Jamesian Philosophy Refreshed

Streetwise Professor, the blogging persona of Craig Pirrong, recently jumped into the fray regarding  high frequency trading. Find his comments here. Unless you've been following the HFT debates carefully already, the opening grafs there might put you off. Pirrong is positioning himself relative to a range of other commenters, Stiglitz, Salmon, DeLong especially. I'll cut to the chase for you. One of the issues created by the existence of HFT --and by the related fact that it is impossible for everybody to be equally fast or equally sophisticated in their algorithms, so there is an arm's race and a have/havenot split -- one of the issues is whether this circumstance discourages the gathering of information. Joe Trader might well believe in making decisions the old-fashioned way -- studying up on the corporation issuing certain stocks and bonds, looking at such factors as the competitive pressure in that corporation's product lines, considering the ratio of boo...

I said a few posts back that in order to understand the assumptions behind the efficient capital markets hypothesis (ECMH), it will help us to state the case for that hypothesis with some clarity. Here we go: when there is a way for someone to make alpha, that way comes about because there is some exploitable inefficiency in the system. For example, XYZ may be listed on stock exchanges in two cities: Philadelphia and Pittsburgh. Due to some inefficiency, XYZ trades at a lower price in Philly than in Pittsburgh. We know that’s inefficiency because the equity of XYZ is worth only what it is worth; there is only one possible complete discounting of all relevant information on that matter. If Pittsburgh and Philadelphia differ, one or both are wrong. Since listed exchange prices are themselves public information, arbitrageurs will almost instantly pickup on this, and will quickly start buying XYZ at the lower price in Philadelphia and then selling it for a risk-free profit for a hi...

In our last post devoted to the mathematics of finance, we mentioned that the standard deviation of a bell curve showing the range of possible returns from an asset can be employed as a surrogate for its risk. I'd like to pursue that point a bit. It is the chanciest corporations,  the ones that do have significant risk, that have to bribe you into buying their bonds with a higher return than their safer brethren need offer: thus, a trade-off. One way of looking at the trade-off is this: suppose I come into your neighborhood and offer to play a simple game. You will roll a pair of dice I provide and I will give you $1,000 times the number shown on the dice when they come to rest. I require only that you pay me $1,000 before we begin. The lowest possible score is 2, so the lowest possible pay-out is twice what you’ll pay me up front. This, then, (if I am honest and actually have the money I’m offering to pay) is a can’t-lose proposition for you. The worst outcome is ...

  We can reasonably hypothesize that “Mr. Market” is rational, and knows a lot of stuff, because there are a lot of people out there looking to make a buck off of any slip-up, looking to get an edge, to learn something he doesn’t know, and to trade on that basis. Further, all their trades on the basis of what they learn in that effort make him smarter. They contribute to determining prices, so that an “edge” that still worked a month ago may be outdated now, as Mr. Market has learned to factor it in. And that is why (especially according to advocates of the ECMH) stock prices move in a random walk. It is random to any observer not as smart as Mr. Market himself. Any given neuron will presumably see the thoughts of the whole of the brain as a random result of who-knows-what. There is nothing mystical about this – the confused neuron, in its own trading, helps to bring the situation about. Now, when I’m asked whether I believe in ECMH, I generally reply, “yes and no.” It ...