frictionless market

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pages: 289 words: 113,211

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

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affirmative action, Albert Einstein, asset allocation, backtesting, 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

In classical physics, any number of real-world effects such as friction or air resistance are assumed away to make mathematical analysis more tractable. Perfect vacuums and ideal gases provide a set of simplifying assumptions that allowed for the development of theories of the physical world. Similarly, in the study of economics it is necessary to assume a construct of frictionless markets to build a market theory out of the tools of mathematics. This assumption of frictionless markets included instantaneous and costless transactions devoid of real-world constraints. Buyers and sellers bought or sold at posted prices, with no associated fees, and their actions had no impact on the market—in the nomenclature of economics, the market participants were atomistic. Moreover, to permit sophisticated spanning arguments and the application of fixed-point theorems from topology, it was assumed there were securities available for every possible contingency; every risk and possible event or state of nature not only was identified, but was also represented by a market security.

Senate hearings, 129–130 Epstein, Sheldon, 46–47, 49 index-amortizing swap, 116 Equity trading profitability, 71–75 proprietary reliance, 73–74 European Monetary System currency crisis (1992), 3 Event risk, 248–249 Factor exposures, 202 Fair value basis, 29 Federal Deposit Insurance Corporation (FDIC), 113 Federal Reserve policy shifts, 85 rate hike, impact, 53 Feduniak, Bob, 42, 52 Feuerstein, Donald, 196 Financial instability, aspects, 3–4 Financial markets, 224–225 Financial risk, 256–257 Fisher, Andy, 59, 80 Fixed income focus, 251–252 Fixed income research (FIR), 8–9, 43–44 Flood, Gene, 190 Franklin, Mark, 97 Free-floating anxiety, 235 Frictionless markets, 209 FrontPoint Partners, 204, 205 FTSE Index, 117 Fundamental data, 166 Furu, example, 233–235 Futures market, 17–19 Futures shock (1635), 175–177 Galbraith, John Kenneth, 16 Gamma, problems, 24–25 General Electric (GE), 41–42 Generally accepted accounting principles (GAAP), 135 Geographic regions, classification, 246 Global Crossing, restatements/liability, 135 Godel, Kurt, 222–224, 227–228 Gold, Jeremy, 8–9 Goldman Sachs acquisition, 75 public offering, delay, 109 Goldstein, Ramy, 116–118 Gracie family, 258–259 Gracie, Gastao, 258 Greenhill, Bob, 73 Greenmail, taxation, 13–14 Gross Domestic Product (GDP), 3–4 Growth bias, 202 Grubman, Jack, 128–130, 134 MCI/BT involvement, 69–71 nursery school admissions, 131–132 Gutfreund, John, 62–63, 105, 195–197 resignation, 199 Haghani, Victor, 102–104, 110, 112 Hall, Andy, 63–67 Hawkins, Greg, 51 Hedgefundedness, 243–244 Hedge funds, 165, 207, 214–215, 243 classification, problem, 245 classification, 245–246 control, 252–253 defining, 245 economic service, 219 existence, question, 244 regulation, 247–250 Heisenberg, Werner, 223–228 Hilibrand, Larry, 79, 110, 113 Human error, 149 272 bindex.qxd 7/13/07 2:44 PM Page 273 INDEX Kaplan, Joel, 44–45 Kaplanis, Costas, 63, 79 Kidder, Peabody, 39–42 Knowledge, limits, 221–230 Krasker, Bill, 86 Liquidity basics, 213–220 complexity, relationship, 145 demand, 26, 191 hedge fund classification, 246 history, 217–218 impact, 212–213 needs, 183 providers, 