frictionless market

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
by Richard Bookstaber
Published 5 Apr 2007

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.

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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.

Social Life of Information
by John Seely Brown and Paul Duguid
Published 2 Feb 2000

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.

Monte Carlo Simulation and Finance
by Don L. McLeish
Published 1 Apr 2005

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?

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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.

Expected Returns: An Investor's Guide to Harvesting Market Rewards
by Antti Ilmanen
Published 4 Apr 2011

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).

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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).

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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.

Optimization Methods in Finance
by Gerard Cornuejols and Reha Tutuncu
Published 2 Jan 2006

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?

The Website Investor: The Guide to Buying an Online Website Business for Passive Income
by Jeff Hunt
Published 17 Nov 2014

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.”

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined
by Lasse Heje Pedersen
Published 12 Apr 2015

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.

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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.

Investing Amid Low Expected Returns: Making the Most When Markets Offer the Least
by Antti Ilmanen
Published 24 Feb 2022

In sum, the risk that investors care about is their portfolio volatility,7 and in a one-factor world an asset's beta tells how much it contributes to portfolio volatility. Now, the real world is more complicated than the CAPM assumes. I could cover extensions based on relaxing any number of the CAPM assumptions (normally distributed returns or mean-variance preferences, one-period model, homogeneous expectations, unlimited leverage, frictionless markets). I will only comment on extensions beyond a one-factor model. Already in the 1970s, research in Merton's (1973) Intertemporal CAPM and Ross's (1975) Arbitrage Pricing Theory pointed to multi-factor models. Later, empirical models dominated the literature and practice. Chen-Roll-Ross (1986) considered interest rate risk and other macro factors as relevant risks to investors beyond equity markets.

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Model errors: The risk/reward trade-off in MVO is based on simplifying assumptions, such as normally distributed returns or mean-variance preferences. Clearly, many investors care about portfolio characteristics beyond mean and variance. Other important preferences may include leverage, liquidity, ESG, and higher moments (e.g. skewness and tail risk). Moreover, a one-period, one-factor model in frictionless markets is hardly realistic; yet multi-period or multi-factor models add complexity, as do market frictions such as trading costs and taxes.13 The biggest error may be to deal with the wrong question or consider a too narrow investment opportunity set. Instead of doing an assets-only optimization, a pension plan could broaden its problem to include pension liabilities and optimize the asset-liability surplus.

Why Information Grows: The Evolution of Order, From Atoms to Economies
by Cesar Hidalgo
Published 1 Jun 2015

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 and Yahia Said
Published 12 Nov 2003

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.

We-Think: Mass Innovation, Not Mass Production
by Charles Leadbeater
Published 9 Dec 2010

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.

How to Be the Startup Hero: A Guide and Textbook for Entrepreneurs and Aspiring Entrepreneurs
by Tim Draper
Published 18 Dec 2017

The tokens purchased could be immediately marketable, and the price would fluctuate as the value of the underlying asset grew. Any project could be funded by a DAO offering, and any startup could raise money by simply initiating their own currency. In fact, it wouldn’t be limited to startups. Anyone could set up an ICO. Imagine the societal change and the frictionless market, the wealth and the jobs that could be created if everyone could raise their own money and have their labor valued through a fresh currency. As of this writing, Draper Associates has funded three ICOs. Bancor has the potential to transform marketplaces for projects and startups, Tezos has the potential to change how we govern ourselves globally, and Credo can be the vehicle we all use to put a value on email attention.

The Globalization Paradox: Democracy and the Future of the World Economy
by Dani Rodrik
Published 23 Dec 2010

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.

Reinventing the Bazaar: A Natural History of Markets
by John McMillan
Published 1 Jan 2002

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.

Planet Ponzi
by Mitch Feierstein
Published 2 Feb 2012

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.

Arguing With Zombies: Economics, Politics, and the Fight for a Better Future
by Paul Krugman
Published 28 Jan 2020

And if the analysis of where we are now rests on this fudge factor, how much confidence can we have in the models’ predictions about where we are going? The state of macro, in short, is not good. So where does the profession go from here? VII. FLAWS AND FRICTIONS Economics, as a field, got in trouble because economists were seduced by the vision of a perfect, frictionless market system. If the profession is to redeem itself, it will have to reconcile itself to a less alluring vision—that of a market economy that has many virtues but that is also shot through with flaws and frictions. The good news is that we don’t have to start from scratch. Even during the heyday of perfect-market economics, there was a lot of work done on the ways in which the real economy deviated from the theoretical ideal.

