airbnb, anti-communist, barriers to entry, bitcoin, blockchain, carbon footprint, cloud computing, conceptual framework, crowdsourcing, cryptocurrency, Donald Trump, Edward Snowden, en.wikipedia.org, endowment effect, Firefox, George Akerlof, Hush-A-Phone, information asymmetry, intangible asset, Internet Archive, Internet of things, Isaac Newton, loss aversion, Marc Andreessen, means of production, minimum wage unemployment, new economy, peer-to-peer, price discrimination, Richard Thaler, ride hailing / ride sharing, rolodex, self-driving car, sharing economy, Silicon Valley, software as a service, software patent, software studies, speech recognition, Steve Jobs, subscription business, telemarketer, The Market for Lemons, transaction costs, winner-take-all economy

Replacing clear property rules with complicated and uncertain contractual ones makes life harder for all of us and impairs the functioning of the economy as a whole. In the language of economists, property rights increase efficiency by lowering transaction costs. Transaction costs are all of the costs aside from the sticker price that we incur when we buy a product or engage in some transaction.22 Let’s say you want to buy a newly released bestseller. The retail price for the book is $25. But that price doesn’t take into account all of the relevant costs of acquiring the book. You have to drive to the bookstore; you have to spend time looking for the book on the shelf; in some cultures, you may have to haggle over the price. These are all transaction costs. Even information about the book comes at a cost. We have to investigate products to determine their quality and characteristics before deciding to buy them.

To go back to a requirement of individualized contracts, he says, would “return transactions to the horse-and-buggy era.” Standardized mass contracts, in contrast, hold out the promise of drastically reducing transaction costs for sellers. Easterbrook is right that standardized contracts lower costs for software makers. They draft one license, likely cobbled together from existing terms, and use it in thousands or even millions of transactions. No messy negotiations, no discussions, no explanations. Undoubtedly, that reduces costs within the software industry. And while it is generally true that reducing transaction costs is a good thing, here those costs are not eliminated. They are just shifted from sellers to buyers. In a world governed by EULAs, life is easier for software companies and much harder for all of us.

In a world governed by EULAs, life is easier for software companies and much harder for all of us. We are the ones expected to read and understand page after page of license text. And those costs add up. The failure to account for them shows that Easterbrook is keenly concerned with transaction costs when they harm software makers, but remarkably insensitive to those costs when they are imposed on individuals. Next, Easterbrook gestures toward competition as a check on abusive license terms. If people are unhappy with a term that restricts how they can use a product, he speculates, surely competitors will offer more attractive terms to win them over. But the information asymmetry between users and license drafters makes it unlikely that the market will reflect consumer preferences. For the average user, the costs of researching license terms far outweigh the value of the goods at issue.


Investment: A History by Norton Reamer, Jesse Downing

activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, break the buck, Brownian motion, business cycle, buttonwood tree, buy and hold, 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, dogs of the Dow, 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, information asymmetry, 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, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Network effects, new economy, Nick Leeson, Own Your Own Home, Paul Samuelson, 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, survivorship bias, 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.


pages: 120 words: 39,637

The Little Book That Still Beats the Market by Joel Greenblatt

backtesting, index fund, intangible asset, random walk, survivorship bias, 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: 492 words: 118,882

The Blockchain Alternative: Rethinking Macroeconomic Policy and Economic Theory by Kariappa Bheemaiah

accounting loophole / creative accounting, Ada Lovelace, Airbnb, algorithmic trading, asset allocation, autonomous vehicles, balance sheet recession, bank run, banks create money, Basel III, basic income, Ben Bernanke: helicopter money, bitcoin, blockchain, Bretton Woods, business cycle, business process, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, cashless society, cellular automata, central bank independence, Claude Shannon: information theory, cloud computing, cognitive dissonance, collateralized debt obligation, commoditize, complexity theory, constrained optimization, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, cryptocurrency, David Graeber, deskilling, Diane Coyle, discrete time, disruptive innovation, distributed ledger, diversification, double entry bookkeeping, Ethereum, ethereum blockchain, fiat currency, financial innovation, financial intermediation, Flash crash, floating exchange rates, Fractional reserve banking, full employment, George Akerlof, illegal immigration, income inequality, income per capita, inflation targeting, information asymmetry, interest rate derivative, inventory management, invisible hand, John Maynard Keynes: technological unemployment, John von Neumann, joint-stock company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, knowledge economy, large denomination, liquidity trap, London Whale, low skilled workers, M-Pesa, Marc Andreessen, market bubble, market fundamentalism, Mexican peso crisis / tequila crisis, MITM: man-in-the-middle, money market fund, money: store of value / unit of account / medium of exchange, mortgage debt, natural language processing, Network effects, new economy, Nikolai Kondratiev, offshore financial centre, packet switching, Pareto efficiency, pattern recognition, peer-to-peer lending, Ponzi scheme, precariat, pre–internet, price mechanism, price stability, private sector deleveraging, profit maximization, QR code, quantitative easing, quantitative trading / quantitative finance, Ray Kurzweil, Real Time Gross Settlement, rent control, rent-seeking, Satoshi Nakamoto, Satyajit Das, savings glut, seigniorage, Silicon Valley, Skype, smart contracts, software as a service, software is eating the world, speech recognition, statistical model, Stephen Hawking, supply-chain management, technology bubble, The Chicago School, The Future of Employment, The Great Moderation, the market place, The Nature of the Firm, the payments system, the scientific method, The Wealth of Nations by Adam Smith, Thomas Kuhn: the structure of scientific revolutions, too big to fail, trade liberalization, transaction costs, Turing machine, Turing test, universal basic income, Von Neumann architecture, Washington Consensus

Also, if working efforts of workers are positively related to the real wage rate, employers may be motivated to set wages above the equilibrium wage in order to increase productivity of their employees. 172 Chapter 4 ■ Complexity Economics: A New Way to Witness Capitalism Menu Costs A menu cost is the cost to a firm resulting from changing its prices. Menu costs can prevent firms from setting their prices optimally, thus causing private profit losses which are, however, lower than these menu costs. By engaging in “near-rational behaviour” these firms deviate from the optimal price (wage) setting. and reduce their transaction costs associated with searching information about demand (labor supply) changes. In such case, profit losses caused by deviations of prices (wages) from their optimal value can be offset by reductions of their transaction costs. Such behaviour cab be optimal from the firm’s perspective but causes significant losses of aggregate output and employment. The extensive use of DSGE models in the past few decades have not been without strife. As the economy has gotten increasing interconnected, greater amounts of data are available to agents.

In decentralized markets with multiple agents, trust becomes a key factor as it has a cost associated to it. Owing to uncertainty, opportunism and limited information (bounded rationality), the lack of trust between agents limits the number of interactions and bonds that are formed in a network. This hesitation to form links based on lack of trust has been extensively studied in the field of transaction cost theory (also called new institutional economics) which was developed by Ronal Coase in 1937. 214 Chapter 4 ■ Complexity Economics: A New Way to Witness Capitalism Transactional cost theory (TCT) is the branch of economics that deals with the costs of transactions and the institutions that are developed to govern them. It studies the cost of economic links and the ways in which agents organize themselves to deal with economic interactions. Coase realized that economic transactions are costly.

