Ravi Kashyap

A Tale of Two Consequences

This article looks at the effect of the tick size changes by the Tokyo Stock Exchange on January 14, 2014, and July 22, 2014, on the TOPIX 100 index stocks. The intended consequence of the change is price improvement and shorter time to execution. The author examines at security level metrics, including the spread, trading volume, number of trades, and the size of trades to establish whether this goal is accomplished. An unintended effect might be the reduction in execution sizes, which would then mean that institutions with large orders would have greater difficulty in sourcing liquidity. He looks at a sample of real orders to see if the execution costs have gone up across the orders since the implementation of this change.

Financial Services, Economic Growth and Well-Being: A Four-Pronged Study

A four-pronged approach to dealing with Social Science Phenomenon is outlined. This methodology is applied to Financial Services, Economic Growth and Well-Being. The four prongs are like the four directions for an army general looking for victory. Just like the four directions, we need to be aware that there is a degree of interconnectedness in the below four prongs. -Uncertainty Principle of the Social Sciences -Responsibilities of Fiscal Janitors -Need for Smaller Organizations -Redirecting Growth that Generates Garbage The importance of gaining a more profound comprehension of welfare and delineating its components into those that result from an increase in goods and services, and hence can be attributed to economic growth, and into those that are not related to economic growth but lead to a better quality of life, is highlighted. The reasoning being that economic growth alone is an inadequate indicator of well-being. Hand in hand with a better understanding of the characteristics of welfare, comes the need to consider the metrics we currently have that gauge economic growth and supplement those with measures that capture well-being more holistically.

Dynamic Multi-Factor Bid–Offer Adjustment Model: A Feedback Mechanism for Dealers (Market Makers) to Deal (Grapple) with the Uncertainty Principle of the Social Sciences

The author seeks to develop a model to alter the bid–offer spread, currently quoted by market makers, that varies with the market and trading conditions. The dynamic nature of financial markets and trading—as with the rest of social sciences, where changes can be observed and decisions can be made by participants to influence the system—means that this model has to be adaptive and include a feedback loop that alters the bid–offer adjustment based on the modifications observed in the market and trading conditions, without a significant time delay. The factors used to adjust the spread are price volatility, which is publicly observable, and trade count and volume, which are generally known only to the market maker, in various instruments over different historical durations in time. The contributions of each factor to the bid–offer adjustment are computed separately and then consolidated to produce a very adaptive bid–offer quotation. The author uses the currency markets to build the sample model because they are extremely liquid and trading in them is not as transparent as other financial instruments, such as equities. Simulating the number of trades and the average size of trades from a lognormal distribution, the parameters of the lognormal distributions are chosen such that the total volume in a certain interval matches the volume publicly mentioned by currency trading firms. This methodology can easily be extended to other financial instruments and possibly to any product with the ability to make electronic price quotations, or can even be used to periodically perform manual price updates on products that are traded non-electronically.

Financial Services, Economic Growth and Well-Being

The primary topic of consideration here is the relationship between the Financial Sector and Economic Growth. This is, of course, a natural extension of studies that focus on various variables that influence economic growth and falls under the wider category of beneficial factors and policies aimed at increasing the welfare or well-being to society. It is worth considering this wider goal, at the outset, since the effective functioning of the financial sector is critically dependent on obtaining a deeper understanding of these factors. These factors will be broadly classified into what we refer to as the four prongs and will be elaborated upon in subsequent sections. The four prongs are like the four directions for an army general looking for victory and any attempt at financial service reform that does not consider all the four prongs will prove to be insufficient and will be incomplete at best.We need to consider all the four prongs because the first one tells us about the limitation of any relationships we uncover; the second tells us about what is the overriding need of the financial sector and whether we are deviating from the intended goals; the third tells us that keeping complexity in check is important for accomplishing our objectives; and the fourth one tells us where unintended growth, that will provide no real benefit, can result, despite the care we take to adhere to the stipulations of the first three. Just like the four directions, we need to be aware that there is a degree of interconnectedness in the below four prongs.1. The Uncertainty Principle of the Social Sciences 2. The Responsibilities of Fiscal Janitors 3. The Need for Smaller Organizations 4. Redirecting Growth that Generates GarbageIt is also important to gain a quick, yet more profound, comprehension of welfare and delineate its components into those that result from an increase in goods and services, and hence can be attributed to economic growth, and into those that are not related to economic growth but lead to a better quality of life. The reasoning here being that economic growth alone is an inadequate indicator of well-being.Hand in hand with a better understanding of the characteristics of welfare, comes the need to consider the measures or metrics we currently have that gauge economic growth and supplement those with factors that capture well-being more holistically. This is important because, there would be little sense in pursuing policies aimed at increasing some widely used metric like Gross Domestic Product, GDP, if such policies do not lead to an increase in welfare and worse still, if they lead to an unintentional decrease in well-being; on a lighter note, it is worth pondering about which meaning of gross is applicable in the context of GDP. With this, we would look to either constructing new metrics all together or looking at ways to improve or supplement existing ones.The ensuing discussion, with the use of several illustrative analogies, is meant to intuitively demonstrate the validity of the four prongs. A formal approach towards proving these will be outlined in the subsequent sections and augmented or amended in later versions of this study.

