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The ideas of economists and political philosophers, both when they are right

and when they are wrong, are more powerful than is commonly understood.
Indeed the world is ruled by little else. Practical men, who believe themselves to
be quite exempt from any intellectual influence, are usually the slaves of some
defunct economist.

--John Maynard Keynes

"Speculators may do no harm as bubbles on a steady stream of enterprise. But

the position is serious when enterprise becomes the bubble on a whirlpool of
speculation. When the capital development of a country becomes a by-product of
the activities of a casino, the job is likely to be ill-done. The measure of success
attained by Wall Street, regarded as an institution of which the proper social
purpose is to direct new investment into the most profitable channels in terms of
future yield, cannot be claimed as one of the outstanding triumphs of laissez-
faire capitalism."

--John Maynard Keynes

Chapter 5

Structure of the Market

5.1 The promise and limitations of EMH

Quite possibly, the efficient market hypothesis is the topic most discussed and
debated in financial economics in both popular and academic literature. And no
wonder: it incorporates the gamut of theories including rational expectations;
elements of the portfolio theory; and the predictability of prices in asset markets,
an issue at the heart of modern finance capitalism.

We discuss below some elements of the structure of todays market, the reality
on the ground, and what other academics have argued on various issues.
5.2 Structure of he Market

5.2.1 Participants Time Horizons

Participants in asset markets - equities, currencies, commodities, bonds or real

estate, -- can be broadly classified under the following categories:

The short term trader/speculator looking for a quick profit, through an in

and out strategy hoping to make money from price changes. (Charles
Kindleberger defined speculation as: buying for resale rather than use in
the case of commodities or for resale rather than income in the case of
financial assets Speculation for profits leads away from normal, rational
behavior). Milton Friedman believed that People who argue that
speculation is generally destabilizing seldom realize that this is largely
equivalent to saying that speculators lose money since speculation can
be destabilizing in general only if speculators on the average sell when
the currency is low in price and buy when it is high, (Essays in Positive
Economics, 1953). As we argue later, the reality is quite different: too
many speculators are trend following, momentum traders.

The investor who buys assets for the long term, looking to make a profit
from return from the investment including both dividends and price
changes: such investors would invest in the so-called value (i.e.
undervalued) stocks based on their estimates of fair values;

The medium term speculator investing in (undervalued) or shorting

(overvalued) stocks on the mean reversion theory. Literature lays a lot of
emphasis on the positive role of such speculators bringing asset prices
closer to fair or intrinsic values.

The participant who has no clear strategy or time horizon but buys rising
stocks and sells falling ones, driven by a fear of missing an opportunity.
Other asset markets also have participants with similarly diverse time horizons
and strategies. Take, for example, currency markets which were born to facilitate
exchange of one currency into another, without which cross-border trade would
not be possible: importers and exporters are the end-users of the market. So are
businesses who borrow foreign currencies for the medium/long term in
expectation of reducing costs compared to domestic currency loans or for other
reasons or make long term investments in other countries creating assets in
currencies other than their home currency. Other participants include currency
traders/speculators. In fact, the transactions of this latter category of
participants are far larger than those of end-users.

Commodity markets also have participation not only from producers and end-
users, but also speculators.

Market prices of various assets are the result of an interaction between all these
classes of participants: given the differing time horizons and strategies, can asset
prices generally, let alone always, reflect fundamentals?

5.2.2 Patience and Finance

The reality in todays financial markets was well articulated by Andrew Haldane,
Executive Director Financial Stability, Bank of England, in an address to a
conference in Beijing in September 2010. Some quotes:

Imagine three classes of investor:

an impatient short-term speculator, who follows the momentum of the

herd, buying when prices are rising and selling when they fall (exactly
opposite to what Friedman had theorized: see paragraph 5.2.1);

a patient long-term investor, who invests according to where prices are

relative to their long-term fundamentals;

an untested investor, who can mimic either the speculator or the long-term
investor, but whose performance either way is assessed at frequent
intervals by end-investors who withdraw or maintain funds accordingly.
(One example of this is mutual or hedge funds.)

Market prices in this model are buffeted by two winds. Momentum-based

speculators cause deviations from fundamentals, while long-term investors drive
prices back towards fundamentals. With a large fraction of momentum
traders, prices deviate persistently from fundamentals. Among untested
investors, momentum strategies now flourish while long-term fundamentalists
fail. The speculative balance of investors rises, increasing the degree of
misalignment in prices. ..

Excess volatility puzzle: There is strong evidence that asset prices, both
real and financial, are both considerably more volatile than fundamentals
and can deviate for persistent periods.

Serial correlation puzzle: There is strong evidence that asset prices do not
follow a random walk, but instead exhibit short-term positive correlation
(for example, due to momentum traders) and medium-term negative
correlation. (EMH argues that price changes should be random.)

Equity premium puzzle: The required yield on equity over safe assets is
greater than can be explained by conventional asset pricing theory - a
puzzle which some have explained using hyperbolic discounting.

Up until 1960s, the average absolute deviation of US equity prices from

fundamentals was just over 20%. Since 1990s, the average absolute deviation
has been well over 100%. ..To bring these market inefficiencies to life,
consider a simple experiment to gauge the relative performance of momentum
and long-term investors. Both are assumed to follow a simple strategy: the
speculator buys (sells) when prices have risen (fallen) in the previous period; the
fundamentalist buys (sells) when prices are low (high) relative to fundamentals.
Portfolios are evaluated and re-optimised on a monthly basis, based on a $1
initial stake. How would these strategies have fared historically? The
speculators $1 stake in US equities in 1880 would by 2009 have grown to
over $50,000. The fundamentalists same $1 stake would have fallen to be
worth around 11 cents. Impatience would have trumped patience by a
factor of half a million. .. In 1940, the mean duration of US equity holdings
by investors was around 7 years. For the next 35 years up until the mid-1970s,
this average holding period was little changed. But in the subsequent 35 years
average holding periods have fallen secularly. By the time of the stock market
crash in 1987, the average duration of US equity holdings had fallen to under 2
years. By the turn of the century, it had fallen below one year. By 2007, it was
around 7 months. ..A number of structural factors help account for these
trends, some of them positive. Transactions costs in equity markets have fallen
significantly. This has encouraged growth in a particular class of investor - high-
frequency traders (HFTs). While HFTs are not new, their speed of execution has
undergone a quantum leap. A decade ago, the execution interval for HFTs was
seconds. Advances in technology mean todays HFTs operate in milli- or micro-
seconds. Tomorrows may operate in nano-seconds.