Other incumbents such as Earthport have been quicker to move. At about the same time that SWIFT was putting a call out for papers, Earthport partnered with Ripple, a company that helps construct quasi-private Blockchains for clients, to implement an instant cross-border payment system. Using Ripple’s blockchain-based RTGS**, Earthport launched the Distributed Ledger Hub (DLH), which provides its clients instant payments and liquidity, transaction cost efficiencies, a high standard of compliance control, and elimination of counterparty risk via pre-funding (Earthport, 2015). As stated by Jonathan Lear, Earthport’s 59 Chapter 2 ■ Fragmentation of Finance President, “The world is getting smaller and payments needs to move faster… The legacy way of making cross-border payments, well there is only one way to describe it—it’s a real bloody mess….


pages: 677 words: 121,255

Giving the Devil His Due: Reflections of a Scientific Humanist by Michael Shermer

Alfred Russel Wallace, anthropic principle, anti-communist, barriers to entry, Berlin Wall, Boycotts of Israel, Chelsea Manning, clean water, clockwork universe, cognitive dissonance, Colonization of Mars, Columbine, cosmological constant, cosmological principle, creative destruction, dark matter, Donald Trump, Edward Snowden, Elon Musk, Flynn Effect, germ theory of disease, gun show loophole, Hans Rosling, hedonic treadmill, helicopter parent, hindsight bias, illegal immigration, income inequality, invisible hand, Johannes Kepler, Joseph Schumpeter, laissez-faire capitalism, Laplace demon, luminiferous ether, McMansion, means of production, mega-rich, Menlo Park, moral hazard, moral panic, More Guns, Less Crime, Peter Singer: altruism, phenotype, positional goods, race to the bottom, Richard Feynman, Ronald Coase, Silicon Valley, Skype, social intelligence, stem cell, Stephen Hawking, Steve Jobs, Steven Pinker, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, WikiLeaks, working poor, Yogi Berra

The Hidden Costs of Market Failures and Moral Hazards Moving from examples to analysis, Frank employs a technical model developed by the economist Ronald Coase that shows precisely how economists can take into account such transaction costs in order to better understand macroeconomic phenomena and correct for market failures. Here Frank claims that the transaction costs of keeping up with the Joneses are not presently included in the price of homes, suits, shoes, and parties in terms of the real benefit to the owners, so this is an example of a market failure (and, he opines, a moral hazard) that he suggests can be remedied through a progressive consumption tax wherein these newfound liabilities would not only adjust the transaction costs to account for the hedonic treadmill while simultaneously curtailing needless consumptive behavior, it would also generate additional tax revenues from the rich that could be used to shore up our crumbling Social Security and Medicare accounts.

There is one final hidden cost in taxing economics arms races – and a hidden benefit in not doing so – that was pointed out to me by the Hampden-Sydney College economist and Director of the Center for Entrepreneurship and Political Economy, Jennifer Dirmeyer: The people who jump on that hedonic treadmill and work so that they can have a yacht that is one foot longer than their neighbor’s produce massive positive external benefits to the rest of us. In order to make money they must use available resources in a way that creates more value than anyone else and with lower costs. In fact, most profit is made from reducing the transactions costs associated with getting products to consumers, which means lower prices. When some guy willingly works 80 hours a week managing the distribution system of a moderately sized corporation everyone else benefits from that hard, and probably dull, work in the form of low prices and increasing quality of goods and services. So, eliminating the “yacht” incentive to reduce transactions costs will just … increase transaction costs, making us all poorer, not just the peacocks.28 Fatal Conceit Redux Robert Frank strikes me as an intelligent and thoughtful man who genuinely wants to employ science and reason to improve the design of society for the betterment of all.

Other Hidden Costs: What Is Seen and What Is Not Seen in Government Actions Even if evolutionary psychologists are wrong in this analysis of sexual selection and costly signaling theory, and it was determined that ostentatious displays of wealth, power, prestige, and creativity should be penalized through a consumption tax because of Frank’s analysis using Coase’s transaction models that reveal the hidden transaction costs of positional ranking and subsequent arms races, there are transaction costs of implementing such a tax. In fact, once you concede the point that at least some government services are necessary and must be paid for by taxes, then to the short list of services such as military, police, courts, and tax collectors, one can bolt on any number of additional services justified under the collective action problem rubric: fire departments, roads and bridges, schools, libraries, national parks and forests, postal service, social security, welfare, Medicare and Medicaid, foreign aid, and countless others embodied in the alphabet soup that this slippery slope line of reasoning has given us.


pages: 316 words: 117,228

The Code of Capital: How the Law Creates Wealth and Inequality by Katharina Pistor

"Robert Solow", Andrei Shleifer, Asian financial crisis, asset-backed security, barriers to entry, Bernie Madoff, bilateral investment treaty, bitcoin, blockchain, Bretton Woods, business cycle, business process, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collateralized debt obligation, colonial rule, conceptual framework, Corn Laws, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Donald Trump, double helix, Edward Glaeser, Ethereum, ethereum blockchain, facts on the ground, financial innovation, financial intermediation, fixed income, Francis Fukuyama: the end of history, full employment, global reserve currency, Hernando de Soto, income inequality, intangible asset, investor state dispute settlement, invisible hand, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Rogoff, land reform, land tenure, London Interbank Offered Rate, Long Term Capital Management, means of production, money market fund, moral hazard, offshore financial centre, phenotype, Ponzi scheme, price mechanism, price stability, profit maximization, railway mania, regulatory arbitrage, reserve currency, Ronald Coase, Satoshi Nakamoto, secular stagnation, self-driving car, shareholder value, Silicon Valley, smart contracts, software patent, sovereign wealth fund, The Nature of the Firm, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, too big to fail, trade route, transaction costs, Wolfgang Streeck

If property rights have been clearly allocated, that is, if the two parties know what their respective rights are and what they are worth in monetary terms, they can calculate the costs each would have to incur, enabling them to resolve their dispute and reach an optimal solution through negotiation. Such an efficient outcome is achievable at least in a world without transaction costs. However, Coase himself stressed that in the real world, transaction costs are ubiquitous, which is why the initial allocation of property rights by the law actually matters a great deal. Yet, as we have seen, landowners did not just bargain with creditors to protect their interests; they employed lawyers who coded their interests in law and thereby helped tilt the playing field in their favor. This then raises the question of where property rights and other legal entitlements such as those associated with the trust come from 46 c h a P te r 2 in the first place.

This only makes sense, because law firms are for-profit operations and their fees reflect the value they help create for their clients. Conversely, given that the greatest value is created by coding capital, most law school graduates flock to the firms that hire them in large numbers to do just that. The account of transactional lawyers as the code’s masters offered here differs from two other accounts that can be found in the literature, one portraying lawyers as transaction cost engineers, the other as rent seekers. Ronald Gilson has characterized lawyers as “transaction cost engineers”; according to him, they navigate complex regulations, structure transactions so as to avoid unnecessary costs, and from time to time negotiate with regulators to obtain clearance for more adventurous transactions.13 In doing so, they are said to reduce the tension between “transaction form and regulatory purpose.”14 There are obvious parallels to their role as master coders, but there is also an important difference.

