FINANCIAL TRADING AND INVESTING

Transcription

1 FINANCIAL TRADING AND INVESTING JOHN L. TEALL ELSEVIER AMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORD PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO Academic Press is an imprint of Elsevier

2 Contents Preface xi 1. Introduction to Securities Trading and Markets 1.1 Trades, Traders, Securities, and Markets 1 Trading Illustration 2,. Securities and Instruments Securities Trading 4 Algorithmic Trading: A Brief Introduction Bargaining Auctions 7 Auction Outcomes 9 Common Value Auctions 10 Google's Dutch Auction Format Introduction to Market Microstructure 11 Market Execution Structures Orders, Liquidity, and Depth Day Trading 15 Online Brokers and Direct Access Trading 16 Trading Platforms 17 Quotations and Price Data 18 Trading Arcadei 20 Additional Reading 21 References Exercises Financial Markets, Trading Processes, and Instruments 2.1 Exchanges and Floor Markets 25 NYSE Euronext The Way It Was 27 National and Regional Exchanges 27 Early Ancestors to Modern Exchanges 27 Traditional New York Stock Exchange Structure 29 Transforming the NYSE 30 Demutualization and Governance Changes 31 Diminished Floor Trading Activity 33 Current New York Stock Exchange Equities - - Membership Types 33 Option Exchanges Over-the-Counter Markets and Alternative Trading Systems 35 Over-the-Counter Markets 36 Alternative Trading Systems The Decline of Brick and Mortar 40 Electronic versus Open Outcry Crossing Networks and Upstairs Markets 43 Internalization Quotation, Intermarket, and Clearing Systems 45 Clearing and Settlement Brokerage Operations Fixed-Income Securities and Money Markets 49 U.S. Treasury Securities and Markets 50 Agency Issues 50 Municipal Securities and Markets 52 Financial Institution Instruments 52 Corporate Bonds and Markets 53 Credit Ratings and Credit Agencies 54 Eurocurrency Instruments and Markets Markets Around the World Currency Exchange and Markets 58 Exchange Rates 59 Forward Exchange Rates and Contracts 60 Futures Markets 62 Currency Trading 62 Interdealer Brokers and Electronic Broking 63 Futures and Other FX Markets 63 Orders, Quotes, and Spreads 64 Additional Reading 65

3 VI CONTENTS References Exercises Institutional Trading 3.1 Institutions and Market Impact Registered Investment Companies 68 ;Managed Investment Company Types 68 Managed Investment Company Fees and Structures 69 ETFs Unregistered Investment Companies 71 Pension Funds 72 Bank Trusts and Private Banking 72 Private Equity 73 Hedge Funds '73 Rule 144A Markets Best Execution, Execution Costs, and Price Improvement 74 Spreads 74 Illustration: Slippage and the Perfect Foresight Half Spread Algorithmic Trading 77 Algo Strategies 79 Illustration: Slicing the Large Transaction Dark Pools Stealth And Sunshine Trading High-Frequency Trading 84 Latency Arbitrage 85 HFT Strategies Flash Trading And Sponsored Access 87 Illustration: A Flash Trade 88 Sponsored Access 88 Additional Reading 89 References Exercises Regulation of Trading and Securities Markets 4.1 Background and Early Regulation 93 Regulatory Approaches 94 Pre-1930s Securities Regulation: The Background U.S. Securities Market Legislation: The Foundation 96 The Bedrock: The Securities Act of 1933 and the Securities Exchange Act of Additional Major Depression-Era Legislation Crises and Updating the Regulatory System 99 The 1960s Go-Go Years and Reform 99 Updating Commodities Trading Regulation and the National Market System 100 Insider Trading Regulation Deregulation, Corporate Scandals, and the Financial Crisis of Deregulation 101 Sarbanes-Oxley 102 Post-SOX 103 The 2008 Financial Crisis Dodd-Frank Government Oversight of Self-Regulation: The Securities and Exchange Commission and Commodity Futures Trading Commission 105 The Securities and Exchange Commission 106 The Commodity Futures Trading Commission Impact of Regulatory Activity Regulation: The International Arena 110 Selected Country Regulatory Authorities Privatization of Regulation and Exchange Rules 111 NYSE Rules 112 NYSE Circuit Breakers 113 Additional Reading 113 References Exercises Adverse Selection, Trading, and Spreads 5.1 Information and Trading 117 Adverse Selection Noise Traders Adverse Selection in Dealer Markets 119 Kyle: Informed Traders, Market Makers, and Noise Traders Adverse Selection and the Spread 127 The Demsetz Immediacy Argument 127