213–215 role, 215–220 squeeze, prospects, 105 suppliers, 22, 192–193 supply, price elasticity, 94–95 transparency, 226 Liquidity crisis cycle, 93–94 prevention, 94–95 providing, hedge funds (impact), 214–215 Long-range forecasting, 228 London Exchange, Rothschild visit, 90 London Interbank Offered Rate (LIBOR) government rates, parity, 57 higher-yielding LIBOR bond, 57 LIBOR-denominated debt, 56 Long-dated call options, 57 Long-Distance Discount Service (LDDS), acquisitions, 70 Long/short equity hedge funds, 200–205 Long-Term Capital Management (LTCM) capital reserves, assumption, 106–108 collapse, 93 decision point, 110 disaster, 57, 60, 92–93, 100, 145 hedge fund debacle/crisis, 1–3 leverage cycle, 97 liquidity risk, 107–108 losses, 108–111 management, initiation, 195–200 market price positions, feedback, 112 market risks, modeling/monitoring, 111–112 problems, public knowledge, 104–105 repurchase agreement, problem, 104 risk arbitrage position, 107 risk burden, 108 Long-term rates, short-term rates (interaction), 47 Loops, usage/impact, 45 Loosely coupled system, 157 Lorenz, Edward, 227–229 deterministic systems, 229–230 Langsam, Joe, 232, 236–237 Laplace, Pierre-Simon, 223, 225 Lead-lag strategy, 193–194 Leeson, Nick (impact), 38–39 Leibowitz, Marty, 8, 51, 53 Leland, Hayne, 10 Leverage, 244 amount, reduction, 260 crisis, occurrence, 111–113 regulations, imposition, 248 Levin, Carl, 130 Lewis, Michael, 52 Liquidation ability, 93 Mack, John, 28, 29, 35, 37 trader emulation, 35 Macro data, usage, 166–167 Macro strategies, 202 Maeda, Mitsuyo, 258 Margin-induced sale, 94 Market aberrations, opportunities, 122 breakdown, reaction, 146 crises, worsening (aspects), 3–4 cycle, basis, 169 decline, respite, 23–24 exponential growth, 17 Illiquidity, cost, 217–218 Index-amortizing swap, 46–48 Information flow, process, 210 implications, derivation, 170–171 overload, 220–230 Information-based trading, 166 Information Technology (IT), support function, 185–186 Initial public offerings (IPOs), 72 creation, 173–174 issuance, amount, 178–179 Innovation, positive effects, 255–256 INSEAD, 66 Intangibles, 137–138 Interactive complexity, 154–157 Interest only (IO), 55 Interest rate, 84–85, 87 International Monetary Fund (IMF) package, 103 Internet bubble, 179–181 businesses, virtual nature, 172 stocks, run-up (1998), 178 Interrelated markets, complexity (by-product), 143 Intraday price movement, 183 Inventory service, 71 Investment buyers, scare, 22 coverage, 249–250 investor behavior, 203–204 strategy, 247 type, classification, 246 Investors, irrational behavior, 203–204 Irrational markets, impact, 180–181 Iverson, Keith, 48 Iverson, Ken Japan, liquidity, 39 Japanese swap spread strategy/profit, 100 Jenkinson, Robert Banks, 89–90 Jett, Joe, 39–41 Jiu Jitsu Academy, 258 Jones, Paul Tudor, 165 Junk bonds, 71 273 bindex.qxd 7/13/07 2:44 PM Page 274 INDEX Market (Continued) failures, safeguards, 239–240 illiquidity, portfolio insurance by-product, 14 innovation, 11–12 makers, problem, 191–192 regulation, 146–154 risk, paradox, 1 volatility, 5, 25 vulnerability, 224–225 Market bubbles, 168–174 Market-to-book ratio, 138 Marx, Karl, 250 Marxist backward market, exploitation, 250 Material adverse change clause, 65 Maughan, Deryck, 59, 73–77 MCI Communications British Telecom (BT), merger/trade, 63–64, 67, 128 conclusion, 74 EPS, decline, 70 renegotiation, willingness, 67–68 stock, decline, 64 Mean-reversion analysis, 190 Mechanical failure, 149 Mercury Asset Management, 196 Mergers and acquisitions (M&A) advice/underwriting, 33 Meriwether, John, 52, 100, 197 resignation, 199 Merrill Lynch, 42 Merton, Robert, 9, 207 Metallgesellschaft Refining and Marketing (MGRM), oil price risk (offloading), 37–38 Mexican Brady bond/Eurobond spread, 107 Mexican peso crisis (1994), 3 Miller, Heidi, 78–80, 140 Modigliani, Franco, 208–209 Money flows, 167 Morgan Stanley APL, usage, 44–45 Dean Witter, merger, 75 IT department, 43 portfolio insurance, 10–12 risk arbitrage department, 15 risk manager, 42 Morgan Stanley Asset Management (MSAM), 11 Morgan Stanley Investment Management (MSIM), 205 Mortgage-backed securities (MBSs), 54–56, 213 Mortgage market, 35, 54–55, 102 Mortgages, opportunities, 35 Mozer, Paul, 195–198 Munger, Charlie, 62, 99, 101, 197–198 Myojin, Sugar, 59, 63, 78–79 Natural catastrophe, 257 New York Stock Exchange (NYSE) specialists, impact, 20–21 stock sale, 13 Noncash exchanges, 40 Norman Conquest, 215 Norris, Floyd (editorial), 91–92 O’Brien, John, 10 One-off events, 249 Opportunistic strategies birth/death cycle, 252 history, 251 Optimal behavior, mathematical framework, 237–240 Options, stripping, 117 Option theory, 24 Orange County, bankruptcy, 38 Organizational dysfunction, 134–136 Pacioli, Luca, 136–137 Pairwise stock trades, 187 Palmedo, Peter, 17, 28–29 Paloma Partners Management Company, 42 Pandit, Vikram, 12 Parets, Andy, 63–69 Parkhurst, Charlie, 85 Partnership model, 37 Perfect market paradigm, 209–210 imperfections, 210–212 liquidity, degree, 212–213 Phibro, Salomon acquisition, 66 Physical processes, modeling, 229 Platt, Bob, 7–8 Portfolio insurance, 10–15 market crash, 22 Portfolio managers, loss (risk), 204–205 Position disclosure, problems, 225 transparency, increase (financial market regulator advocacy), 225 Preference shares, illiquidity, 115 Price convergence, 121–122 Primal risk, 235–237 knowledge, limits, 230–232 Primogeniture, 215–220 implications, 216–217 objective, impact, 216 Principal only (PO), 54–55 Principia Mathematica (Russell), 221–223 Procter & Gamble, losses, 38 Program trading, absence, 24–25 Protest bids, 195–196 Quants, 8–9, 82–84 Quantum Fund, 180–181 Quattrone, Frank, 72 Rational man approach, 231 Real assets, valuation, 137–138 Real-world risk, 237–238 Reed, John, 127 Relative strength index (RSI), 190 Relative value trades, 101–102 Rhoades, Loeb, 125 RISC workstations, 191 Risk control, 220 knowledge, absence, 231–232 management, 36 nature, variation, 249 reduction, 185 progress/refinement, impact, 4 tactical usage, 200 274 bindex.qxd 7/13/07 2:44 PM Page 275 INDEX Risk arbitrage, 15–16, 65, 71 Risk Architecture, 126 Risk-controlled relative value trading, 102–103 Risk-management structure, 238 Robertson, Julian, 165, 179–182 Rosenbluth, Jeff, 59, 83 Rosenfeld, Eric, 51, 79, 86 Rothschild, Nathan, 88–89 trading strategy, 90–93 Waterloo, relationship, 89–90 Rubinstein, Mark, 10 Russell, Bertrand, 221–223 Russia default, 103–104 Russian short-term bonds, 103 Salomon Brothers arbitrage units, 73–74, 80–82 closure, 88–89 tracking error, problems, 86–89 competition, 60–61 fixed income trading floor, 82 Japanese unit, 56–62 July Fourth massacre, 86–89 mortgage position, loss, 55–56 organization, trader involvement, 73 risk arbitrage group, mortgage position, 80–81 Travelers purchase, 77 Salomon North, 81, 100, 199 Salomon Smith Barney convergence trades, 120–124 proprietary trading, reduction, 92 risk management committee, 98–101 risk measuring/monitoring, 126 Travelers, interaction, 125 U.S. fixed income arbitrage group, 91–93 U.S.


