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Whitepaper High Frequency October 21Ratings:

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High Frequency Trading and Market Inefficiencies:A Statistical Physics Viewpoint

E. Pinsky

1

Ph.D, R. Sunitsky

2

CFA

1

Trading Cross Connects US LLC, Wellesley, MA 02481

2

Bay Head CI US LLC, Jersey City, N.J. 07311

October 2009Introduction

High frequency trading involves the use of algorithms, fast computers and low latencynetwork connectivity to detect and exploit “temporary” market inefficiencies. If suchinefficiencies are quickly identified, and the appropriate ultra low latency tradingtechnology is used, then by executing a large number of such transactions, traders canearn substantial profits. It is estimated that today over 50% of the volume on manyexchanges is generated by algorithmic high-frequency trading.In this paper, we use analogies from statistical physics to explain for the existence of market inefficiencies. As an example, we consider an asset pricing model described bythe telegraph equation. We argue that this can be viewed as a generalization of the Black-Scholes formula to high frequency settings. Unlike the standard Black-Scholes formula,the generalized formula for asset pricing contains second-order terms that becomesignificant in high-frequency. We will use analogies from fluid dynamics to explain therationale for the existence of market inefficiencies in such environments.

Black-Scholes Formula from a Statistical Physics Viewpoint

The standard assumption in finance is that price of a risky asset satisfies the stochasticdifferential equation that depends on the instantaneous expected return

)(

t

µ

on the priceratios and the instantaneous volatility )(

t

σ

of the price governed by Brownian motion([4],[8],[14]). If expected return and volatility are assumed to be constant (

µ

and

σ

,respectively) then under suitable transformations we have the Black-Scholes model ([12],[15], [18]) where the price follows the geometric Brownian motion and satisfies the one-dimensional diffusion (or heat equation):

2222

2

xuu

∂∂=∂∂

σ τ

(1)with the distribution function of the diffusing quantity ),(

t xu

corresponding to the assetprice )exp(

rt C

and the diffusion coefficient of

v

corresponding to volatility 2 /

2

σ

. TheBlack-Scholes equation has been studied as a model for the flow of heat in a continuousmedium.In statistical physics, equation (1) describes the density distribution of a material in agiven region over time that is undergoing diffusion where diffusion is defined as themovement of molecules from a higher concentration area to a lower concentration area.Diffusion is a non-equilibrium process that increases the system entropy and transformsthe system closer to equilibrium. Under diffusion we assume that the relaxation time

τ

(time for a system to change to an equilibrium state from a non-equilibrium state) is smalland the external oscillations (with wavelength

w

) on the system are ignored ).1(

<<

τ

w

In statistics, equation (1) is connected with the study of Brownian motion via the Fokker-Planck equation which describes slow diffusion flows with uniform rate. In the languageof physics, the behavior of flow described by equation (1) is the viscoelastic Newtonianbehavior. Therefore, we can think of Black-Scholes equation as describing the casewhere the external changes in option pricing occur slowly (

τ

>>

T

), the time of interest Tis large compared to price change times, so that the market participants can “correctly”estimate pricing and eliminate arbitrage opportunities where mispricing opportunities(oscillations) are rare. In other words, Black-Scholes model ignores second-order effects.Recall that the physical meaning of diffusion is that substance concentration will arise

instantaneously

everywhere this substance is introduced. In other words, diffusionequations model phenomena where information travels with infinite speed. Another wayto look at this is to note that equation (1) is a

parabolic

equation, and if a change is madeto ),(

t xu

at a particular point in ),(

t x

space, for example on the boundary of the solution,its effect is felt instantaneously everywhere else. In other words, we have an “infinite”speed for stock price motion: option price at any time would depend on all possible pricesfor the underlying asset.

Extending Black-Scholes to High Frequency Trading Environment

One of the criticisms of using the geometric Brownian motion to describe the changes ina stock price is the fact that prices have unbounded variations (i.e., prices cantheoretically have any value) and fixed volatility, which may be unrealistic in financialmarkets. It is suggested by several authors to extend this model to consider stochasticvolatilities and jumps (e.g. .[3],[5],[9],[11]). In one such class of models([1],[7],[10],[13],[16],[17]), the asset price satisfies the so-called telegraph equation:

3

2222

xuvt ut u

∂∂=∂∂+∂∂

τ

(2)In physics, the telegraph equation is used to model the flow of electricity in cables fromthe stochastic behavior of charges in linear conductors ([6],[19],[20]). Such hyperbolicequations have a finite velocity of propagation and a finite dependence range. That is, forevery asset price )(

t S

and every

t

, only a finite range of variation of the asset prices willinfluence the computation of the corresponding option prices. As a result, the solution tosuch equation will be less diffusive and will contain some delay. These equations can beused to model Black-Scholes with memory [6] and are more consistent with theviewpoint of technical analysis.To pursue the analogy with statistical physics a bit further, consider the flow generatedby an oscillating plate in a range of frequencies .0

∞<<

ωτ

We can think of theseoscillations as analogous to high-frequency trading on the underlying asset. This is thecase where

τ

≈

T

. In physics, this corresponds to the case where external forces (e.g.,oscillations) cannot be ignored ).1(

>>

τ

w

In such a case, the diffusion equation breaksdown and a new regime emerges ([4],[16]). It can be shown that there is a phasetransition from the viscoelastic Newtonian regime )1(

<<

τ

w

to elastic non-Newtonianregime ).1(

>>

τ

w

In Newtonian fluid, stress and strain rate are linearly related throughthe constant viscosity coefficient, whereas in non-Newtonian regime, flow properties arenot described by a single constant value of viscosity. For the elastic non-Newtonianregime, the resulting stochastic equation is equation (2).Comparing equation (1) this with equation (2) we can write the analog of Black-Scholesin high frequency trading environment:

22222

2

xut ut u

∂∂⋅=∂∂+∂∂

σ τ

(3)Here, the parameter

σ

is some function of stochastic volatility described by theunderlying telegraph process. We can also rewrite the above equation as follows:

4 434 421321

Scholes Black termorder ond

xut ut u

−

∂∂⋅=∂∂+∂∂

222sec22

2

σ τ

(4)

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