Financial Research Focus

Published / Preprint: Mathematical Analysis of Money in the Scope of Austerity. (arXiv:1305.5373v1 [q-fin.GN])

Fri, 24 May 2013 00:30:58 +0000

This summarizes the study of the financial and economic crisis in Europe. The starting questions were\\ 1) Why do we have a crisis? Unde venis? 2) What will be the outcome? Quo vadis?

Published / Preprint: Pricing bonds with optional sinking feature using Markov Decision Processes. (arXiv:1305.5220v1 [q-fin.PR])

Thu, 23 May 2013 00:39:09 +0000

An efficient method to price bonds with optional sinking feature is presented. Such instruments equip their issuer with the option (but not the obligation) to redeem parts of the notional prior to maturity, therefore the future cash flows are random. In a one-factor model for the issuer's default intensity we show that the pricing algorithm can be formulated as a Markov Decision Process, which is both accurate and quick. The method is demonstrated using a 1.5-factor credit-equity model which defines the default intensity in a reciprocal relationship to the issuer's stock price process, termed jump-to-default extended model with constant elasticity of variance (JDCEV).

Published / Preprint: Risk Measure Estimation On Fiegarch Processes. (arXiv:1305.5238v1 [q-fin.RM])

Thu, 23 May 2013 00:39:08 +0000

We consider the Fractionally Integrated Exponential Generalized Autoregressive Conditional Heteroskedasticity process, denoted by FIEGARCH(p,d,q), introduced by Bollerslev and Mikkelsen (1996). We present a simulated study regarding the estimation of the risk measure $VaR_p$ on FIEGARCH processes. We consider the distribution function of the portfolio log-returns (univariate case) and the multivariate distribution function of the risk-factor changes (multivariate case). We also compare the performance of the risk measures $VaR_p$, $ES_p$ and MaxLoss for a portfolio composed by stocks of four Brazilian companies.

Published / Preprint: A note on high-order short-time expansions for ATM option prices under the CGMY model. (arXiv:1305.4719v1 [q-fin.PR])

Wed, 22 May 2013 00:39:49 +0000

The short-time asymptotic behavior of option prices for a variety of models with jumps has received much attention in recent years. In the present work, a novel third-order approximation for ATM option prices under the CGMY L\'{e}vy model is derived, and extended to a model with an additional independent Brownian component. Our results shed new light on the connection between both the volatility of the continuous component and the jump parameters and the behavior of ATM option prices near expiration.

Published / Preprint: Reducing the debt : is it optimal to outsource an investment?. (arXiv:1305.4879v1 [math.PR])

Wed, 22 May 2013 00:39:48 +0000

We deal with the problem of outsourcing the debt for a big investment, according two situations: either the firm outsources both the investment (and the associated debt) and the exploitation to a private consortium, or the firm supports the debt and the investment but outsources the exploitation. We prove the existence of Stackelberg and Nash equilibria between the firm and the private consortium, in both situations. We compare the benefits of these contracts. We conclude with a study of what happens in case of incomplete information, in the sense that the risk aversion coefficient of each partner may be unknown by the other partner.

Published / Preprint: Economics 2.0: The Natural Step towards A Self-Regulating, Participatory Market Society

Tue, 21 May 2013 16:01:34 +0000

Despite all our great advances in science, technology and financial innovations, many societies today are struggling with a financial, economic and public spending crisis, over-regulation, and mass unemployment, as well as lack of sustainability and innovation. Can we still rely on conventional economic thinking or do we need a new approach?
I argue that, as the complexity of socio-economic systems increases, networked decision-making and bottom-up self-regulation will be more and more important features. It will be explained why, besides the "homo economicus" with strictly self-regarding preferences, natural selection has also created a "homo socialis" with other-regarding preferences. While the "homo economicus" optimizes the own prospects in separation, the decisions of the "homo socialis" are self-determined, but interconnected, a fact that may be characterized by the term "networked minds". Notably, the "homo socialis" manages to earn higher payoffs than the "homo socialis".
I show that the "homo economicus" and the "homo socialis" imply a different kind of dynamics and distinct aggregate outcomes. Therefore, next to the traditional economics for the "homo economicus" ("economics 1.0"), a complementary theory must be developed for the "homo socialis". This economic theory might be called "economics 2.0" or "socionomics". The names are justified, because the Web 2.0 is currently promoting a transition to a new market organization, which benefits from social media platforms and could be characterized as "participatory market society". To thrive, the "homo socialis" requires suitable institutional settings such a particular kinds of reputation systems, which will be sketched in this paper. I also propose a new kind of money, so-called "qualified money", which may overcome some of the problems of our current financial system.

