Traders- Risk, Decisions and Management

70+ DVDs FOR SALE & trans degree www. dealers-softwargon. com www. forex-w atomic list 18z. com www. art-softwargon-collelectroconvulsive therapyion. com www. tradestation- vote download-free. com Cont issues email originalfessional mortaltected com email protected ru Skype andreybbrv dealerS This knave intention e truly stretch forth(predicate)y unexp barricadeed white-hot TRADERS essays, Decisions, and Management in pecuniary foodstuffs Mark Fenton-OCreevy Nigel Nicholson Emma Soane Paul Willman 1 chapiter Cl argonn adopt Street, Oxford ox2 6dp Oxford University press appear is a department of the University of Oxford.It furthers the Universitys objective of excellence in research, scholarship, and t distrisolelyivelying by publishing human racewide in Oxford youthful York Auck record Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City capital of Kenya New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan S let onh Korea Poland Portugal capital of Singapore Switzerland Thailand Turkey Ukraine Vietnam Oxford is a registered trade brand of Oxford University Press in the UK and in trusdeucerthy a nonher(prenominal) countries Published in the join States by Oxford University Press Inc. 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British Library Cataloguing in takings Data Data forthcoming Library of Congress Cataloging in Publication Data Data available ISBN 0199269483 3 5 7 9 10 8 6 4 2 print by Newgen Imaging Systems (P) Ltd. , Chennai, India Printed in great Britain on acid-free nurseup by Biddles Ltd. faggots Lynn, Norfolk Ac break it offledgements We grate amply ac companionship the bene concomitantor of the investing fixs which co channelised in this research and provided ? nancial support, and the sparing and Social enquiry Council which provided funding as part of the guess and Human demeanor mastergramme (grant round L211252056). We atomic number 18 oddly grateful to the dealers and falsifyrs who gave us their measure and overlap their seeing. This page intention wholey left b lank Contents contestation of effigys List of Tables viii ix 1INTRODUCTION principals, Markets, and Social Science 1 10 2 THE GROWTH OF m geniustary foodstuff placeS AND THE government agency OF TRADERS 3 ECONOMIC, PSYCHOLOGICAL, AND SOCIAL EXPLANATIONS OF food commercialise BEHAVIOUR 4 TRADERS AND THEIR THEORIES 5 A FRAMEWORK FOR UNDERSTANDING TRADER psychological science 6 RISK TAKERS Pro? ling ko bargainers 28 51 74 wholeness hundred ten 145 178 197 212 221 237 7 8 9 10 BECOMING A TRADER MANAGING TRADERS CONCLUSIONS APPENDIX The Study References Index List of Figures 2. 1 2. 2 2. 3 3. 1 3. 2 4. 1 4. 2 5. 1 5. 2 6. 1 6. 2 6. 3 6. 4Post-war UK equity mercenaryise growth Post-war US equity grocery store growth bena-wide growth in nonprescription(a) several(predicate)ial gears evaluate service scheme Prospect surmise The race surrounded by deport a chance and sound reflection Idealized trader luck pro? les RAT Screenshot Distri exclusivelyion of traders illusion of accommo run across piles A precedent of several(prenominal)(a) venture doings Comparisons of record scores by occupational group happeniness propensity, attempts interpretednow and one season(prenominal) Comparisons of risk propensity scores by occupational group 7. 1 C beer mobility to date 7. 2 Likelihood of a calling change in the close 5 old age 8. Introducing in centimeive and monitoring dumbfound in cin one casertuate to prospect possibility exposition of risk conduct 14 15 16 40 41 55 63 104 106 117 132 136 138 174 175 194 List of Tables 6. 1 venture taking index 6. 2 disposition facetssigni? brush offt engagements amid occupational groups 6. 3 Relationships betwixt RTI and Big five-spot personality f maskors 6. 4 Relationships among RTI and Big Five personality sub measures 6. 5 Regression on total remuneration 8. 1 Controls and incentives associated with b array mental picturesempirical ? ndings 10. A1 Investment evictt sample pr o? le 10.A2 disposition and risk propensity sample pro? le 10. A3 Frequencies of self-ratings of performance 131 133 138 140 143 193 214 215 218 This page intentionally left blank Chapter 1 INTRODUCTION Traders, Markets, and Social Science I grew up in a itty-bitty town in Florida and none of this poppycock rattling exists identical stocks and bewilders and things resembling that. No one I ever k cutting increment up did this sort of thing and to me it all waits like a fantasy friendship base nearly cadences and its genuinely abstract. You know, I apologize to my mother what I do and I tail endt, you smoket put it into words, it just doesnt slang any sense.You hindquarters read overly Portfolio Management QuizzesI am so distant from the daily life of the average person that I think at approximately point this has got to come up to an end. Whether I really believe that or non I dont know save in my head I bouffant-hearted of think this is all fantasy land an d one day Im passing play to vex up and Im going to say I had the near amazing dream, Ive been shits on round place called fence Street, that paid me mint good dealdys of money and I just sat nearly and aimed at computers all day and put these pieces together and everything trifleed out and it was all a mess hall of fun. So in my mind thats kind of what I think.Derivatives Trader, ? rm B We bed in a do chief(prenominal) of a pass away that is do by ? nancial marts and we be all deeply presumeed by their functioning. Our employment prospects, universe our ? nancial aegis, our pensions, the st big businessman of political system of ruless and genius of the participation we live in be all greatly in? uenced by the operation of these food food foodstuffplaces. The intention and importance of inter discipline ?nancial trade places and the traders who lodge them has grown dramatically in the past few decades. The aim of ? nancial ? ows in these gro cery storeplaces coffin nail rise to kinda staggering directs.For example, in the day originally the setting of door exchange rates to the Euro, trades in currencies keying entry the Euro totalled virtually ten times human beings gross domestic product (GDP). At any one time, outstanding derivatives contracts know a total harbor of around cardinal times World GDP. sea captain traders ? gure prominently in media key outs of the workings of ? nancial trade places and the economy. telecasting innovativelys bulletins on the economy or stock food grocery frequently accommodate interviews with senior traders, or footage of a work ? oor. Stories to a greater extent or less rogue traders be sorry refresheds.The decisions of several(prenominal) traders atomic number 18 ofttimes seen as having the potential to spark off markets and affect matter economies. Yet, the portion of the captain trader is principally absent from signifi pharisaismstream ? nancial frugal accounts of markets. Professional traders, we argue, interpret in up a b strayland in markets where many a(prenominal) of the orthodox presumptions of ef? cient, straightaway adjusting legal injurys break-down. They be oft well placed to form market im perfect(a)ions, by virtue of lower dealings costs, rag to privileged cultivation, critical mass, or trademarked knowledge and models.However, at the same time, they work in a fast- mournful embellish of disruption, rumour, unreliable culture, and gropingty. Thus, it is oft dif? cult to part whether an opportunity is real or illusory. This is a book closely captain traders in this noisy borderland what they do, the kind of slew they be, how they perceive the argona they inhabit, how they compel decisions and wad risks. This is similarly a book active how traders argon managed and the institutions they inhabit ? rms, markets, cultures, and theories of how the human race works. Our attack to writi ng this book is explicitly interdisciplinary.We limn on psychology, sociology, and sparingal science in order to illuminate the work of traders and their earth. Our centralize is traders and the ? rms they work in. It is non the purpose of this book to circumstance an extensive critique of the overabundant sagaciousstinting account of ? nancial markets, nor 2 origination is markets our rudimentary focus. We be bear on in the main with clearing the world of the professional trader. However, we do believe our work is germane(predicate) to an understanding of ? nancial markets. First, in order to understand the employment and work of the trader, it is eventful to understand that the classic paradigm of ef? ient markets and keen-sighted scathe breaks down at the margins and that professional traders dickens bene? t from and contri scarcee to this departure from orthodox ? nancial stinting theory. Second, the ef? cient markets paradigm rests on the confidence th at in the absence of uniformly quick of scent investors, in that location is a suf? cient group of rational investors who argon able to drive out plant anomalies finished trade. 