Financial Trading and Investing

Description

Financial Trading and Investing, Third Edition provides a useful introduction to trading and market microstructure for advanced undergraduate as well as master's students. Without demanding a background in econometrics, the book explores alternative markets and highlights recent regulatory developments, implementations, institutions and debates. The text offers explanations of controversial trading tactics (and blunders) such as high-frequency trading, dark liquidity pools, fat fingers, insider trading and flash orders, emphasizing links between the history of financial regulation and events in financial markets. It includes coverage of valuation and hedging techniques, particularly with respect to fixed income and derivative securities. The text adds a chapter on financial utilities and institutions that provide support services to traders and updates regulatory matters. Combining theory and application, this book provides a practical beginner's introduction to today's investment tools and markets with a special emphasis on trading. Front Matter Financial Trading and Investing Financial Trading and Investing Contents Copyright Dedication Preface Acknowledgments 1 Introduction to Securities Trading and Markets 1.1 Trades, Traders, Securities, and Markets Trading Illustration Securities and Instruments 1.2 Securities Trading Algorithmic Trading: A Brief Introduction 1.3 Bargaining 1.4 Auctions Auction Outcomes Common Value Auctions Google’s Dutch Auction Format 1.5 Introduction to Market Microstructure Market Execution Structures Continuous and Call Markets 1.6 Orders, Liquidity and Depth Liquidity Order Precedence Rules 1.7 Day Trading Online Brokers and Direct Access Trading Trading Platforms Quotations and Price Data Trading Arcades and Prop Shops 1.8 Trading and the Broader Economy The Scale of Financial Markets in the U.S. Economy The Scale of Trading in Financial Sectors Financialization Additional Reading References 1.9 Exercises 2 Securities Markets 2.1 Exchanges and Floor Markets 2.2 The Way It Was National and Regional Exchanges Early Ancestors to Modern Exchanges Traditional New York Stock Exchange Structure Transforming the NYSE Demutualization and Governance Changes Diminished Floor Trading Activity Current New York Stock Exchange Equities Membership Types Option Exchanges 2.3 Over-the-Counter Markets and Alternative Trading Systems Over-the-Counter Markets Alternative Trading Systems 2.4 The Decline of Brick and Mortar Electronic versus Open Outcry 2.5 Crossing Networks and Upstairs Markets Internalization 2.6 Fixed-Income Securities and Money Markets U.S. Treasury Securities and Markets Agency and Government-Sponsored Enterprise Issues Municipal Securities and Markets Money Market Issues of Financial Institutions Corporate Bonds and Markets Credit Ratings and Credit Agencies Eurocurrency Instruments and Markets 2.7 Markets around the World 2.8 Currency Exchange and Markets Exchange Rates Cross Rates Forward Exchange Rates and Contracts Futures Markets Currency Trading Interdealer Brokers and Electronic Broking Futures and Other FX Markets Orders, Quotes, and Spreads 2.9 Cryptocurrency and Bitcoin Trading 2.10 Commodities and Futures Commodities Forward and Futures Contracts Futures Contracts and Business Risk 2.11 Swaps and Swap Execution Facilities Examples of Swap Contract Types Swap Execution Facilities Additional Reading References 2.12 Exercises 3 Financial Market Utilities and Securities Trading Support 3.1 Securities Trading Infrastructure 3.2 Price and Quotation Systems 3.3 Brokerage Operations Securities Investors Insurance Corporation Back Office Operations 3.4 