Published / Preprint: Self-healing networks: redundancy and structure

Tue, 21 May 2013 16:01:33 +0000

We introduce the concept of self-healing in the field of complex networks. Obvious applications range from infrastructural to technological networks. By exploiting the presence of redundant links in recovering the connectivity of the system, we introduce self-healing capabilities through the application of distributed communication protocols granting the "smartness" of the system. We analyze the interplay between redundancies and smart reconfiguration protocols in improving the resilience of networked infrastructures to multiple failures; in particular, we measure the fraction of nodes still served for increasing levels of network damages. We study the effects of different connectivity patterns (planar square-grids, small-world, scale-free networks) on the healing performances. The study of small-world topologies shows us that the introduction of some long-range connections in the planar grids greatly enhances the resilience to multiple failures giving results comparable to the most resilient (but less realistic) scale-free structures.

Published / Preprint: A framework for the calibration of social simulation models

Tue, 21 May 2013 16:01:32 +0000

Simulation with agent-based models is increasingly used in the study of complex socio-technical systems and in social simulation in general. This paradigm offers a number of attractive features, namely the possibility of modeling emergent phenomena within large populations. As a consequence, often the quantity in need of calibration may be a distribution over the population whose relation with the parameters of the model is analytically intractable. Nevertheless, we can simulate. In this paper we present a simulation-based framework for the calibration of agent-based models with distributional output based on indirect inference. We illustrate our method step by step on a model of norm emergence in an online community of peer production, using data from three large Wikipedia communities. Model fit and diagnostics are discussed.

Published / Preprint: Modeling self-sustained activity cascades in socio-technical networks

Tue, 21 May 2013 16:01:31 +0000

The ability to understand and eventually predict the emergence of information and activation cascades in social networks is core to complex socio-technical systems research. However, the complexity of social interactions makes this a challenging enterprise. Previous works on cascade models assume that the emergence of this collective phenomenon is related to the activity observed in the local neighborhood of individuals, but do not consider what determines the willingness to spread information in a time-varying process. Here we present a mechanistic model that accounts for the temporal evolution of the individual state in a simplified setup. We model the activity of the individuals as a complex network of interacting integrate-and-fire oscillators. The model reproduces the statistical characteristics of the cascades in real systems, and provides a framework to study time-evolution of cascades in a state-dependent activity scenario.

Published / Preprint: Competition-induced criticality in a model of meme popularity

Tue, 21 May 2013 16:01:30 +0000

Heavy-tailed distributions of meme popularity occur naturally in a model of meme diffusion on social networks. Competition between multiple memes for the limited resource of user attention is identified as the mechanism that poises the system at criticality. The popularity growth of each meme is described by a critical branching process, and asymptotic analysis predicts power-law distributions of popularity with very heavy tails (exponent $\alpha<2$, unlike preferential-attachment models), similar to those seen in empirical data.

Published / Preprint: How to Get Rid of Demand-Supply-Equilibrium for Good

Tue, 21 May 2013 07:18:08 +0000

This paper provides a substantial reconceptualization of the serial clearing of the product market on the basis of structural axioms. The change of premises is required simply because from the accustomed premises only the accustomed conclusions can be derived and these are known to be inapplicable in the real world. This holds in particular for the still popular idea that the working of a market can be described in terms of the triad demand functionâsupply functionâequilibrium. Structural axiomatization provides the complete and consistent picture of interrelated product market events.

