From the abstract: We explain the evolution of the volatility market and present the infamous day of `Volmageddon' as an insightful case study. Our survey focuses on the pricing and trading of volatility-linked assets, highlighting the impact of mechanical hedging in markets for futures and higher-order derivatives. We supplement the vast statistical analysis of volatility derivatives with a financial economists’ perspective.
From the abstract: Institutional investors in equities tend to follow well-defined investment strategies, often based on factors such as size, value, momentum, quality, dividend yield and other stock characteristics. This paper explores the impact of capital flows between investment strategies on the cross-section of their performance. We find that the correlation between factor performance and the cyclical nature of risk premia can be explained by capital flows. The CAPM with a non-mean-variance investor supports these results.
From the abstract: In statistics, samples are drawn from a population in a data-generating process (DGP). Standard errors measure the uncertainty in sample estimates of population parameters. In science, evidence is generated to test hypotheses in an evidence-generating process (EGP). We claim that EGP variation across researchers adds uncertainty: non-standard errors. To study them, we let 164 teams test six hypotheses on the same sample. We find that non-standard errors are sizeable, on par with standard errors. Their size (i) co-varies only weakly with team merits, reproducibility, or peer rating, (ii) declines significantly after peer-feedback, and (iii) is underestimated by participants.
From the abstract: Economic growth transformed the world. Its measurement via GDP has risen to prominence as the pre-eminent metric of economic prowess and political success. How better to tell its story than through the lens of the world's first growing economy? The paper is published in separate parts:
Bearing the Scars: Access to Growth and the Age of Knowledge. Histories (with Julia Wardley-Kershaw), Histories, 2(4), 405-425, 2022.
Economic Growth in the UK: Growth's Battle with Crisis (with Julia Wardley-Kershaw), Histories, 2(4), 374-404, 2022.
Economic Growth in the UK: The Inception (with Julia Wardley-Kershaw), World, 3(2), 162-174, 2022.
Perspectives on the Future of Growth (with Julia Wardley-Kershaw), World, 3(2), 299-312, 2022.
Our contribution to the Evolutionary Models of Financial Markets Special Feature appeared in PNAS on June 29, 2021. Joint work with a Rabah Amir, Igor V. Evstigneev, Thorsten Hens and Valeriya Potapova.
We use an analogy between financial trading strategies and biological species and characterize an evolutionary stable strategy in an ecology with fix-mix strategies. The basis of our paper is that dividends are not exogenous but increase with the wealth invested in an asset, as is the case in a production economy. While this might create positive feedback loops, we show that the dynamical system has a unique evolutionary stable investment strategy that characterizes a locally stable equilibrium state. Our result is of high significance for any market economy since it shows that the dynamic interaction of investment strategies tends to produce stable prices. Mis-pricing therefore occurs only in extraordinary times when the market becomes highly dislocated due to exogenous events.
How to invest in the financial market and be sure to survive no matter what the other investors do? Joint work with Igor V. Evstigneev, Thorsten Hens and Valeriya Potapova.
This paper analyzes a dynamic stochastic equilibrium model of an asset market based on behavioral and evolutionary principles. The core of the model is a non-traditional game-theoretic framework combining elements of stochastic dynamic games and evolutionary game theory. Its key characteristic feature is that it relies only on objectively observable market data and does not use hidden individual agents' characteristics (such as their utilities and beliefs). A central goal of the study is to identify an investment strategy that allows an investor to survive in the market selection process, i.e., to keep with probability one a strictly positive, bounded away from zero share of market wealth over an infinite time horizon, irrespective of the strategies used by the other players. The main results show that under very general assumptions, such a strategy exists, is asymptotically unique and easily computable.
How to play if you must - and worse, if you neither have seen the game before nor will see it ever again. The paper develops solution concepts for such situations by generalizing Nash and using tools from computer science. Joint work with Terje Lensberg.
