arbitrage and the value of time in finance

The Value of TimeArbitrage and the Value of Time

The Value of Time

• In finance we spend a lot of time discussing the time value of money

• Lets toss that concept on its head and look at the revolution in the monetary value of time and its bumping against the physical limitations of the speed of light

Napoleon Semaphore

• Napoleonic semaphore is a system of conveying information by means of visual signals, using towers with pivoting shutters, also known as blades or paddles.

• Information is encoded by the position of the mechanical elements; it is read when the shutter is in a fixed position.

• The system was invented in 1792 in France by Claude Chappe, and was popular in the late eighteenth to early nineteenth century.

• They were much faster than post riders for bringing a message over long distances, and also cheaper in their long-term operating costs, once constructed.

Speed of Information

• Pony Express• From April 3, 1860, to

October 1861• During its 18 months of

operation, it reduced the time for messages to travel between the Atlantic and Pacific coasts to about 10 days

• vital for tying the new state of California with the rest of the United States.

Telegraph

• Morse Code• The first transcontinental

telegraph completed in 1861 was a line that connected an existing network in the eastern United States to a small network in California by a link between Omaha and Carson City via Salt Lake City.

• It was a milestone in electrical engineering and in the formation of the United States of America.

• It served as the only method of near-instantaneous communication between the east and west coasts during the 1860s.

Transcontinental Railroad

• 1,907-mile (3,069 km) contiguous railroad line constructed in the United States between 1863 and 1869 west of the Mississippi and Missouri Rivers to connect the Pacific coast at San Francisco Bay with the existing eastern U.S. rail network at Council Bluffs, Iowa.

Telephone

Financial Markets

• Ticker Tape

• Telephone

• Quotron

Arbitrage

• The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms.

• Trade futures contracts in Chicago against the present price of the individual stacks trading in New York

Chicago Mercantile Exchange

• “the Merc"• Futures Markets• the Merc trades several

types of financial instruments: interest rates, equities, currencies, and commodities.

• It has the largest options and futures contracts open interest (number of contracts outstanding) of any futures exchange in the world.

New York Stock Exchange

• NYSE

• The world clings to an old mental picture of the stock market

Arbitrage

• Every day thousands of moments when prices out of whack

• Sell Future contract for more than the price of the stock that comprised it

• To capture the profit you had to be FAST to both markets at once.

Fast

• What it means to be “fast’ changed

• Before 2007 speed of a trade had human limits

• Human beings worked on the floor of the exchanges and trades had to pass through them

After 2007

• The exchanges simply stacks of computers in data centers

• Trade speed no longer constrained by people.

• Only constraint was how fast an electronic signal could travel between Chicago and New York

Precise Distance

• Between the data center in Chicago that housed the Merc and a data center beside the Nasdaq’s stock exchange in Carteret, New Jersey

Fiber Optic Cable

• Speed Limit:

• Speed of Light

• 186,000 miles per second

• Theoretically possible to round trip Chicago-NYC in roughly 12 milliseconds

Time

• Millisecond: one thousandth of a second

• Microsecond: one millionth of a second

• Nanosecond: one billionth of one second

Telecom Carriers

• Verizon

• ATT

• Level 3

• 16-17 milliseconds

• Verizon “Gold Route” 14.65 milliseconds

• Telecom carriers not set up to understand the new demand for speed

Fortune

• Exploit the discrepancies between prices in Chicago and NYC

• Financial markets had changed, radically, the value of a millisecond

Straight Line

• Allegheny Mountains

• Western Pennsylvania

• Blue rock: hard limestone

• Build a $300 million straight tunnel

Selling Speed

• Only valuable to the extent it is scarce

• What was the degree of scarcity that would maximize the line’s market value?

• How much is it worth to a single player?

• 25 players?

Price & Sell Service

• How to price

• Exploit the discrepancies between price Thing A in Chicago and Thing A in New York

• $20 billion per year

• 400 firms

• only places for 200 of them on the line

Price

• $14 million per year

• Five year contract

• Grand total of $2.8 billion per year