4 CONTENTS Vll Glosten and Milgrom Information Asymmetry Model 128 The Stoll Inventory Model 128 The Copeland and Galai Options Model 130 Additional Reading 131 References Exercises Random Walks, Risk, and Arbitrage 6.1 Market Efficiency and Random Walks 135 Random Walks and Submartingales 135 Brownian Motion Processes 137 Weiner Processes 138' 6.2 Risk 138 Historical Volatility Indicators 139 Extreme Value Estimators 141 Implied Volatilities Arbitrage 144 Pairs Trading and Stat-Arb Limits to Arbitrage 146 Additional Reading 149 References Exercises A.I. Return and Risk Spreadsheet Applications A.2. A Primer on Black-Scholes Option Pricing 156 Calls and Puts 156 The Black-Scholes Model 158 Appendix Exercises 159 Appendix Exercise Solutions A.3. Estimating Implied Black-Scholes Variances 160 Simple Closed-Form Procedures 163 Aggregating Procedures (J Arbitrage and Hedging with Fixed Income Instruments and Currencies 7.1 Arbitrage with Riskless Bonds Fixed Income Hedging 167 Bond Yields and Sources of Risk 167 Fixed Income Portfolio Dedication Fixed Income Portfolio Immunization 170 Bond Duration 171 Portfolio Immunization 173 Convexity Term Structure, Interest Rate Contracts, and Hedging 177 The Term Structure of Interest Rates 178 Term Structure Estimation with Coupon Bonds 179 Bootstrapping the Yield Curve 179 Simultaneous Estimation of Discount Functions Arbitrage with Currencies 184 Triangular Arbitrage 184 Purchase Power Parity, Arbitrage, and Hedging in FX Markets Arbitrage and Hedging with Currency Forward Contracts 186 Parity and Arbitrage in FX Markets Hedging Exchange Exposure 190 Additional Reading 192 References Exercises Arbitrage and Hedging with Options 8.1 Derivative Securities Markets and Hedging Put-Call Parity 199 Illustration: Hedging with a Call, a Put, and a Collar Options and Hedging in a Binomial Environment 200 ' Extending the Binomial Model to Two Periods 203 Extending the Binomial Model to n Time Periods 205 Obtaining Multiplicative Upward and Downward Movement Values 206 Binomial Model: An Illustration The Greeks and Hedging in a Black-Scholes Environment 210 Black-Scholes Model Sensitivities 211 Illustration: Greeks Calculations for Calls 213 Illustration: Hedging with Delta and Gamma Neutral Portfolios 214 Put Sensitivities Exchange Options 216 Illustration: FX Option Valuation 217

5 vm 8.6 Hedging Exchange Exposure with Currency Options 219 Additional Reading 220 References Exercises A.I. The Binomial Model: Additional Considerations 224 A Computationally More Efficient Version of the Binomial Model 224 Obtaining Multiplicative Upward and Downward Movement Values A.2. Deriving the Black-Scholes Model * Evaluating Trading Strategies and Performance 9.1 Evaluating Investment Portfolio Performance 231 Computing Net Asset Value and Returns 232 Net Asset Value and Returns Illustration 233 Portfolio Benchmarking 234 Portfolio Performance Benchmarking Illustration Market Timing Versus Selection 237 The Quadratic Variable Approach 237 The Dummy Variable Approach Trade Evaluation and Volume-Weighted Average Price 240 VWAP 241 VWAP: A Simple Illustration Implementation Shortfall 243 Illustration: Implementation Shortfall Value at Risk 244 Equity Portfolio VaR: Illustration 246 Additional Reading 246 References Exercises The Mind of the Investor 10.1 Rational Investor Paradigms 251 The St. Petersburg Paradox and the Expected Utility Paradigm 252 Von Neuman and Morgenstern: Axioms of Choice 253 CONTENTS 10.2 Prospect Theory 255 Losses and Inconsistency Behavioral Finance 258 The Monty Hall Judgment Error 258 Dumb, Dumber, and Dead 260 Myopia and Overreaction 261 Overconfidence, Gender, Entertainment, and Testosterone 268 Investor Moods, the Weather, and Investment Returns 270 Simplifying the Decision Process 271 Rational Investors and Diversification Neurofinance: Getting Into The Investor's Head The Consensus Opinion: Stupid Investors, Smart Markets? 273 The Football Pool 274 Analyst Estimates 275 Rational Investors and Price Setting 275 Herds and Swarms 276 Additional Reading 277 References Exercises Market Efficiency 11.1 Introduction to Market Efficiency Weak Form Efficiency 286 Price Sequences, Momentum and Mean Reversion 286 Relative Strength 288 Filter Rules and Market Overreaction 288 Moving Averages 289 The January Effect 290 The Small Firm and Price/Earnings Effects 292 The Initial Public Offering Anomaly 292 Sports Betting Markets 293 Summary Testing Momentum and Mean Reversion Strategies Semistrong Form Efficiency 296 Early Tests 297 Stock Splits 298 Corporate Merger Announcements, Annual Reports, and Other Financial Statements 299

6 CONTENTS Information Contained in Publications and Analyst Reports 299 Discounted Cash Flow Analysis and Price Multiples 301. Political Intelligence Units 301 Market Volatility The Event Study Methodology 302 Illustration: Event Studies and Takeovers Strong Form Efficiency and Insider Trading Anomalous Efficiency and Prediction Markets 313 The Challenger Space Shuttle Disaster 313 Prediction Markets ' Epilogue 316 Additional Reading 317 References Exercises Trading Gone Awry 12.1 Illegal Insider Trading 325 Notorious Insider Trading Cases 326 Monitoring Insider Trading Activity Front Running and Late Trading 330 Front Running and Parasitic Trading 330 Market Timing and Late Trading Bluffing, Spoofing, and Market Manipulation 332 Bluffing 332 Spoofing 333 Buy, Lie, and Sell High 334 Banging the Close 334 Corners and Pools 335 Wash Sales 337 Fishing 337 Other Quote Abuses Payment for Order Flow Fat Fingers, Hot Potatoes, and Technical Glitches 340 The Flash Crash 340 Hot Potato Volume 341 A Textbook for $23,698, (Plus $3.99 Shipping) Rogue Trading and Rogue Traders 342 Rogue Traders Trading and Ponzi Schemes 346 Carlo Ponzi 347 Other Ponzi Schemes 347 Additional Reading 348 References Exercises 349 Mathematics Appendix 351 Glossary 369 End-of-Chapter Exercise Solutions Index Ancillary materials are located at the book's companion site at companions/