Inefficient Markets

Damien Challet
CentraleSupelec Paris
Encelade Capital SA

September 16, 2015

Damien Challet

Inefficient Markets

Summary

The prevailing wisdom is that markets are always right.

I take the opposite position.
I assume that markets are always wrong.

George Soros

Damien Challet

Inefficient Markets

Lecture structure

Market deconstruction

Market reconstruction

Profit!?

Damien Challet

Inefficient Markets

Why deconstruction?

Engineering failure

source: Zumbach and Finch (2010)

Damien Challet

Inefficient Markets

Engineering failures

Damien Challet

Inefficient Markets

Takoma bridge (1940)

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Inefficient Markets

What to do with failures? Blame the user

Damien Challet

Inefficient Markets

What to do with failures? Add a protection layer

Philadelphia, 2015

Damien Challet

Inefficient Markets

And yet: the London Wobbly Bridge (2000)

(from Wikipedia) The bridges movements were caused by a positive
feedback phenomenon, known as synchronous lateral excitation
Any bridge with lateral frequency modes of less than 1.3 Hz, and
sufficiently low mass, could witness the same phenomenon with
sufficient pedestrian loading.

Damien Challet

Inefficient Markets

How to avoid future disasters: find causes of crash

De Havilland Comet: 3 crashes in 1953-4.

www.tech.plym.ac.uk/sme/interactive resources/tutorials/FailureCases/sf2.html

Damien Challet

Inefficient Markets

Result:
(note: wrong way to plot)

source:
http://www.boeing.com/resources/boeingdotcom/company/about bca/pdf/statsum.pdf

Damien Challet

Inefficient Markets

Financial market failures

remedies so far: circuit breakers, trading stops

Damien Challet

Inefficient Markets

6 May 2010 flash crash

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Inefficient Markets

Flash crash cause (2010)

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Inefficient Markets

Flash crash cause (2015)

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Inefficient Markets

Part 1: Deconstruction
Myth 1: equilibrium
Wild price fluctuations:
dangerous news, unstable markets, or crazy traders?
1

Blame the weather: news

1
2

Blame the user: traders

1
2

structure+noise
news distribution

Behavioural finance: biases, rationality

Real traders behaviour

Blame the dynamic: unstability

1
2

fixed-point?
non-linear dynamics, chaos
Damien Challet

Inefficient Markets

Part 1: Deconstruction
Myth 2: price efficiency

Efficient market hypothesis

1

Marginally efficient market hypothesis

Adaptive market hypothesis

How to test price efficiency

1

Event studies

Strategy backtest

Speculative fund performance

Damien Challet

Inefficient Markets

And now ?

Credit: Hans Hansen, Volkswagen

Damien Challet

Inefficient Markets

Part 2:
Reconstruction
Aim: to build a model of financial market dynamics
Building blocks:
1

Trader
actions (buy, sell, do nothing)
strategies
learning

Exchange rules
Walras
market orders

Damien Challet

Inefficient Markets

Part 2
Reconstruction: Agent-based models
ABMs allow one to study
1

stabilising and de-stabilising trader behaviour

feedback loops

BIG bonus:
1

Predictability dynamics

Trader ecology

EMH?

Calibration

Damien Challet

Inefficient Markets

Part 3:
Profit: strategies and trading

What, where, how?

Backtest

HFT

Case studies

Algo trading

Damien Challet

Inefficient Markets

You

data analysis
graphs: reading, plotting

programming
mathematics
paper trading account
take risk
understand fluctuations

Damien Challet

Inefficient Markets

This course: admin

https://hec.unil.ch/docs/index.php/dchallet/cours/314
6 credits
Assistant: Nataliya.Gerasimova@unil.ch
20% semester work: wild guesses
Two projects to hand in.
Lectures will be interspersed with hands-on intervals during
which you will implement on the spot an important point of the
lecture.
Programming: your favorite language

80% 2h written exam

Conceptual thinking
Graph reading
Calculus
No lecture notes, no calculator.

