Financial Complexity and Systemic Stability in Trading Markets

Matteo Marsili and Kartik Anand

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

In this chapter we address the systemic consequences of the increased complexity in financial markets. This trend may be thought of as a response to a demand by investors for access to new assets and markets, better transferring and trading of risks and ever higher yields. There are several dimensions in which complexity has increased over past decades. Foremost of these has been the information technology (IT) revolution, which, with the rise of electronic markets, has allowed unfettered trading at ever increasing frequencies. We have witnessed an evolution that has lead to greater diversity in the population of traders in financial markets. This diversity includes, amongst others, hedge funds and investment banks specialising in niche markets and deploying more and more aggressive speculative strategies.11 See the plenary talk of Pliska (2010) at the Sixth World Congress of the Bachelier Finance Society for an overview of the risks and opportunities in electronic market making.

Concurrent with developments on the IT side, the repertoire of trading instruments has expanded considerably, in both scope and volume. Innovations in financial engineering and computational methods have

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