1 Professional traders in coronation shores seem life- periling candidates to number this section. Hence, the flummox the stand that we limn on the ways in which traders can deviate signi? antly from rational economic norms of behavior whitethorn be fruitful in helping to rationalize market phenomena. 1. 1 Our Work and How It Informs the account book This book is based on a knowledge of traders in ? nancial factors in four-spot voluminous investment argots operating in the City of capital of the joined Kingdom. Over the course of 1997 and 1998, we carried out interviews with 118 traders and trader managers in four life-size City of London investment imprecates and smooth qualitative and quantitative data on their roles, conduct, performance, and psychological pro? les. We carri ed out critique interviews in 2002. We hold elaborated quotations from the interviews passim the book. Where we enforce these quotes they are presented verbatim. We had third main concerns. First, we came to the study with a solid stake in decisionmaking and risk. While all phone line is come to to any(prenominal) bit with risk, investment banks and ? nancial traders are almost unique in the extent to which their work is founded on the guidance of risk and the extent to which they must drop decisions about risk. Second, in the vast writings on ? nancial markets comparatively little upkeep has been paid to the role of ? ance professionals in these markets and we cherished to redress this. 3 Introduction Third, we observed that the large belles-lettres on markets and the ( close towhat slimmer) belles-lettres on traders are marked by very antithetical approaches and paradigms in common chord branches of the hearty sciences economic science, sociology, and co gnitive and companionable psychology. We treasured to rent together the insights of these variant disciplines. passim the book we draw both on the data we ga thitherd in this study and on the insights of prior research and lit in ? nancial economics, psychology, and the sociology of markets.We turn now to those literatures. 1. 2 Traders in the Social Science books classic fiscal Economics pecuniary economics is a relatively young person discipline. The origins of new font ( neoclassic) ? nancial economics are much located in the early mid-fifties in the work by Markowitz (1952) on portfolio theory. During this spot, ? fairy go badd from a concern with describing the activities of actors in ? nancial markets to the defecateion of parsimonious models of markets founded on assumptions of rational investor behaviour. The central organizing idea of classic ? nancial economics is the ef? ient markets surmisal, which holds that look on changes are essentially a random crack. all(prenominal) new teaching relevant to prices is incorporated into prices instantaneously (Fama, 1970). This central proposition and some(a)(prenominal) of the theory which springs from it is founded on the idea that any summation which is non rationally priced provides opportunities for pro? t, which harbour be instantly taken up and ca social function prices to converge to the rational level (i. e. arbitrage). This assumption is both illustrated and lampooned in the ? sissy joke about both ef? cient market theorists who pass a $50 board lying in the street.They leave it full and congratu after-hours each other on realizing that if it presented an opportunity for pro? t individual else would excite picked it up al warm. Even the strongest proponents of the ef? cient markets hypothesis do non claim that it represents a good description of the behaviour of individuals in markets. Rather it is claimed to be a good enough description, which should be judged on i ts predictions kinda than its assumptions. 4 Introduction Fama (1970), who set out an early comprehensive account of the ef? cient markets paradigm, has to a greater extent than(prenominal) recently suggested that Like all models, market ef? iency (the hypothesis that prices fully re? ect available tuition) is a faulty description of price formation. Following the standard scienti? c rule, however, market ef? ciency can barely be replaced by a soften speci? c model of price formation, itself potentially rejectable by empirical tests. (Fama, 1998 284) The ? cigarette professional is by and large absent from orthodox ? nancial economic accounts of markets. The assumption of ef? cient markets, with no privileged teaching held by any investor, leaves little room for an account of how professional investors cleverness agnise offend than market authorises.However, to a greater extent recently, on that point has been an step forwardnce pursuance in spite of appearance ? n ancial economics in ex on the face of iting empirically observed departures from the predictions of the ef? cient markets hypothesis and rationaleconomic pricing theories. Many of these scratch in the emerging ? eld of behavioral ? nance. What has drop by the waysideed consideration of the role different types of investor might period of form in markets is the growing cognizance that dead ef? cient markets are not an go awaying consequence of the globe of arbitragers an idea that has been captured articu youthfully by lee(prenominal) (2001 284).I submit that moving from the mechanics of arbitrage to the ef? cient markets hypothesis involves an enormous alternate of faith. It is akin to believing that the ocean is ? at, unvarnishedly because we pick up observed the forces of gravity at work on a icing of water. No one questions the effect of gravity, or the fact that water is eternally want its own level. But it is a extend to infer from this observation that ocean s should look like millponds on a still spend night. If oceans were ? at, how do we explain predictable patterns, much(prenominal) as tides and lives? How can we account for the existence of waves, and of surfers?More to the point, if we are in the championship of training surfers, does it touch on sense to eff by assuming that waves, in theory, do not exist? A more(prenominal) than measured, and more descriptive, statement is that the ocean is ever toilsome to become ? at. In reality, market prices are buffeted by a continuous ? ow of culture, or rumours and innuendos disguised as information. Individuals re playing to these signals, or pseudo-signals, cannot fully calibrate the extent to which their own signal is already 5 Introduction re? ected in price. Prices move as they trade on the base of their imperfect informational endowments.Eventually, done trial and error, the assembly process is completed and prices adjust to fully bump the continue of a specific s ignal. But by that time, some new signals vex arrived, ca use new turbulence. As a publication, the ocean is in a constant state of rest slightness. The market is in a continuous state of adjustment. Lee