HFTs operate in size as well at speed. HFT firms are believed to account for
more than 70% of all trading volume in US equities, 40% of volumes in US
futures and 20% of volumes in US options. In Europe, HFTs account for
around 30-40% of volumes in equities and futures. These fractions have
risen from single figures as recently as a few years ago. And they look set to
continue to rise . Another way of gauging short-termism is to look
at investors implied preferences for income today (dividends) over income
tomorrow (retained earnings). In theory, investors should be indifferent
between these options, as the dividend payout ratio ought not to affect the
value of a firm. Empirical evidence suggests, however, strong evidence of
high and sticky dividend payout ratios, almost irrespective of profits.
. Between 1980 and 2010, the worlds largest 200 companies reduced
dividends only 8% of the time. This was despite dividends being greater than
earnings in over 10% of cases and, indeed, dividends being positive despite
negative earnings in 5% of cases. people dislike goods price inflation, but
like asset price inflation.

5.2.3 The Kay Review of UK Capital Markets

The following extracts from the Report (July 2012) are worth quoting:

The Reviews principal concern has been to ask how well equity markets are
achieving their core purposes: to enhance the performance of UK
companies and to enable savers to benefit from the activity of these
companies though returns to direct and indirect ownership of shares in UK
companies short-termism is a problem in UK equity markets. We
question the exaggerated faith which market commentators place in the
efficient market hypothesis, arguing that the theory represents a poor
basis for either regulation or investment. Regulatory philosophy influenced by
the efficient market hypothesis has placed undue reliance on information
disclosure as a response to divergences in knowledge and incentives across the
equity investment chain. This approach has led to the provision of large
quantities of data, much of which is of little value to users. Such copious data
provision may drive damaging short-term decisions by investors, aggravated by
well-documented cognitive biases such as excessive optimism, loss aversion
and anchoring. We focus on the important, though not clear-cut,
distinction among asset managers between those who invest on the
basis of their understanding of the fundamental value of the company and
those who trade based on their expectations of likely short term
movements in share price. While some trading is necessary to assist the
provision of liquidity to investors, current levels of trading activity exceed
those necessary to support the core purposes of equity markets.

Many long term investors who responded to the Committees questionnaire or

testified before it thought that equity markets have lost sight of the basic purpose.
For example, the Association of Chartered Certified Accountants (ACCA)
observed that it is sometimes forgotten that equity markets exist not solely
to enrich speculators, market makers and intermediaries... Aviva (an
insurance group) expressed a concern that their (the regulators) practical
focus and priority appears to remain targeted at market integrity and
efficiency, primarily for (orderly) trading, at the expense of giving primacy
to the core role and purpose of the capital markets. The Association of
British Insurers (ABI) similarly observed that regulation and market practice
designed to ensure important but secondary goals may be obstructing the
primary purpose.

5.2.4 Taming the Finance Monster

An interesting observation comes from Taming the Finance Monster, by Paul

Woolley and Dimitri Vayanos (Central Banking Journal, December, 2012): Think
of what happened when value managers were being replaced by growth
managers as the technology bubble inflated in 19992000. Once mispricing
gets into the system, investors are tempted to ride the trends for short-term
advantage, instead of investing patiently on the basis of underlying worth
The rise in momentum investing means that the bulk of equity
investment is now conducted without regard to the value of the assets
being traded. The frequency of momentum-fuelled bubbles and flash crashes,
therefore, comes as no surprise. The erratic behaviour and poor returns from
equities during the past decade are now calling into question the very future of
equity markets in developed economies. The EMH is silent on both
momentum and short-termism. It views momentum as an unexplained
anomaly and perceives no difference between a strategy targeting long-run
returns and one seeking to do the best over each of the intervening short-
runs Much of the growth of the finance sector during the past decade
has been associated with the expansion of derivatives trading for which
outstanding contracts are now valued at many multiples of the market
capitalization of the underlying instruments. (We come back to derivatives
later in this chapter.)
5.2.5 Some other aspects/elements of the structure

Apart from the wide divergence between the objectives and time horizons of
market participants, the psychology of market participants contributes to prices
moving significantly away from intrinsic values. The principal elements which
often contribute to the phenomenon, include the following:

The herd instinct of many participants;

Momentum and Feedback loops;

The lack of strong correlation between changes in fundamentals and

changes in prices;

Derivatives which permit leveraged bets on price changes; etc.

We discuss the impact of some of these in the following paragraphs. The herd instinct

As we have argued earlier (Chapter 4), demand: supply curves in financial and
real economies are quite different. In the real economy, the rise in the price of a
commodity reduces demand for it, even as the supply is incentivised. On the
other hand, in the financial market, the rise in the price of an asset (equity,
currency, etc.) often attracts more speculative buyers thus accentuating the price
trend, carrying the price of the asset further away from intrinsic value.

This apart, since it is customary to compare the performance of fund managers,

by far the largest players in equity markets, there is a strong incentive in following
the crowd. As Keynes argued, it is better for (ones) reputation to fail
conventionally than to succeed unconventionally

Michael Lewis has argued in Liars Poker that Most investors are scared of
looking foolish. Investors do not fear losing money as much as they fear solitude,
by which I mean taking risks that others avoid. When they are caught losing
money alone, they have no excuse for their mistake; and most investors, like
most people, need excuses. They are, strangely enough, happy to stand on the
edge of a precipice as long as they are joined by a few thousand others. But
when a market is widely regarded to be in a bad way, even if the problems are
illusory, many investors get out. The fear of losing money when others are
earning too often outweighs the hope of making money by taking a contrarian
position, a point Keynes made a long time back. Even earlier, in his Theory of
Moral Sentiment, Adam Smith had argued that emulating others is a
pervasive and powerful human trait today we call it the herd instinct. And,
the herd instinct produces ever stronger feedback loops in market movements.