pages: 1,088 words: 228,743

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

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

• The efficient markets hypothesis has been challenged by various anomalies and financial crises but its main implication—that beating the market is very difficult—remains valid for most investors. This chapter reviews the revolution in academic thinking about expected returns. Twenty-five years ago the consensus assumptions included• a world with a single risk factor—the asset’s sensitivity to the equity market (i.e., the CAPM beta); • constant expected returns over time; • investors care only about the means and variances of asset returns; • frictionless markets; and • efficient markets/rational investors. The current view is more complex but also more realistic. There are• multiple risk factors (whose required rewards ultimately depend on their covariation with “bad times)”; • time-varying risk premia; • skewness and liquidity preferences (liking lottery tickets and liquid assets); • supply–demand effects on asset prices; and • market inefficiencies (due to investor irrationalities and/or market frictions).

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

The market will price assets so that the expected returns on assets with similar risks are equal. If any particular asset should offer a higher expected return due solely to the increase in the quantity outstanding, investors will soon arbitrage away such profit opportunities. Arbitrage is possible because assets are “not unique works of art” but have close counterparts in other assets or mixes of other assets (Scholes, 1972). If there are perfect substitutes and frictionless markets, buying a highexpected-return asset while selling a substitute with a lower expected return constitutes a riskless arbitrage. Subsequent empirical studies disputed the notion that perfect substitutes exist. Demand effects may play a key role in explaining time-varying risk premia, given the lack of substitutes for market risk exposures. Even the substitutability of single stocks can be challenged.

Monte Carlo Simulation and Finance by Don L. McLeish

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Black-Scholes formula, Brownian motion, capital asset pricing model, compound rate of return, discrete time, distributed generation, finite state, frictionless, frictionless market, implied volatility, incomplete markets, invention of the printing press, martingale, p-value, random walk, Sharpe ratio, short selling, stochastic process, stochastic volatility, survivorship bias, the market place, transaction costs, value at risk, Wiener process, zero-coupon bond, zero-sum game

If we can reproduce exactly the same (random) returns as the derivative provides using a linear combination of other marketable securities (which have prices assigned by the market) then the derivative must have the same price as the linear combination of other securities. Any other price would provide arbitrage opportunities. Of course in the real world, there are costs associated with trading, these costs usually related to a bid-ask spread. There is essentially a different price for buying a security and for selling it. The argument above assumes a frictionless market with no trading costs, with borrowing any amount at the risk-free bond rate possible, and a completely liquid market- any amount of any security can be bought or sold. Moreover it is usually assumed that the market is complete and it is questionable whether complete markets exist. For example if a derivative security can be perfectly replicated using other marketable instruments, then what is the purpose of the derivative security in the market?

Suppose that a security price is an Ito process satisfying the equation dS t = a(St , t ) dt + σ(St , t) dW t (2.33) Assumed the market allows investment in the stock as well as a risk-free bond whose price at time t is Bt . It is necessary to make various other assumptions as well and strictly speaking all fail in the real world, but they are a reasonable approximation to a real, highly liquid and nearly frictionless market: 1. partial shares may be purchased 2. there are no dividends paid on the stock 3. There are no commissions paid on purchase or sale of the stock or bond 4. There is no possibility of default for the bond 5. Investors can borrow at the risk free rate governing the bond. 6. All investments are liquid- they can be bought or sold instantaneously. 78 CHAPTER 2. SOME BASIC THEORY OF FINANCE Since bonds are assumed risk-free, they satisfy an equation dBt = rt Bt dt where rt is the risk-free (spot) interest rate at time t.


pages: 791 words: 85,159

Social Life of Information by John Seely Brown, Paul Duguid

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AltaVista, business process, Claude Shannon: information theory, computer age, cross-subsidies, disintermediation, double entry bookkeeping, Frank Gehry, frictionless, frictionless market, future of work, George Gilder, 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, 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

