Economics and similar, for the sleep-deprived

A subtle change has been made to the comments links, so they no longer pop up. Does this in any way help with the problem about comments not appearing on permalinked posts, readers?

Update: seemingly not

Update: Oh yeah!

Monday, October 03, 2011

Yes but no

I basically agree with this, but there's an important nuance that gets missed. Brad writes, in re foreign exchange intervention and monetary intervention generally:

You want to get the speculators on your side--you want them to think that there is money to be made by betting that your policy will be carried out, rather than that there is money to be made by betting that your policy will break down. Thus the costs of deciding to do whatever it takes and of standing ready to do whatever it takes and announcing that you are going to do whatever it takes will probably, probably be surprisingly low.

Yes, that you want to get the speculators on your side and use them as a force multiplier. But we need to get much tighter on "you want them to think that there is money to be made by betting that your policy will be carried out, rather than that there is money to be made by betting that your policy will break down". Buzzword for the weekend's cocktail parties is the concept of "leaning against a bid", "having a bid to lean against". Let me explain:

Case 1, which should not be done because it is wrong and illegal. Say I am a trader who handles client orders and also trades the firm's capital. I have no special information about the stock of XYZ plc; I don't care whether I am long or short. The price of XYZ is bid 101, offer 99. Now a client places a big buy order in XYZ, at market. Am I long or short?

Smart kids at the front say "I am long, because the client placing a buy order is possibly trading on information, so the order has information content". Let's assume otherwise. Say we know that the order has no information content; it simply happens because XYZ has just been included in an index.

I am still long, on risk/reward grounds. Because I know that if I am short and wrong, I am exposed to normal market risk; if XYZ strikes oil, then the price could gap up on me. But if I am long and wrong, then I know the price cannot gap down on me; if I change my mind I can just sell my long to the client, because he put an order at market. Obviously, if the client had placed a limit order with a limit of 100, then I would not be able to "lean against" this.

Don't do that, by the way - leaning against a client order like this is called "front running" and not only is it market abuse offence basically everywhere, it's also very obviously unethical because by putting your own order in ahead of the client, you're moving the market against them and thus not doing your duty of best efforts execution. Similar offence; putting on a position ahead of publishing a research note that you expect to generate a flood of client orders.

Sorry, where was I?: Oh yes. But anyway, what if it's not you order that's come in, but you have a savvy idea that there is a big client order out there? Like, to take a real world example, you might have seen that a large insurance company had got into regulatory trouble and needed to liquidate a big portfolio of equities. This is public knowledge, so it can't be illegal to deal on it, but if you know there's a big sell order in at market, are you long or are you short?

A fortiori, of course, if a central bank has specifically put out its bid in the market, for the purpose of leaning against it, what do you do? The important thing here is not the size of the order, but the fact that it's completely price insensitive. If you just know that there's a big order that someone would kind of like to execute, then you're subject to market risk; if you know that the order has to be executed, either at market or at a specific price, then you know that there is guaranteed liquidity on one side of the trade, and the risks and rewards are skewed. It wasn't the size of the SNB intervention that moved the market - it was the determination.

In general, economics would be a lot better served if there was much more crossover between macroeconomists and market microstructure theorists. (by the way, secret weapon! this book. Absolutely kills it on the subject of exchange rate economics - if Frankel & Froot (1990) is a Sopwith Camel, this is something close to a General Contact Unit. Buy it for the global macro hedge fund manager in your life today).
1 comments this item posted by the management 10/03/2011 02:45:00 PM

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