Futures Manipulation with “Cash Settlement”

This paper investigates the susceptibility of futures markets to price manipulation in a two-period model with asymmetric information and “cash settlement” futures contracts. Without “physical delivery,” strategies based on “corners” or “squeezes” are infeasible. However, uninformed investors still earn positive expected profits by establishing a futures position and then trading in the spot market to manipulate the spot price used to compute the cash settlement at delivery. We also show that as the number of manipulators grows, profits from manipulation fall to zero. However, even in the limit, manipulation still has a nontrivial impact on market liquidity. More broadly, we interpret manipulation as a form of endogenous “noise trading” which can arise in multiperiod security markets.     

Arbitraging Arbitrageurs

This paper develops a theory of strategic trading in markets with large arbitrageurs. If arbitrageurs are not well capitalized, capital constraints make their trades predictable. Other market participants can exploit this by trading against them. Competitors may find it optimal to lend to arbitrageurs that are financially fragile; additional capital makes the arbitrageurs more viable, and lenders can reap profits from trading against them for a longer time. The strategic behavior of these market participants has implications for the functioning of financial markets. Strategic trading may produce significant price distortions, increase price manipulation, and trigger forced liquidations of large traders.     

The influence of cultural factors on price clustering: Evidence from Asia–Pacific stock markets

Price clustering is the tendency of prices to be observed more frequently at some numbers than others. It increases with haziness, or imprecision, about underlying value. Most research on price clustering has been conducted in Western financial markets, where there is manifest preference for trading at round numbers.We focus on number preferences under Chinese culture. Many Chinese believe some numbers are “unlucky” and to be avoided. For instance, the number 4 is inauspicious because the Cantonese pronunciation of 4 is similar to the phrase “to die”. We first document clustering of daily closing prices on six Asia–Pacific stock markets, three with predominantly Chinese populations. Next, we fit binomial logit models within these markets to estimate the association between structural and economic factors, and culture, on price clustering. We find some support for the influence of Chinese culture and superstition on year-round number preferences of traders, but it is located solely in the Hong Kong market. Furthermore, in the Hong Kong market Chinese culture and superstition help explain the increased avoidance of the number 4 during the auspicious Chinese New Year, Dragon Boat and Mid-Autumn festivals.     

Convex duality in optimal investment and contingent claim valuation in illiquid markets

This paper develops duality theory for optimal investment and contingent claim valuation in markets where traded assets may be subject to nonlinear trading costs and portfolio constraints. Under fairly general conditions, the dual expressions decompose into three terms, corresponding to the agent’s risk preferences, trading costs and portfolio constraints, respectively. The dual representations are shown to be valid when the market model satisfies an appropriate generalization of the no-arbitrage condition and the agent’s utility function satisfies an appropriate generalization of asymptotic elasticity conditions. When applied to classical liquid market models or models with bid–ask spreads, we recover well-known pricing formulas in terms of martingale measures and consistent price systems. Building on the general theory of convex stochastic optimization, we also obtain optimality conditions in terms of an extended notion of a “shadow price”. The results are illustrated by establishing the existence of solutions and optimality conditions for the nonlinear market models recently proposed in the literature. Our results allow significant extensions including nondifferentiable trading costs which arise, e.g., in modern limit order markets where the marginal price curve is necessarily discontinuous.     