So it's no surprise to find that they are capable of tearing rents in that fabric. Experiments at both IBM and MIT with bots in apparently frictionless markets indicate potential for destructive behavior. Not "subject to constraints that normally moderate human behavior in economic activity," as one researcher puts it, the bots will happily destabilize a market in pursuit of their immediate goals. In the experiments, bots engaged in savage price wars, drove human suppliers out of the market, and produced unmanageable swings in profitability. "There's potential for a lot of mayhem once bots are introduced on a wide scale," another researcher concluded. 25 The research suggests that frictionless markets, run by rationally calculating bots, may not be the efficient economic panacea some have hoped for. Social friction and "inertia" may usefully dampen volatility and increase stability.


pages: 504 words: 139,137

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

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

We do not follow math to buried treasure and arbitrage never, ever exists. But outside the classroom, finance professors often run around chasing arbitrage opportunities. Fortunately, the arbitrage pricing theory not only tells you how to price securities in the absence of arbitrage, it also tells you how to exploit arbitrages if they do exist. Simply using the no-arbitrage condition and frictionless markets, we get a beautiful theory of relative asset pricing: A security can be “priced by arbitrage” in the sense that we can compute its fundamental value based on the value of other related securities. Arbitrage pricing can be done in the following three ways (of increasing complexity): 1. If two securities have the same payoffs, they must have the same value. 2. If a portfolio has the same payoff as a security, then the value of the security is equal to the price of the portfolio, which is called a replicating portfolio. 3.

Banks and hedge funds take the other side of this trade, making an expected profit, but not a certain arbitrage profit, as the option prices adjust to an efficiently inefficient level.5 ___________________ 1 See Frazzini and Pedersen (2013). 2 This version of the put-call parity requires that the stock does not pay any dividends before the option expiration. Otherwise, one must subtract the present value of the dividends on the right-hand side. 3 For American-type derivatives, one should check at every “node” in the tree whether exercise is optimal, but early exercise is not optimal for call options written on non-dividend-paying stocks in a frictionless market. 4 See Black and Scholes (1973) and Merton (1973), for which Myron Scholes (whom we meet in the interview in chapter 14) and Robert C. Merton won the Nobel Prize in 1997. (The Nobel Prize is not given posthumously, and Black passed away in 1995.) 5 Bollen and Whaley (2004) find evidence that option demand moves option prices and Gârleanu, Pedersen, and Poteshman (2009) present a model of demand-based option pricing with consistent evidence.


pages: 130 words: 11,880

Optimization Methods in Finance by Gerard Cornuejols, Reha Tutuncu

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

The price of XYZ a month from today is random: Assume that its value will either double or halve with equal probabilities. 80=S (u) 1 * S0 =$40 HH . j20=S (d) H 1 Today, we purchase a European call option to buy one share of XYZ stock for $50 a month from today. What is the fair price of this call option? Let us assume that we can borrow or lend money with no interest between today and next month, and that we can buy or sell any amount of the XYZ stock without any commissions, etc. These are part of the “frictionless market” assumptions we will address later in the manuscript. Further assume that XYZ will not pay any dividends within the next month. To solve the pricing problem, we consider the following hedging problem: Can we form a portfolio of the underlying stock (bought or sold) and cash (borrowed or lent) today, such that the payoff from the portfolio at the expiration date of the option will match the payoff of the option?


pages: 169 words: 43,906

The Website Investor: The Guide to Buying an Online Website Business for Passive Income by Jeff Hunt

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buy low sell high, Donald Trump, frictionless, frictionless market, intangible asset, medical malpractice, passive income, Ralph Waldo Emerson, Skype, software as a service

Methods that attempt to put a value on such things, like traffic statistics or email list count, almost always fail because there are dramatic and substantive differences between one email list and another or one visitor to a website and a visitor to a different website. Market-Driven Comparisons One approach that does have some theoretical reliability involves analyzing actual sale prices of comparable web properties. Websites with similar characteristics should sell for similar prices—assuming a frictionless market. This process works because, at the end of the day, a site is only worth what a real buyer is willing to pay for it. So, given enough transactions by real buyers, one should be able to deduce going market rates. This is how it works when you are buying a house. Homes in the same general location with the same number of rooms, square footage, and amenities are considered “comparable.” Their sales prices constitute a good rule of thumb for purchase of a similar house.