We study one-shot play in the set of all bimatrix games by a large population of agents. The agents never see the same game twice, but they can learn `across games' by developing solution concepts that tell them how to play new games. Each agent's individual solution concept is represented by a computer program, and natural selection is applied to derive stochastically stable solution concepts. Our aim is to develop a theory predicting how experienced agents would play in one-shot games. To use the theory, visit https://gplab.nhh.no/gamesolver.php.
"Pricing defaulted Italian mortgages", Journal of Risk and Financial Management, 13(2), Article 31, 2020, looks at recovery rates at the provincial and regional level. We find huge intra- and inter-regional differences and lower estimated recovery rates than predcited by Moody's model. Joint work with Michela Pelizza.
Our paper forecasts expected recovery rates of defaulted Italian mortgage loans backed by either residential or commercial real estate. We apply an exponential Ornstein-Uhlenbeck process to model the price dynamics at provincial and regional level, and two haircut models to estimate the liquidation value. Compared to our findings, rating agencies such as Moody’s, which use geometric Brownian motion to model the price dynamics, paint a rosier picture with higher recovery rates. As a consequence non-performing mortgage loans held by Italian banks might be overvalued.
"International Trade. Smarten up to talk the talk" is a non-technical introduction to international trade. Joint work with Levi Haas.
International trade is currently under fire from many sides. Protectionist trade policies are on the rise, putting an end to the decade-long march of free trade. Making sense of the daily headlines and having an informed opinion on your own has rarely been more important than it is now. Our work aims to explain the driving forces behind international trade, its history, how it shaped the world, its economic models, issues ranging from job losses to the environment and why eating kangaroos is better than buying local. We summarize the most important academic literature on these topics in a non-technical, educational manner. If the readers conclude that our report has been useful in forming their own views on the pros and cons of international trade and that they can `talk the talk', we are gratified with the fruit of our work.
Backtesting in finance creates an illusion. Three main takeaways of the paper, Journal of Portfolio Management, Vol. 46(4), 81-93, 2020, are: (1) Robustness checks of investment strategies require more than backtesting; (2) An impact test is proposed to measure the effects of crowdedness and cross impact on investment strategies; and (3) A survival test is proposed to assess the long-term effects of investment strategies' competition for market capital. Joint work with Thorsten Hens and Mathis-Hendrik Woesthoff
Two tests can help asset managers to develop more robust investment strategies: an impact test and a survival test. Both tests complement the backtest where one checks how a proposed investment strategy would have performed in the past. The impact test considers the performance of the strategy when assets under management grow (crowdedness) and it checks the impact that a growth of asset under management in competing strategies have on the proposed strategy (cross impact). The survival test considers the effect of the long-term evolution of assets under management in competition for market capital. Using Shiller's S\&P 500 index and bond market data we show that time-series momentum (relative strength) performs best in the backtest and in the impact test but that an expected relative cash-flow rule (relative dividend yield) has the best long-term survival properties.
Long-Run Risk Models entail implausibly high levels of timing and risk premia. Our paper resolves this puzzle by adding durable goods. Joint work with Myroslav Pidkuyko and Raffaele Rossi
Long-run risk models, a cornerstone in the macro-finance literature for their ability to capture key asset price phenomena, are known to entail implausibly high levels of timing and risk premia. Our paper addresses this puzzle by considering consumption of durable goods in addition to that of non-durable goods. In our estimated model, the timing premium is 11 percent and the risk premium is 16 percent of lifetime consumption. These values are about a third of the previously implied premia and are more consistent with empirical and experimental evidence.
Smart-Beta: A survey on smart-beta (factor) investing and its potential economic risks. Joint work with
Smart-beta (or factor) investing industry's assets under management have grown to over $1 trillion. We attempt to survey the merits and risks of this investment style from both professional investors' and academics' points of view. After reviewing academic papers, reports of practitioners in the field and relevant news articles around the topic as well as the literature on herding in financial markets, we conclude that herding in smart-beta is likely taking place, with a distinct and growing possibility of a market correction that would catch many factor investors wrong-footed.
