AC345 Social and Organisational Dimensions of Markets Lecture 6: Markets as organisations 2 This wee

1
AC345 - Social and Organisational Dimensions of
Markets Lecture 6 Markets as organisations
2This week only in room 5N.4.6

• Yuval Millo
• AFM, Essex

2
Review

• Measures of network structures
• Density
• Transitivity
• Strength of Weak Ties
• Structural Holes
• The structure of the network affects the ways
  agents behave, and in aggregate, the way the
  market behaves.

3
Number of market agents and market behaviour

• Neoclassical economics expects markets to be more
  efficient as the number of agents grow.
• Yet, as the number of agents grows, the density
  of the network drops significantly.
• Two reasons for this
• Graph theory
• Selective association

4
Number of market agents and market behaviour

• So, beyond a certain size, a single-crowd market
  breaks down to smaller units within each almost
  all trading is conducted.
• Price volatility increases as more traders join
  the trade. Under similar conditions, the small
  crowds would produce better prices than the
  bigger ones.
• In addition, imposing reciprocity norms is easier
  in small crowds than in large ones

5
Informal Self-regulation and market structure

• Baker shows that agents do not only engage in
  economic activities, but they regulate their
  environment perform normative tasks. For
  example, I will only trade with market makers
  who fulfil their obligations.
• Spatial arrangements also restrict the number of
  potential partners, as those who stand next to
  each are more likely to develop trading
  relationships.

6
The role of networks in making economic decisions

• According to economic theory consumers would like
  to maximize their potential sellers.
• So, why do people buy from others within their
  social network?
• The choice of transaction partners is restricted
• The membership in an embedded network provides
  security

7
Arbitrage

• Arbitrage is trading that exploits price
  discrepancies.
• For example, differences between the prices of
  the same asset at different geographical
  locations
• Arbitrageurs perform economic theory they
  equalise prices of similar assets.

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Institutional foundations of arbitrage

• Feasibility of Arbitrage is based on
• Size of the markets (number of actors)
• Communication between actors
• In which market types (structures) would we
  expect to have more arbitrage opportunities than
  others? Why?

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Dual role of prices

• Prices affect market participants in two ways
• Price determine profitability of transaction
• Current prices help to decide about the movement
  of prices in the future
• So, if there are many investors who use prices as
  indicators, sudden price changes would tend to
  have a big effect on the investor population and
  amplify price changes.

10
LTCM The Russian Bonds default

• Growing problems in Russia motivated the
  government to default on one of its bonds.
• Investors that were involved deeply in this
  market suffered heavy losses and went bankrupt.
• The losses were echoed in breaches of VaR limits
  in other markets.
• These breaches led to enforced portfolio-wide
  liquidations in order decrease expose to risk or
  to provide more reserve capital.

11
LTCM Increased Correlation

• Because of the flight to liquidity one simple
  rule the more liquid, the better seemed to
  replace more sophisticated deliberations.
• Result positions that usually moved in opposite
  directions started moving uniformly.
• Hedging became much more difficult as positions
  could no longer be protected by each other.
• VaR numbers rose, reflecting the increased risk
  of holding positions, positions were liquidated,
  feeding back into the flight to liquidity.

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LTCM Flight to Liquidity

• In itself, the Russian default could not cause a
  market-wide shock arbitrage positions were
  supposed to be protected from such price drops.
• However, the atmosphere in the markets has
  changed.
• Arbitrage opportunities still existed, but
  virtually no one dared to buy assets that were
  potentially illiquid, in the fear that it would
  be hard to sell those assets.

13
LTCM Superportfolio (MacKenzie)

• FtL was amplified by imitation among investors.
• Indication when overall market volatility
  increased, it was expected that the volatility of
  positions held by both LTCM and imitators would
  increase further.

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Discussion class

• Can arbitrage exist in market dominated by
  embedded ties?
• What can structural and historical approaches add
  to our understanding of liquidity?