Finance, Banking, "the Markets"

Probably for as long as there has been money, there have been people who had more of it than they wanted to spend right away, and many more people who wanted to spend more money than they had. If money could somehow pass from the first group to the second, people would be better off; the function of financial markets is to ease this passage. Their point is to keep excess funds from sitting idle, by allocating them among the different people and projects asking for money. Ideally, just as ordinary markets allocate goods and services to those for whom they are most "valuable" (i.e., have the highest combination of desire and ability to pay), financial markets should allocate money — which is, after all, a claim on the resources of the community — to its most valuable, most productive uses.

Such markets are necessarily strange: those who have the money, the savers, by definition do not want any tangible good or service those on the other side, the borrowers, can currently sell. (Otherwise, it would be an ordinary commercial transaction and not finance.) The trick is that borrowers sell savers promises of more money in the future, in return for which they get money now. Etymiologically, at least, to extend credit is to believe (Latin credere) this promise. All this has been going on since Gilgamesh was king in Uruk.

To give some concrete examples: A corporate bond is a promise by the corporation to make regular interest payments for a number of years, ending with a lump-sum principal payment of the bond's face value. A common stock is a promise to get a fixed share of a firm's profits, along with a vote in how it is run. The once-standard home mortgage was a promise to make regular payments over, say, 30 years at a fixed interest rate, with the house, and a down payment on it, as hostages for the fulfillment of this promise.

Because financial instruments are promises, there is an intimate connection between them and predictions. All else being equal, how much you should pay for a bond depends on how much you prefer money now to money later, but also on how likely it is that the company will fulfill its promises. Turned around, a company which is widely believed to be able to keep its promises can offer to pay back less than one which is widely predicted to have trouble coming. Similarly for stock: if you just buy and hold on to a stock, the price to pay for a share depends on your prediction of the firm's future profits.

Since, as the saying goes, "prediction is difficult, especially of the future", this makes pricing financial instruments hard enough, but there are further complications. There are often times when lenders wish they had money now, rather than just a promise. Demanding immediate repayment from their debtors, while it certainly happens, often yields disappointingly little, and can disrupt or even crush a useful enterprise that could have kept making ordinary payments. The second big trick of financial markets is to make promises of payment re-sellable, so that the payments go to whoever currently owns the promise, not the original lender; the promise becomes a marketable "security". When we speak of "the financial markets", we usually mean the secondary markets in promises. When one of these secondary markets exists, the value of a security depends not just on the direct, promised payments, but also on the resale price of the security --- most notably, the value of a share of stock depends not just on what the firm's profits will be, but also on what other people will be willing to pay for a share of them. The latter price, will of course, depend on the same things, but even further into the future, and so on.

At this point, it might seem that the original objective of figuring out good uses for the community's capital has fallen out of view; this is superficial impression is, of course, correct. A large and able school of economists has created a great deal of confusion on this score by pushing something they call "the efficient markets hypothesis", which holds that it is basically impossible to anticipate the evolution of financial market prices. This is not quite true — it is merely very, very difficult and hazardous — but in any case it is very much a separate issue from whether securities prices actually are reliable signals about the relative value of different uses for capital. Nonetheless, in this age of the world we have, collectively, come to decide that financial markets beat any conceivable alternative at this, and accordingly loaded them with more and more power and responsibility; with what results, you can see around you.

— This does not explain how a socialist with no formal training in economics came to write for Quantitative Finance and teach in a computational finance program, but another time.

