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Tuesday, July 08, 2003

On Front Running and the Herd Instinct

Brad is in Platonic mood today, and has a couple of dialogues that seem to be worthy of the old master himself. Firstly on 'understanding' Greenspan, and the mystery of the quarter point strategy:

Socrates: So it would seem that you have proved that restricting yourself to quarter-point moves in monetary policy makes asset prices more, not less, volatile, and thus is more likely, not less likely, to generate situations in which the financial system creeps close to the point at which the safety and soundness of the financial system.

Glaucon: It would seem so, Socrates...

Socrates: "Seem"?!

Admetos: Only this, Socrates. We're monetary economics professors. Alan Greenspan may be the best central banker the world has ever seen. We are confident that we would have done a much worse job than he has done over the past decade and a half had either one of us been in his chair.

Glaucon: And so there is a good chance that he knows something that we do not: that our analysis of the situation is partial, incomplete, and flawed.

Socrates: What could that flaw be?

Glaucon: We have no idea.
Source: Semi Daily Journal

And a second one which touches on a topic dear to my heart: the herd instinct, and the operation of financial markets.

Glaucon: So you are telling me that when the central bank takes steps to alter the gross composition of the private sector's asset portfolio by five-ten-thousands of one percent--and to alter the net composition by much less, for these assets are very close substitutes--this shakes the entire intertemporal price system? That supply and demand elasticities are such that the future one year hence drops in price relative to the present by one-tenth of one percent? Doesn't that imply a cross-elasticity of demand for liquid spending power one year hence of 200? Even in the case when a $1 billion intervention is required, that's a cross-elasticity of 20. And when there is no intervention required, the cross-elasticity is infinite... Aren't these numbers a little... high?

Admetos: But if everyone expects today's open market operation to be followed by a whole sequence of operations in the same direction in the future...

Glaucon: But they don't, do they?

Admetos: But if everybody expects the Federal Reserve to do what it needs to do to make its policy effective...

Glaucon: They will front-run in advance to try to profit, and so change their own desired portfolios. But we no longer have a well-defined private-sector asset demand curve as a function of risk, return, and asset quantities, do we? Instead we have herd behavior coordinated by a single large actor in the marketplace, don't we?

Admetos: It would seem so...

Glaucon: Is this what we teach our students?

Admetos: No...
Source: Semi Daily Journal

And for those who wish to delve a little deeper into this labyrinthine topic, here's a paper that gives a bit of background:


Recent research has shown that institutional herding is a relevant phenomenon in stock markets. Do institutional investors also follow each other in bond markets? This paper focuses on the German bond market and uses data from 57 German mutual funds that invest mainly in DM-denominated bonds, which represents 71% of the total market volume. Due to the variety and large number of bonds that exist, we do not expect mutual funds to herd with regard to separate bonds. We believe instead that bonds with the same characteristics such as interest rate, maturity, collateral, or issuer are considered to be equivalent by institutional investors. Consequently, we construct "bond groups" consisting of similar bonds and analyze herding at a "bond group" level. Our results indicate that there is strong evidence of herding, albeit it is weaker than in stock markets. Further analysis suggests that mutual funds do not place an equal weight on different bond characteristics. Nominal interest rates appear to be most important in the bond selection process.
Source: Institutional Herding in Bond Markets Andreas Oehler and George Goeth-Chi Chao

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