22 ms·

In the hand-wringing over Knight's mistake, the media seems to be missing the massive benefit to many other traders. Specifically, Knight kept buying certain s

by dbecker 14y ago

In the hand-wringing over Knight's mistake, the media seems to be missing the massive benefit to many other traders. Specifically, Knight kept buying certain stocks even as they were driving up prices of these stocks. Everyone who sold these stocks to Knight got the benefit of selling it for a higher price. So, Knight didn't destroy wealth. It just made an unintended gift to people willing to sell them overpriced stock.

rm999 14y ago
>So, Knight didn't destroy wealth Sure it did, it destroyed its own wealth. Inefficient redistributions of money almost always destroy some wealth. The obvious way to see that in this case is that a 440M dollar loss took out 600M dollars of their marketcap.
- tedunangst 14y ago
  That's perhaps not the best way to look at things. Two weeks ago Apple made a profit of $9 billion, but somehow still managed to erase $23 billion in market cap. Whose wealth was destroyed there?
rayiner 14y ago
The flip side of this coin is that when Knight "makes money" it isn't creating wealth either.
- Variance 14y ago
  That's not true, because the idea that Knight's mispurchases were zero-sum isn't correct either. All business enterprises, including stock trading, only operate when their returns can exceed the discount rate of the market [1]. This means that overall, the returns of all players in the stock market will tend to exceed 4-5% on average, and on a time-averaged basis. As a result, the S&P 500 has tended to yield an average return of 5% over the last decades [2]; it was higher before that when markets were younger. What this means is that the stock market isn't zero-sum, but via the EMH, adds value to the economy. The first question you'll probably ask is, but how? The answer is that returns are made by making prices for assets, in this case stocks and other securities, more accurate. When the market has accurate prices it functions more smoothly [3], and this smoothness is attributed to stock investors, who make a profit from doing it. This means that the market is benefited when prices are made more accurate--that is, when companies make profitable stock purchasing decisions. It's harmed when companies make unprofitable decisions. While other companies will buy Knight's errant stocks, their profits will ideally be less than Knight's loss, due to frictional costs. Goldman is just making a marginal profit on these purchases; Knight is taking a $440 million loss. Goldman isn't going to make $440 million on reselling Knight stock. This difference means that the transactions should ideally be a net loss to the market overall, because they were purchased in error and the time integral in the deviations caused in the affected stock prices is the factor by which the broader economy is harmed. But yes, when the market functions correctly, it creates wealth by making prices accurate (price discovery [4]). When it functions incorrectly, a la Knight capital, prices are distorted and wealth (in this case the value of correct prices) is eliminated. [1]http://en.wikipedia.org/wiki/Capital_asset_pricing_model http://en.wikipedia.org/wiki/Capital_asset_pricing_model [2]http://en.wikipedia.org/wiki/S%26P_500#Total_annual_returns_.28b.29 http://en.wikipedia.org/wiki/S%26P_500#Total_annual_returns_... [3]http://www.investopedia.com/articles/basics/09/the-function-of-speculators.asp#axzz22gEQ6BrT http://www.investopedia.com/articles/basics/09/the-function-... [4]http://news.ycombinator.com/item?id=4226738 http://news.ycombinator.com/item?id=4226738
- simonh 14y ago
  Like any trader, when they buy higher than anyone else, or sell lower the counterpartiess to that trade benefits by the margin. The fact they are trading also adds liquidity to the market, making it easier and cheaper for other traders to take and close positions more quickly than they otherwise could.

by dbecker 14y ago

rm999 14y ago

>So, Knight didn't destroy wealth Sure it did, it destroyed its own wealth. Inefficient redistributions of money almost always destroy some wealth. The obvious way to see that in this case is that a 440M dollar loss took out 600M dollars of their marketcap.

tedunangst 14y ago
That's perhaps not the best way to look at things. Two weeks ago Apple made a profit of $9 billion, but somehow still managed to erase $23 billion in market cap. Whose wealth was destroyed there?

rayiner 14y ago

The flip side of this coin is that when Knight "makes money" it isn't creating wealth either.

Variance 14y ago
That's not true, because the idea that Knight's mispurchases were zero-sum isn't correct either. All business enterprises, including stock trading, only operate when their returns can exceed the discount rate of the market [1]. This means that overall, the returns of all players in the stock market will tend to exceed 4-5% on average, and on a time-averaged basis. As a result, the S&P 500 has tended to yield an average return of 5% over the last decades [2]; it was higher before that when markets were younger. What this means is that the stock market isn't zero-sum, but via the EMH, adds value to the economy. The first question you'll probably ask is, but how? The answer is that returns are made by making prices for assets, in this case stocks and other securities, more accurate. When the market has accurate prices it functions more smoothly [3], and this smoothness is attributed to stock investors, who make a profit from doing it. This means that the market is benefited when prices are made more accurate--that is, when companies make profitable stock purchasing decisions. It's harmed when companies make unprofitable decisions. While other companies will buy Knight's errant stocks, their profits will ideally be less than Knight's loss, due to frictional costs. Goldman is just making a marginal profit on these purchases; Knight is taking a $440 million loss. Goldman isn't going to make $440 million on reselling Knight stock. This difference means that the transactions should ideally be a net loss to the market overall, because they were purchased in error and the time integral in the deviations caused in the affected stock prices is the factor by which the broader economy is harmed. But yes, when the market functions correctly, it creates wealth by making prices accurate (price discovery [4]). When it functions incorrectly, a la Knight capital, prices are distorted and wealth (in this case the value of correct prices) is eliminated. [1]http://en.wikipedia.org/wiki/Capital_asset_pricing_model http://en.wikipedia.org/wiki/Capital_asset_pricing_model [2]http://en.wikipedia.org/wiki/S%26P_500#Total_annual_returns_.28b.29 http://en.wikipedia.org/wiki/S%26P_500#Total_annual_returns_... [3]http://www.investopedia.com/articles/basics/09/the-function-of-speculators.asp#axzz22gEQ6BrT http://www.investopedia.com/articles/basics/09/the-function-... [4]http://news.ycombinator.com/item?id=4226738 http://news.ycombinator.com/item?id=4226738
simonh 14y ago
Like any trader, when they buy higher than anyone else, or sell lower the counterpartiess to that trade benefits by the margin. The fact they are trading also adds liquidity to the market, making it easier and cheaper for other traders to take and close positions more quickly than they otherwise could.