The reason why the 2008 crisis was not predicted is that the economic world,
far more than the physical world, is influenced by our beliefs about it. Such
reflexivity leads to the efficient market hypothesis, which claims that
available knowledge is already incorporated in the price of securities. (Ingenuity
and Stupidity Endure, John Kay, Financial Times, September 9, 2011) Momentum and Feedback loops

A corollary of speculation on a gigantic scale, often leveraged, is the existence of

powerful feedback loops which exaggerate price movements in either direction.
As we have seen, most short term speculators in financial markets are trend
followers (momentum trading). Their taking long or short positions based on an
existing trend, further accentuates it, attracting more traders. The result is that
prices typically run up too high or stay too low for far too long, because people
become fixed in their partial convictions. Because of reflexivity, momentum
carries markets far from equilibrium territory (Keynes The Return of the
Master, Robert Skidelsky).

One basic precaution (or risk management principle) most traders follow is
adherence to predetermined stop loss levels: reversing the position when the
trend starts going against the position. While this is essential for the trader, the
stop loss level adherence further accentuates the trend.
To elaborate, consider that the price of a currency (or stock) starts rising, for
whatever reasons. This can lead to a series of trades, which feedback into the
trend, accentuating it:

It would attract demand for the currency from trend followers;

The stop loss levels of those with short positions would be hit forcing
them to reverse the position by buying the currency;

Deltas (or hedge ratios) of those who have sold call options on the
currency will go up, even as deltas of sold put options will fall.
Rebalancing of the deltas would require purchase of the strengthening
currency; etc.

To give another example, this time from the debt market, consider what
happened during the height of the sovereign debt crisis in the euro zone. As
yields in the secondary market went up, speculators/investors bought credit
default swaps, either because their expectations of the probability of default was
more than what was embedded in the price of the CDSs; or to hedge the credit
risk in existing exposures to such bonds. The CDS premium went up and,
chasing it, so did the yields in the secondary market; in turn, this increased the
cost of borrowing for the government, further increasing the possibility of default!

In short, the very structure of the market creates powerful feedback loops,
accentuating a trend, carrying the price further away from intrinsic value: in fact,
this is the reason why the correlation between changes in fundamentals and
changes in prices is often poor.

To quote from a briefing on Momentum in Financial Markets, The Economist,

January 8, 2011:

Since the 1980s academic studies have repeatedly shown that, on

average, shares that have performed well in the recent past continue to
do so for some time. Longer-term studies have confirmed that this
momentum effect has been observable for much of the past century. Nor
is the phenomenon confined to the stock market. Commodity prices and
currencies are remarkably persistent, rising or falling for long periods.
When efficient-market theorists come across a market anomaly, they tend
to dismiss it in one of three ways. The first argument is that the anomaly is
a statistical quirk obtained by torturing the data; it will not persist. But the
momentum effect was noticed in 1985 (by Werner de Bondt, a Belgian
economist now at DePaul University in Chicago, and Richard Thaler, of
the University of Chicago Booth School of Business) and has not gone

The second is that any gains from the strategy will be dissipated in higher trading

The third is that higher returns simply reflect the higher risks of the
If markets are rational, as the efficient-market hypothesis assumed, then
they will allocate capital to its most productive uses. But the momentum
effect suggests that an irrationality might be at work; investors could be
buying shares (and commodities) just because they have risen in price.

The EMH contends that no simple rule based on published information can
generate above average returns: the consistent success of momentum
trading is a clear evidence of market inefficiency.

In short, markets can be reflexive where simple cause and effect relationships
do not work, where effects become causes in feedback loops. Markets
create their own reality independent of the fundamentals! The fact is that
greed and fear; the herd instinct; the confirmation and other biases; etc.
(rather than rational analysis) seem to be far stronger motivators of market
participants and their decisions. In todays financial markets, are rational
expectations too often rationalized expectations, based on imperfect
knowledge, on swings between euphoria, fear and greed? Derivatives

Derivatives permit speculators to take huge leveraged positions: the capital

needed to buy a futures contract on a stock is much less than that needed for
buying the stock in the cash market. Similarly, shorting a stock in the futures
market requires much less capital than taking the same position in the cash

Perhaps the most spectacular example of feedback loops generated by the use
of derivatives, or derivative-like strategies, was the sharp fall of equities in the
now famous stock market crash in October 1987. The then popular portfolio
insurance strategies required the investor, worried about a general fall in prices
of stocks, to create the purchase of a synthetic put option on the index by selling
index futures (delta hedging). In the week previous to the crash, equity prices
had fallen. On Monday, October 19, 1987, as cash market prices started falling,
investors sold index futures on a large scale as a hedge. A gap developed
between the price of the index futures contract and the underlying stocks.
Arbitragers bought the index and sold the stocks, depressing prices further,
generating further sales of the index..! The cycle continued resulting into
the largest ever fall on Wall Street, in a classic example of the feedback
loop. Only prompt regulatory intervention stopped the crash escalating into
a crisis.

Prof. Burton Malkiel, in his article The Efficient Market Hypothesis and its Critics
(Journal of Economic Perspectives Volume 17, Number I Winter 2003
Pages 59-82) (from Chapter 4) has argued that A number of factors could
rationally have changed investors views about the proper value of the stock
market in October 1987; that it is not unreasonable to ascribe the sharp decline
in mid-October to the cumulative effect of a number of unfavourable
fundamental events. The fundamental events he has listed occurred over the
previous few months; implicitly, he acknowledges that prices do not absorb
all fundamentals immediately, which is one of the tenets of EMH. Complexity

Consider one example from the equity market, the so-called VIX index and its
derivatives, supposed to be used by active investors as a measure of future price
volatility (NSE also publishes an India VIX index). The index itself is calculated
from the volatility implied by the prices of traded equity index options. Futures
and options based on the VIX index are actively traded in the global market,
ostensibly to manage the price volatility of equity portfolios.

Consider the complexity involved

First the underlying equity prices;

Then the index of equity prices;

Then the options on the index, at various strikes;

Then the index of volatilities implied by option prices (the VIX index);

Then a futures contract on the VIX index;

Then options on the VIX futures!

It is beyond the comprehension of at least this student of financial markets what

exactly the fourth (or is it fifth?) order derivative means and how it helps in
hedging the price volatility of an equity portfolio. (In fact, sometimes the creators
of innovations themselves do not seem to understand their implications and
vulnerabilities and hence the losses.)

