The global financial markets walk on the razors edge of empiricism and what you see is not what you think, and what you think may very well be impossible anyway. The impossible object in art is an illustration that highlights the limitations of human perception and is an appropriate construct for our modern capitalist dystopia. Famous examples include Necker’s Cube, Penrose Triangle, Devil’s Tuning Fork, and the artwork of M.C. Escher. The formal definition is “an optical illusion consisting of a two-dimensional figure which is instantly and subconsciously interpreted as representing a projection of three- dimensional space even when it is not geometrically possible” (1). The fundamental characteristic of the impossible object is uncertainty of perception. Is it feasible for a real waterfall to flow into itself; or for a triangle to complete itself in both directions? The figures are subject to multiple forms of interpretation challenging whether our naïve perception is relevant to understanding the truth. The impossible object is of vast importance to mathematics, art, philosophy and as I will argue… modern pricing of risk.
Modern financial markets are a game of impossible objects. In a world where global central banks manipulate the cost of risk the mechanics of price discovery have disengaged from reality resulting in paradoxical expressions of value that should not exist according to efficient market theory. Fear and safety are now interchangeable in a speculative and high stakes game of perception. The efficient frontier is now contorted to such a degree that traditional empirical views are no longer relevant.
The volatility of an impossible object is your own changing perception.
It was only a year ago when the world was imploding and the VIX traded at 40+. A few points on the lazy VIX, by Doug Short.
Let’s review the recent volatility, or absence thereof) in the S&P 500. The first chart below features an overlay of the index and the CBOE Volatility Index (VIX) since 2007. The current levels of this index are well below the 20 level, a traditional traditionally associated with increased market risk. A recent WSJ article summarizes the usual interpretation of this indicator.
The point I want to make here is that our brains are not calibrated to deal with the unexpected. Most of us believe we are good risk managers but in reality we are not. Most of us trust that risk can always be quantified and expressed through some fancy modelling whereas, often, it cannot. When I went to lunch on the 11th September, 2001, little did I know – or expect – that less than an hour later I would get a call from my assistant suggesting that it was probably best if I came back to my desk as quickly as I possibly could.
The world is not normal, yet universities continue to teach our young students the wisdom of Markowitz and Sharpe which brought us modern portfolio theory and, more specifically, the capital asset pricing model. Garbage In, Garbage Out, as they say. One of the fundamental assumptions behind modern portfolio theory is that asset returns are normally distributed random variables. I suggest you take a glance at chart 1 below. The bright (smooth) blue line depicts a perfect normal distribution. The darker (uneven) blue line represents actual equity market returns over the past couple of decades. Even the untrained eye can see that the return profile of US equities fairly closely matches that of a normal distribution with the exception of large negative returns. They have come about more frequently than one would or should expect.
The Silver and Gold collapse has attracted many pundits and their beliefs of what is going on. Copper, not in fashion these days, is by many called Dr Copper. Wonder why? It is highly correlated to the SPX and a good measure of the Economy. Copper, having “collapsed” during the past week, is implying SPX to trade lower. Last time Copper traded at these levels, SPX traded at 1050.
Majority of Investors, Traders and Regulators have their opinion on HFT and the Impact on the Markets. With correlations having reached extreme levels lately (everything moving together), an external shock to the system, risks “destroying” the microstructure of the market totally, and the cost to the society will be huge. Below some extracts from a fairly objective report on HFT and Market Impact by Fabozzi, Focardi and Jonas.
It is widely held that HFT provides liquidity to equity markets. However, HFT per se provides liquidity only for a very short time. By the nature of their business, HFTers buy and sell at high frequency. If they do not find a counterparty for a trade in a matter of seconds, orders are cancelled. These are the (in)famous flash trades. Among the academics and industry players we interviewed, opinions were divided as to the nature of liquidity provided by HFTers. Some argue that liquidity provided by HFT is exercisable liquidity; those who question the benefit of HFT liquidity point to its fleeting quality.
The types of tactics used by HFTers leads to cancellation rates that keep exploding. Most orders are now cancelled almost instantaneously. It is not a question of being manipulative; HFTers are just trying to understand the liquidity out there and scale up and trade against it. HFTers (are) also looking for a lack of liquidity. Liquidity provided by HFTers is not an illusion, but it is different from the usual liquidity. The old notion was that traders want everyone else to show their hands without showing their own hand but it does not work that way. You cannot mandate liquidity. You must make it attractive for people to show their hands without the fear of being picked off. If a trader shows impatience, he or she will not get a good price.