Creditors therefore will have to monitor all operations and closely watch the owner (possibly more than one) as well. If, instead, each line of business, each division, or each location can be placed behind a separate legal shield, creditors can focus on the business of their choice. Using a separate legal entity for each operation thus can offer superior protection to creditors. Creditors may not be able to reach other assets of the firm easily, but, if all goes well, they save a lot of transaction costs.20 A good illustration for the power of asset-shielding devices is the partnership system of the Medici, the family that ruled over Florence for almost a century, from 1434 to the 1530s.21 The Medici business included textile manufacturing, banking, and trade, with far-flung operations that crisscrossed Europe and reached as far as Rome, Antwerp, London, Bruges, and Paris. Each line of business and each local operation was organized as a separate partnership with its own books and accounts.


pages: 202 words: 62,901

The People's Republic of Walmart: How the World's Biggest Corporations Are Laying the Foundation for Socialism by Leigh Phillips, Michal Rozworski

Berlin Wall, Bernie Sanders, call centre, carbon footprint, central bank independence, Colonization of Mars, combinatorial explosion, complexity theory, computer age, corporate raider, decarbonisation, discovery of penicillin, Elon Musk, G4S, Georg Cantor, germ theory of disease, Gordon Gekko, greed is good, hiring and firing, index fund, Intergovernmental Panel on Climate Change (IPCC), Internet of things, inventory management, invisible hand, Jeff Bezos, Joseph Schumpeter, linear programming, liquidity trap, mass immigration, Mont Pelerin Society, new economy, Norbert Wiener, oil shock, passive investing, Paul Samuelson, post scarcity, profit maximization, profit motive, purchasing power parity, recommendation engine, Ronald Coase, Ronald Reagan, sharing economy, Silicon Valley, Skype, sovereign wealth fund, strikebreaker, supply-chain management, technoutopianism, The Nature of the Firm, The Wealth of Nations by Adam Smith, theory of mind, transaction costs, Turing machine, union organizing

Models of markets working together in seamless harmony, as well as arguments about the market system producing the best outcomes, relied on the pretty fantastical assumption that each of us have any and all information permanently at our fingertips. As some economists began to question the notion of hyperrational humans, they found Coase’s notion of transaction costs to be a useful concept that could help save the rest of the discipline. The new field of transaction cost economics turned Coase’s insights about planning within capitalism into a story about flawed humanity. If our world diverged from one populated by perfectly rational beings, then some nonmarket transactions could be grudgingly admitted into the market system—as long as our imperfections were more costly than the benefits we could get from markets.

Coase argued that companies do all of this apparent in-house imitation of the Soviet Union simply because the cost is too high of leaving up to markets every last coordinating decision. This was quite a clever explanation for the dissonance between copious corporate planning within and throughout a free market system. Economists are fond of the saying that “there is no free lunch.” Coase applied this to markets themselves. Markets introduce a whole web of what he called “transaction costs.” Writing a contract, setting up a market or finding the best price all take up resources and time. So long as the cost of doing all this was cheaper in house than on the market (and it was), it was only rational to keep it in house. So the “free” market isn’t really free either! Coase argued that it only makes sense that some decisions would be left to planning—a decision is made, and it is done.

Under capitalism, the class of owners (businesspeople or shareholders) receive much more relative to the class of producers (workers). The manager’s exercise of central planning over his small province of tyranny is therefore not simply a better means to an end, as Coase thought, but a reflection of how the economy actually works. The adversarial relationship between bosses and workers that capitalism creates is no accident of markets merely introducing transaction costs that are best avoided through planning. Yet for mainstream economists, the confrontation between workers and managers only comes up in the context of “shirking.” The GPS device in the UPS driver’s truck, the call center badge that monitors washroom breaks or the white-collar worker’s app that tracks web browsing history are the sticks requiring one does as one is told; the bonuses are the carrots.


pages: 523 words: 111,615

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

"Robert Solow", accounting loophole / creative accounting, affirmative action, bank run, banking crisis, Berlin Wall, bonus culture, Branko Milanovic, BRICs, business cycle, 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, different worldview, disintermediation, Edward Glaeser, endogenous growth, 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, hedonic treadmill, Hyman Minsky, If something cannot go on forever, it will stop - Herbert Stein's Law, illegal immigration, income inequality, income per capita, industrial cluster, information asymmetry, intangible asset, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Jane Jacobs, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, knowledge economy, light touch regulation, low skilled workers, market bubble, market design, market fundamentalism, megacity, Network effects, new economy, night-watchman state, Northern Rock, oil shock, Pareto efficiency, principal–agent problem, profit motive, purchasing power parity, railway mania, rising living standards, Ronald Reagan, selective serotonin reuptake inhibitor (SSRI), 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, zero-sum game

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: 337 words: 89,075

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

accounting loophole / creative accounting, airline deregulation, Andrei Shleifer, asset allocation, Bretton Woods, business cycle, buy and hold, 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, John Meriwether, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low cost airline, market bubble, merger arbitrage, money market fund, new economy, passive investing, Paul Samuelson, price mechanism, purchasing power parity, risk tolerance, risk-adjusted returns, risk/return, Ronald Reagan, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, stocks for the long run, survivorship bias, the market place, transaction costs, Y2K, yield curve, zero-sum game

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: 411 words: 80,925

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

Airbnb, barriers to entry, Bernie Madoff, bike sharing scheme, Buckminster Fuller, buy and hold, carbon footprint, Cass Sunstein, collaborative consumption, collaborative economy, commoditize, Community Supported Agriculture, credit crunch, crowdsourcing, dematerialisation, disintermediation, en.wikipedia.org, experimental economics, George Akerlof, global village, hedonic treadmill, 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, peer-to-peer lending, peer-to-peer rental, 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: 791 words: 85,159

Social Life of Information by John Seely Brown, Paul Duguid

business process, Claude Shannon: information theory, computer age, cross-subsidies, disintermediation, double entry bookkeeping, Frank Gehry, frictionless, frictionless market, future of work, George Gilder, George Santayana, global village, Howard Rheingold, informal economy, information retrieval, invisible hand, Isaac Newton, John Markoff, Just-in-time delivery, Kenneth Arrow, Kevin Kelly, knowledge economy, knowledge worker, lateral thinking, loose coupling, Marshall McLuhan, medical malpractice, moral hazard, Network effects, new economy, Productivity paradox, Robert Metcalfe, rolodex, Ronald Coase, shareholder value, Shoshana Zuboff, 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: 270 words: 79,180

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

Affordable Care Act / Obamacare, Airbnb, Al Roth, Ben Horowitz, Black Swan, buy low sell high, Chuck Templeton: OpenTable:, Credit Default Swap, cross-subsidies, crowdsourcing, disintermediation, diversified portfolio, experimental economics, George Akerlof, Goldman Sachs: Vampire Squid, income inequality, index fund, information asymmetry, Jean Tirole, Joan Didion, Kenneth Arrow, Lean Startup, Lyft, Marc Andreessen, Mark Zuckerberg, market microstructure, Martin Wolf, McMansion, Menlo Park, Metcalfe’s law, moral hazard, multi-sided market, Network effects, patent troll, Paul Graham, Peter Thiel, pez dispenser, ride hailing / ride sharing, Robert Metcalfe, 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, uber lyft, 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: 117 words: 31,221

Fred Schwed's Where Are the Customers' Yachts?: A Modern-Day Interpretation of an Investment Classic by Leo Gough

Albert Einstein, banking crisis, Bernie Madoff, corporate governance, discounted cash flows, diversification, fixed income, index fund, Long Term Capital Management, Northern Rock, passive investing, Ralph Waldo Emerson, random walk, short selling, South Sea Bubble, The Nature of the Firm, the rule of 72, The Wealth of Nations by Adam Smith, transaction costs, young professional

JUST BECAUSE SOMEONE WORKS IN THE STOCK MARKET DOESN’T MEAN THEY ARE A GOOD INVESTOR 20. DIVERSIFICATION 21. HAVING YOUR CAKE AND EATING IT 22. EXCEPTIONS ARE THE RULE 23. FUNDAMENTAL ANALYSIS 24. NEW ISSUES 25. TRUSTEES, EXECUTORS AND LAWYERS 26. RETIREMENT PLANNING 27. INDEX INVESTING 28. DON’T INVEST ON A HIGH 29. COMPANIES DON’T OFTEN TURN AROUND 30. RIDE THE WINNERS 31. THE TROUBLE WITH TRANSACTION COSTS 32. CROOKS 33. AVOIDING THE BIG COLLAPSES 34. COUNTER-CYCLICAL INVESTMENT 35. GLOBALISATION 36. NUMERACY REQUIRED 37. SHORT SELLING 38. THOSE CRAZY REGULATORS 39. COLLECTIVE INVESTMENTS 40. MERGERS AND ACQUISITIONS 41. MASSAGING THE FIGURES 42. LOOKING FOR BARGAINS 43. DISCOUNTED CASH FLOW 44. STOCK MARKET NEWSLETTERS 45. LIFE PLAN 46. HEDGE FUNDS 47. SOME IMPORTANT BASICS 48.