Another example comes from the mortgage securities market. While

collateralized debt obligations (CDOs) and CDO 2 were at the heart of the 2008
financial crisis, banks also packaged and traded indices of credit default swaps;
they then sliced the indices and traded the slices. Money was made and lost as
the prices rose or fell, regardless of any actual defaults. Andrew Haldane of the
Bank of England has estimated that the documentation of CDO 2 securities alone
ran to more than a billion pages, and had slices of something like 93 million
mortgages as the underlying assets! Contagion Effect

Another characteristic common to global financial markets is the so-called

contagion effect. More often then not, major price changes in an important
financial market reverberate across the globe and other countries where
fundamentals may be completely different. One example of this is the way the
October 1987 crash on Wall Street led to price falls in many other equity markets,
despite the fact that the factors which led to the rapid fall, were not present or
applicable in other markets. Clearly this contagion effect hardly supports the
EMH which suggests that prices are based on and factor in all the relevant
fundamentals. The same contagion effect was noticed less than a decade and a
half later, after equity prices in the US fell sharply, following the bursting of the
dotcom price bubble.

Another instance of contagion in equity prices, this time in the reverse direction,
occurred in the first decade of the 20 th century, after a major earthquake in San
Francisco. This was the experience also after the 1929 crash of equity prices on
Wall Street.

Bank runs, once again, are contagious across geographical boundaries. One
classic example of this comes from the 1930s when the run on Creditanstalt
Bank in Austria led to runs on many banks throughout Europe. Clearly, beliefs
(about bank solvency for example) and the animal spirits of the investors, the
risk on risk off sentiment matters to stock prices; can these ever be factored as
part of the rational expectations which are supposed to determine investor
decisions? This Time is Different

In This Time is Different: Eight Centuries of Financial Folly, Carmen Reinhart and
Kenneth Rogoff argue that a major technological/geographical change creates
the perception that the old rules of valuation no longer apply Financial Crises
are things that happen to other people in other countries at other times; crises do
not happen to us, here and now. We are doing things better, we are smarter, we
have learned from past mistakes. In the 1890s, stories focused on the railroads;
a century later, it was the dotcom price bubble. The factor underlying the dotcom
boom was the invention of the internet which was supposed to revolutionalise the
way economies work. At the peak of the dotcom boom, stocks were trading
at very large multiples, not of profits because there were none but of
sales! When participants animal spirits are high, they too often rationalize
their optimism drawing comfort from the thought that this time is
different. Media Rationalisations

If prices can deviate from economic fundamentals for a long time, there is always
a plethora of pundits to rationalize and justify any price: retrospective
determinism, as Nassim Taleb terms it. The fact is that in financial markets
it is difficult to distinguish the cause of a price movement from a plausible
rationalization (Financial Times Editorial, April 13, 20020. If this is the reality,
much of the commentary in the electronic and print media plays a role in creating
an impression that there is some consistent and plausible cause and effect
relationship between market movements and economic events or developments.

Consider media predictions on stock prices. There is the story of CNBCs Jim
Cramer telling listeners to buy Bear Stearns stock days before it collapsed; of
Jon Stewart claiming that if he had followed CNBCs advice throughout the
previous year, he would be worth a million dollar now if he had started with a
hundred million! (CNBC is of course by no means unique.) More seriously,
financial media reporting is too often shallow, confident that the reader/listener
will not remember now what the commentator said a week back. But it does help
create a faade of plausible rationalization of what has happened and what

As Nassim Nicholas Taleb argued in The Black Swan the Impact of the Highly
Improbable, the newspapers try to get impeccable facts, but weave them into a
narrative in such a way as to convey the impression of causality (and knowledge)
We are explanation seeking animals who tend to think that everything has an
identifiable cause and grab the most apparent one as the explanation. Algorithmic Trading

The expression algorithm is defined as a well-defined computational procedure

that takes some value, or set of values, as input and produces some value, or
set of values, as output. An algorithm is thus a sequence of computational steps
that transform the input into the output. (Introduction to Algorithms by Thomas
H. Cormen, Charles E. Leiserson, Ronald L. Rivest, Clifford Stein).

Algorithmic Trading (AT) refers to the increasing use of computers to place

orders in equity and currency markets. AT is used for both; and

execution of large orders to reduce impact costs, or market making

generally; and

in proprietary trading based on rule-based technical analysis.

The purpose of computer based AT is to analyse markets and place orders far
faster than human traders can.

Large orders, i.e. for quantities larger than what current market liquidity for the
asset can fulfill, often have impact costs; price moves against the seller or buyer,
as the case may be. To mitigate this, Big institutions often use execution
algorithms, which take large orders, break them up into smaller slices, and
choose the size of those slices and the times at which they send them to the
market in such a way as to minimise slippage. For example, volume
participation algorithms calculate the number of a companys shares bought and
sold in a given period the previous minute, say and then send in a slice of the
institutions overall order whose size is proportional to that number, the rationale
being that there will be less slippage when markets are busy than when they are
quiet....Electronic market-making algorithms replicate what human market
makers have always tried to do continuously post a price at which they will sell
a corporations shares and a lower price at which they will buy them, in the hope
of earning the spread between the two prices but they revise prices as market
conditions change far faster than any human being can (Donald Mackenzie,
How to Make Money in Microseconds, London Review of Books, 2011). These
points are equally relevant to AT in the forex market.

More complex AT systems are used in proprietary trading. For example, they can
use all the rule-based technical analysis models (filters, moving averages,
etc.) far faster than any human mind can. They also use more complicated
models, for example continuously analyzing correlations between the prices of
different assets. If the change in prices disturbs the pattern of established
correlations, AT uses this information to go long and/or short in the assets or
currencies in question.

Some AT systems use what is known as algo-sniffing, i.e. guessing what

other AT systems are doing, in order execution for example, and take
advantage of such guesses to place orders for the asset. While the percentage
gains on such trading positions are generally minuscule, given the size of the
orders, the overall profits can be attractive in relation to transaction costs. In fact,
some kind of trading is possible only because of AT systems: exploitation of
minute differences between the prices of indices (or exchange traded funds) and
the underlying assets. AT systems are also far more disciplined in observing risk
limits than their human counterparts.

Today, some speculators use so-called "intelligent" software. A new breed of

analysts has emerged using neural networks, genetic algorithms and fuzzy logic,
all aimed at identifying the elusive and everchanging patterns to market
movements. Their success record remains mixed: successes get wide publicity,
whereas failures are carefully hidden. Too often, models that test well on past
price movements give disappointing results in practice.

