Dynamics of Markets: The New Financial Economics Book

Preface to the second edition xi

1 Econophysics: why and what 1

1.1 Why econophysics? 1

1.2 Invariance principles and laws of nature 4

1.3 Humanly invented law can always be violated 5

1.4 Origins of econophysics 7

1.5 A new direction in econophysics 8

2 Neo-classical economic theory 10

2.1 Why study "optimizing behavior"? 10

2.2 Dissecting neo-classical economic theory (microeconomics) 12

2.3 The myth of equilibrium via perfect information 18

2.4 How many green jackets does a consumer want? 24

2.5 Macroeconomics 25

3 Probability and Stochastic processes 29

3.1 Elementary rules of probability theory 29

3.2 Ensemble averages formed empirically 30

3.3 The characteristic function 32

3.4 Transformations of random variables 33

3.5 Laws of large numbers 34

3.6 Examples of theoretical distributions 38

3.7 Stochastic processes 43

3.8 Stochastic calculus 57

3.9 Ito processes 63

3.10 Martingales and backward-time diffusion 77

4 Introduction to financial economics 80

4.1 What does no-arbitrage mean? 80

4.2 Nonfalsifiable notions of value 82

4.3 The Gambler's Ruin 84

4.4 The Modigliani-Miller argument 85

4.5 Excess demand in uncertain markets 89

4.6 Misidentification of equilibrium in economics and finance 91

4.7 Searching for Adam Smith's Unreliable Hand 93

4.8 Martingale markets (efficient markets) 94

4.9 Stationary markets: value and inefficiency 98

4.10 Black's "equilibrium": dreams of recurrence in the market 101

4.11 Value in real, nonstationary markets 102

4.12 Liquidity, noise traders, crashes, and fat tails 103

4.13 Long-term capital management 105

5 Introduction to portfolio selection theory 107

5.1Introduction 107

5.2 Risk and return 107

5.3 Diversification and correlations 109

5.4 The CAPM portfolio selection strategy 113

5.5 Hedging with options 117

5.6 Stock shares as options on a firm's assets 120

5.7 The Black-Scholes model 122

5.8 The CAPM option pricing strategy 124

5.9 Backward-time diffusion: solving the Black-Scholes pde 127

5.10 Enron 2002 130

6 Scaling, pair correlations, and conditional densities 133

6.1 Hurst exponent scaling 133

6.2 Selfsimilar Ito processes 135

6.3 Long time increment correlations 139

6.4 The minimal description of dynamics 145

6.5 Scaling of correlations and conditional probabilities? 145

7 Statistical ensembles: deducing dynamics from time series 148

7.1 Detrending economic variables 148

7.2 Ensemble averages constructed from time series 149

7.3 Time series analysis 152

7.4 Deducing dynamics from time series 162

7.5 Early evidence for variable diffusion models 167

7.6 Volatility measures 167

7.7 Spurious stylized facts 168

7.8 An sde for increments? 173

7.9 Topological inequivalence of stationary and nonstationary processes 173

8 Martingale option pricing 176

8.1 Introduction 176

8.2 Fair option pricing 178

8.3 Pricing options approximately via the exponential density 182

8.4 Option pricing with fat tails 185

8.5 Portfolio insurance and the 1987 crash 186

8.6 Collateralized mortgage obligations 186

9 FX market globalization: evolution of the Dollar to worldwide reserve currency 188

9.1 Introduction 188

9.2 The money supply and nonconservation of money 189

9.3 The gold standard 190

9.4 How FX market stability worked on the gold standard 190

9.5 FX markets from WWI to WWII 194

9.6 The era of "adjustable pegged" FX rates 196

9.7 Emergence of deregulation 197

9.8 Deficits, the money supply, and inflation 204

9.9 Derivatives and shadow banking 208

9.10 Theory of value under instability 211

9.11 How may regulations change the market? 212

10 Macroeconomics and econometrics: regression models vs empirically based modeling 214

10.1 Introduction 214

10.2 Muth's rational expectations 216

10.3 Rational expectations in stationary markets 219

10.4 Toy models of monetary policy 222

10.5 The monetarist argument against government intervention 224

10.6 Rational expectations in a nonstationary world 225

10.7 Integration I(d) and cointegration 226

10.8 ARCH and GARCH models of volatility 238

11 Complexity 241

11.1 Reductionism and holism 241

11.2 What does "complex" mean? 244

11.3 Replication, mutations, and reliability 253

11.4 Emergence and self-organization 256

References 261

Index 268