3. Aspects of the financial system Flashcards
“Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents”
The frequency of technological malfunctions and other failures due to increasing amount of computerized algorithmic trading has disenfranchised smaller, less technologically advanced market participants. One of the proposed regulatory responses to protect the retail investors is to introduce a small transaction tax on all financial transactions. Explain how this proposal will affect a) the market liquidity and b) the hedging activity. (6p)
It will reduce market liquidity and weaken hedging activity. E.g., institutional investors often rely on derivative securities such as options and swaps to hedge risk exposures to fluctuations in stock prices, interest rates, and foreign exchange rates. Intermediaries are willing to take the other side of these transactions only if they can mitigate their own risk exposures by dynamically hedging their positions in the underlying stock, bond, and foreign currency markets. Even a small transactions tax would
make such dynamic hedging activity impractical
“Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents”
Discuss at least three new opportunities and three new challenges that algorithmic trading has created for the finance industry and its regulators. (6p)
Opportunities: (1) greater liquidity; (2) improved efficiency by lowering costs, reducing human errors and increasing productivity; (3) arbitrage leads to one price law; (4) easier implementation of quantitative finance.
Challenges: (1) much faster, larger and more complex trading environment; (2) trading errors and software bugs (Facebook’s IPO, Flash Crash, BATS IPO); (3) manipulative actions (839 milliseconds for a manipulation)
Refer to “Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents” for examples.
Define and explain the crowding effect in hedge fund strategies that is likely to occur if multiple hedge funds open the same positions. What are its implications for financial stability in turbulent times? (3p)
“Crowded trade” is phenomenon where everyone rushes to the exit doors at the same time.
In August 2007, many large funds faced huge losses concentrated among quantitatively managed equity market-neutral or “statistical arbitrage” hedge funds. It occurred due to forced liquidation of one or more large equity market-neutral portfolios, subsequent price impact of this massive and sudden unwinding caused other similarly constructed portfolios to experience losses.
(N/A: What are its implications for financial stability in turbulent times?)
Bitcoin: Economics, Technology, and Governance
The complexity of the mathematical puzzles that the participants of the Bitcoin system
may choose to solve may be used as a gauge for the value of bitcoins. Explain why this is so.
(4p)
Higher complexity (1) results in high electricity costs; (2) decreses the supply of bitcoins, as each miner is rewarded with them (more complex the puzzle is, the higher reward**). Taylor (2013) compares the difficulty of solving the puzzle to the bitcoin-dollar exchange rate, finding that spikes in the exchange rate— bitcoins becoming more valuable in terms of US dollars — have been followed by increases in computational difficulty.
**after $21 million bitcoins have been minted, it falls to zero and no further bitcoins will be created
Bitcoin: Economics, Technology, and Governance
Bitcoin intermediaries have become an integral part of the service for many users of the platform. Name and briefly describe 4 types of such intermediaries mentioned in the article “Bitcoin: Economics, Technology, and Governance” Name one most important risk associated with each class of intermediaries. Which of the classes is most often in the spotlight of regulators? (6p)
- Currency exchanges (most often in the spotlight
of regulators -> licensing, registration in FinCEN, certification requirments etc.)
Allow users to trade bitcoins for traditional currencies or other virtual currencies (charge a commission of 0.2-2%).
- Market risk: fluctuations in the exchange rate between bitcoin and other currencies. - Digital wallet services
Keep Bitcoin accounts, recorded transactions, and private keys (not all) on a shared center with access via the web or phone-based apps.
- Privacy-related risk: transactions could be linked back to the people who made
them (real names are often revealed at currency exchanges or in purchase details) - Mixers
Let users pool sets of transactions in unpredictable combinations, preventing tracking across transactions (charge a fee of 1-3%)
- Transaction risk: malevolent participants could double-spend bitcoins, particularly through rapid transactions
before the block chain is updated. - Mining pools.
Combine resources from numerous miners to solve mathematical puzzles and verify transactions (bitcoin creation)
- Operational risk: denial-of-service attack on a mining pool can prevent a pool’s participants
from solving the current puzzle and thus give an advantage to all other miner
“Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents”
What is “spoofing” and “layering”?
Manipulative actions possible due to HFT.
“Spoofing”: intentionally manipulating prices by placing an order to buy or sell a security and then cancelling it shortly and starting a trade in the opposite direction.
“Layering”: placing a sequence of limit orders at successively increasing or decreasing prices to artificially increase or decrease the price (appearance of a change in demand) and cancelling the order thereafter.
“Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents”
What are the 5 proposals for Financial Regulation 2.0?