The latest AT systems are adaptive in the sense that they are continuously
undertaking backtesting of the results from the rules they are using for trading
and adapting them to avoid the mistakes/losses made; and also to what other
players in the market are doing. The logic and strategy are similar to what
poker players use (John von Neumann and Oskar Morgenstern, Theory of
Games and Economic Behavior).

A few points are clear:

AT is rule-based;

Its logic is influenced by what other players are doing; and

Its popularity is growing rapidly, evidencing that it works.

Clearly AT leads to ever larger short term trading, facilitates so-called high
frequency trading (HFT), and has led to a few flash crashes. One has serious
doubts whether it improves pricing efficiency of markets. Chaos Theory

This is a mathematical theory that seeks to explain how very minor, insignificant
factors can be the root cause of major events. The theory attempts to forecast
highly complex systems, weather for example; the often cited example is how a
butterfly flying in one part of the world can become the root cause of a major
storm thousands of miles, and a few months, away! There have been several
attempts to apply the mathematics of Chaos Theory to predicting what happens
in the financial market; so far, nobody has succeeded in doing so.

The reason is that since we can never know all the initial conditions of a complex
system in sufficient (i.e. perfect) detail, we cannot hope to predict the ultimate
fate. Even slight errors in measuring the state of a system will be amplified
dramatically, rendering any prediction useless. Systems often become
chaotic when there is feedback present. A good example is the behavior of the
stock market. As the value of a stock rises or falls, people are inclined to buy or
sell that stock. This in turn further affects the price of the stock, causing it to rise
or fall chaotically. The currency market is no different see paragraph 5.3 below.

To quote from Talebs book again, Poincare was the first known big-gun
mathematician to understand and explain that there are fundamental limits to our
equations. He introduced nonlinearities, small effects that can lead to severe
consequences, an idea that later became popular, perhaps a bit too popular, as
chaos theory Poincares reasoning was simple: as you project into the
future you may need an increasing amount of precision about the
dynamics of the process that you are modeling, since your error rate grows
very rapidly.

Montaigne is quite refreshing to read after the strains of a modern education

since he fully accepted human weaknesses and understood that no philosophy
could be effective unless it took into account our deeply ingrained
imperfections, the limitations of our rationality, the flaws that make us

(To be sure, the theory is not applicable to complex physical or financial systems
alone, but perhaps even more to international politics. The start of the series of
events which led to the First World War, was the assassination of Franz
Ferdinand, the heir to the Austro-Hungarian Empire, by a Serbian nationalist. As
two recent histories document (The War That Ended Peace by Margaret
MacMillan, and The Sleepwalkers by Christopher Clark), the flight of the
butterfly set in motion a series of events culminating in perhaps the costliest war
in world history, in terms of lives lost directly (8.5 mn; another 8 mn permanently

5.3 Currency Market

There is only one theory of the fair value of a currency, namely that determined
by purchasing power parity (PPP), as propounded by Gustav Cassel, a Swedish
economist, back in 1921: the exchange rate between two currencies should be
such as to equate the domestic costs/prices of tradable goods and services in
the two countries. The corollary is that exchange rates should move to reflect the
relative inflation rates. The only modification I have come across is the so-called
Samuelson Balassa thesis that, apart from inflation differentials, changes in
productivity differentials also need to be reflected in the exchange rate.

Do floating exchange rates reflect prices based on PPP? I quote a few examples:

From the late 1970s to roughly 1984, the United States dollar doubled in
value against major currencies, and halved again over the next three
years. More recently, the movement in the USD: EUR exchange rate has
been equally erratic. When the euro was introduced on January 1, 1999,
the general expectation was that it would strengthen against the US
Dollar. It fell almost 30% over the next 22 months. Since its low of October
2000, the euro has been, broadly speaking, appreciating against the dollar
gradually at first, but spectacularly in 2007-08. It reached an all-time
high of $ 1.60 in July 2008, after a 21% rise in the previous 7 months.
Equally inexplicably in terms of fundamentals, the euro depreciated to $
1.39 by end December 2008, even as the US, not the euro zone, was in
the throes of a major financial crisis.
More recently the JPY: USD rate, the second most traded currency pair,
moved from JPY 79 in mid-November 2012 to around 100 in less than six
months, after mostly trading in the 70s for a year and a half.

There was no significant change of any kind between the inflation rates, or
productivity, in these countries, which can anywhere near account for the
changes. To quote from an interview by Nobel Laureate Robert Mundell (The
Wall Street Journal, October 18, 2010), The whole idea of having a free trade
area when you have gyrating exchange rates doesnt make sense at all.. All
this unnecessary noise, unnecessary uncertainty; it just confuses the ability to
evaluate market prices.What economic function did the exchange rate
changes among these islands of stability fulfil? Except for stuffing gift
socks of hedge funds, the answer is none": add to that the trading profits of

To quote from Kenneth Rogoff, Finance and Development, (June 2002), former
Economic Counsellor and Director of IMF's Research Department, there is
some tendency for a country's real exchange rate (the nominal exchange rate
adjusted for differences in relative national price levels) to return to its historical
value. But the adjustment is very slow indeed. All empirical evidence
suggests that one must think in terms of several years, not several
months, for the pull of purchasing power parity to kick in." And, purchasing
power parity in the tradeables sector is the economic fundamental that should
determine exchange rate.

Consider also the belief of too many commentators, analysts and market
participants that monetary easing depreciates a currency (one example:
Investors think that Federal Reserves monetary easing (will) weaken the
dollar. John Authers, Financial Times, April 7th 2013). This belief perhaps comes
from the pioneering attempt to offer an explanation for exchange rate volatility in
the floating rate era, made by Rudiger Dornbusch (1976). To quote once again
from Rogoff (ibid), Dornbusch's 1976 paper became an instant classic because
it seemed to make sense of the chaotic new world of flexible exchange rates,
which had only just replaced the serene 'Bretton Woods' system of fixed rates.