Peter Bernstein, Capital Ideas
Barry Eichengreen, Globalizing Capital: A History of the International Monetary System [Review: Turning the Wheels]
Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street [Review: Twilight of the Efficient Markets]
John Kenneth Galbraith
- 1929: The Great Crash
- A Brief History of Financial Euphoria
- Money: Whence It Came, Where It Went
Doug Henwood, Wall Street: How It Works and for Whom [Free online!]
Michael Lewis
- Liar's Poker
- The Money Culture
Roger Lowenstein
- When Genius Failed: The Rise and Fall of Long-Term Capital Management
- Origins of the Crash: The Great Bubble and Its Undoing [This refers to the crash of 2002 or so, not the crash of 2007 or so. It's hard to keep up.]
Donald MacKenzie
- An Engine, Not a Camera: How Financial Models Shape Markets [Blurb. My comments.]
- "End-of-the-World Trade", London Review of Books 30:9 (8 May 2008) [Online. Nice sociological/popular-scientific piece about credit derivatives, and broader issues in risk assesment and the institutional infrastructure of the financial markets.]
Mantegna and Stanley, An Introduction to Econophysics [Review: Not Exactly Rocket Science]
Karl Polanyi, The Great Transformation
Robert J. Shiller, Irrational Exuberance
Gillian Tett, Fool's Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe [Review: The Tragedy of Getting What You Want]

Alan Blinder, Central Banking in Theory and Practice
Roland Bénabou, "Groupthink: Collective Delusions in Organizations and Markets" [PDF preprint. A really brilliant paper on "individually rational collective reality denial in groups, organizations and markets".]
Joshua D. Coval, Jakub Jurek and Erik Stafford, "The Economics of Structured Finance" (2009) [PDF preprint]
James Crotty
- "Structural Causes of the Global Financial Crisis: A Critical Assessment of the 'New Financial Architecture'" [PDF preprint, August 2008. Summary: it was crazy to expect that minimally regulated financial markets would be safe and efficient, and they weren't.]
- "If Financial Market Competition is so Intense, Why are Financial Firm Profits so High? Reflections on the Current 'Golden Age' of Finance" [A question of intense interest. PDF preprint]
Marcus G. Daniels, J. Doyne Farmer, Laszlo Gillemot, Giulia Iori, and Eric Smith, "A quantitative model of trading and price formation in financial markets", cond-mat/0112422 = "Quantitative Model of Price Diffusion and Market Friction Based on Trading as a Mechanistic Random Process", Physical Review Letters 90 (2003): 108102
J. Bradford DeLong
- Lecture Notes on the Equity Premium Puzzle, Part I
- "Under What Circumstances Can a Financial Market Learn to Distinguish Good Opinions from Bad Ones?" [PDF. See also here.]
J. Bradford DeLong and Konstantin Magin, "The U.S. Equity Return Premium: Past, Present, and Future" [PDF of preliminary draft]
J. Bradford DeLong, Andrei Shleifer, Lawrence H. Summers and Robert J. Waldmann
- "Noise Trader Risk in Financial Markets", Journal of Political Economy 98 (1990): 703--738 [PDF preprint]
- "The Survival of Noise Traders in Financial Markets", Journal of Business 64 (1991): 1--20 [PDF preprint]
James Dow and Gary Gorton, "Stock Market Efficiency and Economic Efficiency: Is There a Connection?" Journal of Finance 52 (1997): 1087--1129 [JSTOR]
Eric Falkenstein, "Value-at-Risk and Derivatives Risk" ["An optimal risk manangement process should work more at getting relevant risks on the radar screen than measuring what appears on the screen more precisely." PDF]
Kirill Ilinsky, Physics of Finance [Review: Gauge Connections for Fun and (More Importantly) Profit]
Simon Johnson and James Kwak, "Finance: Before the Next Meltdown", Democracy 13 (Summer 2009)
Magdoff and Sweezy
- The Irreversible Crisis
- Stagnation and the Financial Explosion
Thomas Mikosch, "Copulas: Tales and Facts" [PDF preprint]
Moody's Global Risk Analysis Group, "Archaeology of the Crisis" [January 2008; link to free PDF, registration required; some commentary by Andrew Leonard]
Heinz Pagels, "The Quick Buck Becomes Quicker"
Frank Partnoy, F.I.A.S.C.O.: Blood in the Water on Wall Street [Life as a credit derivative salesman at Morgan Stanley in the early 1990s]
William Poundstone, Fortune's Formula [The saga of Kelly gambling]
Riccardo Rebonato, Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently [Very good, except that what Rebonato thinks is his philosophical position about the foundations of statistics is wrong, wrong, wrong. Fortunately, his recommendations are not actually based on his stated position. (Further to this point.) Hopefully to be reviewed...]
John Roemer, A Future for Socialism [Why the Revolution needs a stock market. Review: The Red Monday Efficient Allocation Blues]
Robert J. Shiller, Market Volatility
A. N. Shiryaev, Essentials of Stochastic Finance [Review]
David Skeel and Frank Partnoy, "The Promise and Perils of Credit Derivatives", 2008 [SSRN]
Eric Smith, J. Doyne Farmer, Laszlo Gillemot, and Supriya Krishnamurthy, "Statistical theory of the continuous double auction", cond-mat/0210475 = Quantitative Finance 3 (2003): 481--514