Published / Preprint: Fast Estimation of True Bounds on Bermudan Option Prices under Jump-diffusion Processes. (arXiv:1305.4321v1 [q-fin.CP])

Tue, 21 May 2013 00:48:54 +0000

Fast pricing of American-style options has been a difficult problem since it was first introduced to financial markets in 1970s, especially when the underlying stocks' prices follow some jump-diffusion processes. In this paper, we propose a new algorithm to generate tight upper bounds on the Bermudan option price without nested simulation, under the jump-diffusion setting. By exploiting the martingale representation theorem for jump processes on the dual martingale, we are able to explore the unique structure of the optimal dual martingale and construct an approximation that preserves the martingale property. The resulting upper bound estimator avoids the nested Monte Carlo simulation suffered by the original primal-dual algorithm, therefore significantly improves the computational efficiency. Theoretical analysis is provided to guarantee the quality of the martingale approximation. Numerical experiments are conducted to verify the efficiency of our proposed algorithm.

Published / Preprint: Corporate Diversification and the Cost of Capital

Mon, 20 May 2013 16:34:22 +0000

We examine whether organizational form matters for a firm's cost of capital. Contrary to conventional view, we argue that coinsurance among a firm's business units can reduce systematic risk through the avoidance of countercyclical deadweight costs. We find that diversified firms have on average a lower cost of capital than comparable portfolios of standalone firms. In addition, diversified firms with less correlated segment cash flows have a lower cost of capital, consistent with a coinsurance effect. Holding cash flows constant, our estimates imply an average value gain of approximately 5% when moving from the highest to the lowest cash flow correlation quintile. This article is protected by copyright. All rights reserved.

Published / Preprint: The Maturity Rat RaceâErratum

Mon, 20 May 2013 16:12:24 +0000

Published / Preprint: Uncertainty, Time-Varying Fear, and Asset Prices

Mon, 20 May 2013 15:18:28 +0000

I construct an equilibrium model that captures salient properties of index option prices, equity returns, variance, and the risk-free rate. A representative investor makes consumption and portfolio choice decisions that are robust to his uncertainty about the true economic model. He pays a large premium for index options because they hedge important model misspecification concerns, particularly concerning jump shocks to cash flow growth and volatility. A calibration shows that empirically consistent fundamentals and reasonable model uncertainty explain option prices and the variance premium. Time variation in uncertainty generates variance premium fluctuations, helping explain their power to predict stock returns. This article is protected by copyright. All rights reserved.

Published / Preprint: A First-Order BSPDE for Swing Option Pricing. (arXiv:1305.3988v1 [q-fin.PR])

Mon, 20 May 2013 00:35:09 +0000

We study an optimal control problem related to swing option pricing in a general non-Markovian setting in continuous time. As a main result we show that the value process solves a first-order non-linear backward stochastic partial differential equation. Based on this result we can characterize the set of optimal controls and derive a dual minimization problem.

Published / Preprint: A hot-potato game under transient price impact and some effects of a transaction tax. (arXiv:1305.4013v1 [q-fin.TR])

Mon, 20 May 2013 00:35:08 +0000

Building on observations by Sch\"oneborn (2008), we consider a Nash equilibrium between two high-frequency traders in a simple market impact model with transient price impact and additional quadratic transaction costs. We show that for small transaction costs the high-frequency traders engage in a "hot-potato game", in which the same asset position is sold back and forth. We then identify a critical value for the size of the transaction costs above which all oscillations disappear and strategies become buy-only or sell-only. Numerical simulations show that for both traders the expected costs can be lower with transaction costs than without. Moreover, the costs can increase with the trading frequency when there are no transaction costs, but decrease with the trading frequency when transaction costs are sufficiently high. We argue that these effects occur due to the need of protection against predatory trading in the regime of low transaction costs.