In Dornbusch's view, excessive exchange rate volatility was the inevitable result
of the chaotic monetary policies that had led to the break-up of fixed rates in the
first place. If domestic monetary policies are unpredictable, then so, too, will be
domestic inflation differentials. Ergo, the exchange rate must be volatile
because, in the very long run, there has to be a tight link between national
inflation differential and exchange ratesThe stroke of genius in his paper was
'overshooting'. According to Dornbusch's now famous logic, monetary policy
volatility is not only reflected in exchange rate volatility but is also amplified....
Dornbuch's theory, which he spiced up by incorporating the exciting new theory
of 'rational expectations' -- when private agents form exchange rate expectations
based on reasoned and intelligent examination of available economic data --
suggested that modest improvements in monetary stability would be rewarded
with large gains in exchange rate stability". Dornbusch's argument gave
reassurance that there might be some logic to the apparent randomness of
flexible exchange rates, and may be even a cure for volatility.

As Rogoff goes on to point out, however, "Whereas the over-shooting model

is a landmark theoretical achievement, it is an empirical bust, at least as far
as it concerns exchange rates among the United States, Japan, and Europe
(known as the Group of Three, or G-3). The most obvious observation is
that monetary policy in the G-3 is far more stable today than it was in the
mid-1970s after the first oil crisisYet the volatility of G-3 exchange rates
has dropped only marginally since the 1970s.... Where is the windfall that
we were supposed to reap by restoring global monetary stability?

The fact is that the correlation between money supply and exchange rate is poor:
the Japanese central bank has been following an easy monetary policy for two
decades; during this period, the yen has reached new peaks against both the
dollar and the euro!
The underlying cause of such volatility is the domination of speculative trading in
market activity. The daily turnover in the global currency market now exceeds $
5.3 trillion, 100 times global exports involving exchange of currencies, to
serve which the market was born!

More evidence of pricing inefficiency comes from the inability of the forward rate
to predict the future spot rate: since the former is a function of interest
differentials between the two currencies (which would, in general, parallel
inflation differential), the forward margin should be strongly, and positively,
correlated with the changes in the spot rate. It is not.

The other tenet of efficient markets is that speculators step in when prices move
away from fundamentals to make arbitrage profit. In reality, speculators/traders
are trend followers and technical analysis and models often determine their
decisions. According to a study published in the Bank for International
Settlements Quarterly Review, December 2011, the two most popular and
successful trading strategies are momentum trading and carry trades:
momentum trading would not work if price changes were random. Its success
evidences that price changes are not random (as EMH postulates), but often
display auto-regression, one days price change influencing the next days.
Simple rules like technical analysis, based on published and available
information, can make money, as banks trading profits evidence.

Carry trades are in effect a play on the interest rate differential and changes in
the spot rate. Consider the structure:

Borrow a low interest currency, yen for example;

Use the borrowed currency to buy a high interest currency, say

Australian dollar;

Invest the proceeds in the bought currency.

The trader of course takes the risk of the borrowed currency appreciating against
the invested currency. But when enough traders indulge in such carry trades,
often on a highly leveraged basis, the selling pressure on the borrowed currency
depreciates it against the high interest currency. The trader gains not only from
the interest differential, but often also from the movement of the exchange rate.

Were the market efficient in terms of pricing, neither momentum trading nor carry
trade strategies should really work! But, the huge trading profits earned by banks
are enough evidence that they work. As The Economist argued in its Economic
Focus (December 12, 2009), If markets were truly efficient, carry trades
ought not to be profitable because the extra interest earned should be exactly
offset by a fall in the target currency. That is why high-interest currencies trade at
a discount to their current or spot rate in forward markets. Carry trades and
other speculative activities often drive exchange rates a long way from their
fair or equilibrium values.

The result of the highly speculative market is that exchange rates do overshoot
compared with the levels that are consistent with underlying
fundamentals..also because of the self-fulfilling nature of investors
expectations, and the herd behaviour that influences aggregate market
developments. Overshooting is the rule rather than the exception, and is
very difficult to mitigate. (Smaghi, Lorenzo Bini. 2013. Why the currency-war
deniers are wrong, A-List, Financial Times.) To put it differently, Economic
theory is that of the rational economic man. The reality on the ground is that a
herd mentality, impulse buying and insufficient research underlie decision making
more than rationalism. The result is that exchange rates deviate far from their
equilibrium values (quote from a letter by Saro Agnerian in The Economist,
March 9th 2013). As Heiner Flassbeck and Massimiliano La Marca argue in
Global Imbalances and Destabilizing Speculation (UNCTAD paper, 2007), if the
herd behaviour of speculators is sufficient to appreciate the target currency, the
appeal of large returns is sufficient to generate them. It goes on to argue that
(Capital) flows moving from low-yielding, low-inflation countries to high-
yielding, high-inflation countries would cause the currencies of the latter to
appreciate, and provoke the paradoxical and dangerous combination of
surplus economies experiencing pressures to depreciate, and deficit
countries facing a corresponding pressure to appreciate.

the examples also show how much real appreciation (loss of overall
competitiveness for a nation) can result from speculation that is driven by interest
rate differentialsfloating currencies under various monetary policy
regimes, rather than being immune to speculative operations actually
stimulate them.

As John Kay wrote in the Financial Times, July 17, 2013, The market is not the
best place to set a fair price for assetsThe greater the volume of trading (and it
is gigantic in the currency market), the greater the extent to which prices are
determined not by informed assessment of fundamental value but by speculation
In the past decade, the efficient market hypothesis has been mugged by

5.4 Some individual examples

(i) Perhaps the most spectacular example of mis-pricing of assets occurred

in Japan in the late 1980s. It has been estimated that, just before this
bubble burst, the combined value of Tokyo real estate exceeded that of
the entire US! By the end of 1989, the Nikkie Index was within hand
shaking distance of 40,000 even 20 years later, it is around 40% of that
level. The absurd prices and also the crazy gyrations of the exchange rate
(form JPY 160 to a dollar in early 1990, to JPY 79 in 1995, to JPY 147 in
1998 to JPY 111 a few weeks later!) produced by efficient and rational
markets are surely a principal underlying cause of the economy practically
stagnating for two decades!
(ii) In The End of Behavioral Finance, Richard Thaler (Association for
Investment Management and Research November/December 1999) refers
to the case of the Royal Dutch/ Shell Group: Royal Dutch Petroleum and
Shell Transport are independently incorporated in, respectively, the
Netherlands and England. The current company emerged from a 1907
alliance between Royal Dutch and Shell Transport in which the two
companies agreed to merge their interests on a 60/40 basis. Royal Dutch
trades primarily in the United States and the Netherlands and is part of the
S&P 500 Index; Shell trades primarily in London and is part of the
Financial Times Stock Exchange Index. According to any rational
model, the shares of these two components (after adjusting for
foreign exchange) should trade in a 6040 ratio. They do not; the
actual price ratio has deviated from the expected one by more than
35 percent. Simple explanations, such as taxes and transaction costs,
cannot explain the disparity

