Dynamics of Markets: The New Financial Economics
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.
This 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 foreign exchange 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 with empirically based ideas.
This book will interest finance theorists, traders, economists, physicists and engineers, and leads the reader to the frontier of research in time series analysis.
‘A thought provoking book. It does not only argue convincingly that the ‘King – of orthodox economic theory – is naked', but offers a challenging economic alternative interpretation regarding especially the dynamics of financial markets.’
Giovanni Dosi, Laboratory of Economics and Management,Sant'Anna School of Advanced Studies, Pisa
‘The heart of McCauley's book is a closelyreasoned critique of financialeconomic mathematical modeling practice. McCauley's demonstration of the incompatibility between the assumptions of marketclearing equilibrium and informational efficiency is stunning, and sheds muchneeded light on the mathematical modeling failures revealed by the financial meltdown. His unvarnished criticisms of neoclassical economic doctrine deserve equal attention. McCauley opens the windows of the selfreferential world of economics to the fresh air of a mathematical physics point of view grounded in economic history and common sense. Neither monetarist, neoclassical, nor Keynesian schools of economics will take much comfort from McCauley's work, but they all have a lot to learn from it.’
Duncan K. Foley, Leo Model Professor, New School forSocial Research and External Professor, Santa Fe Institute
‘McCauley's mathematically and empirically rigorous Dynamics of Markets is one of those rare works which is challenging, not only to an intellectual orthodoxy (neoclassical economics), but also to its fledgling rival (econophysics). Neoclassical economics and finance theory receive justifiably dismissive treatments for failing empirically, but some econophysics contributions also distort empirical datanotably McCauley shows that “fat tails” in data can be the result of applying an unjustified binning process to nonstationary data. McCauley's essential messages for the future of economics after the Global Financial Crisis is that “There is no statistical evidence for Adam Smith's Invisible Hand”, and that the hand that does exist and must be understood is both nonstationary and far from equilibrium.’
Steve Keen, School of Economics and Finance,University of Western Sydney
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.
Dynamics of Markets
The New Financial Economics
Second Edition
Joseph L. McCauley
University of Houston
CAMBRIDGE UNIVERSITY PRESS
Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi
Cambridge University Press
The Edinburgh Building, Cambridge CB2 8RU, UK
Published in the United States of America by Cambridge University Press, New York
www.cambridge.org
Information on this title: www.cambridge.org/9780521429627
© J. McCauley 2009
This publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press.
First published 2004
Reprinted 2006
Paperback edition 2007
Second edition 2009
Printed in the United Kingdom at the University Press, Cambridge
A catalog record for this publication is available from the British Library
Library of Congress CataloginginPublication DataMcCauley, Joseph L.Dynamics of markets : the new financial economics / Joseph L. McCauley. – 2nd ed.p. cm.Includes bibliographical references.ISBN 9780521429627 (hardback)1. Finance–Mathematical models. 2. Finance–Statistical methods. 3. Business mathematics.4. Markets–Mathematical models. 5. Statistical physics. I. Title.HG106.M4 2009332.01′5195–dc222009015596
ISBN 9780521429627 hardback
Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or thirdparty Internet websites referred to in this publication, and does not guarantee that any content on such websites is, or will remain, accurate or appropriate.
For my stimulating partner Cornelia, who worked very hard and effectively helping me to improve the text in both editions, and for our sons, Finn and Hans.
Contents
Preface to the second edition

xi 
1 Econophysics: why and what

1 
1.1 Why econophysics?

1 
1.2 Invariance principles and laws of nature

4 
1.3 Humanly invented law can always be violated

5 
1.4 Origins of econophysics

7 
1.5 A new direction in econophysics

8 
2 Neoclassical economic theory

10 
2.1 Why study “optimizing behavior”?

10 
2.2 Dissecting neoclassical economic theory (microeconomics)

12 
2.3 The myth of equilibrium via perfect information

18 
2.4 How many green jackets does a consumer want?