Published / Preprint: Economics 2.0: The Natural Step towards A Self-Regulating, Participatory Market Society. (arXiv:1305.4078v1 [q-fin.GN])

Mon, 20 May 2013 00:35:04 +0000

Published / Preprint: Risk-minimization and hedging claims on a jump-diffusion market model, Feynman-Kac Theorem and PIDE. (arXiv:1305.4132v1 [q-fin.PR])

Mon, 20 May 2013 00:35:03 +0000

At first, we solve a problem of finding a risk-minimizing hedging strategy on a general market with ratings. Next, we find a solution to this problem on Markovian market with ratings on which prices are influenced by additional factors and rating, and behavior of this system is described by SDE driven by Wiener process and compensated Poisson random measure and claims depend on rating. To find a tool to calculate hedging strategy we prove a Feynman-Kac type theorem. This result is of independent interest and has many applications, since it enables to calculate some conditional expectations using related PIDE's. We illustrate our theory on two examples of market. The first is a general exponential L\'{e}vy model with stochastic volatility, and the second is a generalization of exponential L\'{e}vy model with regime-switching.

Published / Preprint: A Model for Stock Returns and Volatility. (arXiv:1305.4173v1 [q-fin.ST])

Mon, 20 May 2013 00:35:00 +0000

We prove that Student's t-distribution provides one of the better fits to returns of S&P component stocks and the generalized inverse gamma distribution best fits VIX and VXO volatility data. We further argue that a more accurate measure of the volatility may be possible based on the fact that stock returns can be understood as the product distribution of the volatility and normal distributions. We find Brown noise in VIX and VXO time series and explain the mean and the variance of the relaxation times on approach to the steady-state distribution.

Research Library: Statistical Signatures in Times of Panic: Markets as a Self-Organizing System

Tue, 14 May 2013 09:12:04 +0000

Lisa Borland

Abstract

We study properties of the cross-sectional distribution of returns. A significant anti-correlation between dispersion and cross-sectional kurtosis is found such that dispersion is high but kurtosis is low in panic times, and the opposite in normal times. The co-movement of stock returns also increases in panic times. We define a simple statistic $s$, the normalized sum of signs of returns on a given day, to capture the degree of correlation in the system. $s$ can be seen as the order parameter of the system because if $s= 0$ there is no correlation (a disordered state), whereas for $s \ne 0$ there is correlation among stocks (an ordered state). We make an analogy to non-equilibrium phase transitions and hypothesize that financial markets undergo self-organization when the external volatility perception rises above some critical value. Indeed, the distribution of $s$ is unimodal in normal times, shifting to bimodal in times of panic. This is consistent with a second order phase transition. Simulations of a joint stochastic process for stocks use a multi timescale process in the temporal direction and an equation for the order parameter $s$ for the dynamics of the cross-sectional correlation. Numerical results show good qualitative agreement with the stylized facts of real data, in both normal and panic times.

Research Library: Quantifying Collective Attention from Tweet Stream

Tue, 07 May 2013 14:46:52 +0000

Kazutoshi Sasahara, Yoshito Hirata, Masashi Toyoda, Masaru Kitsuregawa, Kazuyuki Aihara

Abstract

Online social media are increasingly facilitating our social interactions, thereby making available a massive “digital fossil” of human behavior. Discovering and quantifying distinct patterns using these data is important for studying social behavior, although the rapid time-variant nature and large volumes of these data make this task difficult and challenging. In this study, we focused on the emergence of “collective attention” on Twitter, a popular social networking service. We propose a simple method for detecting and measuring the collective attention evoked by various types of events. This method exploits the fact that tweeting activity exhibits a burst-like increase and an irregular oscillation when a particular real-world event occurs; otherwise, it follows regular circadian rhythms. The difference between regular and irregular states in the tweet stream was measured using the Jensen-Shannon divergence, which corresponds to the intensity of collective attention. We then associated irregular incidents with their corresponding events that attracted the attention and elicited responses from large numbers of people, based on the popularity and the enhancement of key terms in posted messages or “tweets.” Next, we demonstrate the effectiveness of this method using a large dataset that contained approximately 490 million Japanese tweets by over 400,000 users, in which we identified 60 cases of collective attentions, including one related to the Tohoku-oki earthquake. “Retweet” networks were also investigated to understand collective attention in terms of social interactions. This simple method provides a retrospective summary of collective attention, thereby contributing to the fundamental understanding of social behavior in the digital era.

