Dynamics of Markets: The New Financial Economics

by Joseph L. McCauley

• ISBN13: 9780521429627
• ISBN10: 0521429625
• Edition: 2nd
• Format: Hardcover
• Copyright: 2009-10-12
• Publisher: Cambridge University Press

Summary

This second edition presents the advances made in finance market analysis since 2005. The book provides a careful introduction to stochastic methods along with approximate ensembles for a single, historic time series. The new edition explains the history leading up to the biggest economic disaster of the 21st century. Empirical evidence for finance market instability under deregulation is given, together with a history of the explosion of the US Dollar worldwide. A model shows how bounds set by a central bank stabilized FX in the gold standard era, illustrating the effect of regulations. The book presents economic and finance theory thoroughly and critically, including rational expectations, cointegration and arch/garch methods, and replaces several of those misconceptions by empirically based ideas. This book will be of interest to finance theorists, traders, economists, physicists and engineers, and leads the reader to the frontier of research in time series analysis.

Author Biography

Joseph L. McCauley is Professor of Physics at the University of Houston, and is an advisory board member for the Econophysics Forum. He has contributed to statistical physics, the theory of superfluids, nonlinear dynamics, cosmology, econophysics, economics, and finance theory.

Table of Contents

Preface to the second edition	p. xi
Econophysics: why and what	p. 1
Why econophysics?	p. 1
Invariance principles and laws of nature	p. 4
Humanly invented law can always be violated	p. 5
Origins of econophysics	p. 7
A new direction in econophysics	p. 8
Neo-classical economic theory	p. 10
Why study "optimizing behavior"?	p. 10
Dissecting neo-classical economic theory (microeconomics)	p. 12
The myth of equilibrium via perfect information	p. 18
How many green jackets does a consumer want?	p. 24
Macroeconomics	p. 25
Probability and Stochastic processes	p. 29
Elementary rules of probability theory	p. 29
Ensemble averages formed empirically	p. 30
The characteristic function	p. 32
Transformations of random variables	p. 33
Laws of large numbers	p. 34
Examples of theoretical distributions	p. 38
Stochastic processes	p. 43
Stochastic calculus	p. 57
Ito processes	p. 63
Martingales and backward-time diffusion	p. 77
Introduction to financial economics	p. 80
What does no-arbitrage mean?	p. 80
Nonfalsifiable notions of value	p. 82
The Gambler's Ruin	p. 84
The Modigliani-Miller argument	p. 85
Excess demand in uncertain markets	p. 89
Misidentification of equilibrium in economics and finance	p. 91
Searching for Adam Smith's Unreliable Hand	p. 93
Martingale markets (efficient markets)	p. 94
Stationary markets: value and inefficiency	p. 98
Black's "equilibrium": dreams of recurrence in the market	p. 101
Value in real, nonstationary markets	p. 102
Liquidity, noise traders, crashes, and fat tails	p. 103
Long-term capital management	p. 105
Introduction to portfolio selection theory	p. 107
Introduction	p. 107
Risk and return	p. 107
Diversification and correlations	p. 109
The CAPM portfolio selection strategy	p. 113
Hedging with options	p. 117
Stock shares as options on a firm's assets	p. 120
The Black-Scholes model	p. 122
The CAPM option pricing strategy	p. 124
Backward-time diffusion: solving the Black-Scholes pde	p. 127
Enron 2002	p. 130
Scaling, pair correlations, and conditional densities	p. 133
Hurst exponent scaling	p. 133
Selfsimilar Ito processes	p. 135
Long time increment correlations	p. 139
The minimal description of dynamics	p. 145
Scaling of correlations and conditional probabilities?	p. 145
Statistical ensembles: deducing dynamics from time series	p. 148
Detrending economic variables	p. 148
Ensemble averages constructed from time series	p. 149
Time series analysis	p. 152
Deducing dynamics from time series	p. 162
Early evidence for variable diffusion models	p. 167
Volatility measures	p. 167
Spurious stylized facts	p. 168
An sde for increments?	p. 173
Topological inequivalence of stationary and nonstationary processes	p. 173
Martingale option pricing	p. 176
Introduction	p. 176
Fair option pricing	p. 178
Pricing options approximately via the exponential density	p. 182
Option pricing with fat tails	p. 185
Portfolio insurance and the 1987 crash	p. 186
Collateralized mortgage obligations	p. 186
FX market globalization: evolution of the Dollar to worldwide reserve currency	p. 188
Introduction	p. 188
The money supply and nonconservation of money	p. 189
The gold standard	p. 190
How FX market stability worked on the gold standard	p. 190
FX markets from WWI to WWII	p. 194
The era of "adjustable pegged" FX rates	p. 196
Emergence of deregulation	p. 197
Deficits, the money supply, and inflation	p. 204
Derivatives and shadow banking	p. 208
Theory of value under instability	p. 211
How may regulations change the market?	p. 212
Macroeconomics and econometrics: regression models vs empirically based modeling	p. 214
Introduction	p. 214
Muth's rational expectations	p. 216
Rational expectations in stationary markets	p. 219
Toy models of monetary policy	p. 222
The monetarist argument against government intervention	p. 224
Rational expectations in a nonstationary world	p. 225
Integration I(d) and cointegration	p. 226
ARCH and GARCH models of volatility	p. 238
Complexity	p. 241
Reductionism and holism	p. 241
What does "complex" mean?	p. 244
Replication, mutations, and reliability	p. 253
Emergence and self-organization	p. 256
References	p. 261
Index	p. 268
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