Although it may work for portfolios that are less than expertly picked, if you really believe in your shares – because you have studied them properly, with your business brain in gear – then there shouldn’t be much that happens that should change your mind, and you ought to be willing to hold onto great companies through some lean times. However, as a psychological trick to keep you from buying and selling too often, it’s probably okay as a creed. 31 THE TROUBLE WITH TRANSACTION COSTS ‘The man who chooses to take his money and churn it furiously … cannot in any way predict his fate, save for a single assurance. So long as any money still clings to the side of the churn, he will not be bored.’ DEFINING IDEA… All there is to investing is picking good stocks at good times and staying with them as long as they remain good companies. ~ WARREN BUFFETT People who have never owned shares often imagine that investors spend their time buying and selling every day, if not every hour – and they also imagine that this is fun.

~ WARREN BUFFETT People who have never owned shares often imagine that investors spend their time buying and selling every day, if not every hour – and they also imagine that this is fun. That might be okay if you are a large institution with a department full of traders with nothing else to do, because financial institutions pay very low transaction charges. For the private investor, though, it’s an expensive activity, because the transaction costs are higher, so the more you trade, the more the charges eat into your overall return. What’s worse, if you like to speculate in less well-known companies, like the ones quoted on AIM (the Alternative Investment Market) or the OTC (the Over The Counter market), you’ll find that the ‘spread’ can be very much wider than in the main market – that’s the difference between the price at which a dealer will buy from you (the ‘bid’) and the price at which he will sell to you (the ‘offer’).


pages: 472 words: 117,093

Machine, Platform, Crowd: Harnessing Our Digital Future by Andrew McAfee, Erik Brynjolfsson

"Robert Solow", 3D printing, additive manufacturing, AI winter, Airbnb, airline deregulation, airport security, Albert Einstein, Amazon Mechanical Turk, Amazon Web Services, artificial general intelligence, augmented reality, autonomous vehicles, backtesting, barriers to entry, bitcoin, blockchain, British Empire, business cycle, business process, carbon footprint, Cass Sunstein, centralized clearinghouse, Chris Urmson, cloud computing, cognitive bias, commoditize, complexity theory, computer age, creative destruction, crony capitalism, crowdsourcing, cryptocurrency, Daniel Kahneman / Amos Tversky, Dean Kamen, discovery of DNA, disintermediation, disruptive innovation, distributed ledger, double helix, Elon Musk, en.wikipedia.org, Erik Brynjolfsson, Ethereum, ethereum blockchain, everywhere but in the productivity statistics, family office, fiat currency, financial innovation, George Akerlof, global supply chain, Hernando de Soto, hive mind, information asymmetry, Internet of things, inventory management, iterative process, Jean Tirole, Jeff Bezos, jimmy wales, John Markoff, joint-stock company, Joseph Schumpeter, Kickstarter, law of one price, longitudinal study, Lyft, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, Marc Andreessen, Mark Zuckerberg, meta analysis, meta-analysis, Mitch Kapor, moral hazard, multi-sided market, Myron Scholes, natural language processing, Network effects, new economy, Norbert Wiener, Oculus Rift, PageRank, pattern recognition, peer-to-peer lending, performance metric, plutocrats, Plutocrats, precision agriculture, prediction markets, pre–internet, price stability, principal–agent problem, Ray Kurzweil, Renaissance Technologies, Richard Stallman, ride hailing / ride sharing, risk tolerance, Ronald Coase, Satoshi Nakamoto, Second Machine Age, self-driving car, sharing economy, Silicon Valley, Skype, slashdot, smart contracts, Snapchat, speech recognition, statistical model, Steve Ballmer, Steve Jobs, Steven Pinker, supply-chain management, TaskRabbit, Ted Nelson, The Market for Lemons, The Nature of the Firm, Thomas Davenport, Thomas L Friedman, too big to fail, transaction costs, transportation-network company, traveling salesman, Travis Kalanick, two-sided market, Uber and Lyft, Uber for X, uber lyft, ubercab, Watson beat the top human players on Jeopardy!, winner-take-all economy, yield management, zero day

Instead, we need to understand subsequent insights from transaction cost economics (TCE), the discipline he was instrumental in founding. The Latest Thinking on Why Companies Are So Common TCE deals with the very basic question of why economic activity is organized the way it is—why, for example, we see markets and companies in the mix that we do. Often called the theory of the firm, TCE is a branch of economics important enough to have merited three Nobel prizes: the first in 1991 to Coase; the second in 2009 to his student Oliver Williamson, who was recognized along with Elinor Ostrom;†† and most recently a third, to Oliver Hart and Bengt Holm-ström, who were recognized in 2016. As you’ve no doubt inferred from the name, transaction costs turn out to be deeply important: when markets have lower total transaction costs, they win out over hierarchies, and vice versa.

