The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Sunday, January 27, 2008

Smoke & Mirrors (or What The Pink Panther Can Teach Us About the Market Meltdown)

What a week! Last week began with an almost unprecedented plunge in global stockmarkets that stretched from Hong Kong to Frankfurt (and places in between) that led to the sharpest interest rate cut in the history of the US Federal Reserve (21 - 22 January 2008). The week finished with the venerable French bank, Societe Generale, announcing that it had lost $7.2 billion -- a figure that easily exceeds the GDP of several countries and rivals Harvard's endowment -- because of the actions of a 'rogue trader,' Monsieur Jerome Kerviel. (Aside: The two events may have been related.)

So how do we make sense of these events? For that matter, how do we get our minds around the whole credit crisis and its messy consequences? The answer: Think of the Pink Panther.

For those of you who are not cinephiles (movie lovers), The Pink Panther (the original version and not the one with Steve Martin) was a 1963 movie starring David Niven as the brilliant jewel thief, Sir Charles Lytton, a.k.a. 'the Phantom,' who planned on stealing a rare diamond, named the Pink Panther. His nemesis was one Inspector Jacques Clouseau, played by the late, great British comedic actor Peter Sellers.

Originally, The Pink Panther was suppose to be a star vehicle for David Niven's character, the Phantom. The Phantom was supposed to be the criminal version of James Bond who would have a movie franchise built around his criminal exploits. In reality, what happened was that Peter Sellers' brilliant performance as the bumbling but preternaturally lucky Inspector Clouseau was so popular that subsequent movies in the Pink Panther series was built around his character. Inspector Clouseau -- rather than the Phantom -- became a household name, recognized by people who have never seen the movies, and became a near universal cultural reference.

And that's the problem. The problem that we are having in analyzing what is happening to the markets during this credit crisis and general collapse of confidence in financial markets is that we are focusing in on the Inspector Clouseaus rather than the Phantoms.

People -- especially during the annual meeting of financial, economic, and political 'luvies' at Davos, Switzerland -- have expressed incredulity at how Jerome Kerviel could have lost the equivalent of the GDP of several countries through bad trades and outright fraud. Some of the thoughts that have been expressed from Wall Street and the City (of London) to the ski slopes of Switzerland include: 'He couldn't have acted alone.' 'How much has he socked away?' 'He didn't even attend a Grandes Ecoles!'

My thoughts on these displays of incredulity are this: He probably did act alone. That is not to absolve the guilt of the Mandarins who did attend the Grandes Ecoles and run SocGen and much of France ... they fell asleep at the helm. But Jerome Kerviel probably knew enough about gaming the system from his experience with back-office work with processing and auditing trades to get away with it as long as he did.

I also believe that he didn't gain much financially from his endeavors. After all, if he did stash away billions (or even millions) of Euros from his fraudulent trades, then why didn't he run off to some exotic locale with an ex-model turned chanteusse in the style of another Frenchmen who's been in the news? His motivation was probably to cover up the fact that he made losing bets on the direction of equity futures. It probably had more to do with ego rather than financial gain. (Some insights into this was given by another infamous 'rogue trader,' Nick Leeson -- the man who brought down the venerable British bank, Barings -- during a recent interview with the BBC that was surprisingly candid and detailed.)

As for the final point, it's true that he didn't attend a Grandes Ecoles, but this brings us to what I call the Pink Panther problem. By focusing on the admitedly tantalizing narrative of some 'rogue trader' bumbling away billions of Euros, Pounds, Dollars, etc., we are missing what ought to be far more disturbing aspects of what is happening to us because of the crisis in the financial markets.

No, Jerome Kerviel didn't attend fancy schools and wasn't a member of the power elite. But what is the responsibility of those who have fancy credentials and connections in the current economic mess? It's easy to scapegoat some low-level employee in a trading outfit or some lowly mortgage broker or realtor straight out of Glengarry Glen Ross for the current troubles, but what about the higher-ups who are pocketing huge bonuses and/or severance packages and will land on their feet despite fubar-ing away billions if not trillions of dollars (all the while people are losing jobs and losing their homes)?

