A computational view of market efficiency |
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Authors: | Jasmina Hasanhodzic Andrew W Lo |
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Institution: | 1. AlphaSimplex Group, LLC , One Cambridge Center , Cambridge, MA 02142, USA;2. MIT Sloan School of Management , 50 Memorial Drive, E52–454, Cambridge, MA 02142, USA |
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Abstract: | We study market efficiency from a computational viewpoint. Borrowing from theoretical computer science, we define a market to be efficient with respect to resources S (e.g., time, memory) if no strategy using resources S can make a profit. As a first step, we consider memory-m strategies whose action at time t depends only on the m previous observations at times t???m,?…?,?t???1. We introduce and study a simple model of market evolution, where strategies impact the market by their decision to buy or sell. We show that the effect of optimal strategies using memory m can lead to ‘market conditions’ that were not present initially, such as (1) market spikes and (2) the possibility for a strategy using memory m′?>?m to make a bigger profit than was initially possible. We suggest ours as a framework to rationalize the technological arms race of quantitative trading firms. |
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Keywords: | Agent based modelling Bound rationality Complexity in finance Behavioral finance |
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