1) Do nothing: will result in cost reductions for intermediaries, but will not address the issue of fair and orderly markets
2) Ban algorithmic trading: will yield a more “fair” and orderly market, but also reduce liquidity, efficiency, and capital formation
3) Change the definition and requirements of market makers to include HFT: will lead to a more fair and orderly market, but will also increase the costs for intermediaries (capital requirements, legal costs, etc.)
4) Fix time intervals between trades (market continuity): need more analysis to evaluate the effects connected with demand for immediacy
5) Introduce a “Tobin tax” on transactions: will reduce trading activity, liquidity and hedging activity (dynamic replication of options) and remove HFT
Bitcoin: Economics, Technology, and Governance
A hedge fund manager is enthusiastic about the future of the block chain technology and
decides to add some bitcoins to his portfolio. Name five most important risks the manager
will be facing. Can bitcoins be used to diversify a portfolio of equities and bonds?
Market risk, the shallow market problem, counterparty risk, transaction risk, operational risk, privacy-related risk, and legal and regulatory risks.
Bitcoin investment had highly distinctive features, including exceptionally high average return and volatility. Its correlation with other assets was remarkably low. Spanning tests confirm that Bitcoin investment offers significant diversification benefits. The inclusion of even a small proportion of Bitcoins may dramatically improve the risk-return trade-off of well-diversified portfolios.
“Towards a Political Theory of the Firm”
What is Medici vicious circle and on what six nonmarket factors it depends upon? Name them and explain.
MVC: money is used to gain political power and political power is then used to make money. (1) The main source of political power (armed forces and police in autocratic regimes); (2) the conditions of the media market (is influenced by the political and economic power) (3&4) the independence of the prosecutorial and judiciary power; (5) the campaign financing laws (when comes from the government the political power is greater, when from private adventures, the economic power is greater); (6) the dominant ideology.
“Towards a Political Theory of the Firm”
A publicly traded firm that is being run inefficiently represents an arbitrage opportunity. Explain the arbitrage opportunity.
A raider can buy the firm, fix the inefficiency, resell the firm or continue to operate it, and make money.
“Towards a Political Theory of the Firm”
Given the legal and social restrictions on explicit bribes in most countries, a company’s ability to obtain what it wants from the political system is highly dependent upon 4 aspects. Name them and briefly explain.
1) Firms ability to make credible long-term promises (for example, future employment opportunities for politicians and regulators), which is highly dependent upon a company’s long-term survival probability;
2) the grip a company has on the market for specific human capital (for example, how many potential employers of nuclear engineers there are);
3) a company’s ability to wrap its self-interest in a bigger, noble, idea (for example, Fannie Mae and the goal that every American should be able to borrow to purchase a house);
4) the control that a company has through its image in society by way of employment, data ownership, media ownership, advertising, research funding, and other methods.
…In economic terms, a firm’s size and the level of concentration within a market affect positively all the crucial factors that determine a firm’s ability to influence the political system.
Deciphering the Liquidity and Credit Crunch 2007–2008
The government of Blatvia has expressed concerns about a too rapid pace of financial innovation in the
country. Your are called in as an international specialist on financial crises. Use Brunnermeier’s article,
Deciphering the Liquidity and Credit Crunch 2007–2008, to identify and briefly explain to the government
(i) the two trends in the banking system before the crisis, and (ii) how each of them affects the stability of
the financial system! (5p)
- Short maturity instrument financing: maturity mismatch between investment projects and financing (funding liquidity risk: unable to roll short-term debt over) e.g. overnight repos
- “Rating at the edge”: banks made sure that tranches were sliced in such a way that they just crossed the dividing line to reach AAA
Deciphering the Liquidity and Credit Crunch 2007-2008
Citigroup’s former chief executive officer has said: „When the music stops, in terms of liquidity, things
will be complicated. But as long as the music is playing, you’ve got to get up and dance.” What does
„dancing” mean in the context of US mortgage market during years 2007-2008? Use the article
Deciphering the Liquidity and Credit Crunch 2007-2008 by Markus Brunnermeier to answer this
question. What did the company in the movie „Margin Call” do when it’s CEO realised that the „music
has stopped”?
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” This game of musical chairs,combined with the vulnerability of banks to dry-ups in funding liquidity, ultimately unfolded into the crisis that began in 2007.
Bitcoin: Economics, Technology, and Governance
What bitcoin does not have?
- Governance structure
- No obligations to verify a user’s identity and country
- No prohibition on sales of particular items
- Payments are irreversible
“Moore’s Law versus Murphy’s Law: Algorithmic Trading and Its Discontents”
What are the benefits of Algorithmic trading?
- Improved efficiency by lowering costs
- Reducing human error
- Increased productivity (can work 24/7)
