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Dynamics of Markets

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  • 19 b/w illus.
  • Page extent: 286 pages
  • Size: 247 x 174 mm
  • Weight: 0.73 kg

Hardback

 (ISBN-13: 9780521429627)

Dynamics of Markets
Cambridge University Press
9780521429627 - Dynamics of Markets - The New Financial Economics - Edited by Joseph L. McCauley
Frontmatter/Prelims

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 closely-reasoned critique of financial-economic mathematical modeling practice. McCauley's demonstration of the incompatibility between the assumptions of market-clearing equilibrium and informational efficiency is stunning, and sheds much-needed light on the mathematical modeling failures revealed by the financial melt-down. His unvarnished criticisms of neoclassical economic doctrine deserve equal attention. McCauley opens the windows of the self-referential 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 data--notably 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 non-stationary 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

Edited by

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 Cataloging-in-Publication DataMcCauley, Joseph L.Dynamics of markets : the new financial economics / Joseph L. McCauley. – 2nd ed.p. cm.Includes bibliographical references.ISBN 978-0-521-42962-7 (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 978-0-521-42962-7 hardback

Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party 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       Neo-classical economic theory
10
2.1     Why study “optimizing behavior”?
10
2.2     Dissecting neo-classical 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 backward-time diffusion
77
4       Introduction to financial economics
80
4.1     What does no-arbitrage 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    Long-term 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     Backward-time 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 self-organization
256
References
261
Index
268



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