What about all of the supposedly non-rogue traders and derivatives salesmen who made decisions that were far more reprehensible and stupid than what Jerome Kerviel allegedly did? Those people aren't being arrested ... no, they're the ones who are running off to exotic locales with trophy wives/mistresses while they leave behind a trail of victims that lost a substantial chunk of what little they had.

What about the sanctimonious cheiftains of investment banks, hedge funds, etc., that ridicule single mothers, the lost youth of the inner cities and the countryside, and others who are less fortunate than they when they sincerely need help all the while these captains of industry are going around panhandling for money from goverment backed investment vehicles?

What about the politicians that looked the other way when all of this was going on? They weren't being wined and dined by the Jerome Kerviels of the world nor were they concerned about what would happen to ordinary Joes and Joannes that voted for them when the supposedly non-rogue, but (in some ways) far more crazy financial dealings of those who were wining and dining officials blew up. No, it was the business-world's equivalents of 'Sir Charles Lytton' that did attend the Grandes Ecoles, the Ivy Leagues, etc., that got our leaders and regulators to look the other way.

And looking the other way is at the heart of our crisis. One of the basic tricks of magicians is to use devices that distract the audiences' attention from what they should be focused in on in order to not get tricked ... smoke and mirrors. A good magician knows that human beings are more likely to be interested in the stumbling and bumbling Inspector Clouseau rather than the coldly calculating Phantom.

The mess that we are in is because we believed in a mirage, a possibility suggested in an excellent article by David Leonhardt of the New York Times. Just as Inspector Clouseau repeatedly escaped death by pure dumb luck, we had managed to escape financial disaster (until now that is) by Clouseau-esque good fortune. Sadly, Peter Sellers is no longer with us, and it is obvious now that the economy is also mortal.

People thought that the "spreading of financial risk, across institutions and around the world, had reduced the odds of a crisis" (from David Leonhardt's article). Quite the contrary, it is the spreading of financial risk that has led to the spreading of the crisis. Just as infectious diseases become more contagious when a virus or a bacteria takes advantage of the network effects of the interlinked relationships between their human hosts, financial contagion can now spread through more channels than in the past.

We were told that financial derivatives is another way of taming risk. Although derivatives can be validly used in risk and investment management, there are those who want to -- in the infamous, quasi-fictional words of Satyajit Das' 'Nero Tulip' -- lever up as much as possible via ever dizzying combinations of options, swaps, futures, special purpose entities, etc. In the recent past, we were lucky on a Clouseau-esque level to not have had all this 'hidden' leverage blow-up on us. Our luck ran out.

Risk can't be tamed. It can't be controled in some simplisitic, mechanstic way. That's the mirage we believed in. We put our faith in the good fortune of Jacques Clouseau all the while missing the thieves getting way with the loot.

Risk can't be waved away with a magic wand nor can we shuffle it off somewhere without it feeding back on us. Scapegoating some low-level flunky misses the point ... although there are plenty of villains (including, allegedly, Mr. Kerviel) ... because the really reprehensible characters will probably get away with it.

We can respect risk. We may be able to understand it on some level (although I doubt we can fully unravel its mysteries). But risk isn't subject to us, we are subject to it.

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Wednesday, January 16, 2008

VIX Shows Greater Sense of Uncertainty in the Markets

I just did some analysis of VIX (the index of the implied volatilities in S&P 500 options created by the Chicago Board of Options Exchange) data from 2004 to this Tuesday (15 Jan. 2008). The VIX is widely considered to be the one of the best indicators of the market's sentiment on volatility, risk, and uncertainty.

