Financial innovation is a virus!

"Financial innovation is like a virus, finding weaknesses in existing inventive schemes and regulations. When something is growing very fast, that suggests they have found a weakness." - Jeremy Stein Harvard University. 

This is one way to think about financial innovation, but it is not very appealing. It argues that innovation is just an attempt to evade regulation. There is no doubt that some goals of innovation are evasion, but there are also other reasons, such as market efficiency. Nonetheless, one can argue that regulation reduces efficiency, and innovation attempts to address the problem. If the problem is corrected, there will be more growth in innovation. Securitization, derivatives, and ETFs are all significant innovations that make the markets more efficient, while also addressing regulatory concerns.

Knowledge and wisdom for picking your financial facts

 

"Knowledge is a process of picking up facts, wisdom lies in their simplification" - Martin H. Fischer 

from story on Jane Street's traders:

Jane Street software engineer Ian Henry said the firm's traders all need "fighter pilot eyes" to deal with "extremely high information density" while making trading decisions. Henry said that, when making tools for these traders, he has to fine tune their size by a matter of pixels, in order for traders to maximize what's on the screen.

Henry says one of two main categories of applications built at Jane Street is focused on "managing traders' attention," ensuring they're alerted to interesting things amid that sea of information. He says the challenge for engineers is around "balancing noisiness" and stopping those tools from annoying traders with unnecessary information. 

Is the problem for Jane Street the acquisition of knowledge or its simplification? I want more information because I never know what will be helpful, but then I have to be selective to focus my attention. 

The trend trader will say that I focus my attention on only a limited number of issues—the trend in price. All other information is unimportant. The discretionary trader will argue that all information is essential, and I don't want to be constrained by limits on what I can review. 

Where is the trade-off, and how much information is enough, is one of the key issues for any investor

Bond and equity expectations are different

 

A recent paper by AQR, "Why are bond investors contrarian while equity investors extrapolate," makes an interesting observation. I have always thought that bond investors were mena reverting based on their conservative nature. There are limits to where yields can go. Equity investors are optimists, which means that returns can always move higher based on unlimited possibilities. Overoptimism will lead to the extrapolation of good news. Of course, this does not explain what happens to markets when they start to move negatively. The pessimism of bond investors forms beliefs about limitations and the notion that good news cannot last.

AQR states that the cause is information salience, the attention -grabbing qualities of certain information. This, however, does not focus on why there is salience that is different across markets and why it may persist. Nonetheless, it is essential to think about differences in how expectations are formed in major asset classes. 

CBOE dispersion index mean reverting

 

The CBOE dispersion index, DSPX, measures the difference in volatility of individual stocks versus the volatility of the S&P 500 index. It peaked during the period of maximum trade uncertainty because the market could not determine the impact of trade tariffs on individual firms. Now that trade risk has declined, the DSPX has also declined, as the market now focuses on other factors that are more likely to impact all stocks. The key question now is whether we will have a recession.