GAMBLING, SPECULATION, AND INSURANCE: WHY THEY CONTINUE TO BE CONFUSED AND CONDEMNED

Governments and the media have often attacked financiers for “speculating” in their countries' currencies, thereby forcing them to make drastic and sometimes painful changes in monetary and fiscal policies. This article argues that such accusations have no basis in economic theory, and that “such rhetoric should be seen for what it is: an attempt by politicians and policy-makers to divert attention and blame from their own mismanagement.” More generally, the author argues that the failure of the general public to understand the social benefits of financial activies such as trading in government bonds, commodity futures, and, more recently, financial derivatives has led throughout history to “prejudice, bad laws, and bad regulations.” Much as the charging of interest and certain forms of insurance were proscribed by the medieval Church, agricultural commodity futures were attacked in the 19th century (and in much of the 20th as well) in the U.S. and elsewhere as thinly disguised forms of gambling. Moreover, the same restrictions that were imposed on gambling and futures markets during the 19th and early 20th centuries are now imposed in many Third-World countries. Instead of encouraging the use of forward markets by small producers and traders, and promoting the development of organized commodity markets and banks in local centers, most less-developed countries today support national and international “stabilization” measures such as buffer stocks and regulations like price floors, price ceilings, and crop quotas. Meanwhile, in Western nations, governments continue to accuse financial markets of “destabilizing speculation” and of a myopic obsession with short-term profitability—even as the U.S. IPO market continues to assign record values to companies that have yet to show profits. Viewed in this light, the media and regulatory assaults on the junk bond markets in the late 1980s and on derivatives in the early 1990s are only the latest in a long line of misguided attacks on financial innovation.     

Legal insider trading and market efficiency

Does legal insider trading contribute to market efficiency? Using refinements proposed in the recent microstructure literature, we analyzed the information content of legal insider trading. We used data on 2110 companies subject to 59,244 aggregated daily insider trades between January 1995 and the end of September 1999. Our main finding is that, even though financial markets do not respond strongly in terms of abnormal returns to insider trading activities, the significant change in price sensitivity to relative order imbalance due to abnormal insider trades reveals that price discovery is hastened on insider trading days.     

Statement of the Financial Economists Roundtable* Reforming the OTC Derivatives Markets

In investigations of the causes of the crisis, a major focus has been the role of derivative securities, particularly credit-default swaps (CDS). Despite widespread claims to the contrary, however, the 51 economists who signed this statement begin by asserting that CDS and other derivatives contracts were not a primary cause of the financial crisis. At the same time, derivatives markets are said to play an important economic role by shifting risks from businesses and individual investors to parties more willing (and generally better able) to bear them. But, as illustrated during the crisis, derivatives also can be used to transmit risk in ways that have the potential to pervade the entire financial system. With the aim of limiting systemic risk associated with the use of derivatives, the statement recommends the following:

• • measures that encourage migration of more derivatives transactions to central-clearing facilities, including higher capital requirements and stricter criteria (including segregation) for the collateralization of positions that are not cleared;
• • data reporting and repository requirements designed to help regulators and market participants to understand systemic risk exposures in the financial system;
• • post-trade price transparency for all sufficiently standardized OTC products;
• • continued migration of trading in actively traded OTC products to exchanges.

Finally, although the economists support regulations against market manipulation, they oppose potential restrictions on speculative trading, including the holding of “naked” CDS, while affirming that both hedging and speculation are important and socially beneficial activities in our financial system.     

Macroeconomic Implications of “Deep Habits” in Banking

Recent empirical evidence shows that price‐cost margins in the market for bank credit are countercyclical in the U.S. economy and that this cyclical behavior can be explained in part from the fact that switching banks is costly for customers (i.e., from a borrower hold‐up effect). Our goal, in this paper, is to study the “financial accelerator” role of these countercyclical margins as a propagation mechanism of macroeconomic shocks. To do so, we apply the “deep habits” framework in Ravn, Schmitt‐Grohé, and Uribe (2006) to financial markets to model this hold‐up effect within a monopolistically competitive banking industry. We are able to reproduce the pattern of price‐cost margins observed in the data, and to show that the real effects of aggregate total factor productivity shocks are larger the stronger the friction implied by borrower hold‐up. Also, output, investment, and employment all become more volatile than in a standard model with constant margins in credit markets. An empirical contribution of our work is to provide structural estimates of the deep habits parameters for financial markets.     

Arbitrage and deflators in illiquid markets

This paper presents a stochastic model for discrete-time trading in financial markets where trading costs are given by convex cost functions and portfolios are constrained by convex sets. The model does not assume the existence of a cash account/numeraire. In addition to classical frictionless markets and markets with transaction costs or bid–ask spreads, our framework covers markets with nonlinear illiquidity effects for large instantaneous trades. In the presence of nonlinearities, the classical notion of arbitrage turns out to have two equally meaningful generalizations, a marginal and a scalable one. We study their relations to state price deflators by analyzing two auxiliary market models describing the local and global behavior of the cost functions and constraints.