pages: 242 words: 68,019

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

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Ada Lovelace, Albert Einstein, Arthur Eddington, assortative mating, 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, 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

He noted that descriptions of the economy overlooked obvious aspects, such as the fact that workers who relocate from one department to another within a company are responding not to the price system but to the orders of a manager, or that drafting and executing contracts often involves an awful lot of work. Coase noted that economic transactions were not easy, and that the economy was not as fluid as many of his colleagues liked to assume. In Coase’s view, the economy was not a collection of fluid and frictionless market transactions but a set of islands of conscious power, shielded from each other and from the dynamics of the price mechanisms. Firms are hierarchical, Coase emphasized, and the interactions between a firm’s workers are often political. 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.

Global Governance and Financial Crises by Meghnad Desai, Yahia Said

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Asian financial crisis, bank run, banking crisis, Bretton Woods, capital controls, central bank independence, corporate governance, creative destruction, credit crunch, crony capitalism, currency peg, deglobalization, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, financial repression, floating exchange rates, frictionless, frictionless market, German hyperinflation, information asymmetry, knowledge economy, liberal capitalism, liberal world order, Long Term Capital Management, market bubble, Mexican peso crisis / tequila crisis, moral hazard, Nick Leeson, oil shock, open economy, price mechanism, price stability, Real Time Gross Settlement, rent-seeking, short selling, special drawing rights, structural adjustment programs, Tobin tax, transaction costs, Washington Consensus

It is based not on states and intergovernmental co-operation, but on the logic of markets and capital accumulation. Financial crises are understood in a number of ways within this perspective. There is, first, the neo-liberal position, the dominant political economy perspective of the present period. There are several strands within neo-liberalism. At one extreme, neo-liberals are hyper-globalists, believing that globalisation is sweeping away all obstacles to free competition and frictionless markets (Held et al. 1999). The main obstacles that remain are nation-states and their attempts to safeguard and police their territorial jurisdictions. For these neo-liberals, the cause of financial crises is to be sought in the powers and activities of governments, which by intervening in inappropriate ways in financial markets, prevent them from working as they should and precipitate crises. In completely free markets, financial crises would not occur, or at least there would be only mild fluctuations and adjustments.


pages: 313 words: 84,312

We-Think: Mass Innovation, Not Mass Production by Charles Leadbeater

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1960s counterculture, Andrew Keen, barriers to entry, bioinformatics, c2.com, call centre, citizen journalism, clean water, cloud computing, complexity theory, congestion charging, death of newspapers, Debian, digital Maoism, double helix, Douglas Engelbart, Edward Lloyd's coffeehouse, frictionless, frictionless market, future of work, game design, Google Earth, Google X / Alphabet X, Hacker Ethic, Hernando de Soto, hive mind, Howard Rheingold, interchangeable parts, Isaac Newton, James Watt: steam engine, Jane Jacobs, Jaron Lanier, Jean Tirole, jimmy wales, John Markoff, John von Neumann, Kevin Kelly, knowledge economy, knowledge worker, lone genius, M-Pesa, Mark Shuttleworth, Mark Zuckerberg, Marshall McLuhan, Menlo Park, microcredit, new economy, Nicholas Carr, online collectivism, planetary scale, post scarcity, Richard Stallman, Shoshana Zuboff, Silicon Valley, slashdot, social web, software patent, Steven Levy, Stewart Brand, supply-chain management, The Death and Life of Great American Cities, the market place, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Whole Earth Catalog, Zipcar

Far from losing a sense of identity younger generations growing up with the web seem both more individualistic and more collaborative than their elders. That is not to say that these critics do not raise important points, but they are qualifiers, not the main story. The fourth group argue the net will be mainly good for us. The members of this group, however, differ over why and how the net will be useful for society. The libertarian, free market wing believe the Internet is creating more diversity and choice, resulting in faster, frictionless markets and an abundance of free culture. In fact, the web is no less than a capitalist cornucopia. Chris Anderson, the editor of Wired and author of The Long Tail is the cheerleader for this camp. The communitarian optimists take a contrary view. They see in the Internet the possibility of community and collaboration, commons-based, peer-to-peer production, which will establish non-market and non-hierarchical organisations.