argues that the relationship mingled with inef? cient pricing and arbitragers whitethorn be like predator guttle dynamics. In offset there must be both predator and prey. Similarly, in equilibrium there get out be both arbitragers and arbitrage opportunities in the market place.There is other authorized way in which ? nancial markets are widely accepted as departing from the ef? cient markets paradigm. Investors trade much more often than the theory suggests they should. More recent ? nancial economics accounts often distinguish both types of investors noise traders and smart traders (a recent example is Daniel, Hirshleifer, and Teoh, 2002). ruffle commerce is duty on the footing of information that is either irrelevant to price or has already been discounted by the market. clean traders are those who act rationally, calling tho on the rump of genuinely new and relevant information.This distinction is sometimes taken to map on to the exit amid naive investors and trained professional investors (e. g. Ross, 1999 Shapira and Venezia, 2001). behavioural Finance There has been increasing interest within the ? eld of ? nancial economics in victimisation what is cognise about unrelenting biases in human cognition to explain departures of market behaviour from the predictions of ef? cient markets theory. Collectively known as behavioural ? nance, these models and empirical studies mostly look for to explain market behaviour that deseparate from the predictions of orthodox ? ancial economics by adduce to systematic cognitive bias among investors or historic subgroups of investors. 3 Behavioural ? nance draws to a great extent on work from behavioural decision-making, a branch of psychology touch on with modelling human decision-making p rocesses. While, in the main, this literature does not distinguish between professional traders and other investors, there nonplus been 6 Introduction some attempts to compare the power to biases of ? nance professionals to that of the wider population.For example, Shapira and Venezia (2001) found professional brokers less hypersensitised than in attendent investors to one park bias, the disposition effect (a bias towards marketing stocks more quickly to suck up gains than to realize losings), although they were not immune to the bias. In an experimental study Anderson and Sunder (1995) compared the behaviour of lab markets populated by see good and stock traders with the behaviour of markets populated by MBA student traders. They found the amount of merchandise experience to be an main(prenominal) determining(prenominal) of how well market outcomes approximated (ef? ient market) equilibrium predictions. disciple traders markets exhibited departures from rational price s founded in unwashed cognitive biases tour bias levels in markets with experienced traders were substantially lower. However, as we explore in Chapter 5, our own research offers narrate that professional traders are just as susceptible as other groups to some forms of bias, with grand consequences for their behaviour and performance. Sociology of Markets Sociologists interested in markets take in paid sort of more help to the role of professionals than fill ? ancial economists. Unlike ? nancial economists who take markets to be naturally occurring, sociologists tend to speech pattern the social embeddedness of markets and the ways in which they are sustained as social institutions by dint of active preventive and legislation. angiotensin-converting enzyme important strand of work is concerned with the social networks that operate within markets and in point the ways in which professionals within markets act by means of these social networks and exercise sluttish sa nctions over participants departing from accepted norms of behaviour (e. g.Baker, 1984a Abola? a, 1996). Research by ? nancial economists similarly demonstrates the signi? cant effect the limited structure and organisation of markets4 can select on the ? ow of information, fluidness, and prices (e. g. Amihud, Mendelson, and Lauterback, 1997 Lipson, 2003). Others nurse been concerned with the spirit and consequences of ? nancial economic theory. Traders, from this perspective, do not simply inhabit markets they enact them. That is, the beliefs they hold 7 Introduction about the nature of markets affect those markets in non-trivial ways.MacKenzie (2002), for example, describes how the adoption of the minatoryScholes equivalence for option pricing by traders did not simply modify more effective pricing of options, exclusively helped to express about conditions that better ? tted the assumptions on which it was based. The destruction empirical ? t between the predictions of the equation and options prices was bought about, at least in part, by the use of the equation to identify arbitrage opportunities. The empirical ? t has deteriorated subsequently as beliefs have changed to incorporate, inter alia, changed beliefs about the likelihood of market crashes.We pick up this stalk of the re? exive relationship between beliefs and markets in Chapter 4. 1. 3 Overview of Book Chapters 2 and 3 set the context for our study and geographic expedition of the role of traders. Chapter 2, The emersion of monetary Markets and The employment of Traders, considers the growth of inter issue ? nancial markets in a historic context and outlines the role investment banks and professional traders have come to play. In Chapter 3, Economic, Psychological, and Social Explanations of Market Behaviour, we take a more percentage pointed look at differing economic, psychological, and social explanations of market behaviour.Chapter 4, Traders and Their Theories, considers t he nature of traders knowledge and the interplay between their subscriptions to theories of the way the world works founded in neoclassic ? nancial economics and their more especial(a)ist and idiosyncratic theories of how to work the world. Chapter 5, A Framework for Understanding Trader Psychology, haves by outlining a psychological model of the trader founded in a self principle public figurework. It draws on the qualitative and quantitative evidence that we have about trader decision-making and bias. It challenges the ? ancial economics dichotomy between rational and non-rational and explains the different rationalities that arise as a consequence of internal goal states. We as well present evidence on the vulner exponent of traders to match illusions and the consequences for their performance. 8 Introduction Chapter 6, Risk Takers Pro? ling Traders presents a new model of risk taking that provides how trader behaviour emerges from a web of circumstantial and individual ca uses. The remainder of the chapter explores these individual differences in greater depth, especially how personality reachs different kinds of risk taking and decision-making.The chapter explores what kinds of people traders are, focusing in particular on personality and risk propensity, but in like manner drawing on what we know about their demographics and background. Chapter 7, Becoming a Trader, uses a career transitions framework and a model of social learning to frame trader education and entry into a community of job practice. We examine the ways in which they both learn and construct knowledge about the process of employment. In Chapter 8, Managing Traders, we explore the ways in which traders are monitored and managed within investment banks.We toweringlight the fact that traders are often not managed at all, so much as monitored. Our reason chapter (Chapter 9) draws together the implications of our ? ndings for traders, their concern and regulation, and for furth er research. Notes 1. trade purchasing currencies, securities, or commodities in one market for resale in others in order to pro? t from price differences. The effect of arbitrage is to act as a mechanism to bring about convergence of prices in different locations and markets or between equivalent securities. . A more detailed account of the sample and methods is given in the appendix. 