24 
2.5 Macroeconomics

25 
3 Probability and stochastic processes

29 
3.1 Elementary rules of probability theory

29 
3.2 Ensemble averages formed empirically

30 
3.3 The characteristic function

32 
3.4 Transformations of random variables

33 
3.5 Laws of large numbers

34 
3.6 Examples of theoretical distributions

38 
3.7 Stochastic processes

43 
3.8 Stochastic calculus

57 
3.9 Ito processes

63 
3.10 Martingales and backwardtime diffusion

77 
4 Introduction to financial economics

80 
4.1 What does noarbitrage mean?

80 
4.2 Nonfalsifiable notions of value

82 
4.3 The Gambler's Ruin

84 
4.4 The Modigliani–Miller argument

85 
4.5 Excess demand in uncertain markets

89 
4.6 Misidentification of equilibrium in economics and finance

91 
4.7 Searching for Adam Smith's Unreliable Hand

93 
4.8 Martingale markets (efficient markets)

94 
4.9 Stationary markets: value and inefficiency

98 
4.10 Black's “equilibrium”: dreams of recurrence in the market

101 
4.11 Value in real, nonstationary markets

102 
4.12 Liquidity, noise traders, crashes, and fat tails

103 
4.13 Longterm capital management

105 
5 Introduction to portfolio selection theory

107 
5.1 Introduction

107 
5.2 Risk and return

107 
5.3 Diversification and correlations

109 
5.4 The CAPM portfolio selection strategy

113 
5.5 Hedging with options

117 
5.6 Stock shares as options on a firm's assets

120 
5.7 The Black–Scholes model

122 
5.8 The CAPM option pricing strategy

124 
5.9 Backwardtime diffusion: solving the Black–Scholes pde

127 
5.10 Enron 2002

130 
6 Scaling, pair correlations, and conditional densities

133 
6.1 Hurst exponent scaling

133 
6.2 Selfsimilar Ito processes

135 
6.3 Long time increment correlations

139 
6.4 The minimal description of dynamics

145 
6.5 Scaling of correlations and conditional probabilities?

145 
7 Statistical ensembles: deducing dynamics from time series

148 
7.1 Detrending economic variables

148 
7.2 Ensemble averages constructed from time series

149 
7.3 Time series analysis

152 
7.4 Deducing dynamics from time series

162 
7.5 Early evidence for variable diffusion models

167 
7.6 Volatility measures

167 
7.7 Spurious stylized facts

168 
7.8 An sde for increments?

173 
7.9 Topological inequivalence of stationary and nonstationary processes

173 
8 Martingale option pricing

176 
8.1 Introduction

176 
8.2 Fair option pricing

178 
8.3 Pricing options approximately via the exponential density

182 
8.4 Option pricing with fat tails

185 
8.5 Portfolio insurance and the 1987 crash

186 
8.6 Collateralized mortgage obligations

186 
9 FX market globalization: evolution of the Dollar to worldwide reserve currency

188 
9.1 Introduction

188 
9.2 The money supply and nonconservation of money

189 
9.3 The gold standard

190 
9.4 How FX market stability worked on the gold standard

190 
9.5 FX markets from WWI to WWII

194 
9.6 The era of “adjustable pegged” FX rates

196 
9.7 Emergence of deregulation

197 
9.8 Deficits, the money supply, and inflation

204 
9.9 Derivatives and shadow banking

208 
9.10 Theory of value under instability

211 
9.11 How may regulations change the market?

212 
10 Macroeconomics and econometrics: regression models vs empirically based modeling

214 
10.1 Introduction

214 
10.2 Muth's rational expectations

216 
10.3 Rational expectations in stationary markets

219 
10.4 Toy models of monetary policy

222 
10.5 The monetarist argument against government intervention

224 
10.6 Rational expectations in a nonstationary world

225 
10.7 Integration I(d) and cointegration

226 
10.8 ARCH and GARCH models of volatility

238 
11 Complexity

241 
11.1 Reductionism and holism

241 
11.2 What does “complex” mean?

244 
11.3 Replication, mutations, and reliability

253 
11.4 Emergence and selforganization

256 
References

261 
Index

268 
© Cambridge University Press