CRIS DOLOC is a leading computational scientist with more than 25 years of experience in quantitative finance. He holds a PhD in Computational Physics and is currently teaching at the University of Chicago in the Financial Mathematics program. Cris is also the founder of FintelligeX, a technology platform designed to promote data-driven education, and he is very passionate about the opportunities that recent developments in Cognitive Computing and Computational Intelligence could bring to the field of Quant education.

About the Author xvii

Acknowledgments xix

About the Website xxi

Introduction xxiii

Motivation xxiv

Target Audience xxvi

Book Structure xxvii

1 The Evolution of Trading Paradigms 1

1.1 Infrastructure-Related Paradigms in Trading 1

1.1.1 Open Outcry Trading 2

1.1.2 Advances in Communication Technology 2

1.1.3 The Digital Revolution in the Financial Markets 3

1.1.4 The High-Frequency Trading Paradigm 5

1.1.5 Blockchain and the Decentralization of Markets 6

1.2 Decision-Making Paradigms in Trading 7

1.2.1 Discretionary Trading 8

1.2.2 Systematic Trading 8

1.2.3 Algorithmic Trading 9

1.3 The New Paradigm of Data-Driven Trading 11

References 14

2 The Role of Data in Trading and Investing 15

2.1 The Data-Driven Decision-Making Paradigm 15

2.2 The Data Economy is Fueling the Future 17

2.2.1 The Value of Data – Data as an Asset 18

2.3 Defining Data and Its Utility 20

2.4 The Journey from Data to Intelligence 24

2.5 The Utility of Data in Trading and Investing 30

2.6 The Alternative Data and Its Use in Trading and Investing 34

References 36

3 Artificial Intelligence – Between Myth and Reality 39

3.1 Introduction 39

3.2 The Evolution of AI 41

3.2.1 Early History 41

3.2.2 The Modern AI Era 43

3.2.3 Important Milestones in the Development of AI 44

3.2.4 Projections for the Immediate Future 48

3.2.5 Meta-Learning – An Exciting New Development 49

3.3 The Meaning of AI – A Critical View 51

3.4 On the Applicability of AI to Finance 54

3.4.1 Data Stationarity 57

3.4.2 Data Quality 58

3.4.3 Data Dimensionality 59

3.5 Perspectives and Future Directions 60

References 62

4 Computational Intelligence – A Principled Approach for the Era of Data Exploration 63

4.1 Introduction to Computational Intelligence 63

4.1.1 Defining Intelligence 63

4.1.2 What is Computational Intelligence? 64

4.1.3 Mapping the Field of Study 66

4.1.4 Problems vs. Tools 68

4.1.5 Current Challenges 69

4.1.6 The Future of Computational Intelligence 70

4.1.7 Examples in Finance 71

4.2 The PAC Theory 72

4.2.1 The Probably Approximately Correct Framework 73

4.2.2 Why AI is a Very Lofty Goal to Achieve 75

4.2.3 Examples of Ecorithms in Finance 78

4.3 Technology Drivers Behind the ML Surge 81

4.3.1 Data 82

4.3.2 Algorithms 82

4.3.3 Hardware Accelerators 82

References 84

5 How to Apply the Principles of Computational Intelligence in Quantitative Finance 87

5.1 The Viability of Computational Intelligence 87

5.2 On the Applicability of CI to Quantitative Finance 91

5.3 A Brief Introduction to Reinforcement Learning 94

5.3.1 Defining the Agent 96

5.3.2 Model-Based Markov Decision Process 98

5.3.3 Model-Free Reinforcement Learning 101

5.4 Conclusions 104

References 104

6 Case Study 1: Optimizing Trade Execution 107

6.1 Introduction to the Problem 107

6.1.1 On Limit Orders and Market Microstructure 109

6.1.2 Formulation of Base-Line Strategies 111

6.1.3 A Reinforcement Learning Formulation for the Optimized Execution Problem 112

6.2 Current State-of-the-Art in Optimized Trade Execution 114

6.3 Implementation Methodology 116

6.3.1 Simulating the Interaction with the Market Microstructure 116

6.3.2 Using Dynamic Programming to Optimize Trade Execution 118

6.3.3 Using Reinforcement Learning to Optimize Trade Execution 119

6.4 Empirical Results 122

6.4.1 Application to Equities 122

6.4.2 Using Private Variables Only 123

6.4.3 Using Both Private and Market Variables 123

6.4.4 Application to Futures 124

6.4.5 Another Example 126

6.5 Conclusions and Future Directions 127

6.5.1 Further Research 127

References 128

7 Case Study 2: The Dynamics of the Limit Order Book 129

7.1 Introduction to the Problem 129

7.1.1 The New Era of Prediction 130

7.1.2 New Challenges 131

7.1.3 High-Frequency Data 132

7.2 Current State-of-the-Art in the Prediction of Directional Price Movement in the LOB 133

7.2.1 The Contrarians 136