3. We give a more detailed treatment of behavioural ? nance arguments in Chapter 3. 4. Often referred to as the institutional microstructure. 9 Chapter 2 THE GROWTH OF FINANCIAL MARKETS AND THE ROLE OF TRADERS Hardly a day passes without newspapers and tv carrying a story about ? nancial markets and their allude on our lives. Even a fooling perusal of these news stories makes it apparent that the activities of ? ancial institutions and markets have come to play a central role in our economic wel off the beaten track(predicate)e and security whether through and through their direct impact on indi vidual investments and pensions or through their pervasive impact on the level of economic activity within nations and across the globe. The last decade of the 20th coulomb was marked by a serial of inter subject field ? nancial crises. These underlined both the interdependence of national economies and ? nancial markets and the orbiculate scope of those markets. fiscal crises in Latin America, the Asian Tiger economies, and Russia highlighted the swiftness at which capital can ? e produce of Financial Markets countries in which investors have lost con? dence and the impotence of national governments to control such out? ows. The impact around the world of these crises on economies and ? nancial institutions demo the passing interconnected nature of ? nancial markets. In the same period a number of ? nancial institutions suffered very signi? cant ? nancial losings as a consequence of the actions of single traders. One of the best publicized of these was Nick Leesons role in bringing about the fizzle of Barings Brothers, in 1995.The twig of Barings ca utilise Alan Greenspan of the US Federal Reserve to comment that It is plausibly fair to say that the very ef? ciency of spheric ? nancial markets, engendered by the rapid proliferation of ? nancial products, also has the expertness of transmitting mistakes at a far faster pace passim the ? nancial system in ways that were unknown a generation ago . . . Certainly, the recent Barings Brothers emergence shows that large losses can be bring ind quite ef? ciently. Todays engineering changes single individuals to initiate massive proceeding with very rapid execution.Clearly, not single has the productivity of global ? nance increase markedly, but so, obviously, has the mogul to generate losses at a precedently unacceptable rate. Moreover, increasing global ? nancial ef? ciency, by creating the mechanisms for mistakes to funk throughout the global ? nancial system, has patently change magnitude t he potential for general risk. (Greenspan, 1995) While the behaviour of individual traders has at times hard damaged the ? rms they work for, individual ? nancial institutions have also shown the capacity to endanger the stability and operation of ? nancial markets around the world.In 1998, the collapse of gigantic Term Capital Management, a defer fund holding positions in ? nancial derivatives with a notional apprise of $1,250 billion badly endangered the stability of the worlds ? nancial systems. How could a single trader bring down a bank? How could a single hedge fund threaten the stability of the worlds ? nancial systems? The answer lies in the way in which derivatives allow for the multiplication of market risks (and returns). The very throws that make derivatives1 so useful as a tool for managing risk provide for the supposition of massively increasing risks.In this chapter, we argue that the role of ? nancial markets, in both world and national economies, has change magnitude dramatically. 11 gain of Financial Markets The potential, and sometimes actual, impact of individual traders on ? rms, markets, and economies is enormous. In the personifying chapters we show that ? nancial markets are neither as rational nor as natural as ? nancial economists paint them and that we requisite to bring a wider diverge of social science theory to bear on understanding traders, their ? rms, and the markets they operate in.As we show below, the incumbent globalization of ? nancial markets is not new but simply the latest of several passs of multinational ? nancial integrating over two millennia. In particular, the recent growth in foreign ? nancial markets could be seen as a return to levels of supranational ? nancial integration seen at the end of the nineteenth nose candy and interrupted by a period, which included two world wars and the Great Depression. However, the depth and casing of these markets does seem to be different this time and the growing of new forms of ? ancial instruments, derivatives, capable of massively multiplying thinkable risks and returns has led to a qualitative difference in the potential impact of individual actions on institutions, markets, and economies. 2. 1 A apprise History of Financial Markets International ? nancial markets are not a purely con unstable phenomenon. Basic forms of ? nancial exchange can be found throughout recorded archives and worldwide ? nancial systems are known to have existed two millennia ago. Historical evidence suggests that there have been a series of cycles of international ? nancial integration (Lothian, 2002).In the three centuries following the collapse of the Roman Empire, currencies were very un enduring and always debased. However, in the quaternate- vitamin C AD, the Emperor Constantine introduced a stable gold coinage, the bezant (also known as the nomisa or solidus). This became widely used throughout the Mediterranean region. It was produced in B yzantium till the 13th cytosine and kept more or less the same gold heart through till the eleventh century. Until the demonstration of the dinar in the Muslim world in the seventh century, it had no competitors as an international mass intermediate of exchange.While records are patchy, it is open(a) that the existence of a stable medium of international 12 harvest-festival of Financial Markets exchange during the period between the fourth and eleventh centuries allowed quite train ? nancial proceeding to take place (Lopez, 1986 Lothian, 2002). The thirteenth century was another period of growth in international trade, both within atomic number 63 and between Europe and other move of the world. untold of this was organized around stiff international trade fairs (most notably at Champagne and Brie).This period was marked by the growth of an extensive and sophisticated banking system and by the increase of ? nancial instruments such as bills of exchange (which acted joint ly as a credit and foreign exchange relations). It is crystallise from the records of the dominant northern Italian banks of the time that not besides were there quite sophisticated foreign exchange markets, but also that arbitrage was a common activity (Lothian, 2002). During the fourteenth century the importance of these trade fairs and the Italian banks declined. By the ? fteenth century, capital of The Netherlands was the more important centre of ? ancial activity. The one-sixteenth century saw the development, in capital of The Netherlands, of transferrable ? nancial instruments such as discounting commercial paper and, by the seventeenth century, the development of ageless bonds, time to comes contracts, handleing pitiful, and other such ? nancial instruments and techniques that would be easily recognized in modern ? nancial markets (Homer and Sylla, 1996 Lothian, 2002). By the start of the eighteenth century, the capital of The Netherlands permutation, the centre of D utch barter, had become a world market in which a wide range of commodities and securities were traded.During this period, London took on increasing importance as a centre for international ? nancial trade. With the grantment of the brim of England and the London argumentation deepen and the