Damien Challet

Inefficient Markets

This course: you

Lecture notes:
Available the day before on the course website.
Attending lectures is necessary to make sense of them.
During lectures, I will emphasize what is very important for the
exam.
IT:
Always take a fully charged laptop with you.
Tablets are ill-suited for data analysis and programming.
Make sure that your wifi connexion works BEFORE the lecture
Have your favorite programming environment pre-installed
(Matlab, rstudio for R).
Assignements:
1

ABM

Trading strategies
Damien Challet

Inefficient Markets

Why this lecture: MYTHS!

Markets can compute

Markets are well-behaved
Markets are clever
Markets are efficient
Markets maths are simple

Damien Challet

Inefficient Markets

Reality:

Markets are messy

Markets are complex
Markets are unstable
Markets are inefficient

MORE INTERESTING
Damien Challet

Inefficient Markets

Markets are messy

Human made
laws
behavioural finance

Computer
Computers are useless. They can only give you answers. (Pablo
Picasso)
To err is human, but to really foul things up you need a
computer. (Paul Ehrlich)

Chaos
Non-linear systems
Unstability

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Inefficient Markets

Markets are complex

What do you know about financial markets?
Much less than you think/should
What do you know about financial products?
Much less than you should/think

Ever heard about past crises?

How many of them?

Damien Challet

Inefficient Markets

Crises

Remember
2012, 2011, 2010, 2009, 2008, 2007?
2001,2000 ?
1998, 1997?
1992?
1987?
1971?
1929?

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Inefficient Markets

Markets are INHERENTLY unstable

Canonical view
external news main source of fluctuations
remaing fluctuations: noise traders
convergence to equilibrium

Realistic view
internal/external fluctuations
cascading reactions
overreaction
instability
e.g. stick balancing, J. L. Cabrera and J. G. Milton, On-off intermittency in a
human balancing task, Phys. Rev. Lett. 89 158702 (2002).

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Inefficient Markets

Markets are inefficient

Information removal:

Find fair price:

Equibrium:

Well-behaved: :

fair?
???
only exceptionnaly

60-95%

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Inefficient Markets

The point of view of this lecture: science/engineering

Markets: systems
1

BIG-DATA: empirical approach

1
2

Theoretical approach:
1
2

passive
active: poke markets! see them react!

MECHANISMS
reverse-engineering

Engineering:
1
2

CONTROL fluctuations, risk, etc?

market design

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Inefficient Markets

Markets efficiency: resilience to perturbation

Optimistic hypothesis
At time t 0, price at fundamental price log p = 0 = x
At time t = 0, important news perturbation
Convergence towards x ?
force that pulls back price
force that brakes

Example: damped oscillator

Damien Challet

Inefficient Markets

Resilience to perturbations: damped oscillator

Force that pulls back

Fspring = kx
Force that slows down price speed
Fdamp = c

dx
dt

Evolution equation
m

d 2x
= Fspring + Fdamp
dt 2

Damien Challet

Inefficient Markets

Resilience to perturbations: damped oscillator

3 regimes, =

c
2 mk

over- damping > 1

critical damping = 1

under-damping < 1

Damien Challet

Inefficient Markets

Market efficiency: resilience to perturbation

1.0

1.0

0.6
0.4

cos(x) * exp(3 * x)

0.6
0.4

cos(x) * exp(x)

0.2

0.2

0.0

0.0

0.0

0.5

cos(x) * exp(0.1 * x)

0.5

0.8

0.8

1.0

Critical dampening of perturbations

200

400

600

800

1000

200

Index

400

600

800

1000

Index

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10

20

30
Index

40

50

Markets resilience: quality control

UBS (UBSN.VX)
UBSN.VX

diff price

40

30

20
10

price

50

60

UBSN.VX

2002

2004

2006

2008

2010

Damien Challet

2002

2004

Inefficient Markets

2006

2008

2010

Markets resilience: quality control

UBS (UBSN.VX): LOG prices
UBSN.VX

0.1
0.0

log price returns

0.1

3.0

0.2

2.5
2.0

log price

3.5

0.2

4.0

UBSN.VX

2002

2004

2006

2008

2010

Damien Challet

2002

2004

Inefficient Markets

2006

2008

2010

Markets resilience: quality control

UBS (UBSN.VX): exponential dampening?