Clearing and Settlement Clearing Firms and Clearinghouses Trade Confirmation and Comparison Netting Custody and Trade Settlement End of Day Settlement Margin, Collateral, and Hypothecation Delivery 3.5 Other Financial Market Utilities and Functions Dividends Transfer Agents Debt Market Utilities 3.6 Systemically Important Financial Market Utilities Additional Reading References 3.7 Exercises 4 Institutional Trading 4.1 Institutions and Market Impact 4.2 Registered Investment Companies Managed Investment Company Types Managed Investment Company Fees and Structures ETFs 4.3 Unregistered Investment Companies Pension Funds Bank Trusts and Private Banking Private Equity Hedge Funds 4.4 Best Execution, Execution Costs, and Price Improvement Spreads Illustration: Slippage and the Perfect Foresight Half Spread 4.5 Algorithmic Trading Algo Strategies Illustration: Slicing the Large Transaction 4.6 Dark Pools 4.7 Stealth and Sunshine Trading 4.8 High-Frequency Trading Latency Arbitrage Other HFT Strategies HFT Impact on Market Quality Reaction to HFT: The IEX 4.9 Flash Trading and Sponsored Access Illustration: A Flash Trade Sponsored Access Additional Reading References 4.10 Exercises 5 Regulation of Trading and Securities Markets 5.1 Regulatory Approaches and the Regulatory Balance Regulatory Powers Regulatory Approaches The Regulatory Balance 5.2 Pre-1930s Securities Regulation: The Background The Blue Sky Laws New York State Regulation and Enforcement Market Abuses: An Introduction 5.3 U.S. Securities Market Legislation: The Foundation The Bedrock: The Securities Act of 1933 and the Securities Exchange Act of 1934 Additional Major Depression-Era Legislation 5.4 Crises and Updating the Regulatory System The 1960s Go-Go Years and Reform Updating Commodities Trading Regulation The National Market System Insider Trading Regulation Supreme Court Interpretations 5.5 Deregulation, Corporate Scandals, and the Financial Crisis of 2008 Deregulation Sarbanes-Oxley Post-SOX The 2008 Financial Crisis 5.6 Dodd–Frank Post Dodd–Frank: The JOBS Act 5.7 Government Oversight of Self-Regulation The Securities and Exchange Commission Enforcement of Securities Regulation The Commodity Futures Trading Commission 5.8 Impact of Regulatory Activity Sarbanes-Oxley Impact Impact of Reg NMS Dodd–Frank and the Volcker Rule: Impact on Trading 5.9 Regulation: The International Arena IOSCO Basel ESMA MiFID Risk Taking, Clawbacks, and Malus Selected Country Regulatory Authorities 5.10 Privatization of Regulation and Exchange Rules NYSE Listing Standards NYSE Circuit Breakers and Trading Halts Additional Reading References 5.11 Exercises 6 Adverse Selection, Trading, and Liquidity 6.1 Market Microstructure, Liquidity, and Spreads Asset Pricing and the Bid-Ask Spread 6.2 Information and Trading Adverse Selection 6.3 Noise Traders 6.4 Adverse Selection in Dealer Markets Kyle: Informed Traders, Market Makers, and Noise Traders The Setting: Kyle’s Adverse Selection Model Informed Trader Demand Market Maker Price-Setting Illustration: Kyle’s Adverse Selection Model Kyle: Empirical Evidence 6.5 Adverse Selection, Dealer Inventories, and the Spread The Demsetz Immediacy Argument Glosten and Milgrom Information Asymmetry Model 6.6 Risk, Risk Aversion, and Dealer Spreads The Stoll Inventory Model The Copeland and Galai Options Model Additional Reading References 6.7 Exercises Appendix 6.A 6.A.1 The Kyle Adverse Selection Model The Informed Trader’s Problem: Profit Maximization Dealer Price Setting Informed Trader Demand and Dealer Price Adjustment 7 Random Walks, Risk, and Arbitrage 7.1 Market Efficiency and Random Walks Random Walks and Martingales Brownian Motion Processes 7.2 