The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

Jean-Philippe Bouchaud

Contents

Introduction to 'Lessons from the Financial Crisis'

1.

The Credit Crunch of 2007: What Went Wrong? Why? What Lessons Can be Learned?

2.

Underwriting versus Economy: A New Approach to Decomposing Mortgage Losses

3.

The Shadow Banking System and Hyman Minsky’s Economic Journey

4.

The Collapse of the Icelandic Banking System

5.

The Quant Crunch Experience and the Future of Quantitative Investing

6.

No Margin for Error: The Impact of the Credit Crisis on Derivatives Markets

7.

The Re-Emergence of Distressed Exchanges in Corporate Restructurings

8.

Modelling Systemic and Sovereign Risks

9.

Measuring and Managing Risk in Innovative Financial Instruments

10.

Forecasting Extreme Risk of Equity Portfolios with Fundamental Factors

11.

Limits of Implied Credit Correlation Metrics Before and During the Crisis

12.

Another view on the pricing of MBSs, CMOs and CDOs of ABS

13.

Pricing of Credit Derivatives with and without Counterparty and Collateral Adjustments

14.

A Practical Guide to Monte Carlo CVA

15.

The Endogenous Dynamics of Markets: Price Impact, Feedback Loops and Instabilities

16.

Market Panics: Correlation Dynamics, Dispersion and Tails

17.

Financial Complexity and Systemic Stability in Trading Markets

18.

The Martingale Theory of Bubbles: Implications for the Valuation of Derivatives and Detecting Bubbles

19.

Managing through a Crisis: Practical Insights and Lessons Learned for Quantitatively Managed Equity Portfolios

20.

Active Risk Management: A Credit Investor’s Perspective

21.

Investment Strategy Returns: Volatility, Asymmetry, Fat Tails and the Nature of Alpha

Why do asset prices move so frequently and why is the volatility so high? Why do prices move at all? These are obviously fundamental questions in theoretical economics and quantitative finance, which encompass other, related issues: what is the information reflected by prices, and to what extent market prices reflect the underlying economic reality? Do we understand the origin of crises and crashes?

In this chapter, we review the evidence that the erratic dynamics of markets is to a large extent of endogenous origin, ie, determined by the trading activity itself and not due to the rational processing of exogenous news. In order to understand why and how prices move, the joint fluctuations of order flow and liquidity, and the way in which these impact on prices, become the key ingredients. Impact is necessary for private information to be reflected in prices but, by the same token, random fluctuations in order flow necessarily contribute to the volatility of markets. Our thesis is that the latter contribution is in fact dominant, resulting in a decoupling between prices and fundamental values, at least on short-to-medium timescales. We argue that markets operate in a regime of

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