The benefit of investor patience
is highlighted in the paper Patience is a Virtue - In Value Investing (with Thorsten Hens) International Review of Finance, 20(4), 1019-1031, 2020.
This note illustrates a simple but important insight for financial investment. In a heterogeneous agent-based evolutionary finance market model with long-lived assets, markets are stable if clients of fundamental (`value') investment funds are more patient than clients of other funds.
Computational Finance applied to HFT
Crypto-Currencies: Two survey papers on crypto-currencies are now available. Both papers are joint work with
Octavian Nica and Karolina Piotrowska
Since Bitcoin brought cryptocurrencies into the spotlight in the early 2010s, the number and diversity of digital coins expanded dramatically. With this report, we aim to provide a concise introduction on the emergence and defining features of cryptocurrencies for researchers (and students) in economics, finance, mathematics and computer science. In doing so, we survey both the academic and non-academic literature in order to offer a brief history of cryptocurrencies, starting from the early 1980s, and we describe the key innovative aspects behind cryptocurrencies.
We group these innovations into two broad categories: technological innovation and governance innovation. The main technological innovation behind cryptocurrencies is the blockchain - a public ledger of all transactions, secured through cryptography. We provide a non-technical description of the blockchain and of all the auxiliary tools and systems that are used to transact cryptocurrencies. In terms of governance, the main innovation is the ability of any user to transact cryptocurrencies without the involvement of a 3rd party. Although this fact is used to justify the security of cryptocurrencies, we point out that each cryptocurrency is still controlled, to a certain extent, by a set of agents that operate (within or outside of the blockchain) with disproportionate power. We provide an overview of these agents, and a classification of cryptocurrencies based on their governance structure. The report also contains a list of the most relevant cryptocurrencies at the moment of writing.
Since the emergence of Bitcoin in 2009, the number of cryptocurrencies, their applications and market value grew significantly. There is a surge in the number of businesses, financial institutions and authorities, investors and governments interested in the adaptation of the cryptocurrencies and/or blockchain technology. In this report, we aim to provide an overview of the economic benefits and risks of cryptocurrencies for researchers and students in economics, finance, mathematics and computer science. The report offers the summary of the academic and non-academic literature concerning this topic published to this day as well as the list of future research perspectives, review of Bank of England research on cryptocurrencies, and contributions from University of Manchester researchers specialising in various academic fields.
Among the economic benefits, we discuss the defining characteristics of cryptocurrency users and the potential benefits for small and large businesses and the society as a whole. We also focus on the new, low-cost and unregulated form of early-stage company financing which was propagated by some of the blockchain start-ups, the Initial Coin Offerings (ICOs). Subsequently, we acknowledge the risks posed by the adaptation of cryptocurrencies, analyse their efficiency and stability issues. We also address the problem of illegal activities benefiting from the anonymity offered by the system, focusing predominantly on tax evasion, money laundering, the economy of dark markets and terrorism financing. The report also covers the responses of governments and central banks to this phenomenon and the current state of legal definitions of cryptocurrencies in chosen countries.
Mathematical Financial Economics: A Basic Introduction
"Mathematical Financial Economics (A Basic Introduction) is indeed a work accessible to the general public and can give a great contribution to the dissemination of knowledge in these areas, so important in modern everyday life. Indispensable either to professionals or to curious people, whether practical or academics, whether graduate or post-graduate students. In short: a true knowledge transfer book." (Manuel Alberto M. Ferreira, Acta Scientiae et Intellectus, Vol. 2(6), 2016)
Jan Mossin Memorial Symposium on Financial Markets, NHH, June 9-10, 2016
The Jan Mossin Memorial Symposium held every 5th year at NHH is a tribute to former NHH Professor Jan Mossin and his essential contributions to modern finance, and brings together academics and practitioners for an exchange of ideas on investments, asset allocation and asset pricing. During this year's symposium, experts from practice and academia will share insider views of how today's financial markets work, and spell out the implications for investors and regulators.