pages: 356 words: 103,944

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

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affirmative action, Asian financial crisis, bank run, banking crisis, bilateral investment treaty, borderless world, Bretton Woods, British Empire, capital controls, Carmen Reinhart, central bank independence, collective bargaining, colonial rule, Corn Laws, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, currency manipulation / currency intervention, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, Doha Development Round, en.wikipedia.org, 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, labour market flexibility, labour mobility, 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 “rational expectations” revolution, which took as its premise that individuals do not make systematic prediction errors about the future course of the economy, gave us a better appreciation of the role that anticipatory, forward-looking behavior by firms, workers, and consumers plays in shaping economic outcomes. The “efficient market hypothesis,” built on the joint supposition of rational expectations and frictionless markets, taught us about the good that financial markets can do in the absence of transaction costs. These ideas made useful contributions to economics and to economic policy. But they did not upend everything we already knew. They simply gave us additional tools with which we could anticipate the economic consequences of different circumstances. An honest practitioner of academic economics should respond with a blank stare when asked what the implications of his work are for policy.


pages: 350 words: 103,988

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

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accounting loophole / creative accounting, Albert Einstein, 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

It can’t. Since price dispersion continues to exist, it must be that even internet markets are subject to frictions—there are still some transaction costs. These are not costs of locating sellers or learning their prices, for those costs are close to zero. The remaining transaction costs are more subtle. They come from difficulties of observing quality. The internet has not created perfectly frictionless markets. The need for buyers to be able to trust sellers has been heightened by the internet. The hype notwithstanding, the internet in fact has not made information free. If shopping were merely a matter of finding the lowest price, the internet’s comparison shopping devices would eventually force all retailers to match their lowest-priced competitors. But a book offered by one retailer may be distinguishable, in a shopper’s perception, from the same book offered by another retailer, even though they are physically identical objects.


pages: 393 words: 115,263

Planet Ponzi by Mitch Feierstein

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Affordable Care Act / Obamacare, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Bernie Madoff, break the buck, centre right, collapse of Lehman Brothers, collateralized debt obligation, commoditize, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, disintermediation, diversification, Donald Trump, energy security, eurozone crisis, financial innovation, financial intermediation, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, high net worth, High speed trading, illegal immigration, income inequality, interest rate swap, invention of agriculture, light touch regulation, Long Term Capital Management, mega-rich, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, obamacare, offshore financial centre, oil shock, pensions crisis, Plutocrats, plutocrats, Ponzi scheme, price anchoring, price stability, purchasing power parity, quantitative easing, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, too big to fail, trickle-down economics, value at risk, yield curve

That sad tale is the story of the next chapter. 11 Collecting nickels in front of steamrollers The previous chapter looked at the monumental risks that have built up in a system dedicated to the management, dispersal, and efficient pricing of risk. There’s quite a paradox here. Financial markets are often said to come as close as is possible to the economists’ ideal of a competitive, well-informed, frictionless market. If neoclassical economic theory made any kind of sense, financial markets should be its showcase: the best possible example of markets in action. Unfortunately, markets don’t follow theory; they prefer reality. And reality is messy, full of compromise and skewed, absent, or contradictory incentives. As long as those incentives are so badly flawed as they are now, the system will always create risks that threaten to destroy the entire capitalist system.


pages: 442 words: 39,064

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

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

As a consequence, Bachelier and Samuelson argued that any advantageous information that may lead to a profit opportunity is quickly eliminated by the feedback that their action has on the price. Their point is that the price variations in time are not independent of the actions of the traders; on the contrary, it results from them. If such feedback action occurs instantaneously, as in an idealized world of idealized “frictionless” markets and costless trading, then prices must always fully reflect all available information and no profits can be garnered from information-based trading (because such profits have already been captured). This fundamental concept introduced by Bachelier, now called “the efficient market hypothesis,” has a strong counterintuitive and seemingly contradictory flavor to it: the more active and efficient the market, the more intelligent and hard working the investors; as a consequence the more random is the sequence of price changes generated by such a market.