0.0

cos(x) * exp(0.1 * x)

0.0

0.5

0.1
0.2

log price returns

0.1

0.5

0.2

1.0

UBSN.VX

2002

2004

2006

2008

2010

200

400

600
Index

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Inefficient Markets

800

1000

Markets resilience: quality control

UBS (UBSN.VX): power-law dampening?

0.5

0.0

0.5

cos(x) * x^0.2

0.0
0.1
0.2

log price returns

0.1

1.0

0.2

1.5

UBSN.VX

2002

2004

2006

2008

2010

200

400

600
Index

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Inefficient Markets

800

1000

Markets resilience: quality control

UBS (UBSN.VX): log dampening?

0.0

0.2

cos(x)/log(1 + x * 100)

0.0
0.1

0.2

0.2

log price returns

0.1

0.4

0.2

UBSN.VX

2002

2004

2006

2008

2010

200

400

600
Index

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Inefficient Markets

800

1000

Markets resilience: quality control

UBS (UBSN.VX): log dampening?

0.0

0.2

cos(x)/log(1 + x * 100)

0.0
0.1

0.2

0.2

log price returns

0.1

0.4

0.2

UBSN.VX

2002

2004

2006

2008

2010

2000

4000

6000
Index

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Inefficient Markets

8000

10000

Omori Law

Earth quakes
Intensity of replica decreases as t
Large volatility decreases as t
More precisely
fix a threshold
n(t) = number of times |return| larger than
n(t) t 1

Damien Challet

Inefficient Markets

Markets resilience: quality control

How often are markets normal (Gaussian)?
UBSN.VX: 1 std 65% of the time
UBSN.VX

10

UBSN.VX, QQ plot of daily close log returns

0.500

1cdf
0.005

0.001

Sample Quantiles

0
5

0.050

0.1

0.2

Theoretical Quantiles

0.5

1.0

2.0

standardized log return

Damien Challet

Inefficient Markets

5.0

10.0

Financial crises: forgotten correlations

realized correlations between SPDR XLE and SPDR XLK (taken
from Cont & Wagalth 2011)
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

2005

2007

Damien Challet

15/09/2008

2010

Inefficient Markets

Financial crises: systemic risk

Systemic affects whole system
Cross-ownership network
Distress propagation
Vanishing liquidity
Ex:
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0

2005

2007

Damien Challet

15/09/2008

2010

Inefficient Markets

Financial crises: bubbles

Remember
2007: USA, Spain, UK, Ireland?
1995: UK?
1980s: Switzerland?
1995-2000: dot-com?
1720: South Sea Company?

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Inefficient Markets

Financial crises: bubbles

What is a bubble?

How to detect it?

When does it end? How does it end?

Damien Challet

Inefficient Markets

Financial crises: bubbles

What is a bubble?

How to detect it?

When does it end? How does it end?

Damien Challet

Inefficient Markets

Financial crises: bubbles

What is a bubble?

How to detect it?

When does it end? How does it end?

Damien Challet

Inefficient Markets

Financial crises: bubbles

What is a bubble?

How to detect it?

When does it end? How does it end?

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Inefficient Markets

Financial crisis theory crisis

Any theory has limited domain of application

Which limits ?
Improve theory
Expand domain of application
Today: infancy of finance theory
in your lifetime, finance theory will evolve
TREMENDOUSLY

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Inefficient Markets

Financial crisis theory crisis (read this at home)

Reflections on the nature of monetary policy non-standard measures and

finance theory
Jean-Claude Trichet, President of the ECB
Opening address at the ECB Central Banking Conference
Frankfurt, 18 November 2010
When the crisis came, the serious limitations of existing economic and
financial models immediately became apparent. Arbitrage broke down in
many market segments, as markets froze and market participants were
gripped by panic. Macro models failed to predict the crisis and seemed
incapable of explaining what was happening to the economy in a
convincing manner. As a policy-maker during the crisis, I found the
available models of limited help. In fact, I would go further: in the face
of the crisis, we felt abandoned by conventional tools.