Research Library: Quantifying Trading Behavior in Financial Markets Using Google Trends

Thu, 25 Apr 2013 20:18:18 +0000

This article has been covered at the BBC here.

By Tobias Preis, Helen Susannah Moat & H. Eugene Stanley

Abstract

Crises in financial markets affect humans worldwide. Detailed market data on trading decisions reflect some of the complex human behavior that has led to these crises. We suggest that massive new data sources resulting from human interaction with the Internet may offer a new perspective on the behavior of market participants in periods of large market movements. By analyzing changes in Google query volumes for search terms related to finance, we find patterns that may be interpreted as “early warning signs” of stock market moves. Our results illustrate the potential that combining extensive behavioral data sets offers for a better understanding of collective human behavior.

Research Library: Existential Risk Prevention as a Global Priority

Wed, 24 Apr 2013 08:55:40 +0000

This paper was recently covered by the BBC: How are humans going to become extinct?

(2012) Nick Bostrom
Faculty of Philosophy & Oxford Martin School
University of Oxford
www.nickbostrom.com
www.existential-risk.org
[Global Policy (2013), forthcoming]

Abstract:

Existential risks are those that threaten the entire future of humanity. Many theories of value imply that even relatively small reductions in net existential risk have enormous expected value. Despite their importance, issues surrounding human-extinction risks and related hazards remain poorly understood. In this paper, I clarify the concept of existential risk and develop an improved classification scheme. I discuss the relation between existential risks and basic issues in axiology, and show how existential risk reduction (via the maxipok rule) can serve as a strongly action-guiding principle for utilitarian concerns. I also show how the notion of existential risk suggests a new way of thinking about the ideal of sustainability.

Research Library: Open Access to Data: An Ideal Professed but Not Practised

Tue, 23 Apr 2013 12:58:44 +0000

Patrick Andreoli Versbach
Max Planck Institute for Intellectual Property and Competition Law; Ludwig-Maximilians-Universität Munich - Munich Graduate School of Economics (MGSE)

Frank Mueller-Langer
Max Planck Institute for Intellectual Property and Competition Law; International Max Planck Research School for Competition and Innovation (IMPRS-CI)

RatSWD Working Paper Series No. 215
Max Planck Institute for Intellectual Property & Competition Law Research Paper No. 13-07

Abstract:
We provide evidence for the status quo in economics with respect to data sharing using a unique data set with 488 hand-collected observations randomly taken from researchers' academic webpages. Out of the sample, 435 researchers (89.14%) neither have a data&code section nor indicate whether and where their data is available. We find that 8.81% of researchers share some of their data whereas only 2.05% fully share. We run an ordered probit regression to relate the decision of researchers to share to their observable characteristics. We find that three predictors are positive and significant across specifications: being full professor, working at a higher-ranked institution and personal attitudes towards sharing as indicated by sharing other material such as lecture slides.

Research Library: A Guide to Modeling Counterparty Credit Risk

Mon, 25 Mar 2013 10:12:22 +0000

Steven H. Zhu
Morgan Stanley; Banc of America Merrill Lynch

Michael Pykhtin
Bank of America

GARP Risk Review, July/August 2007

Abstract

Michael Pykhtin and Steven Zhu offer a blueprint for modelling credit exposure and pricing counter-party risk. They focus on two main issues: modelling credit exposure and pricing counter-party risk. In the part devoted to credit exposure, we will define credit exposure at contract and counter-party levels, introduce netting and margin agreements as risk management tools for reducing counter-party-level exposure and present a framework for modelling credit exposure. In the part devoted to pricing, we will define credit value adjustment (CVA) as the price of counter-party credit risk and discuss approaches to its calculation.