., 305 Spotify, 146–48 stacks, 295–96, 298 Stallman, Richard, 243 standard partnership creativity and, 119, 120 defined, 37 demand for routine skills and, 321 HiPPO and, 45, 59 inversion of, 56–60 modified by data-driven decision making, 46–60 structure of, 31 Starbucks, 185 statistical pattern recognition, 69, 72–74, 81–82, 84 statistical prediction, 41 status quo bias, 21 steampunk, 273 Sterling, Bruce, 295, 298 S3 (Amazon Web Service), 143 Stites-Clayton, Evan, 263 STR, 221 “stranger-danger” bias, 210 streaming services, 146–48 Street, Sam, 184 Street Bump, 162–63 Stripe, 171–74, 205 structured interviews, 57 students, gifted, 40 Sturdivant, Jeremy, 286 subscription services, 147–48 suitcase words, 113 Suleyman, Mustafa, 78 “superforecasters,” 60–61 supervised learning, 76 supply and demand; See also demand; demand curves; supply curves O2O platforms for matching, 193 platforms and, 153–57 and revenue management, 47 supply curves, 154–56 Supreme Court, US, 40–41 surge pricing, 55 Svirsky, Dan, 209n Sweeney, Latanya, 51–52 Swift, Taylor, 148 switching costs, 216–17, 219 Sydney, Australia, hostage incident (2014), 55 symbolic artificial intelligence, 69–72 introduction of, 69–70 reasons for failure of, 70–72 synthetic biology, 271–72 systems integration, 142 System 1/System 2 reasoning, 35–46 and confirmation bias, 57 defined, 35–36 and second-machine-age companies, 325 undetected biases and, 42–45 weaknesses of, 38–41 Szabo, Nick, 292, 294–95 Tabarrok, Alex, 208–9 Tapscott, Alex, 298 Tapscott, Don, 298 Tarantino, Quentin, 136n TaskRabbit, 261, 265 taxi companies, Uber’s effect on, 201 TCE (transaction cost economics), 312–16 TechCrunch, 296 technology (generally) effect on employment and wages, 332–33 effect on workplace, 334 as tool, 330–31 Teespring, 263–64 Teh, Yee-Whye, 76 telephones, 129–30, 134–35 tenure predictions, 39 Tesla (self-driving automobile), 81–82, 97 Tetlock, Philip, 59 text messages, 140–41 Thank You for Being Late (Friedman), 135 theories, scientific, 116–17 theory of the firm, See TCE (transaction cost economics) Thierer, Adam, 272 “thin” companies, 9 Thingiverse, 274 Thinking, Fast and Slow (Kahneman), 36, 43 Thomas, Rob, 262 Thomke, Stefan, 62–63 3D printing, 105–7, 112–13, 273, 308 Thrun, Sebastian, 324–25 TNCs (transportation network companies), 208 TØ.com, 290 Tomasello, Michael, 322 Topcoder, 254, 260–61 Torvalds, Linus, 240–45 tourists, lodging needs of, 222–23 Tower Records, 131, 134 trade, international, 291 trading, investment, 266–70, 290 Transfix, 188, 197, 205 transparency, 325 transportation network companies (TNCs), 208; See also specific companies, e.g.: Uber Transportation Security Administration (TSA), 89 Tresset, Patrick, 117 trucking industry, 188 T-shirts, 264 tumors, 3D modeling of, 106 Turing, Alan, 66, 67n Tuscon Citizen, 132 TV advertising, 48–51 Tversky, Amos, 35 Twitter, 234 two-sided networks credit cards, 214–16 Postmates, 184–85 pricing in, 213–16, 220 pricing power of, 210–11 switching costs, 216–17 Uber, 200, 201, 218–19 two-sided platforms, 174, 179–80 Two Sigma, 267 Uber driver background checks, 208 future of, 319–20 information asymmetry management, 207–8 lack of assets owned by, 6–7 as means of leveraging assets, 196–97 network effects, 193, 218 as O2O platform, 186 origins, 200–202 and Paris terrorist attack, 55 pricing decisions, 212–15, 218–19 rapid growth of, 9 regulation of, 201–2 reputational systems, 209 routing problems, 194 separate apps for drivers and riders, 214 and Sydney hostage incident, 54–55 value proposition as compared to Airbnb, 222 UberPool, 9, 201, 212 UberPop, 202 UberX, 200–201, 208, 212, 213n Udacity, 324–25 unbundling, 145–48, 313–14 unit drive, 20, 23 Universal Music Group, 134 University of Louisville, 11 University of Nicosia, 289 unlimited service ClassPass Unlimited, 178–79, 184 Postmates Plus Unlimited, 185 Rent the Runway, 187–88 unsupervised learning, 76, 80–81 Upwork, 189, 261 Urmson, Chris, 82 used car market, information asymmetry and, 207 Usenet, 229, 271 user experience/interface as platforms’ best weapon, 211 and successful platforms, 169–74 users, as code developers, 242 “Uses of Knowledge in Society, The” (Hayek), 235–37 utilization rate, O2O platforms, 196–97 Van Alstyne, Marshall, 148 Van As, Richard, 272–74 Vancouver, Canada, Uber prohibition in, 202 venture capital, DAO vs., 302 verifiability, 248 verifiable/reversible contributions, 242–43 Verizon, 96, 232n Veronica Mars (movie), 262 Veronica Mars (TV show), 261–62 Viant, 171 video games, AI research and, 75 videos, crowd-generated, 231–32 Viper, 163 virtualization, 89–93; See also robotics vision, Cambrian Explosion and, 95 “Voice of America” (Wright), 229–30 von Hippel, Eric, 265 wage declines, 332 Wagner, Dan, 48–50 Waldfogel, Joel, 144 Wales, Jimmy, 234, 246–48 Walgreens, 185 Walmart, 7, 47 Wanamaker, John, 8–9 warehousing, 102–3, 188 Warner Brothers, 262 Warner Music Group, 134 Washington Post, 132 Washio, 191n waste reduction, 197 Watson (IBM supercomputer) health claim processing, 83 Jeopardy!

As you’ve no doubt inferred from the name, transaction costs turn out to be deeply important: when markets have lower total transaction costs, they win out over hierarchies, and vice versa. We can’t possibly do a fair job of conveying here all the insights of transaction cost economics; there’s too much rich and excellent work. Instead, we want to concentrate on one aspect of TCE that’s especially helpful for understanding the impact of the powerful new digital technologies of the crowd. It starts with the basic rule of thumb that markets often have lower production costs (all the costs that come with making goods and services), while hierarchies typically have lower coordination costs (all the costs associated with setting up the production and keeping it running smoothly). The technologies discussed in this book are great cost reducers, and especially good at reducing coordination costs. It’s easy to see how search engines, cheap global communication networks, and the free, perfect, and instant economies of information goods in general would drive down coordination costs.


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

Albert Einstein, anti-communist, asset allocation, beat the dealer, Benoit Mandelbrot, Black-Scholes formula, Brownian motion, buy and hold, buy low sell high, capital asset pricing model, Claude Shannon: information theory, computer age, correlation coefficient, diversified portfolio, Edward Thorp, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John Meriwether, John von Neumann, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Myron Scholes, New Journalism, Norbert Wiener, offshore financial centre, Paul Samuelson, publish or perish, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Rubik’s Cube, 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, zero-sum game

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: 580 words: 168,476

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

"Robert Solow", affirmative action, Affordable Care Act / Obamacare, airline deregulation, Andrei Shleifer, banking crisis, barriers to entry, Basel III, battle of ideas, Berlin Wall, business cycle, 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, information asymmetry, invisible hand, jobless men, John Harrison: Longitude, John Markoff, John Maynard Keynes: Economic Possibilities for our Grandchildren, Kenneth Arrow, Kenneth Rogoff, London Interbank Offered Rate, lone genius, low skilled workers, Marc Andreessen, Mark Zuckerberg, market bubble, market fundamentalism, mass incarceration, medical bankruptcy, microcredit, moral hazard, mortgage tax deduction, negative equity, obamacare, offshore financial centre, paper trading, Pareto efficiency, patent troll, Paul Samuelson, 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%, wealth creators, women in the workforce, zero-sum game

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: 336 words: 90,749

How to Fix Copyright by William Patry

A Declaration of the Independence of Cyberspace, barriers to entry, big-box store, borderless world, business cycle, business intelligence, citizen journalism, cloud computing, commoditize, creative destruction, 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, moral panic, 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, winner-take-all economy, zero-sum game

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.


pages: 330 words: 91,805

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

Airbnb, Amazon Web Services, Andy Kessler, banking crisis, barriers to entry, basic income, Benevolent Dictator For Life (BDFL), bitcoin, blockchain, Burning Man, business climate, call centre, car-free, cloud computing, collaborative consumption, collaborative economy, collective bargaining, commoditize, congestion charging, creative destruction, crowdsourcing, cryptocurrency, decarbonisation, different worldview, do-ocracy, don't be evil, Elon Musk, en.wikipedia.org, Ethereum, ethereum blockchain, Ferguson, Missouri, Firefox, frictionless, Gini coefficient, hive mind, income inequality, index fund, informal economy, Intergovernmental Panel on Climate Change (IPCC), 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, peer-to-peer lending, peer-to-peer model, 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 Future of Employment, The Nature of the Firm, transaction costs, Turing test, turn-by-turn navigation, Uber and Lyft, uber 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: 280 words: 73,420