intervention of the Napoleonic wars, London came to eclipse Amsterdam as a ? nancial centre by the start of the nineteenth century. The nineteenth century saw a marked elaboration of international trade and further development of ? nancial markets. The growth of the US economy covey much of this intricacy. The New York Stock Exchange was open in 1817 and by the end of 1886 it hit its ? st day on which more than a million portions were traded. By the late 1920s New York had overtaken London as a world ? nancial centre. However, the early twentieth century, a period that included two world wars and the Great Depression, saw the collapse of international 13 emergence of Financial Markets trade and the rise of national regulation and controls on international ? ows of capital, which effectively unwound the integration of international ? nancial markets. Rajan and Zingales (2003) show that on a range of indicators of ? nancial development including stock market capitalization as a similitude of GDP, world ? ancial markets did not regain their pre-war (1913) levels until the late 1980s. The southward half of the twentieth century once again saw a very substantial increase in international ? nancial integration. As we have seen, there is historical evidence that the current period of globalization of ? nancial markets is not a new phenomenon. Rather there have been cycles of high international integration of markets interspersed with periods of low integration throughout the last two millennia. However, it is also clear that with each new cycle the nature and depth of those markets has been changing. Changes in the sophistry of ? ancial instruments and technologies, and changes in communications and information technologies have all been important factors in? uencing the scale and interlinkingity of ? nancial markets. The period since the 1970s has seen a very substantial increase in the size of ? nancial markets. Figure 2. 12 shows the increase in categoryly 2500 Value of yearbook swage (? billion) 2000 30 1500 25 20 grounds 15 10 5 0 1965 0 1970 1975 1980 1985 course of instruction 1990 1995 2000 40 Number of bargains (million) 35 Value account trades 500 Fig. 2. 1 Post-war UK equity market growthUK equity turnover 19652002 blood line London Stock Exchange. 4 Growth of Financial Markets Value of annual turnover ($ billion) 12000 coulomb00 8000 6000 4000 2000 0 1967 Value inform trades 600 500 400 300 200 100 0 2002 Number of bargains (million) 1972 1977 1982 1987 Year 1992 1997 Fig. 2. 2 Post-war US equity market growthNew York Stock Exchange equity turnover 19672002 tooth root New York Stock Exchange. value of shares traded on th e London Stock Exchange between 1965 and 2002. Figure 2. 2 shows the change in annual number of shares traded on the New York Stock Exchange between 1960 and 2002 and the annual value of shares traded from 1985.Both markets show exponential growth over the period, but the real story over the last decade is the growth in derivatives merchandise. By 2002, outstanding over-the-counter derivatives3 ( over-the-counter(a)) contracts had a notional value of $128 trillion, around four times greater than total world GDP. Figure 2. 3 shows the growth in number of active contracts between 1992 and 2002. more of the recent concern about systemic risks in markets has centred on the role of derivatives. All ? nancial investments carry risk. However, there is a difference of degree with derivative avocation.They involve contracts which are contingent upon(p) on the price of central assets and because of the way in which trades are regulated, derivatives4 enable investors to speculate on th e price of an asset while only depositing a menial proportion of the underlying asset price (margin requirements) (Zhang, 1995). In other words, the ? nancial risk borne in an options trade may be many times the money actually deposited to make the trade. Financial ? rms which do not have sophisticated control mechanisms to manage their characterisation to derivatives risk may 15 Growth of Financial Markets 000 Gross market value ($ billion) Gross market value 6000 5000 4000 3000 2000 1000 0 92 93 94 95 96 97 98 99 00 01 19 19 19 19 19 19 19 19 20 20 20 02 160 000 Notional amounts 120 000 100 000 80 000 60 000 40 000 20 000 0 Notional amounts ($ billion) 140 000 Fig. 2. 3 Global growth in OTC derivativesglobal value of outstanding contracts Source 20002, banking concern for International Settlements 19949, Swaps Monitor publications Inc. unknowingly ? nd themselves exposed to potential losses greater than the total ? rm assets. Such risks can emerge very rapidly in the course of employment and require psychodepth psychology of the whole ? ms current portfolio of trading assets in real time to identify potential overexposure to market risk. Of course, the leverage effect of derivatives does not only affect market risk but also ampli? es risk in the other categories. For example, since derivatives typically have greater volatility than the underlying asset, even a short period in which a ? rm is unable(p) to trade (say due to computer wearure) could event in signi? cant risk exposure. The complexity of some derivatives may mean that managers are ill-equipped to understand the trades dealers are engaging in, increasing behavioural risk (Chorafas, 1995 16).In evidence given to the US House of Representatives, George Soros, a exceedingly successful ? nancial speculator, said of derivative instruments There are many of them, and some of them are so esoteric, that the risks involved may not be properly understand by even the most sophisticated of investo rs. nearly of these instruments appear to be 16 Growth of Financial Markets speci? cally designed to enable institutional investors to take gambles which they would otherwise not be permitted to take. For example, some bond cash have invested in synthetic bond issues that carry a 10 or 20-fold multiple of the risk within de? ed limits. And some other instruments offer majestic returns because they carry the seeds of a total traverse out. (Soros, 1995 312) 2. 2 The Role of Investment Banks in Financial Markets To understand the role of modern investment banks it is essential to understand how world ? nancial markets have come to be dominate by an American model of ? nance. Much as Byzantium, Lombardy, Amsterdam, and London have been the dominant centres of ? nancial innovation and power in previous eras, US ? nancial markets and institutions are today.The central feature of the US model that emerged in the post-war years was the decline of relationship banking and the increasing commoditization of ? nancial products and services. The grow of this system lie in the accidental consequences of anti-trust and banking legislation passed in the fall in States during the 1930s. The segregation of commercial and investment banking in the United States laid the foundation for the development of a strong investmentbanking sector. The fragmentation of the banking industry, imposed by legislation, created conditions in which ? ancial effects were more readily managed through markets than within large banks. The excretory product of ? xed commissions for broking ? nancial instruments in 1975 provided a further curl for competition. More and more, ? rms sampleing to raise ? nance looked to impersonal markets sort of than relationships with banking institutions. Progressively more transparent and liquid markets in both corporate debt and equity and the corresponding increased competition in these markets served as a signi? cant stimulus to ? nancial innovation.A s these markets developed it became apparent to market participants and to the government that effective market operation could only be retained through active intervention and regulation. A series of waves of external and self-regulation, often in response to market crises, led to the development of regulations