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Trading Rules Over Fundamentals: A Stock Price Formula for High Frequency Trading, Bubbles and Crashes

The Financial Industry Regulatory Authority (FINRA) held a conference here on May 23, 2011 in which several proposals addressing the impact of high frequency trading (HFT) on stock and derivative prices were setforth. In fact, HFT is one of the most actively researched areas of market microstructure and asset pricing theories at this time. The evidence suggests that computer algorithms that portend HFT do not price assets on the basis of fundamental valuation. They appear to be driven by arbitrage opportunities. Fortuitiously, while addressing here issues raised in an award winnning paper by Prof. Robert Jarrow entitled Active Portfolio Management and Positive Alphas: Fact or Fantasy?, a stock price formula for high frequency trading was developed. As far as this writer knows, it is the only stock price formula for HFT. That formula plainly shows how the stock price of highly liquid stocks is influenced by high frequency traders strategies. It is based on exposure to hedge factors, and the volatility of hedge factors. For instance, the forrmula allows an analyst to  price a spot index using data on exposure to and volatility of the relevant E-mini contracts. That paper is entitled Trading Rules Over Fundamentals: A Stock Price Formula for High Frequency Trading, Bubbles and Crashes. While the math may be fairly sophisticated to some, the salient characteristics are reported in relatively nontechnical terms in the introduction. Hopefully, the stock price formula stimulates others to derive a better formula.