FINANCIAL
TRADING AND
INVESTING
JOHN L. TEALL
AMSTERDAM • BOSTON • HEIDELBERG • LONDON NEW YORK • OXFORD • PARIS • SAN DIEGO SAN FRANCISCO • SINGAPORE • SYDNEY • TOKYO
Contents
Preface xi
1. Introduction to Securities Trading and Markets
1.1 Trades, Traders, Securities, and Markets 1 Trading Illustration 2 ,. •
Securities and Instruments 2 1.2 Securities Trading 4
Algorithmic Trading: A Brief Introduction 5
1.3 Bargaining 6 1.4 Auctions 7
Auction Outcomes 9 Common Value Auctions 10 Google's Dutch Auction Format 11 1.5 Introduction to Market Microstructure 11
Market Execution Structures 12 1.6 Orders, Liquidity, and Depth 13 1.7 Day Trading 15
Online Brokers and Direct Access Trading 16
Trading Platforms 17 Quotations and Price Data 18 Trading Arcadei 20
Additional Reading 21 References 21
1.8 Exercises 22
2. Financial Markets, Trading Processes, and Instruments
2.1 Exchanges and Floor Markets 25 NYSE Euronext 25
2.2 The Way It Was 27
National and Regional Exchanges 27 Early Ancestors to Modern Exchanges 27 Traditional New York Stock Exchange
Structure 29
Transforming the NYSE 30
Demutualization and Governance Changes 31
Diminished Floor Trading Activity 33 Current New York Stock Exchange Equities - - Membership Types 33
Option Exchanges 34
2.3 Over-the-Counter Markets and Alternative Trading Systems 35
Over-the-Counter Markets 36 Alternative Trading Systems 37 2.4 The Decline of Brick and Mortar 40
Electronic versus Open Outcry 42 2.5 Crossing Networks and Upstairs
Markets 43 Internalization 45
2.6 Quotation, Intermarket, and Clearing Systems 45
Clearing and Settlement 46 2.7 Brokerage Operations 48
2.8 Fixed-Income Securities and Money Markets 49
U.S. Treasury Securities and Markets 50 Agency Issues 50
Municipal Securities and Markets 52 Financial Institution Instruments 52 Corporate Bonds and Markets 53 Credit Ratings and Credit Agencies 54 Eurocurrency Instruments and
Markets 56
2.9 Markets Around the World 57 2.10 Currency Exchange and Markets 58
Exchange Rates 59
Forward Exchange Rates and Contracts 60
Futures Markets 62 Currency Trading 62
Interdealer Brokers and Electronic Broking 63
Futures and Other FX Markets 63 Orders, Quotes, and Spreads 64 Additional Reading 65
VI CONTENTS References 65
2.11 Exercises 65
3. Institutional Trading
3.1 Institutions and Market Impact 67 3.2 Registered Investment Companies 68
;Managed Investment Company Types 68 Managed Investment Company Fees and
Structures 69 ETFs 70
3.3 Unregistered Investment Companies 71 Pension Funds 72
Bank Trusts and Private Banking 72 Private Equity 73
Hedge Funds '73 Rule 144A Markets 73
3.4 Best Execution, Execution Costs, and Price Improvement 74
Spreads 74
Illustration: Slippage and the Perfect Foresight Half Spread 76 3.5 Algorithmic Trading 77
Algo Strategies 79
Illustration: Slicing the Large Transaction 80
3.6 Dark Pools 81
3.7 Stealth And Sunshine Trading 82 3.8 High-Frequency Trading 84
Latency Arbitrage 85 HFT Strategies 86
3.9 Flash Trading And Sponsored Access 87 Illustration: A Flash Trade 88
Sponsored Access 88 Additional Reading 89 References 89
3.10 Exercises 90
4. Regulation of Trading and Securities Markets
4.1 Background and Early Regulation 93 Regulatory Approaches 94
Pre-1930s Securities Regulation: The Background 94
4.2 U.S. Securities Market Legislation: The Foundation 96
The Bedrock: The Securities Act of 1933 and the Securities Exchange Act of 1934 96 Additional Major Depression-Era
Legislation 97
4.3 Crises and Updating the Regulatory System 99
The 1960s Go-Go Years and Reform 99 Updating Commodities Trading Regulation
and the National Market System 100 Insider Trading Regulation 100
4.4 Deregulation, Corporate Scandals, and the Financial Crisis of 2008 101