and supervisory arrangements designed to contain insider purpose of markets and ensure free 17 Growth of Financial Markets ? ow of information. On the demand side, the expansion of institutional investment (insurance, pensions, and mutual funds) ruttish and was stimulated by the growth of these ? ancial markets. The dilatory growth of ? nancial markets and institutions in other parts of the world meant that, as other countries began to follow the United States in opening up competition, US ? nancial institutions were well placed to play a major role. In the wake of the major changes in market regulation in 1986, the long-established London merchant banks were sweep away by the US-based investment banks and non-US owned European investment banks have increasingly adopted US approaches. The principal hawkish reinforcement of American ? rms lay in their expertise in managing risk (Steinherr, 2000 49).Investment banks manage risk in four main ways they douse risk for clients, they act as intermediaries for the diversi? cation of risk, they advise on the management of risk and they engage in patented tradingtaking risk on their own account in the interest of returns (Casserley, 1991). Absorbing Risk Investment banks absorb risk for clients in a number of different ways. For example, when they act on behalf of a client they absorb credit risk (the risk the client get out slight on payment for the traffic and they are unable to unwind the transaction at a favourable price).They underwrite issues of securities (e. g. commercial paper5 to cover shortterm ? nancing needs), guaranteeing to barter for from the client at a ? xed price should the secu rity fail to give its expected price in the open market. They also play an important risk engrossment role in trading markets. In some of these the bank will act as a market-maker,6 providing liquidity in a particular ? nancial instrument. The bank ? xes prices at which it will buy or stag a ? nancial instrument and stands ready to buy or sell at those prices even if there is no party to pass the transaction on to immediately.In return for the spread between these prices the bank absorbs the risk of the market moving against them. Risk Intermediation In other cases the bank will act as an go-between for the diversi? cation of clients risk. This may be by acting as an intermediary in trading 18 Growth of Financial Markets markets or by move together complex OTC deals that rely on aggregating (or disaggregating) ? nancial instruments provided by third parties. The banks bene? t from this intermediation work in two principal ways. First, they forethought commission and second, th ey have access via their guests to information about order ? ws in the markets in which they operate. Such ? ow information provides opportunities to cause temporary market imperfections and pro? t through trading on their own account. Risk Advice The risk advice role overlays risk absorption and risk intermediation. For example, the bank may play an important advisory role relate to underwriting activities or in putting together a complex OTC deal. The role of the bank in providing risk advice to clients rests not just on technical skills and experience in managing risk, but also in a (sometimes) greater overview of the markets in which they operate.An important issue here is the stress between the banks desire to make pro? ts on its own account and to earn a return through providing effective advice and services to customers. This tension is re? ected to some extent in tensions which emerge in most banks between trading and sales desks. As we will see later in the book, banks vary in the priority they give to serving customer needs versus adjudicateing opportunities for returns through trading on their own account. 7 proprietorship Trading In providing services to customers, investment banks ca-ca up information on order ? ws, they develop expertise in valuing particular securities or in economic fundamental principle in particular sectors or countries, they build proprietorship models of price behaviour and they build up data on historic behaviour of prices and relationships between them. This can place them in a better position to judge risks and returns than other market participants and opens up the possibility of earning good returns on their own account. This activity typically takes two forms short-term (often intra-day) trades designed to exploit knowledge of temporary price ? ctuations linked to ? ows of orders in the market and longerterm trades, often based on arbitrage (exploiting pricing inconsistencies between different securities, ma rkets, or time periods). 19 Growth of Financial Markets 2. 3 The Role compete by Traders The work of traders can be divided into three broad categories trading on behalf of customers, market-making, and proprietary trading. 8 Traders acting on behalf of customers take the least risk on behalf of the bank, while proprietary trading potentially involves the greatest risk.However, in practice, the three spheres of activity often overlap. For example, a trading desk acting on behalf of clients may also have authority to take intra-day positions to bene? t from short-term price movements in the markets they operate in. Alternatively, in some circumstances, while not strictly acting as a market-maker, they may stand ready to create liquidity for important clients by get or exchange to those clients when they cannot ? nd a counterparty for their trades. As one senior trader told us We are paid to be on the wrong side of the market for our customers.If we have an institution that pays us xxx million dollars a year in commissions, we will, on occasion at their request, be a buyer for them when there are only marketers on the market or be a seller for them when there are only buyers. When theyre in a more normal market environment where there is plenty of liquidity and good two-way ? ow, they dont necessarily need our capital. In fact they prefer not to use our capital because all that does then is create another buyer or another seller in the market with them.But when the market is heavily tilted in one education than the other, even the markets selling off, there are much more sellers than buyers or a very strong market where there are much more buyers than sellers. Thats when they need us to step in and serve as that intermediary to facilitate the execution of their order. 9 Alternatively, a trading desk operating as a market-maker may combine this with some proprietary trading. One trader draw the activity of his desk We have a P&L pro? t and loss, budget of about $20m a year through plain vanilla market making with customers.However, we make about half the money in proprietary trading using the ? ow and information from customersputting it on our book sort of of putting it back into the market. For the ? rst half of this year we were number one for turnover in our niche with between 10% and 15% of the market. The 20 Growth of Financial Markets more that number increases, the better information we would have for proprietary trading, but we would probably start losing money from the market making function because prices would have to be so keen, so there is a balance.Equally, traders mostly meshed in proprietary trading will seek opportunities to generate customer channel I do proprietary military control and Im supposed to be doing proprietary but I porthole with the ? ow desk so I would be looking at customer line of work trying to generate customer business. My slant is proprietary but Im always trying to emphasise customer bus iness using my positions. 2. 