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

algorithmic trading, automated trading system, Bernie Madoff, Bernie Sanders, Bretton Woods, buttonwood tree, buy and hold, computerized trading, corporate raider, creative destruction, credit crunch, Credit Default Swap, financial innovation, fixed income, 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, Myron Scholes, 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

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, commoditize, Computer Numeric Control, crowdsourcing, dark matter, David Ricardo: comparative advantage, death of newspapers, dematerialisation, Elon Musk, factory automation, Firefox, future of work, global supply chain, global village, IKEA effect, 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, private space industry, profit maximization, QR code, race to the bottom, Richard Feynman, Ronald Coase, Rubik’s Cube, 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

Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, break the buck, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, 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, endogenous growth, 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, information asymmetry, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, margin call, Mark Zuckerberg, McMansion, money market fund, mortgage debt, mortgage tax deduction, Myron Scholes, negative equity, 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 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, Thales of Miletus, 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: 462 words: 129,022

People, Power, and Profits: Progressive Capitalism for an Age of Discontent by Joseph E. Stiglitz

"Robert Solow", affirmative action, Affordable Care Act / Obamacare, barriers to entry, basic income, battle of ideas, Berlin Wall, Bernie Madoff, Bernie Sanders, business cycle, Capital in the Twenty-First Century by Thomas Piketty, carried interest, central bank independence, clean water, collective bargaining, corporate governance, corporate social responsibility, creative destruction, Credit Default Swap, crony capitalism, deglobalization, deindustrialization, disintermediation, diversified portfolio, Donald Trump, Edward Snowden, Elon Musk, Erik Brynjolfsson, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, Firefox, Fractional reserve banking, Francis Fukuyama: the end of history, full employment, George Akerlof, gig economy, global supply chain, greed is good, income inequality, information asymmetry, invisible hand, Isaac Newton, Jean Tirole, Jeff Bezos, job automation, John Maynard Keynes: Economic Possibilities for our Grandchildren, John von Neumann, Joseph Schumpeter, labor-force participation, late fees, low skilled workers, Mark Zuckerberg, market fundamentalism, mass incarceration, meta analysis, meta-analysis, minimum wage unemployment, moral hazard, new economy, New Urbanism, obamacare, patent troll, Paul Samuelson, pension reform, Peter Thiel, postindustrial economy, price discrimination, principal–agent problem, profit maximization, purchasing power parity, race to the bottom, Ralph Nader, rent-seeking, Richard Thaler, Robert Bork, Robert Gordon, Robert Mercer, Robert Shiller, Robert Shiller, Ronald Reagan, secular stagnation, self-driving car, shareholder value, Shoshana Zuboff, Silicon Valley, Simon Kuznets, South China Sea, sovereign wealth fund, speech recognition, Steve Jobs, The Chicago School, The Future of Employment, The Great Moderation, the market place, The Rise and Fall of American Growth, the scientific method, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transaction costs, trickle-down economics, two-sided market, universal basic income, Unsafe at Any Speed, Upton Sinclair, uranium enrichment, War on Poverty, working-age population

There are many other areas where markets fail to do what they should and where collective action can improve well-being. The reason we have a variety of social insurance programs (from retirement annuities, to health care for the aged, to unemployment insurance) is simple: these are big risks that, accordingly, have large impacts on individual well-being, but before the government came along, the market either didn’t provide insurance against these risks, or did so only at very high prices with high transaction costs.6 Dynamic economies are always in transition, and markets don’t manage these transitions well on their own. We are now moving from a manufacturing economy to a globalized, urbanized, service and innovation economy, with marked changes in demography. So too, coordinating a large, complex economy is difficult. Prior to active government policies managing the macroeconomy, there were frequently long periods of extended unemployment.

Mass incarceration may have had many motives,5 but clearly one of its effects has been mass disenfranchisement: some 7.4 percent of African Americans—2.2 million in total—were unable to vote in the 2016 election because of these state laws preventing voting.6 In some Republican-dominated states,7 there is also an attempt to control the vote by making it more difficult for working people to register or to make it to the polling booth. Republicans can’t impose a poll tax, as states of the segregated South once did; but they can increase the transaction costs of registering and voting, and this can be just as effective a deterrent. Rather than making it as easy as possible to register—to exercise one’s basic right as a citizen—say, by registering as one gets one’s driver’s license, they make it as difficult as they can get away with. They can, for instance, demand hard-to-get identification papers. Historically, no party had a monopoly on attempts at disenfranchisement: when the Democrats controlled the South, they tried to discourage voting by African Americans and the poor, as we already noted.

Again, large risks like these and ones associated with unemployment, health, and retirement, are risks that markets do not handle well.16 In some cases, like unemployment and health insurance for the aged, markets simply do not provide insurance; in other cases, like retirement, they provide annuities only at high costs, and even then, without important provisions—such as adjustments for inflation. That is why almost all advanced countries provide social insurance to cover at least many of these risks. Governments have become fairly proficient in providing this insurance—transaction costs for the US Social Security system are a fraction of those associated with comparable private insurance. We need to recognize, however, that there are large gaps in our system of social insurance, with many important risks still not being covered either by markets or by government. Unemployment insurance One of the biggest gaps in our system of social protection is that our unemployment insurance program covers a relatively small risk—being unemployed for twenty-six weeks—but leaves the much more serious risk of long-term unemployment unaddressed.


pages: 920 words: 233,102

Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State by Paul Tucker

Andrei Shleifer, bank run, banking crisis, barriers to entry, Basel III, battle of ideas, Ben Bernanke: helicopter money, Berlin Wall, Bretton Woods, business cycle, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, centre right, conceptual framework, corporate governance, diversified portfolio, Fall of the Berlin Wall, financial innovation, financial intermediation, financial repression, first-past-the-post, floating exchange rates, forensic accounting, forward guidance, Fractional reserve banking, Francis Fukuyama: the end of history, full employment, George Akerlof, incomplete markets, inflation targeting, information asymmetry, invisible hand, iterative process, Jean Tirole, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, liberal capitalism, light touch regulation, Long Term Capital Management, means of production, money market fund, Mont Pelerin Society, moral hazard, Northern Rock, Pareto efficiency, Paul Samuelson, price mechanism, price stability, principal–agent problem, profit maximization, quantitative easing, regulatory arbitrage, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Robert Bork, Ronald Coase, seigniorage, short selling, Social Responsibility of Business Is to Increase Its Profits, stochastic process, The Chicago School, The Great Moderation, The Market for Lemons, the payments system, too big to fail, transaction costs, Vilfredo Pareto, Washington Consensus, yield curve, zero-coupon bond, zero-sum game

Rather, it was that the case for regulation turned on the existence of irremediable and material transaction costs standing in the way of efficiency. In other words, it was not sufficient simply to cite an externality to motivate regulatory intervention. There are three things to be said about this. Creating New Property Rights Can Entail Regulation First, even where governments choose to address externality problems via creating new property rights, they sometimes opt to regulate the new markets for trading those rights (e.g., pollution permits). Simply invoking “transaction costs” does not seem sufficient to explain or warrant the choice between judicial and regulatory oversight.29 Keeping Perspective: The Infeasibility of Committing to Compensate for Financial Instability Second, some transaction costs can be reduced; others cannot. A classic example of the latter, vital to part IV’s exploration of postcrisis central banking, helps to motivate regulatory intervention to preserve the stability of the financial system.