Damien Challet

Inefficient Markets

Financial crisis theory crisis

Reflections on the nature of monetary policy non-standard measures and
finance theory
First [...] the atomistic, optimising agents underlying existing models do not
capture behaviour during a crisis period. We need to deal better with
heterogeneity across agents and the interaction among those heterogeneous
agents.
Second, we may need to consider a richer characterisation of expectation
formation
Third, we need to better integrate the crucial role played by the financial
system into our macroeconomic models. [...]
dealing with the non-linear behaviour of the financial system will be important,
In this context, I would very much welcome inspiration from other disciplines:
physics, engineering, psychology, biology.
A large number of aspects of the observed behaviour of financial markets is
hard reconcile with the efficient markets hypothesis, at the heart of most
conventional models

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Inefficient Markets

Role of Markets

Exchange goods
Fair price
Easily
E.g.: Fish markets, Ebay, NYSE
The more people, the more efficient

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Inefficient Markets

Role of Financial Markets

Exchange assets
Fair price
efficiency

Easily
liquidity
small spreads

Damien Challet

Inefficient Markets

Role of Financial Markets

Exchange assets
Fair price
efficiency

rational agents

Easily
liquidity
small spreads

many agents

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Inefficient Markets

Why market efficiency

Price information
Ideal case:
rational agents
no arbitrage

Historicity:
neo-classical Economics
simple mathematics
no computers
little data

Arrogant traders

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Inefficient Markets

Rationale

Traders are smart

Obvious arbitrage opportunities do not exist

Markets: complex
Better assume they are perfect

Equilibrium markets are unpredictable

Equilibrium optimal resource allocation

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Inefficient Markets

Rationale

Traders are smart

Obvious arbitrage opportunities do not exist

axiomatic

Markets: complex
Better assume they are perfect

axiomatic

Equilibrium markets are unpredictable

axiomatic

Equilibrium optimal resource allocation

axiomatic

Damien Challet

Inefficient Markets

This course

Financial markets:
complex, noisy,
non-linear systems
with feedback

Damien Challet

Inefficient Markets

This course

Market (in-)efficiency
High-frequency
Fluctuations rather than expectations
Endogeneous vs exogeneous

Predictability
ROAD to efficiency
Agent-based models
Mathematics of interaction and heterogeneity
Dynamics of efficiency

Damien Challet

Inefficient Markets

This course

Market (in-)efficiency
High-frequency
Fluctuations rather than expectations
Endogeneous vs exogeneous

mechanistic

Predictability
ROAD to efficiency
Agent-based models
Mathematics of interaction and heterogeneity
Dynamics of efficiency

Damien Challet

Inefficient Markets

mechanistic

Market efficiency

Hypotheses: at time t
Pt = price of asset
Pt = fundamental price
t = all available information
Efficient Market Hypothesis (EMH)
Pt = E (Pt |t )
Current prices incorporate all available information
without bias

Damien Challet

Inefficient Markets

Fair price

Efficient Market Hypothesis (EMH)

Pt = E (Pt |t )
Equivalence:
Current price reflects all available information without bias
Fair price
Right price
Market finds the optimal price
Trust the market

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Inefficient Markets

Price evolution

|
Pt+1 = E (Pt+1
t+1 )

Best forecast:

| )
E (Pt+1
t

t+1 ?
= (1 + r )Pt
t+1 N (0, )

Pt+1 = (1 + r )Pt + t+1

Bacheliers random walk

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Inefficient Markets

EMH: consequences

Price change news change

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Inefficient Markets

EMH: consequences

Price change news change

Fund managers:

useless

Information dynamics:
Information price:
To mathematical finance

Damien Challet

Inefficient Markets

useless
useless
priceless

Market efficiency?