Risk Historical Volatility Indicators Extreme Value Estimators Implied Volatilities6 7.3 Arbitrage Pairs Trading and Stat-Arb 7.4 Limits to Arbitrage Additional Reading References 7.5 Exercises Appendix 7.A 7.A.1 Return and Risk Spreadsheet Applications 7.A.2 A Primer on Black-Scholes Option Pricing Calls and Puts The Black-Scholes Model Appendix Exercises Appendix Exercise Solutions 7.A.3 Estimating Implied Black-Scholes Variances Simple Closed-Form Procedures Aggregating Procedures 8 Arbitrage and Hedging With Fixed Income Instruments and Currencies 8.1 Arbitrage With Riskless Bonds 8.2 Fixed Income Hedging Bond Yields and Sources of Risk Fixed Income Portfolio Dedication 8.3 Fixed Income Portfolio Immunization Bond Duration Portfolio Immunization Immunization Illustration Convexity 8.4 Term Structure, Interest Rate Contracts, and Hedging The Term Structure of Interest Rates Term Structure Estimation With Coupon Bonds Bootstrapping the Yield Curve Simultaneous Estimation of Discount Functions The Evolution of Short-Term Rates2 8.5 Arbitrage With Currencies Triangular Arbitrage Purchase Power Parity, Arbitrage, and Hedging in FX Markets Purchase Power Parity in Spot Markets 8.6 Arbitrage and Hedging With Currency Forward Contracts Parity and Arbitrage in FX Markets Purchase Power Parity Example 1: Purchase Power Parity Violation and Arbitrage Interest Rate Parity Example 2: Interest Rate Parity Violation and Arbitrage Exchange Rate Expectations The Fisher Effect The International Fisher Effect 8.7 Hedging Exchange Exposure Illustration: Managing Transactions Exposure Unhedged Alternative Forward Market Hedge Money Market hedge Other Hedging Strategies Additional Reading References 8.8 Exercises 9 Arbitrage and Hedging With Options 9.1 Derivative Securities Markets and Hedging 9.2 Put–Call Parity Illustration: Hedging With a Call, a Put and a Collar 9.3 Options and Hedging in a Binomial Environment Arbitrage in the One-Time Period Case Extending the Binomial Model to Two Periods Illustration: Two-Time-Period Hedges Extending the Binomial Model to n Time Periods Illustration: Three Time Periods Obtaining Multiplicative Upward and Downward Movement Values Binomial Model: An Illustration 9.4 The Greeks and Hedging in a Black-Scholes Environment Black-Scholes Model Sensitivities Illustration: Greeks Calculations for Calls Illustration: Hedging With Delta and Gamma Neutral Portfolios Put Sensitivities 9.5 Exchange Options Illustration: FX Option Valuation 9.6 Hedging Exchange Exposure With Currency Options Additional Reading References 9.7 Exercises Appendix 9.A 9.A.1 The Binomial Model: Additional Considerations A Computationally More Efficient Version of the Binomial Model Obtaining Multiplicative Upward and Downward Movement Values 9.A.2 Deriving the Black-Scholes Model 10 Evaluating Trading Strategies and Performance 10.1 Evaluating Investment Portfolio Performance Computing Net Asset Value and Returns Net Asset Value and Returns Illustration Portfolio Benchmarking Portfolio Performance Benchmarking Illustration 10.2 Market Timing Versus Selection The Quadratic Variable Approach The Dummy Variable Approach 10.3 Trade Evaluation and Volume-Weighted Average Price VWAP VWAP: A Simple Illustration 10.4 Implementation Shortfall Illustration: Implementation Shortfall 10.5 Value at Risk Derivatives Portfolio VaR: Illustration Issues Arising with VaR Applications VaR and SPAN Equity Portfolio VaR: Illustration Additional Reading References 10.6 Exercises 11 The Mind of the Investor 11.1 Rational Investor Paradigms The St. Petersburg Paradox and the Expected Utility Paradigm Von Neuman and Morgenstern: Axioms of Choice 11.2 Prospect Theory