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.

Wednesday, May 17, 2006

Good Intentions, Bad Advice: How some economists are potentially encouraging financial disaster in the Third World

I recently read an article that argued that poor nations are wasting their money by holding large foreign currency reserves (usually, dollar reserves). As the article points out, developing nations around the world have been accumulating reserves at an unprecedented level. Most of these reserves are 'invested' (so to speak), especially by Asian countries like China, in dollar (and euro) denominated government securities. U.S. Treasuries are typically low-yielding investments and would not cover the debt obligations paid out by these developing countries (much less be useful as a revenue generator for more tangible uses by these governments).

Larry Summers -- the soon to be ex-president of Harvard University and the former Treasury Secretary -- is among those who argue that developing nations should relax their accumulation of reserves and, instead, should invest such money in infrastructure projects and in other ways that they believe might provide better returns than simply parking the cash in U.S. Treasuries.

Simply put, this is terrible advice.

The reason why many of these governments hold onto large dollar (and euro) reserves is because they want to protect themselves from the types of financial disasters that roiled developing nations (and, indeed, the capital markets of developed nations) throughout the 1990s and early 2000s. During these catastrophes, developing nations repeatedly ran out of foreign currency reserves and had to default on their debt obligations. By holding unto larger reserves, they can better protect themselves from default risk and the inevitable turmoil associated with it.

Economists who argue for the relaxation of reserve accumulation and the re-investment of the money devoted to reserve accumulation argue that developing nations are currently holding foreign currency reserves that are in "excess" of what is necessary to insure against such catastrophes. These so-called "excess reserves" should be re-deployed -- so they argue -- since these developing nations are paying too high a price -- by "leaving money on the table" by being so thoroughly focused on U.S. Treasuries -- for peace of mind.

I have a major problem with this type of argument. My biggest objection is that the risk calculations being performed by these economists are based on the Gaussian, 'normal' distribution. These types of calculations are going to grossly understate the risk of these developing nations suffering extreme financial crises. These countries are especially vulnerable to 'wild', non-Gaussian randomness where the level of risk can unexpectedly jump to extreme levels that cannot fit the paradigms of these economists.

Another problem I have with their argument is that they often ignore the increasing inter-dependence and connectedness between and among developing nations and developed nations. A financial catastrophe in one nation can easily spill over into other nations and regions -- even when they seem to have little in common in terms of either geography or economic status.

One example that comes to mind is the Russian crisis of 1998. When Russia defaulted on its loans, it triggered a financial avalanche that adversely affected other developing nations and took down many traders and investors -- including Long-Term Capital Management (an investment management company that included two Nobel Prize winning economists, Myron Scholes and Robert Merton (both of Black-Scholes fame), among its principals) -- in developed markets.

To be fair to Summers and his compatriots, they do make a valid point about how poor nations might be better off employing relatively scarce financial resources to infrastructure projects and other instruments of fiscal policy that might improve the standard of living and yield higher returns. However, even this laudable intent is undermined by the fact that poor nations are probably better off by having a solid reputation in the financial markets by prudentially guarding against financial catastrophes rather than 'investing' in projects that could just as well lead to lower returns (or even losses) compared to simply parking their cash in U.S. Treasuries.

Larry Summers is officially stepping down as president of Harvard in a few months. With a few exceptions, I generally liked his presidency of Harvard and I wish he was staying on. Dispensing (generally) good advice to a faculty that won't heed it is a lot better than dispensing bad advice to poor countries that might heed it.

Monday, May 08, 2006

Stock Prices Cluster Around Strike Prices on Option Expiration Dates

According to research done at the University of Illinois, Urbana-Champaign, prices of stocks that serve as underlying assets on options tend to cluster around the strike prices of those options on the expiration dates. This pattern is not seen in non-optionable stocks. The research paper can be downloaded from:

(The diagram below is an excerpt from the research paper: Stock Price Clustering on Option Expiration Dates by Ni, Pearson, and Poteshman.)

This pattern can be partially explained by delta-hedging by market makers and other sophisticated market participants. However, this benign explanation cannot completely account for the clustering of prices around option strike prices on expiration dates. The authors found that some of the clustering can be explained by the incentive to manipulate the prices of underlying assets by option writers (sellers) who have an incentive to keep stock prices close to the At-The-Money (ATM) price in order to minimize or eliminate losses.

Mark Hulbert, in his New York Times column, The Mystery of the Stock Price and the Strike Price (May 7, 2006), gave a succinct explanation for the possibility of price manipulation:

The study's authors don't disagree that market makers play a large role. But they found that the market makers' activities could not fully explain the clustering. They say it is likely that manipulation is also taking place.

Who would have an incentive to manipulate stocks this way? One group would be those who sell options short, known as option writers. Traders in this group in effect are betting that the options' underlying stocks will rise (in the case of puts they have sold short) or fall (in the case of calls). They could lose big if these stocks move too far in the wrong direction.

You would need to be a very wealthy investor indeed to be able to buy or sell enough shares of a stock to move its price in a given direction. But the researchers believe that some would qualify. They focused special attention on a group known as firm proprietary traders, which includes employees of large investment banks who are trading options for those banks' accounts. The researchers argue that these traders would be in a position to manipulate stock prices by selling large numbers of shares whose prices they wanted to keep from rising and by buying other shares whose prices they wanted to support.