Hypotheses: at time t
Pt = price of asset
Pt = fundamental(?) price
t = all available information
Efficient Market Hypothesis (EMH)
Pt = E (Pt |t )
Current prices incorporate all available information
without bias

Damien Challet

Inefficient Markets

Market efficiency??

Hypotheses: at time t
Pt = price of asset
Pt = fundamental(?) price
t = all(?) available information
Efficient Market Hypothesis (EMH)
Pt = E (Pt |t )
Current prices incorporate all available information
without bias

Damien Challet

Inefficient Markets

Market efficiency???

Hypotheses: at time t
Pt = price of asset
Pt = fundamental(?) price
t = all(?) available(?) information
Efficient Market Hypothesis (EMH)
Pt = E (Pt |t )
Current prices incorporate all available information
without bias

Damien Challet

Inefficient Markets

Market efficiency????

Hypotheses: at time t
Pt = price of asset
Pt = fundamental(?) price
t = all(?) available(?) information
Efficient Market Hypothesis (EMH)
Pt = E (Pt |t )
Current prices incorporate(?) all available information
without bias

Damien Challet

Inefficient Markets

Market efficiency?????

Hypotheses: at time t
Pt = price of asset
Pt = fundamental(?) price
t = all(?) available(?) information
Efficient Market Hypothesis (EMH)
Pt = E (Pt |t )
Current prices incorporate(?) all available information
without bias(?)

Damien Challet

Inefficient Markets

Market efficiency????????

Hypotheses: at time t
Pt = price of asset
Pt = fundamental(?) price
t = all(?) available(?) information
Efficient Market Hypothesis (EMH)
Pt = E (Pt |t )
Current prices incorporate(?) all(?) available(?)
information(?) without bias(?)

Damien Challet

Inefficient Markets

Market efficiency?????????
Hypotheses: at time t
Pt = price of asset
Pt = fundamental(?) price
t = all(?) available(?) information
Efficient Market Hypothesis (EMH)
Pt = E (Pt |t )
Current prices incorporate(?) all(?) available(?)
information(?) without bias(?)
FLUCTUATIONS ?

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Inefficient Markets

Arbitrages

Risk-free
Sell short over-priced asset
Buy under-priced asset with same characteristics
Similar asset?
Risk-free?

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Inefficient Markets

Arbitrages: classic example

Similar asset: Royal-Dutch / Shell

Risk-free? LTCM
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Inefficient Markets

Arbitrage: modern securities: ETFs

Mean-reversion between ETF and benchmark. From B. R. Marshall,
et. al., ETF Arbitrage: Intraday Evidence (2013)

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Inefficient Markets

Impossible risk-free arbitrages

Shleifer chap 2:
Noise traders
Risk-adverse arbitrageurs
Price does not converge to fundamental price

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Inefficient Markets

Statistical Arbitrages

Noise traders risk

Risk utility function
EMH: abnormal risk-adjusted returns
more risk, more returns

Testing EMH Testing pricing and risk models

EMH: no consistent abnormal returns
NB: spurious arbitrages (tax, transaction costs, liquidity, number
rounding)

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Inefficient Markets

Evidence of price predictability

t = : EMH OK
t = {ptk }: 5-years reversal in the UK (Arnold & Baker,
2007), by deciles

Damien Challet

Inefficient Markets

Evidence of price predictability

t = : EMH OK
t = {ptk }: momentum/reversal
(taken from M. K. Brunnermeier)

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Inefficient Markets

Event studies

Dividend changes
Split
Merger/Take over
Index inclusion/removal
Important news

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Inefficient Markets

Events

Choose event type

N events at time ti , i = 1, . . . , N
Compute average abnormal returns
r t =

1
N

[ri,t + t rm,t + t ]
i

i=1

Plot

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Inefficient Markets

Take-over

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Inefficient Markets

CEO death
(taken from M. K. Brunnermeier)

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Inefficient Markets

Splits
Fama-French-Fischer-Jensen-Roll (1969)

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Inefficient Markets

Summary

Crises, crises, crises

Start from high-frequency data, not assumptions
Fluctuations not expectations
Mechanisms, not axioms

Damien Challet

Inefficient Markets