Solving the Equity Risk Premium Puzzle and Inching Towards a Theory of Everything

The crux of the equity premium puzzle is that the return on equities has far exceeded the average return on short-term, risk-free debt and cannot be explained by conventional representative-agent, consumption-based equilibrium models. The author reviews several attempts undertaken over the years to explain this anomaly and explores whether a fusion of the approaches supplemented with better methods to handle various reservations would provide a more realistic and yet tractable framework to tackle the various conundrums in the social sciences. The rationale for a unified theory is that beauty can emerge from chaos and many long-standing puzzles seem to have been resolved using different techniques.

Solving Society’s Big Ills, A Small Step

We look at a collection of conjectures with the unifying message that smaller social systems, tend to be less complex and can be aligned better, towards fulfilling their intended objectives. We touch upon a framework, referred to as the four pronged approach that can aid the analysis of social systems. The four prongs are: 1. The Uncertainty Principle of the Social Sciences 2. The Objectives of a Social System or the Responsibilities of the Players 3. The Need for Smaller Organizations 4. Redirecting Unintended Outcomes Smaller organizations mitigating the disruptive effects of corruption is discussed and also the need for organizations, whose objective is to foster the development of other smaller organizations. We consider a way of life, which is about respect for knowledge and a desire to seek it. Knowledge can help eradicate ignorance, but the accumulation of knowledge can lead to overconfidence. Hence it becomes important to instill an attitude that does not knowledge too seriously, along with the thirst for knowledge. All of this is important to create an environment that is conducive for smaller organizations and can be viewed as a natural extension of studies that fall under the wider category of understanding factors and policies aimed at increasing the welfare or well-being to society.

David vs Goliath (You against the Markets), A Dynamic Programming Approach to Separate the Impact and Timing of Trading Costs

A traders conundrum is whether (and how much) to trade during a given interval or wait for the next interval when the price momentum is more favorable to his direction of trading. We develop a fundamentally different stochastic dynamic programming model of trading costs based on the Bellman principle of optimality. Built on a strong theoretical foundation, this model can provide insights to market participants by splitting the overall move of the security price during the duration of an order into the Market Impact (price move caused by their actions) and Market Timing (price move caused by everyone else) components. Plugging different distributions of prices and volumes into this framework can help traders decide when to bear higher Market Impact by trading more in the hope of offsetting the cost of trading at a higher price later. We derive formulations of this model under different laws of motion of the security prices. We start with a benchmark scenario and extend this to include multiple sources of uncertainty, liquidity constraints due to volume curve shifts and relate trading costs to the spread. We develop a numerical framework that can be used to obtain optimal executions under any law of motion of prices and demonstrate the tremendous practical applicability of our theoretical methodology including the powerful numerical techniques to implement them. This decomposition of trading costs into Market Impact and Market Timing allows us to deduce the zero sum game nature of trading costs. It holds numerous lessons for dealing with complex systems, especially in the social sciences, wherein reducing the complexity by splitting the many sources of uncertainty can lead to better insights in the decision process.

Combining Dimension Reduction, Distance Measures and Covariance

Market Microstructure is the investigation of the process and protocols that govern the exchange of assets with the objective of reducing frictions that can impede the transfer. In financial markets, where there is an abundance of recorded information, this translates to the study of the dynamic relationships between observed variables, such as price, volume and spread, and hidden constituents, such as transaction costs and volatility, that hold sway over the efficient functioning of the system.We consider a measure of similarity, the Bhattacharyya distance, across distributions of these variables. We illustrate a novel methodology based on the marriage between the Bhattacharyya distance and the Johnson Lindenstrauss Lemma, a technique for dimension reduction, providing us with a simple yet powerful tool that allows comparisons between data-sets representing any two distributions. We demonstrate a relationship between covariance and distance measures based on a generic extension of Steins Lemma. The degree to which different markets or sub groups of securities have different measures of their corresponding distributions tells us the extent to which they are different. This can aid investors looking for diversification or looking for more of the same thing. We consider an asset pricing application and then briefly discuss how this methodology lends itself to numerous Marketstructure studies and even applications outside the realm of finance / social sciences.

Securities Lending Strategies, Exclusive Auction Bids

The objective is either to design an appropriate securities lending auction mechanism or to come up with a strategy for placing bids, depending on which side of the fence a participant sits. There are two pieces to this puzzle. One is the valuation of the portfolio being auctioned subject to the available information set. The other piece would be to come up with the best strategy from an auction perspective once a valuation has been obtained. We derive valuations under different assumptions and show a weighting scheme that converges to the true valuation. We extend auction theory results to be more applicable to financial securities and intermediaries. All the propositions are new results and they refer to existing results which are given as Lemmas without proof. Lastly, we run simulations to establish numerical examples for the set of valuations and for various bidding strategies corresponding to the different auction settings.

Auction theory adaptations for real life applications

We develop extensions to auction theory results that are useful in real life scenarios. 1. Since valuations are generally positive we first develop approximations using the log-normal distribution. This would be useful for many finance related auction settings since asset prices are usually non-negative. 2. We formulate a positive symmetric discrete distribution, which is likely to be followed by the total number of auction participants, and incorporate this into auction theory results. 3. We develop extensions when the valuations of the bidders are interdependent and incorporate all the results developed into a final combined realistic setting. 4. Our methods can be a practical tool for bidders and auction sellers to maximize their profits. The models developed here could be potentially useful for inventory estimation and for wholesale procurement of financial instruments and also non-financial commodities. All the propositions are new results and they refer to existing results which are stated as Lemmas.