Budish, Cramton and Shim on High Frequency Trading

Today I taught a really nice paper to my MBA class, "The High-Frequency Trading Arms Race" by Eric Budish, Peter Cramton and John Shim. I've been fascinated by high frequency trading for a while (Some previous posts in the new "trading" label on the right.)

Eric, Peter and John look at the arbitrage between the Chicago S&P500 e-mini future and the New York S&P500 SPDR.  This is a nice case, because there are no fancy statistical strategies involved: high speed traders simply trade on short-run deviations between these two essentially identical securities. Some cool graphs capture the basic message.

First, we get to look at the quantum-mechanical limits of asset pricing. At a one hour frequency, the two securities are perfectly correlated.

But as we look at finer and finer time intervals, price changes become less and less correlated.  If the ES rises in Chicago, somebody has to send a buy message to New York. We write down Brownian motions for convenience, but when you actually look at very high frequency they break down.

It's not obvious this activity "adds liquidity." If you leave a SPY limit order standing, then the fast traders will pick you off when they see the ES rise before you do. The authors  call this "sniping."

Cost-Benefit Analysis for Financial Regulation

Is cost-benefit analysis a good idea for financial regulation? Ostensibly an essay addressing that question, this piece expanded to a rather critical survey of financial regulation, as I thought about what the costs and benefits of financial regulation are. It's based on a presentation I gave at the Sloan Conference on Benefit-Cost Analysis at the University of Chicago Law School last fall, with many interesting papers, most of them more optimistic.

HTML here, to make it easy to read. Pdf and permanent link here which is where updates and a final (I hope) published version will reside.

Introduction

Regulations should only be enacted if their benefits exceed their costs. Who can object to that?

That’s not the question. The question is whether legal requirements for cost-benefit analysis, a new legal and regulatory process erected around such calculations, a “judicially enforced quantification” (Coates 2014) on top of the current regulatory procedure, would produce better policies. Would laws forcing regulatory agencies to produce cost/benefit analysis, of certain specified types, with specified codified methods, and allowing proponents and opponents of regulation – who often have strong private reasons to favor one outcome or other – to challenge regulations on the basis of cost/benefit analysis – and especially, to challenge the cost-benefit process – overall produce better policy results?

In Box

It is a delight of being an economist how many fascinating papers come through the in box. It is a deep frustration that I don't have the time to read them all.  Here are a few on my in-box today, courtesy of NBER, SSRN, and AEA email lists. Disclaimer: I've only read the abstracts so far. (If you can't get NBER working papers, Google usually finds ungated versions on authors' webpage or ssrn.)

1. The Demise of U.S. Economic Growth: Restatement, Rebuttal, and Reflections by Robert J. Gordon. http://papers.nber.org/papers/W19895

A Brief History of the Efficient Markets Hypothesis

Back in 2008, Gene Fama made a nice video for the American Finance Association on the history of the efficient markets hypothesis. The video is finally out on the new AFA youtube channel here. You may have to drag the cursor back to see the introduction, on which I did a pretty good job if I do say so myself.

Calomiris and Meltzer on Financial Reform

Charles Calomiris and Alan Meltzer have a very nice Op-Ed on financial reform in the Feb 13 Wall Street Journal

At a Senate hearing in January, Elizabeth Warren asked a bipartisan panel of four economists (including Allan Meltzer ) whether the Dodd-Frank Act would end the problem of too-big-to-fail banks. Every one answered no.

See, economists can agree on something!

Mulligan interview

Source: Wall Street Journal

The Saturday Wall Street Journal has a nice interview / overview of Casey Mulligan, including this cool cartoon.

Casey has done pioneering work looking really hard at how the ACA and other social programs work, figuring out exactly what their disincentives are, and calculating how much those disincentives are likely to affect people's decisions to work, go to school, and so forth.

This is hard work. Most of the punditocracy (I'm guilty too) sort of waves our hands at disincentives as a big source of economic malaise. Casey puts together the numbers. It's so much easier to just wave your hands about "demand," invent a multiplier, and conclude all our troubles would be over if the government would only spend so many trillions.  Disagree with him if you like, but only by doing the same thing and coming up with different numbers.

Mooconomics

An Economist article and Alex Tabarrok in a Marginal Revolution blog post weigh in on the future and economic structure of moocs (massively open online classes).

A few thoughts on this question, based on my experience teaching a Coursera mooc last fall. (This was supposed to be a short post, and grew out of control. Oh well.)

Yes, moocs potentially upend the fundamental economic structure of teaching. Teaching had been a high marginal cost business. Moocs are a nearly zero marginal cost business.

But.. For now, Moocs are a quite high fixed-cost business. Putting a class up in a mooc is not quite as much work as writing a textbook, but it's nowhere near as easy as teaching a new class. If you're tempted, beware!  Preparing, taping, editing and uploading a lecture is not the same as walking in, telling a few jokes, and getting through the week. Fixing anything that went wrong or updating is costly too.

Phillips curve, RIP

From February 6 Wall Street Journal. So much macro discussion presumes that inflation is always and everywhere driven by booming economies, it's worth remembering rather striking contrary evidence.

I'm looking for a good graphic, but this last week's failure of emerging market central banks to put a dent in their currencies by raising interest rates is also an important reminder of the limits of monetary policy. As surely Argentina's and Venezuela's troubles are beyond anything a central bank can fix by any finite interest rate.

A mean-variance benchmark

"A mean-variance benchmark for intertemporal portfolio theory." Journal of Finance 69:1-49 (Feburary 2014) DOI: 10.1111/jofi.12099 (ungated version here.)

After all these years, it is still a thrill when an article gets published, and this being a bit of a personal day on the blog (see last post), I can't resist sharing it.

Two stories.

This paper started when John Campbell presented "Who should buy long-term bonds?" (with Luis Viceira, American Economic Review) in the late 1990s at the Booth (then, GSB) finance workshop.  John pointed out that long term bonds are the riskless asset for long-term investors, so we should build portfolio theory around indexed perpetuities, not one-month T bills.

I thought, "that's so obvious!" and, simultaneously, kicking myself, "why didn't I think of that?," a sign of a great paper. (I was also inspired by Jessica Wachter's "Risk Aversion and the Allocation to Long Term Bonds" which came out in the Journal of Economic Theory 2003.)

Favorite Book

My favorite book is back, via the University of Chicago press, in both electronic and print form. A consequence of digital technology, books that once were permanently out of print now can be found again. E-books and short-batch print are great innovations. (Most if it is also on Google Books, a great place to sample.)

I won't pretend objectivity -- or that this has much of anything to do with economics or finance.

What's so great about the book? The writing for one. Sit back and enjoy. Read between the lines too for the breathtaking primary-source scholarship.

This is a book about dead white men and their ideas in an unfashionable time -- the Medici as grand dukes, not the republic and early renaissance. Start right in on p.6-9 with the realities of why the republic did not work, in the circumstance of 16th century Florence. But if you didn't like unfashionable ideas, you wouldn't be here.

It's greatest lesson, to me at least, is empathy. It forces you to work hard to understand how people saw things, and not to fall prey to that common habit of reading our own values and judgments on historical characters. Decisions that make little sense from modern sensibilities become inevitable if you really understand the circumstances, knowledge and mindset of people at the time.

Unemployment

Another nice graph from Torsten Slok at Deutsche Bank