Liquidity, Markets, and Pricing: A Contemporary Example
A lot of trading in the Fixed Income (and especially FX) market is done for “liquidity” purposes. There is often an underlying goal involved (e.g., push prices higher with small lots, sell large ones at the elevated prices) and frequently such strategies are discussed as “algorithmic trading.” (Example: the algorithm estimates that you will need to buy 5 $100MM lots of JPY at incrementally higher rates to be able to sell $1B USD at the higher JPY level.)
The liquidity of the “markets” is facilitated by algorithmic trading: the seller for the first five trades in the above example doesn’t care about the purpose of the counterparty’s trade, just that the price bid is agreeable.
Then there are the times when algorithmic pricing goes terribly wrong:
Eisen began to keep track of the prices until he caught on to what was happening: The two sellers of that particular book — bordeebook and profnath — were adjusting their product prices algorithmically based on competitors:
Once a day profnath set their price to be 0.9983 times bordeebook’s price. The prices would remain close for several hours, until bordeebook “noticed” profnath’s change and elevated their price to 1.270589 times profnath’s higher price. The pattern continued perfectly for the next week.
The biologist continued to watch the prices grow higher and higher until they hit a peak price of $23,698,655.93 on April 19. On that day “profnath’s price dropped to $106.23, and bordeebook soon followed suit to the predictable $106.23 * 1.27059 = $134.97.” This means that someone must’ve noticed what was happening and manually adjusted the prices. [italics mine]
As a mathematical exercise, the shift from $106.23 to $23,000,000 and change is clear: one dealer must price their copy higher than the other dealer. (If both do so, you get to the same point or higher even quicker.) Similarly, if both dealers price at a fraction below 1.000 of the other, the price will converge toward $0.00 as the algorithm progresses.
Consider the implication for a potential third seller, though. Depending on when they check, they may believe they have a book that will make them (if and when sold) rich. But the “market” they see is two computers offering against each other—there is no bid-side shown, and pricing “to sell” (say, $850K when both of the others are offered at around $1.7MM) implies that the third potential seller is carrying that asset at an inflated value.
Market transactions do not require two entities to like each other, or even to understand what the other is trying to do. Indeed, if your alogirthm is buying at 85.3 JPY/USD and mine is selling at that level, neither of us necessarily cares why the other is transacting. And the rest of the market sees an actual trade against which they can adjust their pricing.
It’s only when the algorithms are trying to do the same thing that $23MM+ books are offered.
The implication for mark-to-market valuation seems obvious, and is left as an exercise to the reader.
could you explain to the simple minded among us what this has to do with the efficiency of the free market? and investments that create jobs and raise the standard of living?
and why this sort of thing should be subsidized by special low tax rates?
Obvious? Only if by obvious you mean there’s no implication since there’s no actual transaction; no money changes hands.
I am re-reading the quants and the amazon case is an example of what it discusses happend in Aug 2007 when all the stat arb funds had to sell at once. Just like the two sellers got into a price raising game, in that case the sellers kept knocking the price down. Or take the 1888 1 day sale on train fares from Chicago to La when the marketing departments got into a contest and the fare fell to $1 for a morning, before calmer heads intervened. It appeas that in general the market is efficient except when it is not. Efficient market theory does not account for the herd effect when traders make like lemmings and head for the cliff.
A definitely beneficial submit by you my buddy. We have bookmarkedlouis vuitton outletthis web page and can appear again following several blogs.
coberly – See below, but the Glib Answers are Not Much, Very Little, and No Economic Reason.
Sigmund – See Lyle’s comment for the obvious real-life example. Overbuying doesn’t return to Equilibrium–the “intrinsic value” (“support level” during a downturn, if you prefer) isn’t a primary pricing consideration–but rather leads to Overselling as “fair value” investors come into the market.
(As an aside, failure to transact isn’t always useless–one of the Principals of Apollo Management [Leon Black’s PE firm, not the ones who own U of Phx] once claimed to be worth much less than anyone believed because he valued his holdings based on a non-executed [ridiculously lowball] bid from a few months before.)
Private holdings get to play that game more than the public market, yes, but public firms do it with (especially) HTM assets that can be marked either at “market value” (what someone might pay) or “fair value” (what the known/expected flows should be worth). Both are stock, not flow, indicators. This makes for messy accounting, since A = L + E remains an identity.
If you’re working on an Estate Sale that has the third copy of The Life of a Fly, one day it looks as if the heirs won the lottery; the next, they can’t even afford good seats at a Broadway show. (If it’s a divorce, you go from trading the book for the Greenwich estate to maybe being able to get a room for a few hours at the Lincoln Tunnel Motel).
There’s a reason we were all bashing Joe Gagnon’s determinedly positive view of the Maiden Lane assets this morning.
These arguments are weak and unconvincing as applied to mark-to-market accounting. Your sentence about overbuying and overselling is jibberish. The theoretical Estate sale/divorce is a poor example. Back to the drawing board with this one.
I’ve googled “joe gagnon maiden lane”and nothing substantial comes up. I realize you may be referring to this conference you attended re: the Fed, but that is not obvious from your comment. Non sequitors like this one are very common coming from you and are annoying. They also come off as rude and condescending.
A lot of trading in the Fixed Income (and especially FX) market is done for “liquidity” purposes. There is often an underlying goal involved (e.g., push prices higher with small lots, sell large ones at the elevated prices) and frequently such strategies are discussed as “algorithmic trading.” (Example: the algorithm estimates that you will need to buy 5 $100MM lots of JPY at incrementally higher rates to be able to sell $1B USD at the higher JPY level.)
Maybe that was true in the 1920s, but I’ve never seen modern trading strategies that do, or estimate, anything of the sort in typical market conditions.
The one exception is squeezes and the breaking of squeezes, but that is definitely not “a lot of trading” in either FI or FX.
That’s just like real markets today. Investment houses post thousands of orders per minute, not that they intend to trade, but to post bid or ask prices for other investment houses to scan algorithmically as part of their automated price seeking. Needless to say, the more sophisticated traders have spam filters that try to ignore spurious trades, but they cannot always be successful, so a properly managed series of requests can result in a bid or ask advantageous to the spammer. This transaction is where they make their money. All it takes is a slight bit of overshoot now and then to produce a regular profit stream. This kind of false market signalling can be very effective. People used to make good money conducting bear raids using controlled orders placed by ostensibly independent parties to convince people to dump their stock so the raiders can cover their long shot short positions.
The efficiency of the free market has yet to be demonstrated. You can usually make good money by betting that the market is extremely inefficient and dominated by hysteresis and path dependency. Assuming market efficiency is a good way to go broke.
Munster
I don’t know anything about the subject at hand, but I can tell you that your comment fails to offer anything like an argument… comes off as rude and condescending.
Ken’s first comment in his response to mine boils down to “Overbuying leads to overselling”. As written, it’s a non-statement. I called it jibberish. I stand by that. The Estate example doesn’t pass the smell test. No lawyer would claim a piece of property would have that kind of value based on a one-off situation like this, even if it was an actual transaction, (keep in mind the OP was about a non-transaction. Ken’s comment about Apollo Mgmt or whoever has no bearing). The opposing lawyer could argue that the previous sale price was clearly the product of fraud or accident and he would have a good argument. The judge or mediator would have the discretion to come up with a more reasonable figure.
If there’s a reason for the Joe Gagnon comment that Ken caps off the post, I’d like to know what it is. It’s not clear from the context of the post.
Munster
I still don’t know anything about the subject matter, and your comment still doesn’t help me. Try not to think of this as an argument against you, just an observation that you are not making your case.