Trading Risk: Enhanced Profitability Through Risk Control
by Kenneth L. Grant
Published 1 Sep 2004

In particular, for some longer-term strategies (e.g., private equity investments), trade execution considerations and liquidity constraints may be such that you may have to suffer significant drawdown in order to achieve the desired returns. In such a case, it is instructive to understand the associated magnitudes. By contrast, short-term trading of liquid securities in relatively frictionless markets should not demand that enormous pain be endured in order to achieve your targeted objectives. • Return over Maximum Drawdown (ROMAD). This statistic, in which annual returns are expressed as a percentage of the worst drawdown experienced over a specified period of analysis, actually represents what many people believe to be the most accurate available measure of risk-adjusted return.

Lean Analytics: Use Data to Build a Better Startup Faster
by Alistair Croll and Benjamin Yoskovitz
Published 1 Mar 2013

Visualizing a Two-Sided Marketplace Figure 13-1 illustrates a user’s flow through a two-sided marketplace, along with the key metrics at each stage. Figure 13-1. Two-sided marketplaces—twice the metrics, twice the fun Wrinkles: Chicken and Egg, Fraud, Keeping the Transaction, and Auctions In the early days of the Web, pundits predicted an open, utopian world of frictionless markets that were transparent and efficient. But as Internet giants like Google, Amazon, and Facebook have shown, parts of the Web are dystopian. Two-sided marketplaces are subject to strong network effects—the more inventory they have to offer, the more useful they become. A marketplace with no inventory, on the other hand, is useless.

Adam Smith: Father of Economics
by Jesse Norman
Published 30 Jun 2018

And as with physics, it purported to be memoryless; for what could the point be of memory or history in a hard science, where present results supersede past ones? And the idea of homo economicus changed as well. As general equilibrium thinking moved to centre stage, individuals came to be seen increasingly not even as human at all, but as mere economic agents, atoms cut off from others, perfectly rational, operating in an exceptionless way in frictionless markets possessed of perfect information. The theory itself was highly abstract, not to say utopian—no such state of affairs existed or ever could exist in nature—and rather than reasoning from nature directly, it took perfect market conditions as its starting point. And it was static in character.

The Tyranny of Nostalgia: Half a Century of British Economic Decline
by Russell Jones
Published 15 Jan 2023

It might have been expected, therefore, that such a dramatic shock to the global financial and economic systems would encourage profound changes in macroeconomic theory and its application to policy, and that the previously dominant new classical–new Keynesian conventional wisdom would be superseded by very different thinking and action – even if that new thinking offered a less-alluring vision than that of a perfect, frictionless, market system. This is, after all, what happened following the Great Depression – although admittedly it took a decade or so to come to fruition. Generally speaking, however, this was not the case after 2009. Notwithstanding the efforts of a small group of largely US-based economists to resurrect a particularly extravagant form of unreconstructed Keynesianism (so-called modern monetary theory, or MMT), there was no radical transformation of beliefs or approach – no revolution in thought or action.

Analysis of Financial Time Series
by Ruey S. Tsay
Published 14 Oct 2001

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.

Why Stock Markets Crash: Critical Events in Complex Financial Systems
by Didier Sornette
Published 18 Nov 2002

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.

Money Changes Everything: How Finance Made Civilization Possible
by William N. Goetzmann
Published 11 Apr 2016

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.

Enlightenment Now: The Case for Reason, Science, Humanism, and Progress
by Steven Pinker
Published 13 Feb 2018

They allow people to transfer money, order supplies, track the weather and markets, find day labor, get advice on health and farming practices, even obtain a primary education.50 An analysis by the economist Robert Jensen subtitled “The Micro and Mackerel Economics of Information” showed how South Indian small fishermen increased their income and lowered the local price of fish by using their mobile phones at sea to find the market which offered the best price that day, sparing them from having to unload their perishable catch on fish-glutted towns while other towns went fishless.51 In this way mobile phones are allowing hundreds of millions of small farmers and fishers to become the omniscient rational actors in the ideal frictionless markets of economics textbooks. According to one estimate, every cell phone adds $3,000 to the annual GDP of a developing country.52 The beneficent power of knowledge has rewritten the rules of global development. Development experts differ on the wisdom of foreign aid. Some argue that it does more harm than good by enriching corrupt governments and competing with local commerce.53 Others cite recent numbers which suggest that intelligently allocated aid has in fact done tremendous good.54 But while they disagree on the effects of donated food and dollars, all agree that donated technology—medicines, electronics, crop varieties, and best practices in agriculture, business, and public health—has been an unalloyed boon.