(iii) In an article, Remember when the markets made sense? in Business

Week (March 31, 1991), Alan Blinder, (later a vice chairman of the US
Federal Reserve) claimed that speculative markets seem increasingly
to have lost touch with economic fundamentals and developed a life
of their own, quite independent of any other reality. Understanding
economics is of little apparent use in deciphering these markets--
and may even be a hindrance. After citing examples from other
markets, he concluded with an example from the bond market: A few
weeks ago, a weak employment report induced the Federal Reserve
Board to push short-term interest rates down another notch--apparently
because that worsened its view of the economic outlook. Deeper
recessions spell more disinflation; lower inflation is good for bonds.
These, I know, are fundamentals. Yet the bond market fell on the news.
Why? According to the media, the market was worried that the Fed had
eased too much--which would be inflationary!
Either the media or the market should have its head examined.
Probably both

(iv) The case of Long Term Capital Management (LTCM), a hedge fund which
collapsed in 1998, is a good example of how mean reversion strategy
requires the speculator betting on it, to have huge liquidity; as Keynes
famously said, prices can remain irrational longer than an investor can
remain solvent!.

LTCM was a very respected hedge fund, with a spectacular performance

record since inception. It had Nobel Laureates Myron Scholes (famous for
the Black Scholes option pricing model) and Robert Merton, as well as a
former Vice Chairman of the US Federal Reserve, amongst its partners. In
other words, it had the best possible knowledge base in terms of the
economics profession, and dozens of PhDs in mathematics and physics
amongst its employees.

At the material time, based on its analysis of past data, it believed that, for
one thing, the yield difference between sovereign and corporate bonds
was much higher than mean levels; also, with the euro due to be formed in
a few months, it expected the yield difference between German and Italian
government bonds to narrow. Based on this expectation, it shorted the US
and German government bonds, and went long in corporate and Italian
government bonds (such highly leveraged long/short strategies was the
reason why hedge funds came to acquire their name: in the present case,
the strategy depended purely on mean reversion of the yield gap,
irrespective of whether yields as a whole went up or down).

What was not expected was that Russia would default on domestic
currency sovereign bonds; but it did. There was a flight to quality
amongst investors, who bought US and German government bonds,
selling other fixed income securities. The result was a wider yield gap,
resulting into margin calls from the banks which had provided leverage to
the positions. The leveraging was so high that LTCM could not meet
margin calls, and in a rescue led by the New York Federal Reserve, the
banks took over LTCM. The lesson is that the time when mean reversion
will take place and prices return to their intrinsic values, is always
extremely uncertain: as it happened, the banks which took over LTCM,
ultimately made money on the portfolio!

(v) The LTCM case also illustrates another reality in financial markets:
how market prices depend on the willingness of
lenders/counterparty banks to leverage the instrument used for
speculation. After the collapse of LTCM in 1998, most lenders cut credit
lines and leverage ratios for all hedge funds, many of whom were active in
carry trades shorting the low interest yen. As such trades were reversed
(with cuts in bank funding), the yen appreciated from JPY 146 to JPY
112 in a matter of seven weeks. Is the willingness to leverage carry
trades on the part of the banking system a fundamental for the yen:
dollar exchange rate?

(vi) Consider Alan Greenspans experience in the commodity futures market:

in an article in Financial Times (October 25, 2013), based on an interview
with him, Gillian Tett wrote Back then he thought he could predict cotton
values from the outside, looking at supply-demand forces. But when he
actually bought a seat in the market and did a lot of trading he discovered
that rational logic did not always rule. There were a couple of guys in that
exchange who couldnt tell a hide from copper sheeting but they made a
lot of money. Why? They werent trading a commodity but human
nature and there is something about human nature which is not
rational.. In the non-financial part of the system (rational economic
theory) works very well, he says. But money is another matter: Finance
is wholly different from the rest the economy. More specifically, while
markets sometimes behave in ways that models might predict, they can
also become irrational, driven by animal spirits that defy maths.
(vii) As for prices reflecting fundamentals, consider the current (summer 2013)
debate about the overvaluation or otherwise of the US stock market. Two
leading market analysts/economists, Shiller (author of Irrational
Exuberance) and Jeremy Siegel (author of Stocks for the Long Run) come
to exactly opposite conclusions. Shiller has developed a well accepted
cyclically adjusted price earnings (CAPE) multiple model which suggests
that the US market is 60% overvalued; Siegel has developed a modified
version of CAPE which signals that US equities are cheap. Other analysts
believe that U.S. market is around its fair value!

(viii) Gordon Brown, the Prime Minister of U.K., and Nicolas Sarkozy, the
President of France, wrote in an article in the Wall Street Journal in mid-
July 2009, First (the oil price) rose by more than $ 80 a barrel, then fell
rapidly by more than $ 100, before doubling to its current level of around $
70. In that time, however, there has been no serious interruption of supply
. Such erratic price movement in one of the worlds most crucial
commodities is a growing cause for alarm. The surge in prices last
year gravely damaged the global economy and contributed to the
downturn Those who rely on oil and have no substitutes readily have
been the victims of extreme price fluctuations beyond their control and
apparently beyond reason. Importing countries, especially in the
developing world, find themselves committed to big subsidies to shield
domestic consumers from potentially devastating price shifts .. We
therefore call upon (regulators) to consider improving transparency and
supervision of futures markets to reduce damaging speculation. This
would serve the interests of orderly and adequate investment in future
supplies. Volatility and opacity are the enemies of growth.

5.5 Irrational Exuberance: manias, panics and crashes

Historically, the best known examples of mispricing of assets are the Tulip
Mania in Holland in the 1630s; the Mississippi Scheme which swept France in
1720; and the South Sea Bubble in England around the same year. The last
was described as an undertaking of vast importance . so secret that nothing
more can be revealed. In each case the prices first went to absurd levels, before
the inevitable crash. (All these cases have been described in detail in Charles
Mackays Extraordinary Popular Delusions and the Madness of Crowds (1841)).