4 How do Traders take Pro? ts? If, in ef? cient markets, price changes are essentially a random walk and all new information relevant to prices is incorporated into prices instantaneously (Fama, 1970), then how do traders make money? The ? st answer is that they jerk commission for their intermediation and advisory role. By aggregating customer orders they can reduce transaction costs. However, as we will explore in Chapter 3, in practice, markets are not all ef? cient and information asymmetries exist. Traders essentially earn economic rents10 by exploiting information wagess. These may come from a number of sources, including information on asset ? ows within markets (e. g. from having a large customer base) privileged information on the economic basis for an asset price proprietary databases allowing more accurate count of probabilities (e. . historical asset volatility for pricing options) models of the relationship between prices and economic f undamentals models for extracting the information inherent in historical price changes of an asset and other link up assets and effective understanding of the sentiment and in all likelihood behaviour of other market actors. All of these information emoluments are potentially short-lived. The very act of trading may reveal information to other parties. Others may imitate models. Others may access the same sources of information.New information may wipe out the utility of earlier information. At the same time markets are in practice very noisy. That is to say, there is a lot of trading going on that is not based on information 21 Growth of Financial Markets genuinely relevant to the underlying value of an asset. Black (1986) tell in his presidential address to the American Finance Association that Traders can neer be sure that they are trading on information rather than noise. What if the information they have is already re? ected in prices? Trading on that kind of information will be just like trading on noise.Traders can only earn above market returns, on average, over time, if they are genuinely trading on new and relevant information. However, on any individual trade it will be dif? cult to tell whether a positive outcome is the result of trading on information or of essentially unpredictable market movements (as a result of noise trading in the market, changes in sentiment, or new unexpected events). Similarly, for any individual trade it is dif? cult to determine whether a negative outcome is the result of trading on noise rather than information or the result of unforeseeable market movements.So it will often be the case that trading outcomes are not contingent on the traders strategy or information. Further, it will often be dif? cult to determine once an outcome is achieved whether the outcome was indeed contingent on a traders information and skill. While trading is a skilful activity, many trading outcomes are not contingent on skill. At the s ame time traders are highly motivated to establish causal relationships between information they hold and prices, since a signi? cant source of rent for any trader is the capacity to establish contingent relationships beforehand others observe them.This problem of determining the colligate between behaviour and outcome for traders is one we will return to repeatedly in the book. While the detail of different trading strategies is not our principal focus, we describe some common trading approaches to set the stage for our later discussions. In order for traders to achieve better than average market returns, it is not suf? cient that markets are imperfect it is also necessary they have some competitive advantage relative to others who seek to exploit those imperfections. inwardly this fast-moving and uncertain world, traders adopt a mix of strategies to exploit the information and expertise to which they have access. These can be divided into four main categories insider strategies , technical strategies, fundamental strategies, and ? ow strategies. 22 Growth of Financial Markets Insider Strategies Insider strategies involve achieving advantage by exploiting privileged access to information (Casserley, 1991). Of course, some such strategies are illegal. It is, for example, illegal to exploit privileged access to advanced knowledge of company earnings news or potential takeovers.However, most of these strategies are concerned with utterly legitimate attempts to build an information advantage over rivals. The extent to which it is attainable to achieve such information advantages varies signi? cantly from market to market. For example, in relatively undeveloped markets such as the emerging markets there may be frequent and persistent information asymmetries. In these circumstances, traders who are able to establish good personal networks may build an advantage, which enables them to anticipate price movements. However, in mainstream equities markets, the move and ef? iency of information dissemination may make such advantages dif? cult to achieve. Insider strategies can improve a traders ability to anticipate market movements. However, as we state earlier, it is often dif? cult or undoable for a trader to determine whether they have a genuine information advantage or whether their information is simply noise, already discounted by the market. Technical Strategies If markets are perfectly ef? cient, then historic prices contain no information that can be used to infer future price movements. However, many traders claim to do just that.They seek to exploit market imperfections through the analysis of past price information. One form of technical trade concerns using patterns in price data to identify likely turning points in price skids (charting). Traders seek to identify trends early, buy into those trends and exit before the trend breaks. Many traders consider these patterns and trends in market prices to be set by underlying inve stor sentiment. While there is some evidence that supports the existence of exploitable patterns in market prices (e. g. Kwon and Kish, 2002), many ? ancial economists are questioning of their existence. Fama (1970) brush off technical analysis as a futile undertaking on the grounds that historical prices have no predictive validity. However, more recent arguments against technical 23 Growth of Financial Markets trading strategies take a weaker position that while there is some predictability in market movements, exploiting these does not, on average, make returns in dissipation of transaction costs (e. g. Allen and Karjalainen, 1999). A second important technical strategy requires the analysis of historical price relationships between different ? ancial instruments. Traders crease markets looking for discrepancies in pricing relative to these relationships on the assumption that they will move back to the historical pattern. Often the gains on technical trades will be little and over short time periods, frankincense these trades often depend on an ability to identify opportunities rapidly and frequently. This allows the trader to make large numbers of such trades each making a small pro? t. To bene? t from such trading strategies requires the ability to trade at low transaction costs, frequently, with considerable IT support.Many traders use technical strategies to tag on other approaches. For example, a trader having established a trade on the basis of customer ? ow information may use technical information on trend behaviour to determine the precise point at which to take pro? ts or cut losses. Others, while fundamentally sceptical about strategies relying on historical trend data, win prices will be driven to some extent by investors using such models. For example, one trader told us A lot of traders are chartists and a lot of people here dont like you looking at charts, they dont believe in them.However, I look at a chart if I am putting on a larg e position, or looking for something to trade because if there are people out there who use charts as a model to trade, this will affect how things trade in the markets whether I believe in it or not. extreme Strategies Technical strategies are purely concerned with anticipating trends and pay no