Richard Bookstaber, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation
George Cooper, The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy [A good exposition of credit cycle ideas, melded with a very unfair take on actual economics, and some truly weird and regressive Friedmanite policy proposals. (Not all his policy ideas are bad.)]
Charles P. Kindleberger, Manias, Panics and Crashes: A History of Financial Crises [This comes highly recommended from usually reliable authorities (Samuelson and Solow most notably), but, at least in the edition I read (the 5th, of 2005, revised by Robert Aliber), it's a disappointing. There is a lot of information in it, and the basic story about the credit cycle is sound, but the writing is fragmented, disjointed and repetitive. More fundamentally, it tries to be an analysis, or even an anatomy, of the recurring parts and phases of crises, and it tries to illustrate this by recounting the appropriate sections of the histories of many crises in each chapter, without giving these tales any kind of narrative or historical context. (For instance, I don't think he ever explains what the South Sea Bubble was, or John Law's land-company bank in France, despite many consequential references to both.) This might work if you already know the stories of all the major and many of the minor financial crises of the capitalist core from the 18th century until now, but not otherwise.]
Andrew Lo, Hedge Funds: An Analytic Perspective [Really a not-especially-well-integrated selection of Lo's recent papers. Some interesting material but definitely for specialists only (who may well have read the papers already). Some truly unholy linear and logistic regressions.]
Robert Shiller, The New Financial Order: Risk in the Twenty-First Century [I agree with everything in the eviscerating review by Steve Laniel]