There is sufficient empirical evidence to suggest that crowds have not

necessarily become saner even in the 20th century. In fact, as asset markets have
grown rapidly, there are an increasing number of cases of mispricing of an entire
asset class. Lord Rathmore, then a director of the Bank of England, has been
quoted as saying, People were apparently mad; I do not know what other
word to use; they seemed to think that every company that came out was
worth double its value before it had even started business. Incidentally, he
was commenting on the equity market in Cairo in the first decade of the 20 th
century! But the remark is perhaps equally applicable to the Japanese equity
and real estate markets in the 1980s and the internet stock price bubble in the
late 1990s.

During the internet stock IPOs (initial public offerings) a decade later, the cash
flows of startups, which had no hopes of making profits for the next several
years, were projected for, say, 15 years; and the IPO price justified using a
suitable discount rate. The weaknesses of the assumptions underlying the
models used were obvious once the crash occurred in early 2000. At the height
of the dot com bubble, the NASDAQ Composite Index, which included most
of the internet stocks, was trading at 5400; almost 14 years later the index
is still around 4000 and this even after a few of the internet based
companies have done spectacularly well (Amazon, Google, etc.) And, this
happened in a supposedly mature and efficient market in which information
was available practically without cost. Even otherwise very successful
speculators, George Soros and Julian Robertson for example, resisted the
temptation of internet stocks for a long time before joining the party and lost
heavily. One investor who never touched the dot com stocks was Warren Buffet,
the worlds most successful investor, who does not need anything more complex
than a calculator to make his investment decisions. His reason was that he could
not understand the business plan of the companies coming in the market and
would not invest in businesses which he did not understand. Schiller had
surmised that a bubble was forming; his book Irrational Exuberance came out in
the very year the bubble burst, 2000.

Too often, investment decisions are made on how much the asset price has gone
up in the recent past, extrapolating the past to the future, rather than making
decisions based on rational expectations of the returns in the future. When the
bubble is growing, greed overcomes fear; once it bursts the psychology is
reversed. (In India, there were several cases of well-educated professionals like
lawyers and doctors selling their businesses to invest in the booming stock
market during the securities scam of the early 1990s!) Evidence suggests that, at
such times, some participants are aware of the egregious mispricing; they still
buy the asset on what is referred to as the the greater fool theory: that they will
be able to sell the asset at an even higher price to a greater fool.

Investors do not seem to have become much more rational even in the 21 st
century, as the mortgage market collapse in 2008 witnesses. Just before the
market collapsed, the then Citibank Chairman memorably said that You have to
keep dancing till the music stops. For him, it stopped in a few days!

5.5.1 The Allocative Efficiency of markets

There is enough empirical evidence that speculation driven trading, the market
structure and feedback loops they lead to, often carry prices far away from
fundamentals. What about the allocative efficiency of capital markets, the belief
that markets allocate capital to businesses and areas that would produce the
maximum return? Several recent cases raise questions about this assumption as
well: the oil importers debt financing by banks in the 1970s on the belief that
companies can go bankrupt, countries cannot, a statement attributed to the
then Citibank Chairman; the junk bond financed takeovers of the 1980s; the
dotcom equity prices in the 1990s; the mortgage securities market in the first
decade of the 21st century; all are examples of misallocation of capital on a
gigantic scale, by the supposedly mature and efficient US financial market.

Too many of these less-than-rational outcomes represent a gigantic misallocation

of capital, while efficient allocation of capital to produce the maximum output is
the raison detre of financial markets. In many ways, in an increasingly globalised
world, volatility of prices of currencies and commodities perhaps affect human
welfare far more than stock prices as they directly affect investment,
employment, and consumption.

There are of course those who defend market efficiency but argue that efficiency
has nothing to do with socially desirable pricing (Robert Lucas). This of course
begs the question: in that case, how can markets be relied upon to allocate
capital where it will do the most good?

5.6 Are markets efficient?

After studying financial markets for more than 50 years, one conclusion I have
come to is that markets are efficient in the sense that prices cannot be predicted
with any degree of certainty; they are not efficient in the sense that prices
always, or even generally, reflect fundamentals, or that price changes are
random. In fact, ruling prices are often significantly different from intrinsic

I can do no better than conclude with some comments in John Kays The Map Is
Not the Territory: An Essay on the State of Economics (Institute for New
Economic Thinking, October 04, 2011), The economic world, far more than the
physical world, is influenced by our beliefs about it. .The efficient market
hypothesis is an illuminating idea, but it is not Reality As It Is In Itself.
Information is reflected in prices, but not necessarily accurately, or completely.

There is a trivial sense in which the deviations from efficient markets are too
small to matter and a more important sense in which these deviations are the
principal thing that matters. the belief that profit opportunities that
have not been arbitraged away still exist ,,, it explains why there is so much trade
in securities (or in other asset classes).

The preposterous claim that deviations from market efficiency were not only
irrelevant to the recent crisis but could never be relevant is the product of an
environment in which deduction has driven out induction and ideology has taken
over from observation. The belief that models are not just useful tools but also
are capable of yielding comprehensive and universal descriptions of the world
has blinded its proponents to realities that have been staring them in the face.

In many ways, John Maynard Keynes was not only the greatest macro-economist
of the 20th century (and relevant for the 21 st century democracies, who all
followed Keynesian prescriptions to stem the largest drop in global output since
the 1930s, after the financial crisis of 2008): his insights on financial economics,
some of which we have quoted, are equally relevant and realistic. One reason
could well be that he was not sitting in an ivory tower formulating theories and
models: he speculated in markets; was a civil servant, policy-maker and political
activist; an academic; a connoisseur of arts comfortable in the company of
writers, critics and artists; an author with an excellent turn of phrase; a pragmatic,
not an ideologue, willing to change his mind when new facts contradicted
his earlier beliefs. One wonders how many economists can boast such well-
rounded experience and personalities! I can do no better than end the Chapter
with a thought borrowed from him: in the long run market prices do reflect
fundamentals; but, in the long run, we are all dead! (To be sure, he wrote this in
a different context: inflation)