If you look at the chart I created (see below -- click it to see a larger image), you can clearly see that -- from late Summer of 2007 -- the market's consensus on volatilty has been elevated to a substantially higher level. Another thing that is striking from this chart I created is how 'jumpy' risk is. Not only are there sizable spikes but there seems to be some anecdotal evidence of what econometricians call 'regime switching.' In this case, the regime we have switched to is that of higher volatility and uncertainty in the marketplace.

These upward jumps and spikes in risk seems to coincide pretty well with the credit crises and other negative economic and financial news. Of course, this isn't a careful study of the data, but I thought I would offer up a tiny bit of real world financial data analysis to readers of this blog.

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Sunday, January 13, 2008

Google vs. New Hampshire: Prediction Markets & Networks

As an American ex-pat living in the UK, I seem to be following the Presidential primary process with a greater degree of interest than I would have had I still been in the States. So when I read some articles recently about Google and a separate set of articles on how the pundits were surprised by Hillary Clinton's surprise victory over Barack Obama despite polls to the contrary, I thought there could be an interesting 'mash up' between these two seemingly unrelated issues. Oddly enough, the last week or so has shown that there are surprising commonalities between one of Google's business practises and how predictions of an Obama landslide failed to materialise.

Google encourages it's employees to use a prediction market to place bets on forecasts of events such as 'Will Google open a Russia office?' or 'How many users will Gmail have at the end of the quarter?' The reward for making correct predictions? Goobles (rhymes with rubles) which can be converted into prizes. Economists, Justin Wolfers (who has been featured on several blog posts on this site -- do a Google search of this blog), Eric Zitzewitz, and Bo Cogwill, wrote up a research report, Using Prediction Markets to Track Information Flows: Evidence From Google, that reaches an interesting conclusion: Information -- in the form of correlation in betting -- is "shared most easily and effectively among office neighbors, even at an Internet company where instant messaging and e-mail are generally preferred to face-to-face discussion," and that this type of information or social network -- based on "microgeography" (i.e., how people are [literally in this case] located in relation to each other) -- outweighs even friendship as a factor in information transmission within Google (as a business).

Although the use of prediction markets within Google is an interesting topic in it of itself, it got me thinking about how the findings from the research on Google's prediction markets might relate to making predictions about the electoral process -- especially, after the mini-debacle in New Hampshire. New York Times columnist, John Tierney wrote in his blog that prediction markets -- specifically Intratrade -- was the idea venue for coming up with accurate predictions in elections. Unfortunately for Mr. Tierney (and perhaps Intratrade as well), the results of the Democratic primary in New Hampshire made it, in John Tierney's words, "the wrong day to tout the Intratrade futures market." That's an understatement! (Although in fairness to Mr. Tierney and Intratrade, the tide started to turn toward Hillary at Intratrade a lot faster than it did in the news media.)

A less sanguine blog post was written by another New York Times columnist, David Leonhardt. In his post, Primary Predictions Popped, Mr. Leonhardt likened what happened on prediction markets, like Intratrade, where Barack Obama was given a greater than 95% chance of winning, to the bursting of "their version of the dot-com bubble." Part of the problem is that, as Mr. Leonhardt points out, the markets for these prediction markets are "thin" -- in stockmarket-speak, 'illiquid' -- which makes these markets especially vulnerable to bubbles and volatility.

Although I agree with Mr. Leonhardt, I think there is something else going on here -- which is precisely what the research shows on Google's prediction market -- the importance of the old real estate addage: 'Location, location, location.' In other words, the 'microgeography' -- or how people in a business or social environment interact with each other both by physical proximity and institutional strictures -- of how politicos, whether they be political operatives, journalists, pundits or 'experts', etc. -- can bias the information flow. Such swarming or coalescing of information flow can lead to bubbles in both political prediction (whether or not it takes place in a formal marketplace) and in the stockmarkets (this was one of the points that Didier Sornette made in his book, Why Stock Markets Crash: Critical Events in Complex Financial Systems [you can read my review of that book here]).