June 9, 2016 Ronan Ryan (IEX Group) "Building An Exchange for Investors", Maureen O'Hara (Cornell University) "High Frequency Market, Microstructure", David Easley (Cornell University) "Network Analysis of Financial Markets"
June 10, 2016 Thierry Foucault (HEC Paris) "Data Abundance and Asset Price Informativeness", Nikolaus Hautsch (University of Vienna) "Volatility, Information Feedback and Microstructure Noise: A Tale of Two Regimes", Bernt Arne Ødegaard (University of Stavanger) "Throttling Hyperactive Robots - Order to Trade Ratios at the Oslo Stock Exchange", Katya Malinova (University of Toronto) "'Modern' Market Makers", Jean-Edouard Colliard (HEC Paris) "Financial Transaction Taxes, Market Composition, and Liquidity", Mark Van Achter (Rotterdam School of Management) "Trading Speed Competition: Can the Arms Race Go Too Far?"
PhD short course on Financial Market Microstructure, NHH, June 6-7, 2016
Trimester Program at Hausdorff Research Institute for Mathematics
Research straight from the desk
Popular Press Articles
KTP with Yorkshire Bank receives ESRC award for 'Best Application of Social Science in a KTP 2011'
Stability of Financial Markets: An Evolutionary Approach
This joint project with Terje Lensberg (NHH, Bergen, Norway) is funded by the Norwegian Finance Market Fund (2008-2010). The research output comprises:
Darwin and Finance
Financial market research celebrates Charles Darwin's 200th birthday with the publication of the Handbook of Financial Markets: Dynamics and Evolution. This volume in the Handbooks in Finance series presents contributions of leading researchers to the evolutionary dynamics in financial markets. Darwin's insights on natural selection continue to inspire 150 years after their publication!
HANDBOOK OF FINANCIAL MARKETS: Dynamics and Evolution, edited by Thorsten Hens and Klaus Reiner Schenk-Hoppé, North-Holland, 2009. 608 pages. Volume of the Handbooks in Finance edited by William T. Ziemba
Andrei Shleifer (Harvard University)
"Mathematical analysis of evolutionary dynamics in financial markets has made significant strides in the last 20 years. The chapters in this Handbook present some of the most important contributions to this expanding literature."
William A. Brock (University of Wisconsin at Madison)
"The research frontier of finance is moving in an ecological direction where trading strategies compete for profits like species in an ecosystem. This volume, written by leaders in the field, does an excellent job of bringing the reader up to date in this novel, important, and fascinating research area."
Hersh Shefrin (Santa Clara University)
"Hens and Schenk-Hoppé's edited collection provides deep and important insights about the impact of investor heterogeneity on market dynamics. Focused research on this topic is long overdue, making this book a welcome advance."
Thorsten Hens and Klaus Reiner Schenk-Hoppé
CHAPTER 1. "Thought and Behavior Contagion in Capital Markets"
David Hirshleifer and Siew Hong Teoh
CHAPTER 2. "How Markets Slowly Digest Changes in Supply and Demand"
Jean-Philippe Bouchaud, J. Doyne Farmer, and Fabrizio Lillo
CHAPTER 3. "Stochastic Behavioral Asset-Pricing Models and the Stylized Facts"
CHAPTER 4. "Complex Evolutionary Systems in Behavioral Finance"
Cars Hommes and Florian Wagener
CHAPTER 5. "Heterogeneity, Market Mechanisms, and Asset Price Dynamics"
Carl Chiarella, Xue-Zhong He and Roberto Dieci
CHAPTER 6. "Perfect Forecasting, Behavioral Heterogeneities, and Asset Prices"
CHAPTER 7. "Market Selection and Asset Pricing"
Lawrence Blume and David Easley
CHAPTER 8. "Rational Diverse Beliefs and Market Volatility"
CHAPTER 9. "Evolutionary Finance"
Igor V. Evstigneev, Thorsten Hens, Klaus Reiner Schenk-Hoppé
`Managing Demand' for Peer Reviews
Parking: Unwanted Insights from Economics