Deregulation 101 Sarbanes-Oxley 102 Post-SOX 103
The 2008 Financial Crisis 104 4.5 Dodd-Frank 104
4.6 Government Oversight of Self-Regulation: The Securities and Exchange Commission and Commodity Futures Trading
Commission 105 The Securities and Exchange
Commission 106
The Commodity Futures Trading Commission 107
4.7 Impact of Regulatory Activity 108 4.8 Regulation: The International Arena 110
Selected Country Regulatory Authorities 111
4.9 Privatization of Regulation and Exchange Rules 111
NYSE Rules 112
NYSE Circuit Breakers 113 Additional Reading 113 References 114
4.10 Exercises 115
5. Adverse Selection, Trading, and Spreads
5.1 Information and Trading 117 Adverse Selection 117 5.2 Noise Traders 118
5.3 Adverse Selection in Dealer Markets 119 Kyle: Informed Traders, Market Makers, and
Noise Traders 119
5.4 Adverse Selection and the Spread 127 The Demsetz Immediacy Argument 127
CONTENTS Vll
Glosten and Milgrom Information Asymmetry Model 128 The Stoll Inventory Model 128 The Copeland and Galai Options
Model 130 Additional Reading 131 References 131
5.5 Exercises 132
6. Random Walks, Risk, and Arbitrage 6.1 Market Efficiency and Random Walks 135
Random Walks and Submartingales 135 Brownian Motion Processes 137 Weiner Processes 138'
6.2 Risk 138
Historical Volatility Indicators 139 Extreme Value Estimators 141 Implied Volatilities 142 6.3 Arbitrage 144
Pairs Trading and Stat-Arb 145 6.4 Limits to Arbitrage 146 Additional Reading 149 References 149
6.5 Exercises 150
6.A.I. Return and Risk Spreadsheet Applications 154
6.A.2. A Primer on Black-Scholes Option Pricing 156
Calls and Puts 156
The Black-Scholes Model 158 Appendix Exercises 159
Appendix Exercise Solutions 160 6.A.3. Estimating Implied Black-Scholes
Variances 160
Simple Closed-Form Procedures 163 Aggregating Procedures (J 64
7. Arbitrage and Hedging with Fixed Income Instruments and Currencies 7.1 Arbitrage with Riskless Bonds 165 7.2 Fixed Income Hedging 167
Bond Yields and Sources of Risk 167 Fixed Income Portfolio Dedication 169 7.3 Fixed Income Portfolio Immunization 170
Bond Duration 171
Portfolio Immunization 173 Convexity 175
7.4 Term Structure, Interest Rate Contracts, and Hedging 177
The Term Structure of Interest Rates 178 Term Structure Estimation with Coupon
Bonds 179
Bootstrapping the Yield Curve 179 Simultaneous Estimation of Discount
Functions 182
7.5 Arbitrage with Currencies 184 Triangular Arbitrage 184
Purchase Power Parity, Arbitrage, and Hedging in FX Markets 185 7.6 Arbitrage and Hedging with Currency
Forward Contracts 186
Parity and Arbitrage in FX Markets 186 7.7 Hedging Exchange Exposure 190 Additional Reading 192
References 193 7.8 Exercises 193
8. Arbitrage and Hedging with Options 8.1 Derivative Securities Markets and
Hedging 197 8.2 P u t - C a l l Parity 199
Illustration: Hedging with a Call, a Put, and a Collar 199
8.3 Options and Hedging in a Binomial Environment 200 ' Extending the Binomial Model to Two
Periods 203
Extending the Binomial Model to n Time Periods 205
Obtaining Multiplicative Upward and Downward Movement Values 206 Binomial Model: An Illustration 207 8.4 The Greeks and Hedging in a Black-Scholes
Environment 210
Black-Scholes Model Sensitivities 211 Illustration: Greeks Calculations for
Calls 213
Illustration: Hedging with Delta and Gamma Neutral Portfolios 214 Put Sensitivities 215
8.5 Exchange Options 216
vm CONTENTS 8.6 Hedging Exchange Exposure with Currency
Options 219 Additional Reading 220 References 220-8.7 Exercises 221
8.A.I. The Binomial Model: Additional Considerations 224
A Computationally More Efficient Version of the Binomial Model 224 Obtaining Multiplicative Upward and