7.3 Using Support Vector Machines and Random Forest Classifiers for Directional Price Forecast 138

7.3.1 Empirical Results 139

7.4 Studying the Dynamics of the LOB with Reinforcement Learning 141

7.4.1 Empirical Results 142

7.4.2 Conclusions 144

7.5 Studying the Dynamics of the LOB with Deep Neural Networks 145

7.5.1 Results 148

7.6 Studying the Dynamics of the Limit Order Book with Long Short-Term Memory Networks 149

7.6.1 Empirical Results 152

7.6.2 Conclusions 153

7.7 Studying the Dynamics of the LOB with Convolutional Neural Networks 153

7.7.1 Empirical Results 155

7.7.2 Conclusions 156

References 157

8 Case Study 3: Applying Machine Learning to Portfolio Management 159

8.1 Introduction to the Problem 159

8.1.1 The Problem of Portfolio Diversification 160

8.2 Current State-of-the-Art in Portfolio Modeling 161

8.2.1 The Classic Approach 161

8.2.2 The ML Approach 162

8.3 A Deep Portfolio Approach to Portfolio Optimization 163

8.3.1 Autoencoders 164

8.3.2 Methodology – The Four-Step Algorithm 166

8.3.3 Results 167

8.4 A Q-Learning Approach to the Problem of Portfolio Optimization 167

8.4.1 Problem Statement 168

8.4.2 Methodology 169

8.4.3 The Deep Q-Learning Algorithm 169

8.4.4 Results 170

8.5 A Deep Reinforcement Learning Approach to Portfolio Management 170

8.5.1 Methodology 170

8.5.2 Data 171

8.5.3 The RL Setting: Agent, Environment, and

Policy 172

8.5.4 The CNN Implementation 172

8.5.5 The RNN and LSTM Implementations 172

8.5.6 Results 173

References 174

9 Case Study 4: Applying Machine Learning to Market Making 175

9.1 Introduction to the Problem 175

9.2 Current State-of-the-Art in Market Making 177

9.3 Applications of Temporal-Difference RL in Market Making 180

9.3.1 Methodology 180

9.3.2 The Simulator 181

9.3.3 Market Making Agent Specification 182

9.3.4 Empirical Results 185

9.4 Market Making in High-Frequency Trading Using RL 189

9.4.1 Methodology 190

9.4.2 Experimental Setting 191

9.4.3 Results and Conclusions 192

9.5 Other Research Studies 192

References 193

10 Case Study 5: Applications of Machine Learning to Derivatives Valuation 197

10.1 Introduction to the Problem 197

10.1.1 Problem Statement and Research Questions 199

10.2 Current State-of-the-Art in Derivatives Valuation by Applying ML 200

10.2.1 The Beginnings: 1992–2004 201

10.2.2 The Last Decade 202

10.3 Using Deep Learning for Valuation of Derivatives 204

10.3.1 Implementation Methodology 205

10.3.2 Empirical Results 207

10.3.3 Conclusions and Future Directions 208

10.3.4 Other Research Studies 208

10.4 Using RL for Valuation of Derivatives 210

10.4.1 Using a Simple Markov Decision Process 210

10.4.2 The Q-Learning Black-Scholes Model (QLBS) 212

References 214

11 Case Study 6: Using Machine Learning for Risk Management and Compliance 217

11.1 Introduction to the Problem 217

11.1.1 Challenges 218

11.1.2 The Problem 219

11.2 Current State-of-the-Art for Applications of ML to Risk Management and Compliance 219

11.2.1 Credit Risk 219

11.2.2 Market Risk 220

11.2.3 Operational Risk 221

11.2.4 Regulatory Compliance Risk and RegTech 222

11.2.5 Current Challenges and Future Directions 223

11.3 Machine Learning in Credit Risk Modeling 224

11.3.1 Data 225

11.3.2 Models 225

11.3.3 Results 226

11.4 Using Deep Learning for Credit Scoring 227

11.4.1 Introduction 227

11.4.2 Deep Belief Networks and Restricted Boltzmann Machines 228

11.4.3 Empirical Results 230

11.5 Using ML in Operational Risk and Market Surveillance 230

11.5.1 Introduction 230

11.5.2 An ML Approach to Market Surveillance 232

11.5.3 Conclusions 233

References 233

12 Conclusions and Future Directions 237

12.1 Concluding Remarks 237

12.2 The Paradigm Shift 239

12.2.1 Mathematical Models vs. Data Inference 240

12.3 De-Noising the AI Hype 243

12.3.1 Why Intellectual Honesty Should Not Be Abandoned 244

12.4 An Emerging Engineering Discipline 245

12.4.1 The Problem 246

12.4.2 The Market 246

12.4.3 A Possible Solution 246

12.5 Future Directions 247

References 248

Index 249

The New copy of this book will include any supplemental materials advertised. Please check the title of the book to determine if it should include any access cards, study guides, lab manuals, CDs, etc.

The Used, Rental and eBook copies of this book are not guaranteed to include any supplemental materials. Typically, only the book itself is included. This is true even if the title states it includes any access cards, study guides, lab manuals, CDs, etc.