Research Library: The New Investor

Mon, 18 Mar 2013 16:48:15 +0000

Tom C. W. Lin

University of Florida - Fredric G. Levin College of Law

Abstract

A sea change is happening in finance. Machines appear to be on the rise and humans on the decline. Human endeavors have become unmanned endeavors. Human thought and human deliberation have been replaced by computerized analysis and mathematical models. Technological advances have made finance faster, larger, more global, more interconnected, and less human. Modern finance is becoming an industry in which the main players are no longer entirely human. Instead, the key players are now cyborgs: part machine, part human. Modern finance is transforming into what this Article calls cyborg finance.

This Article offers one of the first broad, descriptive, and normative examinations of this sea change and its wide-ranging effects on law, society, and finance. The Article begins by placing the rise of artificial intelligence and computerization in finance within a larger social context. Next, it explores the evolution and birth of a new investor paradigm in law precipitated by that rise. This Article then identifies and addresses regulatory dangers, challenges, and consequences tied to the increasing reliance on artificial intelligence and computers. Specifically, it warns of emerging financial threats in cyberspace, examines new systemic risks linked to speed and connectivity, studies law’s capacity to govern this evolving financial landscape, and explores the growing resource asymmetries in finance. Finally, drawing on themes from the legal discourse about the choice between rules and standards, this Article closes with a defense of humans in an uncertain financial world in which machines continue to rise, and it asserts that smarter humans working with smart machines possess the key to better returns and better futures.

Research Library: Cyclic Game Dynamics Driven by Iterated Reasoning

Mon, 18 Mar 2013 16:07:03 +0000

Published in PLOS One:

Seth Frey, Robert L. Goldstone

Abstract

Recent theories from complexity science argue that complex dynamics are ubiquitous in social and economic systems. These claims emerge from the analysis of individually simple agents whose collective behavior is surprisingly complicated. However, economists have argued that iterated reasoning–what you think I think you think–will suppress complex dynamics by stabilizing or accelerating convergence to Nash equilibrium. We report stable and efficient periodic behavior in human groups playing the Mod Game, a multi-player game similar to Rock-Paper-Scissors. The game rewards subjects for thinking exactly one step ahead of others in their group. Groups that play this game exhibit cycles that are inconsistent with any fixed-point solution concept. These cycles are driven by a “hopping” behavior that is consistent with other accounts of iterated reasoning: agents are constrained to about two steps of iterated reasoning and learn an additional one-half step with each session. If higher-order reasoning can be complicit in complex emergent dynamics, then cyclic and chaotic patterns may be endogenous features of real-world social and economic systems.

Research Library: Head and Shoulders above the Rest? The Performance of Institutional Portfolio Managers who Use Technical Analysis

Mon, 04 Feb 2013 15:15:42 +0000

H/T Phil Pearlman

David Smith, Christophe Faugère and Ying Wang

Abstract

This study takes a novel approach to testing the efficacy of technical analysis. Ratherthan testing specific trading rules as is typically done in the literature, we rely oninstitutional portfolio managers’ statements about whether and how intensely they usetechnical analysis, irrespective of the form in which they implement it. In our sample of more than 10,000 portfolios, about one-third of actively managed equity and balancedfunds use technical analysis. We compare the investment performance of funds that usetechnical analysis versus those that do not using five metrics. Mean and median (3 and 4-factor) alpha values are generally slightly higher for a cross section of funds usingtechnical analysis, but performance volatility is also higher. Benchmark-adjusted returnsare also higher, particularly when market prices are declining. The most remarkablefinding is that portfolios with greater reliance on technical analysis have elevated skewness and kurtosis levels relative to portfolios that do not use technical analysis.Funds using technical analysis appear to have provided a meaningful advantage to theirinvestors, albeit in an unexpected way.

Head and Shoulders above the Rest? The
Performance of Institutional Portfolio
Managers who Use Technical Analysis by

Research Library: An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets

Fri, 25 Jan 2013 14:03:06 +0000

H/T Mark Buchanan over at the Physics of Finance Blog who comments on this paper.

