Preface to the Special Issue on “Changing Dynamics in Financial Economics”

• Author: D. Sykes Wilford,Bluford H. Putnam
• Published date: 01 April 2015
• Date: 01 April 2015
• DOI: http://doi.org/10.1016/j.rfe.2015.03.001

Preface to the Special Issue on “Changing Dynamics in

Financial Economics”

Reviewof Financial Economics25 (2015) 1–2

The landscapeof financial economics is dynamicand rapidly evolv-

ing. Ever-faster processing of da ta and information and increasingly

more powerful computers have led to micro-second trading capabili-

ties. Unforeseencrises, new sources of financialturbulence in markets,

and ever-accelerating globalization have led to a greater appreciation

of some of the myths and fallacies embedded in traditional portfoli o

and financial risk management. All of these factorsare stirring the pot

of financial economics. In this contextthe term “Dynamics in Financial

Economics”is appropriatefor a special issue of the Review of Financial

Economics.

Once therisk came out of the box,as was the case in the 2008finan-

cial crisis, it cannotsimply be put back into its old boxwith the policy,

regulatory, portfolio, and ri sk management tools of the past. Bet ter

tools are needed. Tools in andof themselves are never enough to cure

any problem or deal with any situation even if designed by th e best

maker, especially if the assumptions embedded deep inside the tools

are not well understoodor the significance well appreciated. Dynami-

cally evolving financial markets demand a review of the finan cial

economist's toolkit and the underlying relationships of those tools to

key assumptions.

In thisSpecial Issue severalareas affected bysuch a dynamic environ-

ment areconsidered. The ideasin focus range from a changein the rela-

tionship of inflationto unemploymentto exchange regimesin emerging

economiesto the mechanics of risk measurement and market's adjust-

ment to uncertainty. Also, new conceptual perspectives on the forces

drivingthe dynamic system in whichwe now live are needed to appre-

ciate the relationship of the energy insidethe global financial and eco-

nomic system, in all its various forms, wi th the quickness of price

discoveryprocesses and informationflow.

Many argue that thespeed of information transference andgreater

information availability ha s meant that all old theories are t o be

discarded. We do not believethis is the case. We do believe, however,

thata better understandingof the problemsof the risk in the worldmar-

ketsis needed. Risk may be putinto a box in one marketby a given set of

policies or regulations,yet risks can simply show up elsewhere, in dif-

ferent markets or in future time periods. Risk may be bottled up by a

centralbank policy to be pushedinto a crisis in the future.Risk may ap-

pear in political developments that can reshapemarkets; risk may in-

volve significant disruptions of normal business flows; risk means

changing financialand asset class relationships; however,risk will not

simply go away. The unleashed turbulence of 2008 reminded us that

we need a better understanding of market relationships, of the useful-

nessor foolishness of certainpolicies, andof the dynamics of how turbu-

lence is likelyto reappear over time even ifthere are periods of calm.

We often refer to our conceptof the conservation of volatility as il-

lustrative of the nature of risk. Intuitively,we have the balloon theory

of the conservation of volatility. Pi cture a balloon that is full of air.

Now assume that one side of the balloon is flattened by, say, a rule or

regulation,or central bank policy. Hasthe air left the balloon or simply

been shifted?The answer is obvious.It is still there, popping outsome-

where else in our space–time continuum. Onoccasion, once the policy

does not work or the regulation unleashes unintended consequences,

at some pointthe balloon pops and the supposedlycontrolled volatility

explodes in a m anner most unexpected.

How should onethink about this risk problemand how should one

deal with it from a policy perspectiveand an investment perspective?

Answers are not easy, yet avenues for invest igation are many. Focus

on understanding why a market worksor not. Understand underwhat

conditions a theorycan be utilized in a simplistic form, and appreciate

when the burden of embeddedassumptions is too much to bear and a

morerobust derivativeset of tools is moreapplicable. Even ifone cannot

predict thetiming or intensity of certainevents, attempt to understand

the environmentor market conditions which may beconducive to ex-

treme disruptions and turbulence . Even deeply embedded patterns

can be detectedby the algorithms drivingmachine learning.Yet pattern

recognitioncan face severe challengeswhen there are adversarialrela-

tionships (i.e., your actions influence the actions ofothers and so forth)

or where there are changing structural causaliti es (i.e., new policies,

newregulations, newtechnologies, etc.).We are, indeed,at a fascinating

juncture in time, in whichmarket dynamics appear to be accelerating,

challenging many of our traditional rules of thumb and legacy tools

and theories becausethey embed a much too heavy or simplistic view

of how our marketsand financial environment evolve.

Each of the papers in the Special Issue has a contribution to under-

standing the dynamic issues that financial economists must address.

Our first two papers considerhow and why markets behave to handle

new information, shocks, andtransformative developments. Orlowski

examines the transition to electronic trading and assesses the impact

of price volatilityin the US Treasury futures market.Speed of informa-

tion and crisis adjustment are themes that carry through to the next

paper by Rutledge,who is looking at some of the sources of turbulence

by steppingback and considering the issueof energy as a framework in

which to look at how an economy createswealth. By considering eco-

nomic output within a totalenergy supply context (not just carbon or

windor oil or anyone typeof energy), he addressessome of the relation-

ships ofrelative pricing of energyresources from humanenergy to coal,

from costs of transportation to the implicationsfor relative benefits to

trade. In doing so he allowsone to consider the turbulence that canbe

shoved into a marketby a policy change and by the naturalflow of in-

stantaneousnews and information.

Next, the paper by Karagliannidis and Wilford focus es on a set of

tools to deal with the impact of turbule nce; or, more aptly put, the

http://dx.doi.org/10.1016/j.rfe.2015.03.001

1058-3300/©2015 Elsevier Inc. All rightsreserved.

Contents listsavailable at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe