An Engine, Not a Camera

The following are my notes (or what I have learnt) from the book, ‘An Engine, Not a Camera'. It is written by a sociologist. I would recommend those who are interested in financial theories and its effects on the market to read it. My notes may not be self-explanatory if one lacks the context behind the book.

The notes are:

1) Financial theories may be performacity or counter-performacity. Performacity are theories that act to make the markets to conform more towards the theory. For example, B-S options model when known actually help the option prices to converge to B_S model. But after 1987, B-S model becomes off-the-mark as traders become more risk-averse (introduction of volatility smile). Efficient market hpothesis (EMH) lead to index funds which may have the counter-performacity effects. Shares that are announced to be included in the S&P index may have an increase in prices of these shares. The announcement of shares being removed from an index would lead to a decrease in the prices of these shares. As such, such price movements due to inclusion or exclusion of shares in index are anti-EMH.

2) Levy distribution, as recommended by Mandelbroit, may be used in options models to take care of fat-tails or Black Swan problem after the 1987 crash.

3) The fall of LTCM is due to the feedback mechanism and the size of the fund. The feedback mechanism in the markets may cause the correlation of seemingly uncorrelated financial productions to increase sharply (ie when investors’ risk aversion has increased sharply due to adverse events). The size of the fund may lead to the speculation that the fund may be in trouble and if the fund being seen as large as the market, traders may converge to cause a negative feedback effect on the fund’s products. This is what has caused the fall of LTCM where first, investors’ risk appetite has fallen due to some external events. LTCM start to lose money and it become known to investors and outsiders. Outsiders speculate that LTCM is large and thus would have impact on the market if it starts to dispose its positions. So funds and traders start to converge by acting like anti-LTCM positions. As LTCM is a leveraged fund and it has recently returned cash to investors, it is not able to withstand the onslaught and thus a liquidity crisis has formed.

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