Eric A. Posner
University of Chicago - Law School

E. Glen Weyl
University of Chicago; University of Toulouse 1 - Toulouse School of Economics

Abstract

The financial crisis of 2008 was caused in part by speculative investment in complex derivatives. In enacting the Dodd-Frank Act, Congress sought to address the problem of speculative investment, but merely transferred that authority to various agencies, which have not yet found a solution. We propose that when firms invent new financial products, they be forbidden to sell them until they receive approval from a government agency designed along the lines of the FDA, which screens pharmaceutical innovations. The agency would approve financial products if they satisfy a test for social utility that focuses on whether the product will likely be used more often for insurance than for gambling. Other factors may be addressed if the answer is ambiguous. This approach would revive and make quantitatively precise the common-law insurable interest doctrine, which helped control financial gambling before deregulation in the 1990s.

Research Library: High-Frequency Trading and the Execution Costs of Institutional Investors (pdf)

Thu, 24 Jan 2013 12:21:04 +0000

H/T @CarlCarrie on Twitter

Jonathan Brogaard, Terrence Hendershott, Stefan Hunt, Torben Latza, Lucas Pedace, Carla Ysusi

FSA OCCASIONAL PAPERS IN FINANCIAL REGULATION

While some institutional investors are concerned that high frequency trading increases the cost of investing, others suggest that high frequency trading has been beneficial, for example by creating more accurate and faster pricing of securities and adding liquidity to the market. Understanding the facts, and so which of these viewpoints is closer to reality, is a much-needed input to policy formation. The FCA will remain open and interested in creating and compiling the evidence.

Martin Wheatley, CEO-Designate, Financial Conduct Authority

Abstract

This paper studies whether high-frequency trading (HFT) increases the execution costs of institutional investors. We use technology upgrades that lower the latency of the London Stock Exchange to obtain variation in the level of HFT over time. Following upgrades, the level of HFT increases. Around these shocks to HFT, as far as can be measured, institutional traders’ execution costs remain unchanged. Thus, we find no evidence that these increases in HFT activity impacted institutional execution costs.

Research Library: The Trading Profits of High Frequency Traders

Thu, 17 Jan 2013 16:41:18 +0000

Via The Big Picture

Matthew Baron, Jonathan Brogaard and Andrei Kirilenko

Abstract

We examine the profitability of high frequency traders (HFTs). Using transaction level data with user identifications, we find that high frequency trading (HFT) is highly profitable: HFTs collectively earn over $23 million in trading profits in the E-mini S&P 500 futures contract during the month of August 2010. The profits of HFTs are mainly derived from Opportunistic traders, but also from Fundamental (institutional) traders, Small (retail) traders, and Non-HFT Market Makers. While HFTs bear some risk, they generate unusually high average Sharpe ratios with a median of 4.5 across firms in August 2010. Finally, HFTs profits are persistent, new entrants have a higher propensity to underperform and exit, and the fastest firms (in absolute and in relative terms) earn the highest profits.

Baron_Brogaard_Kirilenko by

Research Library: Unlimited Growth and Innovation: Paradise or Paradox?

Tue, 15 Jan 2013 10:05:39 +0000

H/T Mark Buchanan over at The Physics of Finance Blog who mentions this paper in his article: Unlimited growth... why the idea is just silly

Andrew J. Sutter
Rikkyo University, College of Law and Politics; Sutter International Law Office

November 15, 2010

Abstract

Ever since the dire predictions of The Limits to Growth (Meadows & al. 1972) failed to come true on time, it's been all too easy to ridicule environmentally-based arguments against economic growth as pessimistic and "Malthusian." In contrast, this paper accepts, for the sake of argument, the most wildly optimistic estimates for the continuity of economic growth, which range to the billions of years. It then asks: which is more ridiculous – a world with limits to growth, or a world without them?

After some preliminary definitions (Part I), the paper briefly reviews the post-World War II rise of growth-based policies and academic growth theory (Solow 1956 and 1957; Romer 1990), and some of the rhetoric surrounding them (Part II), including the prospect offered by Paul Romer and others of growth continuing for "billions" of years. Next, a simple "thought experiment" involving an egg (Part III) demonstrates by reductio ad absurdum that even when environmental issues are ignored, visions of limitless growth don’t make much sense. In particular, they obscure difficult questions and paradoxes concerning the nature of what’s growing, and why that growth should matter. For example, within historical, rather than geological, time scales, either the real prices of everyday goods must increase by tens of orders of magnitude, or else the entire value of the economy must be ascribed to as-yet unknown goods and services priced at a similar multiple above those available today. Our infatuation with the Promethean myth of mastery over nature tempts us to ignore or to be indifferent to these implausibilities.