Worse, they might be programmed or choose to favor some groups in society over others, possibly reflecting a capacity within big business to influence the rules of the game of politics itself. Economists who opposed the regulatory state offered their own solution: address market failures by taking steps toward more complete markets. Coase versus Pigou: Property Rights and Transaction Costs In 1960 Ronald Coase, a British-born economist working in Chicago, explained how regulatory interventions were not warranted where, instead, property rights could be clarified (or created) and where the transaction costs of enforcing those rights were low (theoretically zero). Such legal rights could be traded and hedged via markets, opening up the option of the work of regulation being performed instead by the law of contract and of torts enforced via the courts: as typically put, private choice rather than public choice.

These choices are not immediately explicable since, as we have seen in this and the previous chapter, twentieth-century economists took very different views on how best to promote market efficiency; on the relative reliability of courts, regulators, and elected politicians; and on the separability of efficiency and equity. If institutions, broadly conceived (e.g., private law, a monetary regime, a constitution), are mechanisms for reducing transaction costs across space and time, that doesn’t help us much unless we are clear about goals and values. Away from the academy, economic liberalism permeates policy and political debates about the structure of the state in quite different ways on either side of the Atlantic. In the US, it is deployed by those preferring minimal government to argue against regulation and in favor of private, market-based orderings underpinned by courts enforcing property rights of various kinds; but it is resisted by Left liberals who support regulators under presidential control that pursue efficiency in combination with distributional and other social goals.


pages: 443 words: 112,800

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

"Robert Solow", 3D printing, additive manufacturing, Albert Einstein, American ideology, 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, industrial cluster, informal economy, Intergovernmental Panel on Climate Change (IPCC), invisible hand, Isaac Newton, job automation, knowledge economy, manufacturing employment, marginal employment, Martin Wolf, Masdar, megacity, Mikhail Gorbachev, new economy, off grid, oil shale / tar sands, oil shock, open borders, peak oil, Ponzi scheme, post-oil, purchasing power parity, Ray Kurzweil, Ronald Reagan, scientific worldview, 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

"Robert Solow", affirmative action, Albert Einstein, asset allocation, backtesting, beat the dealer, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commoditize, commodity trading advisor, computer age, computerized trading, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, Edward Thorp, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, intangible asset, Jeff Bezos, John Meriwether, 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, Myron Scholes, new economy, Nick Leeson, oil shock, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, selection bias, 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, William Langewiesche, yield curve, zero-coupon bond, zero-sum game

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.


Trading Risk: Enhanced Profitability Through Risk Control by Kenneth L. Grant

backtesting, business cycle, buy and hold, commodity trading advisor, correlation coefficient, correlation does not imply causation, delta neutral, diversification, diversified portfolio, fixed income, frictionless, frictionless market, George Santayana, implied volatility, interest rate swap, invisible hand, Isaac Newton, John Meriwether, Long Term Capital Management, market design, Myron Scholes, performance metric, price mechanism, price stability, risk tolerance, risk-adjusted returns, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, two-sided market, value at risk, volatility arbitrage, yield curve, zero-coupon bond

For example, you may find that your net market value might be negatively correlated to your holding periods, which might reinforce the notion that it is easier to hold for extended periods of time positions with small directional overhang and more difficult to retain position profiles that have large net market exposures. Similarly, correlation patterns between transaction size and capital usage might reveal interesting insights into factors such as liquidity, transaction costs, and other dynamics that will be pertinent to portfolio performance. Be creative. No matter what two factors you try to correlate against each other, I promise you that there have been sillier ones based on less intelligent premises. BABY’S ON FIRE It is very easy to take correlation analysis to extremes. I once worked with a guy who was obsessed with this and who would seek to find correlations in the strangest of places.

In a very meaningful (though imperfect) way, these positions have similar risk characteristics; and it becomes a relatively simple mathematical exercise to view your positions not just in terms of number of shares or contracts (bad), but in terms of dollar value invested (better) or units of expected volatility (better still). As we will discuss later in the book, the primary sets of circumstances under which these relationships break down are those involving large position sizes, where transaction costs begin to increase due to liquidity concerns. These concerns certainly arise with greater frequency in large institutional portfolios but should not deter anyone from understanding the volatility-adjusted exposures tied to the individual positions in their accounts. You can generate similar incremental benefits by introducing the concept of correlation into the mix, which will give you some insight as to how much diversification positions on the same side of the market are generating for your portfolio and how much direct exposure offset you are achieving with positions on opposite sides of the market.

Of course, day traders wishing to modify the amount of time they are willing to hold positions for the purpose of decreasing their market exposures have much less latitude. Any move to shorten holding periods that already fail to extend beyond one trading session is not likely to reduce the risk of loss in individual securities and may in fact increase it––due to such unavoidable market factors as commissions, bid/offer spreads, and other types of transactions costs. By contrast, those whose holding periods extend beyond one day have a better opportunity to use this variable as a means of targeting the appropriate exposure levels in their portfolios. Once again, a useful rule of thumb is that your exposure will increase and decrease as a function of the square root of the number of days you hold the position. Thus, the risk associated with holding a position for a week (five trading days) is slightly more than double (i.e., the square root of five) the risk that would be associated with a single day; a position carried for a month would be just over four times the daily amount (i.e., the square root of twenty); and so on.


pages: 202 words: 58,823

Willful: How We Choose What We Do by Richard Robb

activist fund / activist shareholder / activist investor, Alvin Roth, Asian financial crisis, asset-backed security, Bernie Madoff, capital asset pricing model, cognitive bias, collapse of Lehman Brothers, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, delayed gratification, diversification, diversified portfolio, effective altruism, endowment effect, Eratosthenes, experimental subject, family office, George Akerlof, index fund, information asymmetry, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, lake wobegon effect, loss aversion, market bubble, market clearing, money market fund, Pareto efficiency, Paul Samuelson, Peter Singer: altruism, principal–agent problem, profit maximization, profit motive, Richard Thaler, Silicon Valley, sovereign wealth fund, survivorship bias, the scientific method, The Wealth of Nations by Adam Smith, Thomas Malthus, Thorstein Veblen, transaction costs, ultimatum game

Thaler points out the inconsistency of a man refusing to hire somebody to mow his lawn for eight dollars but then turning down the opportunity to mow a neighbor’s similarly sized lawn for twenty dollars. Thaler attributes this paradox to cognitive bias.3 Rational choice economists might point to different reasons for this behavior: if the man hired himself out as a mower, he could suffer diminished status among his neighbors or incur transaction costs in negotiating the terms of the job, as well as additional income tax. If he hired a mower, coordinating and monitoring would impose additional costs. But this is unconvincing: people would mow their own grass but not their neighbor’s for pay, even if they could work in disguise to uphold their status, income taxes were eliminated, and quality was easy to monitor. This paradox arises in a strict purposeful choice framework, with agents evaluating work according to factors like pay and pleasantness of the task, while ignoring authenticity.

Finally, I ask: “How many of you know that a non-diversified portfolio conflicts with economic theory?” They all raise their hands and laugh. My students are not alone in ignoring the precept that they can maximize return and minimize risk by holding a portfolio of assets that is diversified. Investors often diversify far less than the capital asset pricing model advises and overweight their portfolio toward their home country more than transaction costs alone can justify. This tendency is a notorious embarrassment to portfolio theory. But we need not resort to cognitive biases to account for it. The explanation lies in the importance of choice, whether or not that choice strictly maximizes profit. Suppose people are drawn to four or five investments, based on admiration of certain companies, tips from friends, or trends they believe will benefit certain businesses.

