Dynamics of Markets: Econophysics and Finance

From the Publisher

Standard texts and research in economics and finance ignore the absence of evidence from the analysis of real, unmassaged market data to support the notion of Adam Smith's stabilizing Invisible Hand. In stark contrast, this text introduces a new empirically-based model of financial market dynamics that explains the volatility of prices options correctly and clarifies the instability of financial markets. The emphasis is on understanding how real markets behave, not how they hypothetically 'should' behave.

Table of Contents

1 The moving target 1
2 Neo-classical economic theory 9
3 Probability and stochastic processes 31
4 Scaling the ivory tower of finance 63
5 Standard betting procedures in portfolio selection theory 91
6 Dynamics of financial markets, volatility, and option pricing 121
7 Thermodynamic analogies vs instability of markets 147
8 Scaling, correlations, and cascades in finance and turbulence 161
9 What is complexity? 185

Excerpts

In economics, in contrast with physics, there exist no known inviolable mathematical laws of "motion"/Behavior. Instead, economic law is either legislated law, dictatorial edict, contract, or in tribal societies the rule of tradition. Economic "law" like any legislated law or social contract, can always be violated by willful people and groups. In addition, the idea of falsification via observation has ot yet taken root. Instead, an internal logic system called neo-classical economic theory was invented via postulation and dominates academic economics.

Econophysics is not like academic economics. We are not trying to make incremental improvements in theory, we are trying instead to replace the standard models with something completely new.

There is no microeconomic basis for either Keynesian economics or Monetarism, both of which make empirically illegitimate assumptions about equilibrium.

A better way to understand Keynes' original idea is to assume that the market is not in equilibrium.

A flea market is an example where equilibrium is never reached.

There is an important distinction between gambling in a casino and gambling in a financial market. In the former the probabilities are fixed: no matter how many people bet on red, if the roulette wheel turns up black they all lose. In the market, the probability that you win increases with the number of people making the same bet as you. (...) You win if you sell before the others get out of the market. That is, in order to win you must (as Keynes pointed out) guess correctly what other people are going to do before they do it.

There are no springs in the market, only unbound diffusion of stock prices with nothing to pull them back to your notion of "fair value".

Excess demand is approxmiated by drift plus noise.

Financial asset prices appear to be random, completely unpredictable, even on the shortest trading time scale on the order of a second: given the price of the last trade, one doesn't know if the next tade will be up or down, or by how much. In contrast, deterministic chaotic systems are pseudo-random at long times but cannot be distinguished from nonchaotic systems at the shortest times.

Limit book orders prevent the markets from approaching any equilibrium.

Agents who want to make money do not want stability, they want big returns. Big returns occur when agents collectively bid up the price of assets. In this case agents contribute to market instability via positive feedback effects.

The market, as Osborne taught us, consists of unfilled limit book orders that are step fucntions.

The believers in the efficient market hypothesis cannot argue that stocks may be over- or under-valued because according to their picture, the market is always right, the market price is the fair price.

In looking for an analogy with thermodynamics we will concentrate on three things, using as observable variables the prices and quantities held of financial assets: an empirically meaningful definition of reversibility, analogy of the heat bath, and the appearance of entropy as the measure of market disorder.

Another famous example of misplaced trust in neo-classical economic belief is the case of LTCM, where it was assumed that prices would always return to historic averages (...) Entropy of the market is always increasing, never reaching a maximum, and is consistent with large fluctuations that have unknown and completely unpredictable relaxation times.

One cannot have both completely unregulated markets and stability; the two conditions are apparently incompatible.

Entropy-based information:

They (economists) believe that the market "fairly" evaluates an asset at all times. Our perspective is different. Coming from physics, we expect that one starts with imperfect knowledge of the market, and that "information" is degraded as time goes on, represented by the market entropy increase, unless new knowledge is received.

In neo-classical economics theory the information content is zero because there is no noise, no ambiguity or uncertainty.