We can shine a light on these problems with the help of Aristotle's Politics (Part IV). Its distinction between use value and exchange value was known, in a significantly altered form, to Adam Smith and Karl Marx; but even this watered-down version has been erased intentionally during the past 150 years of neoclassical economics (NCE). In the course of tracing this historical development, a simple but significant inconsistency between microeconomic theory and macroeconomic policy is exposed. Part V contrasts the explanatory power of NCE and Aristotle's distinction for resolving the paradoxes and difficulties uncovered in the previous parts of the paper. Aristotle's original conception of use value as a quality with ethical implications, rather than as a quantity, can help us not only to slice through these puzzles but to find an alternative to the meaninglessness of "unlimited growth." The paper concludes by proposing that enhancing the use value available to communities should replace GDP growth as a policy goal, beginning in countries that are already wealthy today.

Research Library: A Brief Introduction to the Basics of Game Theory

Mon, 14 Jan 2013 12:39:21 +0000

Matthew O. Jackson
Stanford University - Department of Economics; Santa Fe Institute; Canadian Institute for Advanced Research (CIFAR)

December 5, 2011

Abstract

I provide a (very) brief introduction to game theory. I have developed these notes to provide quick access to some of the basics of game theory; mainly as an aid for students in courses in which I assumed familiarity with game theory but did not require it as a prerequisite.

Research Library: Using Agent-Based Models for Analyzing Threats to Financial Stability (pdf)

Mon, 14 Jan 2013 12:16:30 +0000

This paper was referenced in an article in the New York Times.

Richard Bookstaber

Abstract

Existing models of financial instability tend to be based on top-down, partial-equilibrium views of markets and their interactions; they are unable to incorporate the complexity of behavior among heterogeneous firms or the tendency for all types of firms to change their behavior during a crisis. This paper argues that agent-based models (ABMs)—which seek to explain how the behavior of individual firms or “agents” can affect outcomes in complex systems—can make an important contribution to our understanding of potential vulnerabilities and paths through which risks can propagate across the financial system.

Extract

The financial crisis revealed important weaknesses in the risk models used by financial institutions, supervisors, and financial economists to understand and respond to risks in the financial system. The current generation of models is unable to model financial vulnerabilities, the shocks that might expose these vulnerabilities, and the process by which such shocks might propagate through the financial system. Rectifying these weaknesses is a critical first step in developing the capability for dealing with threats to financial stability. The Office of Financial Research has a responsibility to contribute to the development of models that can be used to identify and analyze shocks that may affect financial stability and to facilitate a rapid response to those shocks.

Much of the criticism since the crisis has focused on Value-at-Risk (VaR) models, which measure the risk of loss of a portfolio over a given time horizon and probability. VaR is the most broadly applied risk management tool, underlying Basel II and most industry risk management systems. Although VaR has demonstrated value in gauging risk during typical day-to-day market moves—which reflect the same distribution as the recent past—it does not perform well in times of market dislocation. Given its reliance on historical statistical relationships, it should not be expected to do so.

Another widely applied approach to risk measurement is stress testing. In the last decade stress testing came into its own for regulatory and supervisory purposes. Yet even as stress testing became standard fare in the period up to and following the 2008 crisis, its limitations grew increasingly apparent. Stress tests did not anticipate the extreme shocks that occurred during the crisis, failed to shed light on some of the sectors and risk factors that were instrumental in the development of the crisis, and ignored the dynamics between the sectors that ultimately were affected. To take one example, the IMF offered a reassuring assessment not long before Iceland’s systemic breakdown: “The banking system’s reported financial indicators are above minimum regulatory requirements and stress tests suggest that the system is resilient.”...