Downward Movement Values 225 8.A.2. Deriving the Black-Scholes Model * 227
9. Evaluating Trading Strategies and Performance ••
9.1 Evaluating Investment Portfolio Performance 231
Computing Net Asset Value and Returns 232
Net Asset Value and Returns Illustration 233
Portfolio Benchmarking 234 Portfolio Performance Benchmarking
Illustration 236
9.2 Market Timing Versus Selection 237 The Quadratic Variable Approach 237 The Dummy Variable Approach 239 9.3 Trade Evaluation and Volume-Weighted
Average Price 240 VWAP 241
VWAP: A Simple Illustration 242 9.4 Implementation Shortfall 243
Illustration: Implementation Shortfall 243 9.5 Value at Risk 244
Equity Portfolio VaR: Illustration 246 Additional Reading 246
References 247 9.6 Exercises 247
10. The Mind of the Investor 10.1 Rational Investor Paradigms 251
The St. Petersburg Paradox and the Expected Utility Paradigm 252 Von Neuman and Morgenstern: Axioms of
Choice 253
10.2 Prospect Theory 255
Losses and Inconsistency 255 10.3 Behavioral Finance 258
The Monty Hall Judgment Error 258 Dumb, Dumber, and Dead 260 Myopia and Overreaction 261
Overconfidence, Gender, Entertainment, and Testosterone 268
Investor Moods, the Weather, and Investment Returns 270
Simplifying the Decision Process 271 Rational Investors and
Diversification 271
10.4 Neurofinance: Getting Into The Investor's Head 272
10.5 The Consensus Opinion: Stupid Investors, Smart Markets? 273
The Football Pool 274 Analyst Estimates 275
Rational Investors and Price Setting 275 Herds and Swarms 276
Additional Reading 277 References 277
10.6 Exercises 280
11. Market Efficiency 11.1 Introduction to Market Efficiency 285 11.2 Weak Form Efficiency 286
Price Sequences, Momentum and Mean Reversion 286
Relative Strength 288
Filter Rules and Market Overreaction 288 Moving Averages 289
The January Effect 290
The Small Firm and Price/Earnings Effects 292
The Initial Public Offering Anomaly 292 Sports Betting Markets 293
Summary 293
11.3 Testing Momentum and Mean Reversion Strategies 294
11.4 Semistrong Form Efficiency 296 Early Tests 297
Stock Splits 298
Corporate Merger Announcements, Annual Reports, and Other Financial
CONTENTS Information Contained in Publications and
Analyst Reports 299
Discounted Cash Flow Analysis and Price Multiples 301.
Political Intelligence Units 301 Market Volatility 302
11.5 The Event Study Methodology 302 Illustration: Event Studies and
Takeovers 304
11.6 Strong Form Efficiency and Insider Trading 312
11.7 Anomalous Efficiency and Prediction Markets 313
The Challenger Space Shuttle Disaster 313 Prediction Markets ' 314 11.8 Epilogue 316 Additional Reading 317 References 317 11.9 Exercises 320
12. Trading Gone Awry 12.1 Illegal Insider Trading 325
Notorious Insider Trading Cases 326 Monitoring Insider Trading Activity 330 12.2 Front Running and Late Trading 330
Front Running and Parasitic Trading 330
Market Timing and Late Trading 331
12.3 Bluffing, Spoofing, and Market Manipulation 332
Bluffing 332 Spoofing 333
Buy, Lie, and Sell High 334 Banging the Close 334 Corners and Pools 335 Wash Sales 337 Fishing 337
Other Quote Abuses 338 12.4 Payment for Order Flow 339
12.5 Fat Fingers, Hot Potatoes, and Technical Glitches 340
The Flash Crash 340 Hot Potato Volume 341
A Textbook for $23,698,655.93 (Plus $3.99 Shipping) 341
12.6 Rogue Trading and Rogue Traders 342 Rogue Traders 343
12.7 Trading and Ponzi Schemes 346 Carlo Ponzi 347
Other Ponzi Schemes 347 Additional Reading 348 References 348
12.8 Exercises 349
Mathematics Appendix 351 Glossary 369
End-of-Chapter Exercise Solutions Index 425
381
Ancillary materials are located at the book's companion site at www.elsevierdirect.com/ companions/9780123918802