Since the 1960s, detractors of the efficient market hypothesis have identified potential anomalies in the data that a savvy trader could exploit, and defenders have counterattacked with one of three claims: (1) The detractors looked at hundreds of possible anomalies and only published one—even if markets are perfectly unpredictable, some patterns will appear by chance, (2) There’s a flaw in the detractors’ analysis (for instance, transaction costs would chew up apparent profit or the securities were not really available at the published price), or (3) Any above-market returns can be attributed to risk, since the payoff is positively correlated with other financial assets or human capital. In return, detractors point to alleged cognitive biases, such as loss aversion, as the reason that money-making opportunities persist. Defenders then respond that some people may be biased some of the time, but even a small number of arbitrageurs can force the market to its proper level.1 I am neither in favor of the efficient market hypothesis, nor against it.


pages: 317 words: 106,130

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

asset allocation, backtesting, Bernie Madoff, Black Swan, business cycle, buy and hold, 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, Myron Scholes, passive investing, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, statistical model, stocks for the long run, survivorship bias, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve, zero-sum game

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: 261 words: 103,244

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

"Robert Solow", accounting loophole / creative accounting, Affordable Care Act / Obamacare, Albert Einstein, asset allocation, bank run, barriers to entry, Basel III, Bernie Madoff, British Empire, buy and hold, central bank independence, collective bargaining, commodity trading advisor, corporate governance, creative destruction, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, diversified portfolio, financial deregulation, George Akerlof, illegal immigration, income inequality, inflation targeting, information asymmetry, Jean Tirole, job satisfaction, Joseph Schumpeter, Kenneth Arrow, knowledge worker, law of one price, light touch regulation, Long Term Capital Management, low skilled workers, mandatory minimum, market bubble, market clearing, market fundamentalism, means of production, minimum wage unemployment, moral hazard, new economy, obamacare, old-boy network, open economy, Pareto efficiency, Paul Samuelson, 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, Vilfredo Pareto, 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.


pages: 7,371 words: 186,208

The Long Twentieth Century: Money, Power, and the Origins of Our Times by Giovanni Arrighi

anti-communist, Asian financial crisis, barriers to entry, Bretton Woods, British Empire, business climate, business process, colonial rule, commoditize, Corn Laws, creative destruction, cuban missile crisis, David Ricardo: comparative advantage, declining real wages, deindustrialization, double entry bookkeeping, European colonialism, financial independence, financial intermediation, floating exchange rates, income inequality, informal economy, invisible hand, joint-stock company, Joseph Schumpeter, late capitalism, London Interbank Offered Rate, means of production, money: store of value / unit of account / medium of exchange, new economy, offshore financial centre, oil shock, Peace of Westphalia, profit maximization, Project for a New American Century, RAND corporation, reserve currency, spice trade, the market place, The Nature of the Firm, The Wealth of Nations by Adam Smith, Thorstein Veblen, trade liberalization, trade route, transaction costs, transatlantic slave trade, transcontinental railway, upwardly mobile, Yom Kippur War

They originated in a new internalization of costs within the economizing logic of capitalist enterprise. Just as the Dutch regime had taken world-scale processes of capital accumulation one step further than the Genoese by internalizing protection costs, and the British regime had taken them a step further than the Dutch by internalizing production costs, so the US regime has done the same in relation to the British by internalizing transaction costs. The notion of an internalization of transaction costs as the distinguishing feature 0F the F0urth (US) systemic cycle 0F accumulation is derived from Richard Coase’s (1937) pioneering theoretical study 0F the competitive advantages of vertically integrated business organizations, from Oliver Williamson’s (1970) expansion 0F C0ase’s analysis, and from Alfred Chandler’s historical study 0F the emergence and swift expansion 0F modern US corporations in the late nineteenth and early twentieth centuries.

It was a continental military-industrial complex with sufficient power to provide a wide range of subordinate and allied governments with effective protection and to make credible threats of economic strangulation or military annihilation towards unfriendly governments anywhere in the world. Combined with the size, insularity, and natural wealth of its own territory, this power enabled the US capitalist class to “internalize” not just protection and production costs, as the British capitalist class had already done, but transaction costs as well, that is to say, the markets on which the self-expansion of its capital depended. This steady increase in the size, complexity, and power of the leading agencies of capitalist history is somewhat obscured by another feature of the temporal sequence sketched in figure 3.4. This is the double movement — forward and backward at the same time — that has characterized the sequential development of systemic cycles of accumulation.

Similarly, the internalization of production costs by the British regime in comparison with, and in relation to, the Dutch regime occurred through a revival in new, enlarged and more complex forms of the strategies and structures of Genoese cosmopolitan capitalism and Iberian global territorialism, the combination of which had been superseded by the Dutch regime. As anticipated in chapter 1 and argued further in chapter 4, the same pattern recurred with the rise and full expansion of the US regime, which internalized transaction costs by reviving in new, enlarged, and more complex forms the strategies and structures of Dutch corporate capitalism which had been superseded by the British regime. This recurrent revival of previously superseded strategies and structures of accumulation generates a pendulum-like movement back and forth between “cosmopolitan-imperial” and “corporate-national” organizational structures, the first being typical of “extensive” regimes, as the Genoese and the British were, and the second of “intensive” regimes, as the Dutch THE “ENDLESS” ACCUMULATION OF CAPITAL 225 and the US were.


pages: 130 words: 11,880

Optimization Methods in Finance by Gerard Cornuejols, Reha Tutuncu

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

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: 571 words: 106,255

The Bitcoin Standard: The Decentralized Alternative to Central Banking by Saifedean Ammous

Airbnb, altcoin, bank run, banks create money, bitcoin, Black Swan, blockchain, Bretton Woods, British Empire, business cycle, capital controls, central bank independence, conceptual framework, creative destruction, cryptocurrency, currency manipulation / currency intervention, currency peg, delayed gratification, disintermediation, distributed ledger, Ethereum, ethereum blockchain, fiat currency, fixed income, floating exchange rates, Fractional reserve banking, full employment, George Gilder, global reserve currency, high net worth, invention of the telegraph, Isaac Newton, iterative process, jimmy wales, Joseph Schumpeter, market bubble, market clearing, means of production, money: store of value / unit of account / medium of exchange, moral hazard, Network effects, Paul Samuelson, peer-to-peer, Peter Thiel, price mechanism, price stability, profit motive, QR code, ransomware, reserve currency, Richard Feynman, risk tolerance, Satoshi Nakamoto, secular stagnation, smart contracts, special drawing rights, Stanford marshmallow experiment, The Nature of the Firm, the payments system, too big to fail, transaction costs, Walter Mischel, zero-sum game

This could potentially raise the transaction volume of Bitcoin to the millions of payments per day, and as the transaction costs rise higher, this is more and more likely to become a popular option. Another possibility for scaling Bitcoin is digital mobile USB wallets, which can be made to be physically tamper‐proof and can be checked for their balance at any time. These USB drives would carry the private keys to specific amounts of Bitcoins, allowing whoever holds them to withdraw the money from them. They could be used like physical cash, and each holder could verify the value in these drives. As fees have been rising on the network, there has been no respite in the growth of demand for Bitcoin, as evidenced by its rising price, indicating that users value the transactions more than the transaction costs they have to pay for them. Instead of the rising fee