Roy E. Bailey, The Economics of Financial Markets [blurb]
George P. Baker and George David Smith, The New Financial Capitalists: Kohlberg Kravis Roberts and the Creation of Corporate Value [Blurb]
Ole E. Barndorff-Nielsen and Neil Shephard, "Econometric analysis of realised covariation: high frequency covariance, regression and correlation in financial economics" [PDf]
Kevin E. Bassler, Joseph L. McCauley, Gemunu H. Gunaratne, "Nonstationary Increments, Scaling Distributions, and Variable Diffusion Processes in Financial Markets", physics/0609198
Erhan Bayraktar, Ulrich Horst and Ronnie Sircar
- "Queueing Theoretic Approaches to Financial Price Fluctuations", math.PR/0703832
- "A Limit Theorem for Financial Markets with Inert Investors", math.PR/0703831
Ricardo Bebczuk, Asymmetric Information in Financial Markets: Introduction and Applications [Blurb]
William T. Bernhard and David Leblang, Democratic Processes and Financial Markets: Pricing Politics [Blurb]
Lucy Bernholz, Creating Phlanthropic Capital Markets: The Deliberate Evolution [Author's book site]
Paul Blustein, And the Money Kept Rolling in (and Out): Wall Street, the IMF, and the Bankrupting of Argentina
Jean-Philippe Bouchaud
- "An introduction to statistical finance," Physica A 313 (2002): 238--251 [PDF]
- "The subtle nature of financial random walks", Chaos 15 (2005): 026104
Reuven Brenner, Force of Finance: Triumph of the Capital Markets
Laurent E. Calvet and Adlai J. Fisher, Multifractal Volatility: Theory, Forecasting, and Pricing [Thanks to Prof. Calvet for bringing this to my attention]
Youssef Cassis, Capitals of Capital: A History of International Financial Centres, 1780--2005 [blurb
Carl Chiarella and Giulia Iori
- "The Impact of Heterogeneous Trading Rules on the Limit Order Book and Order Flows" [PDF]
- "A simulation analysis of the microstructure of double auction markets", Quantitative Finance 2 (2002): 346--353
P. Cizek, W. Hardle, V. Spokoiny, "Adaptive pointwise estimation in time-inhomogeneous conditional heteroscedasticity models", arxiv:0903.4620 [I'm more interested in the idea of adaptively estimating non-stationary time series here than the finance application...]
Michel M. Dacorogna, Ramazan Gencay, Ulrich A. Müller, Richard B. Olsen and Olivier V. Pictet, An Introduction to High-Frequency Finance
Satyajit Das, Traders Guns and Money: Knowns and Unknowns in the World of Derivatives
E. Philip Davis and Benn Steil, Institutional Investors [Blurb]
Gerald F. Davis, Managed by the Markets: How Finance Re-Shaped America
Davis, Duffie, Fleming and Shreve (eds.), Mathematical Finance
Paul De Grauwe and Marianna Grimaldi, The Exchange Rate in a Behavioral Finance Framework [Blurb, ch. 1]
Emanuel Derman
- "The Perception of Time, Risk and Return During Periods of Speculation," cond-mat/0201345
- My Life as a Quant
Gerard Dumenil and Dominique Levy, Capital Resurgent: Roots of the Neoliberal Revolution [Blurb]
Barry Eichengreen
- Capital Flows and Crises
- Toward a New International Financial Architecture: A Practical Post-Asia Agenda
Robert Engel, Anticipating Correlations: A New Paradigm for Risk Management [blurb, ch. 1]
Cheoljun Eom, Gabjin Oh, Woo-Sung Jung, "Relationship between degree of efficiency and prediction in stock price changes", arxiv:0708.4178 [I should read this before dismissing it, but it seems from the abstract that they're almost missing the point...]
Todd Feldman, "Portfolio Manager Behavior and Global Financial Crises" [PDF]
Philip Hans Franses and Dick Van Dijk, Non-Linear Time Series Models in Empirical Finance
Xavier Gabaix, Parameswaran Gopikrishnan, Vasiliki Plerou and H. Eugene Stanley, "A theory of power-law distributions in financial market fluctuations", Nature 423 (2003): 267--270
Ramazan Gencay, Faruk Selcuk and Brandon Whitcher, An Introduction to Wavlets and Other Filtering Methods in Finance and Economics
Anne Goldgar, Tulipmania: Money, Honor, and Knowledge in the Dutch Golden Age
Vygintas Gontis and Bronislovas Kaulakys
- "Multiplicative point process as a model of trading activity", Physica A 343 (2004): 505--514 = cond-mat/0303089 [Despite the journal, the abstract actually sounds interesting and possibly-not-insane.]