The New York Times article, Analyzing the New Hampshire Surprise (Jan. 10, 2008), by Jacques Steinberg and Janet Elder, seems to provide some evidence for my hypothesis. The article suggests that some political journalists and pundits were getting on the Barrack Obama bandwagon too soon (a particularly pointed example was Newsweek all-but annointing him on its front cover). This type of 'information cascade' may have at least indirectly contributed to incorrectly predicting the outcome of the Democratic primary in New Hampshire.

Perhaps the anecdote to these types of predictive mishaps is what Google does -- presumably based, in part, on its research into its own prediction markets -- with its employees: Move them around frequently. Political pundits, journalists, and operatives need to get out and about more often with people who are dis-similar to them rather than always hanging out with people who do more or less the same thing they do: making politics cynical and downright silly.

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Tuesday, January 01, 2008

Putting a Face on the Victims of Credit Derivatives

I came across an extremely interesting New York Times article this Sunday by Gretchen Morgenson: The Debt Crisis, Where It’s Least Expected (Dec. 30, 2007). One of the things I liked about this article is that it put a very sympathetic face -- the Indiana Children's Wish Fund -- to a very abstract and complex problem -- credit derivatives and the monsterous affect it has had on fueling the wildfire of the credit crises.

It turns out that this charity, which is dedicated to fulfilling the wishes of extremely ill children (many of them terminally ill), was tricked into investing in complex credit derivatives! It's the same old story: Unwitting small time investors lured into investments that promise higher yields at supposedly low risk; unbeknownst to them, they are writing options (i.e., could lose their shirts) in exchange for that slightly higher yield. But this time, the victims are truly sympathetic ... the director of the Wish Fund went out of her way to make sure the investments were as safe as CDs and money market funds. The (unscrupulous) broker -- no doubt selling her some propaganda about AAA rated mortgage-backed securities (we know what those ratings are worth ... zilch) -- bamboozled the fund into buying into credit derivatives as all hell was about to break lose.

This is one of the -- if not THE -- best articles I have read on the credit crises. There are many interesting aspects to this article. The one I found darkly humorous was mortgage-backed securities hedge fund 'hotshot,' John Devaney, owning a yacht called "Positive Carry." The name of the yacht is derived from the 'carry trade' ... and as I have written about this in the past (just do a search of the blog) ... this is essentially, as Nassim Nicholas Taleb so aptly puts it, "stepping in front of steamrollers to pick up pennies." Apparently, the steamroller finally caught up with "Positive Carry" ... apologies for a bit of schadenfreude.

As for the Indiana Children's Wish Fund, there is some good news. They were able to get a very quick settlement (thanks, in part, to the exposure by the New York Times) from their brokers. If anyone needed a concrete example of how the shameless marketing of credit derivatives to investors who have NO business getting mixed up with complex financial derivatives, then the Wish Fund serves as Exhibit A. Without the settlement, the credit crises would have meant that nine children's wishes would have gone unfulfilled. When you see a photo of a terminally ill child getting to meet Indiana Colt's quaterback, Peyton Manning ... sadly, the child in the photo died a few weeks after meeting his hero ... one can get a full sense of the gravity of the damage that some hotshot traders and derivatives salesmen have caused in ordinary people's lives on their way to buying yachts, luxury homes, etc.

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Sunday, December 16, 2007

Follow up to Mind Time

I noticed an article -- Why Time Seems to Slow Down in Emergencies at Live Science (11 December 2007) -- that serves as an interesting follow-up to my previous blog post on 'mind time'.

The Live Science article discusses research being done at Baylor University on why people have the sensation that time 'slows down' during stressful situations. Those researchers believe that this neurological phenomenon is related to how memories are formed rather than a physiological reaction like increased adrenaline. Basically, they argue that our brains tend to imprint memories in a deeper way when we're under stress than in normal situations; this leads to the sensation that time 'stretches' under stressful situations.

Interesting research. I don't know if it fully explains the 'mind time' phenomenon, but it sounds like a reasonable explanation. By the way, there is also a short video of the experiment.

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