attention to the underlying economic basis for evaluation of the security being traded. By contrast, fundamental strategies are concerned with the fundamental relationship between economic value of the underlying asset and market price.Traders following these strategies essentially seek to use expertise and information in the accurate valuation of securities, on the assumption that market values will 24 Growth of Financial Markets converge to suppositious values. To the extent that traders can establish an advantage in valuation of securities, they may be able to earn pro? ts from identifying securities that are undervalued or overvalued by the market. One highly successful trader told us I tend to take positions that depend a lot on central bank decisions e. g. nterest rates, so depend on macro economic position of the country, the judgement about how the Bank of England is going to behave and how the market is going to proceed. I try to put myself in Eddie Georges11 feet and try to understand. We have been mental synthesis a model of Bank of England reactions to economic events. I have lunches with people who specify our interest rates and try to understand how they think . . . It all comes down to focus and completely immersing myself in an area. However, as with insider strategies it can be genuinely dif? cult for a trader to understand whether they have a genuine advantage in valuation.Further, as we will see in Chapter 3, trading on valuation advantage depends on the market converging to a value in a time scale over which you can ? nance a trade. Flow Strategies This strategy predicts prices as a function of demand and supply for securities in the market. Pa rticularly for securities in which there is not much liquidity,12 large trades can stimulate prices signi? cantly. Where a bank has a large customer base in a particular niche, this can give them access to valuable market information, in particular, information on trading ? ows.These kinds of advantage are more readily achieved in OTC markets, which lack the transparency of trades organized through exchanges. However, in any given market niche, there will be a very limited number of ? rms that can capture suf? cient order ? ow information to give them a genuine advantage. Feldman and Stephenson (1988) studied the use of ? ow information in the US treasury bonds market. They suggest that through the use of idle information trading with customers, a ? rm with a 34 per cent share in trading may have a good sense of what is going on in 30 per cent or more of the market.However, they also show that medium sized players in these markets are often unable to exploit their customer relati onships effectively. They argue that large players systematically 25 Growth of Financial Markets shut medium sized players out of information networks while providing good market information to littler players who they mostly relate to as customers rather than competitors. As we have seen, ? nancial markets have a long history and have been through multiple cycles of global ? nancial integration over the last two millennia, but their development into domains of such immense complexity and global in? ence has occurred only within the last 50 years. The volume of trading and of traders has no historical precedent, nor has the complexity and variety of the instruments traded. Within this context, the activities of traders within investment banks are important not just to their customers, but also at the level of national and international economies. Naturally, these phenomena have attracted the attention of academics and commentators, from a variety of disciplines, who have, as we shal l show in the next chapter, different and sometimes competing explanations of what in? uences and explains behaviour within global ? ancial markets. Notes 1. Derivatives are ? nancial products, which depend on or derive from other assets. 2. Values in all ? gures are nominal (non-in? ation-adjusted). 3. OTC derivatives are not traded in an exchange but are contracted directly between the two contracting parties. 4. Exchange requirements generally only require traders selling options to deposit a proportion of the potential claim. Further, speculation using derivatives is often highly leveraged (funded through borrowed funds). 5. Market traded short-term corporate debt. 6. Market-makers stand ready to buy or sell an asset or class of assets.Typically a market-maker quotes a buy (bid) and sell (offer) price to a client before the client declares whether they like to buy or sell. The spread between bid and offer both provides a return and some protection against market movements in th e time taken for the marketmaker to adapt their holdings after a trade. 7. There are also important differences between the United States and the United Kingdom in how this tension is regulated. UK banks face fewer constraints on the relationship between customer business and proprietary trading. 26 Growth of Financial Markets 8. The types of ? ancial instruments dealt in by traders cut across these categories. Some traders specialize by a particular type of instrument (e. g. equities or bonds in a particular sector), others deal in a range of instruments related to a particular geographical region or sector. 9. See also Abola? a (1996) for a description of such market stabilize behaviour by market-makers. 10. Returns in excess of the market risk premium. 11. Eddie George was Governor of the Bank of England at the time of interview. 12. Liquidity the availableness of parties willing to buy or sell a security at any given time. 27 Chapter 3ECONOMIC, PSYCHOLOGICAL, AND SOCIAL EXPLAN ATIONS OF MARKET BEHAVIOUR For at least xl years psychologists have amassed evidence that economic man is very unlike a real man and that reasonfor now, de? ned by the principles that underlie expected utility theory, Bayesian learning and rational expectationsis not an enough basis for a descriptive theory of decision making. De Bondt, 1998 I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that ? nancial markets tend towards equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which ? ancial markets Market Behaviour cannot perchance discount the future correctly because they do not merely discount the future they help to shape it. Soros, 1995 111 If we are to understand traders, we have to ? rst understand the markets they inhabit. Neoclassical economics has been extraordinarily successful in explaining most market behaviour in the aggregate. However, it has two principal weakne sses for our purposes. The ? rst concerns what it does not address and the second concerns some important failures at the margins. Neoclassical ? nancial economics treats markets as a given, or naturally arising.Investor preferences and risk appetites are do by as external to the model but predictably ordered and distributed. Markets are modelled as adjusting instantaneously with little attention to the detail of how such adjustments come about. While neoclassical ? nancial economic models effectively explain a great deal of market behaviour, there are some important failures at the margins. There is a wide range of anomalies which are dif? cult to explain within this paradigm. If markets instantaneously adjust and are perfectly ef? cient, then the only role for professional traders is as intermediaries who cannot earn above market returns, but ssentially earn commission as intermediaries. There is nothing to be pull in by arbitrage activities or speculation. Indeed, it is not eve n clear within neoclassical accounts of markets that there is a role for intermediation. However, if we assume markets to be only nearly perfect and sticky, the traders role as someone with privileged expertise, inexplicit knowledge, and access to private information (within limits) makes more sense. Here, traders are the oil in the market machine they are on