Analysis of Financial Time Series by Ruey S. Tsay

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Asian financial crisis, asset allocation, Bayesian statistics, Black-Scholes formula, Brownian motion, capital asset pricing model, compound rate of return, correlation coefficient, data acquisition, discrete time, frictionless, frictionless market, implied volatility, index arbitrage, Long Term Capital Management, market microstructure, martingale, p-value, pattern recognition, random walk, risk tolerance, short selling, statistical model, stochastic process, stochastic volatility, telemarketer, transaction costs, value at risk, volatility smile, Wiener process, yield curve

The existence of bid-ask spread, although small in magnitude, has several important consequences in time series properties of asset returns. We briefly discuss the bid-ask bounce—namely, the bid-ask spread introduces negative lag-1 serial correlation in an asset return. Consider the simple model of Roll (1984). The observed market price Pt of an asset is assumed to satisfy S Pt = Pt∗ + It , 2 (5.9) 180 HIGH - FREQUENCY DATA where S = Pa − Pb is the bid-ask spread, Pt∗ is the time-t fundamental value of the asset in a frictionless market, and {It } is a sequence of independent binary random variables with equal probabilities (i.e., It = 1 with probability 0.5 and = −1 with probability 0.5). The It can be interpreted as an order-type indicator, with 1 signifying buyer-initiated transaction and −1 seller-initiated transaction. Alternatively, the model can be written as +S/2 with probability 0.5, Pt = Pt∗ + −S/2 with probability 0.5.


pages: 695 words: 194,693

Money Changes Everything: How Finance Made Civilization Possible by William N. Goetzmann

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Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, banking crisis, Benoit Mandelbrot, Black Swan, Black-Scholes formula, Bretton Woods, Brownian motion, capital asset pricing model, Cass Sunstein, collective bargaining, colonial exploitation, compound rate of return, conceptual framework, corporate governance, Credit Default Swap, David Ricardo: comparative advantage, debt deflation, delayed gratification, Detroit bankruptcy, disintermediation, diversified portfolio, double entry bookkeeping, Edmond Halley, en.wikipedia.org, equity premium, financial independence, financial innovation, financial intermediation, fixed income, frictionless, frictionless market, full employment, high net worth, income inequality, index fund, invention of the steam engine, invention of writing, invisible hand, James Watt: steam engine, joint-stock company, joint-stock limited liability company, laissez-faire capitalism, Louis Bachelier, mandelbrot fractal, market bubble, means of production, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, new economy, passive investing, Paul Lévy, Ponzi scheme, price stability, principal–agent problem, profit maximization, profit motive, quantitative trading / quantitative finance, random walk, Richard Thaler, Robert Shiller, Robert Shiller, shareholder value, short selling, South Sea Bubble, sovereign wealth fund, spice trade, stochastic process, the scientific method, The Wealth of Nations by Adam Smith, Thomas Malthus, time value of money, too big to fail, trade liberalization, trade route, transatlantic slave trade, transatlantic slave trade, tulip mania, wage slave

Like Bachelier, they relied on a model of variation in prices—Brownian motion—although unlike Bachelier, they chose one that did not allow prices to become negative—a limitation of Bachelier’s work. The Black-Scholes formula, as it is now referred to, was mathematically sophisticated, but at its heart it contained a novel economic—as opposed to mathematical—insight. They discovered that the invisible hand setting option prices was risk-neutral. Option payoffs could be replicated risklessly, provided one could trade in an ideal, frictionless market in which stocks behaved according to Brownian motion. Later researchers4 developed a simple framework called a “binomial model” that was able to match the payoff of a put or a call by trading just the stock and a bond through time. These solutions to the option pricing problem linked finance and physics together forever afterward. In fact, it turned out that the Black-Scholes option pricing model was the same as a problem in thermodynamics—a “heat” equation, in which molecules—not stock prices—were drifting randomly.