Losses and Inconsistency Frames versus Substance Maintaining the Status Quo: Joe and His Opera Tickets Anchoring 11.3 Behavioral Finance The Monty Hall Judgment Error Dumb, Dumber, and Dead Myopia and Overreaction Myopia Hyperbolic Discounting Overreaction Investor Moods, the Weather, and Investment Returns Simplifying the Decision Process Rational Investors and Diversification 11.4 Body and Mind of the Trader Overconfidence Overconfidence and Gender Entertainment and Sensation-Seeking Professional Traders and Hormones 11.5 Neurofinance: Getting Into the Investor’s Head 11.6 The Consensus Opinion: Stupid Investors, Smart Markets? The Football Pool Analyst Estimates Rational Investors and Price Setting Herds and Swarms Additional Reading References 11.7 Exercises 12 Market Efficiency 12.1 Introduction to Market Efficiency 12.2 Weak Form Efficiency and Technical Analysis Technical Analysis: A Brief Introduction Price Sequences, Momentum and Mean Reversion Relative Strength Filter Rules and Market Overreaction Moving Averages The January Effect The January Effect and Tax-Driven Selling The January Effect and Window Dressing The Small Firm and Price/Earnings Effects The Initial Public Offering Anomaly Charting Sports Betting Markets Summary 12.3 Testing Momentum and Mean Reversion Strategies 12.4 Semistrong Form Efficiency Early Tests Stock Splits Corporate Merger Announcements, Annual Reports, and Other Financial Statements Information Contained in Publications and Analyst Reports Analyst Reports and Conflicts of Interest Discounted Cash Flow Analysis and Price Multiples Political Intelligence Units Market Volatility 12.5 The Event Study Methodology Illustration: Event Studies and Takeovers 12.6 Strong Form Efficiency and Insider Trading 12.7 Anomalous Efficiency and Prediction Markets The Challenger Space Shuttle Disaster Prediction Markets 12.8 Epilogue Additional Reading References 12.9 Exercises 13 Trading Gone Awry 13.1 The Dark Side of Finance 13.2 Illegal Insider Trading Notorious Insider Trading Cases William Duer Albert H. Wiggin Dennis Levine, Ivan Boesky, and Michael Milken Martha Stewart Raj Rajaratnam SAC Capital Loeffler, Burr and Chris Collins Monitoring Inside Trading Activity 13.3 Front Running and Late Trading Front Running and Parasitic Trading Market Timing and Late Trading 13.4 Bluffing and Market Manipulation Bluffing Spoofing Illustration: Spoofing Spoofing in the Era of Dodd-Frank The Flash Crash Buy, Lie, and Sell High Banging the Close Corners and Pools Vanderbilt v. Drew Modern Day Corners Wash Sales Fishing The Odd Eighths Scandal LIBOR and Fraudulent Trading Other Quote Abuses 13.5 Payment for Order Flow 13.6 Fat Fingers, Hot Potatoes, and Technical Glitches Technical Glitches Hot Potato Volume A Textbook for $23,698,655.93 (Plus $3.99 Shipping) 13.7 Rogue Trading and Rogue Traders Rogue Traders Grant & Ward Nick Leeson and Barings Bank John Rusnak and AllFirst Orlando Joseph Jett and Kidder Peabody Jérôme Kerviel and Société Générale Potentially Authorized Trading Gone Wild 13.8 Hiding Trading Losses with Ponzi Schemes Carlo Ponzi Other Ponzi Schemes Additional Reading References 13.9 Exercises Mathematics Appendix A.1 A Brief Overview of Elementary Statistics Mean, Variance, and Standard Deviation Co-movement Statistics Hypothesis Testing Hypothesis Testing: Two Populations Introduction to Simple OLS Regression A.2 Essentials of Matrices and Matrix Arithmetic Matrix Arithmetic Multiplication of Matrices Inverting Matrices Solving Systems of Equations A.3 Derivatives of Polynomials A.4 Reference Tables End-of-Chapter Exercise Solutions Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Glossary Index