- "Long-range memory model of trading activity and volatility", physics/0606115
Christian Gourieroux and Joann Jasiak, The Econometrics of Individual Risk: Credit, Insurance, and Marketing [Blurb, ch. 1]
Larry Harris, Trading and Exchanges: Market Microstructure for Practitioners
Jasmina Hasanhodzic, Andrew W. Lo, Emanuele Viola, "A Computational View of Market Efficiency", arxiv:0908.4580
Christopher Hoag, "The Atlantic Telegraph Cable and Capital Market Information Flows", The Journal of Economic History 66 (2006): 342--353 ["an event study on the introduction of the Atlantic Cable in July 1866. Using daily data on one security with a dual listing on the New York and London stock exchanges ... the information lag between the two markets shortened from ten days to zero days. Cointegration analysis confirms the result. Historical markets priced securities so well that transatlantic steamship crossing times can be recovered from stock prices."]
Jacques Janssen, Semi-Markov Risk Models for Finance, Insurance and Reliability
Eric Jondeau, Ser-Huang Poon and Michael Rockinger, Financial Modeling Under Non-Gaussian Distributions
Taisei Kaizoji, "Power laws and market crashes", physics/0603138
Ethan B. Kapstein, Governing the Global Economy: International Finance and the State
Dan Krier, Speculative Management: Stock Market Power and Corporate Change
Edward LiPuma and Benjamin Lee, Financial Derivatives and the Globalization of Risk [Blurb]
James Macdonald, A Free Nation Deep in Debt: The Financial Roots of Democracy [Blurb, intro]
Randy Martin, Financialization of Daily Life
Hilton McCann, Offshore Finance [blurb]
Ross M. Miller, "Don't Let Your Robots Grow Up To Be Traders: Artificial Intelligence, Human Intelligence, and Asset-Market Bubbles" [PDF]
Terence C. Mills and Raphael N. Markellos, The Econometric Modelling of Financial Time Series
Bernadette A. Minton, Rene M. Stulz and Rohan Williamson, "How Much Do Banks Use Credit Derivatives to Reduce Risk?" [SSRN/785364. But data are from 1999--2003.]
J. F. Muzy, E. Bacry and A. Kozhemyak, "Extreme values and fat tails of multifractal fluctuations", Physical Review E 73 (2006): 066114 = cond-mat/0509357 [Abstract promises financial applications]
Heikki Patomaki, Democratizing Globalization: The Leverage of the Tobin Tax
Louis M. Pauly, Who Elected the Bankers? Surveillance and Control in the World Economy
Huyen Pham, "Some applications and methods of large deviations in finance and insurance",math.PR/0702473
Jocelyn Pixley, Emotions in Finance: Distrust and Uncertainty in Global Markets [Blurb]
Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly [blurb. This paper on the now-contemporary US financial crisis is a bit of a preview, apparently.]
Mark J. Roe, Strong Managers, Weak Owners: The Political Roots of American Corporate Finance
Bertrand M. Roehner, Patterns of Speculation: A Study in Observational Econophysics [Blurb]
Frank Schwed, Where Are the Customers' Yachts? or a Good Hard Look at Wall Street
Kenneth J. Singleton, Empirical Dynamic Asset Pricing: Model Specification and Econometric Assessment [Blurb, with links to PDFs of first three chapters]
D. Sornette, "Critical Market Crashes," cond-mat/0301543 [90 page summary of his book Why Stock Markets Crash, and innumerable other papers]
James B. Stewart, Den of Thieves
Susan Strange, Mad Money: When Markets Outgrow Governments
Torsten Strulik and Helmut Willke (eds.), Towards a Cognitive Mode in Global Finance?: The Governance of a Knowledge-Based Financial System [Blurb]
Stephen J. Taylor, Asset Price Dynamics, Volatility, and Prediction [Blurb, introduction; author's book-site]
Samuel E. Vazquez, Simone Farinelli, "Gauge Invariance, Geometry and Arbitrage", arxiv:0908.3043
R. Vilela Mendes, R. Lima and T. Araujo, "A Process-Reconstruction Analysis of Market Fluctuations," cond-mat/0102301
Xavier Vives, Information and Learning in Markets: The Impact of Market Microstructure [Blurb, ch. 1, ch. 7, lecture slides]
David Weiss, After the Trade Is Made: Processing Securities Transactions
Biao Wu, "Interacting Agent Feedback Finance Model", math.PR/0703827

Notebooks

Finance, Banking, "the Markets"