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.

Friday, July 27, 2007

Derivatives, Leverage, and the Case of the Vanishing Bond Market Vigilantes

A recent article in The Economist -- Vanishing vigilantes: Why the markets may be undermining central banks (July 19, 2007) -- points out that the so-called bond market "vigilantes" that used to punish central banks for being soft on inflation have gone awol. Bond yields have been low even for countries that have incurred large current account deficits.

One of the reasons offered by the article for this phenomena is that financial derivatives have allowed traders to take on greater leverage. This leverage has increased the prices of bonds (or assets linked to them) and that, conversely, means lower yields. This phenomena, along with the carry trade (where traders borrow in low-yielding currencies and invest in higher yielding ones), may have contributed to the case of the vanishing vigilantes.

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Wednesday, July 18, 2007

Do Investors Have Too Much Information?

A recent Buttonwood column (July 12) in The Economist magazine made the case for the idea that investors may have too much information to make good financial decisions. As the late, great Fischer Black pointed out, much of the 'information' -- whether they be news items, data, or even valuation models -- that is consumed by financial decision makers are essentially noise. As the article suggests, an increase in the amount of noise (in the guise of information) that investors are exposed to increases the level of confidence in their investment decisions. Unfortunately, this 'confidence' is over-confidence; various studies in the social sciences have pointed out that having more information does not correspond to improved performance in decision making and/or prediction of uncertain events.

This problem is referred to as 'noise trading' (I believe Fischer Black was one of the first finance intellectuals to rigorously study this idea). The ways investors try to 'solve' the problem of financial decision making in the midst of noise often lead to anomalies that are the bane of neoclassical financial economists (but are a boon to their 'behavioralist' brethren). For example, one study Buttonwood cites found that American mutual fund managers tended to favor investing in companies where senior officers went to the same universities as they did. Obviously, this is a silly and simplistic 'solution' to a complex problem, but silly and over-simplistic heuristics are what human beings often gravitate towards in the face of complexity.

Buttonwood suggests that a better solution to the problem of noise trading would be to exercise discipline in financial decision making. Rather than (over-)reacting to the latest bit of news on the financial wires, take the information (usually, noise) with a grain of salt and base decisions in a more equanimous manner. Sadly, this is easier said then done.

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Wednesday, July 04, 2007

Success in Poker: How much of it is luck? How much of it is skill?

Since the Main Event of the 2007 World Series of Poker is coming up in a matter of days, I found an article I came across in the July 2007 issue of Bluff magazine written by Aaron Brown and Brandon Adams that combined quantitative social science with poker to be extremely interesting. Aaron Brown, a financial trader and poker aficionado, has written a book about the intersection between poker and finance: The Poker Face of Wall Street. Brandon Adams has written a couple of books dealing with similar themes: Broke: A Poker Novel and The Story of Behavioral Finance.

What was interesting to me about their article, Luck and Skill in Poker, is that they came up with a way to quantify the extent to which luck (and skill) contribute to success in poker. They took the pre-tournament betting odds posted on of various professional poker players for the Main Event of the World Series of Poker. The authors used these odds to come up with implied probabilities of success (at least for the players whose odds were quoted on; in effect, they use and the odds it quotes as a predictive market. Using this probability function, they applied the Gini coefficient -- which is a concept usually used by economists to measure the inequality of income -- to the problem of how to measure the relative contributions of luck and skill to success in poker.

A Gini coefficient, as applied to poker rather than income, of zero would imply that poker is all luck. A Gini coefficient of one would imply that poker is all skill. The authors of the article found that the Gini coefficient applied to their method of assigning the probability of success to poker players is 24%. In other words, poker (at least by the authors' measure) is 24% skill and 76% luck.

From my personal experiences with poker, I think this split between three-quarters luck and one-quarter skill is about right (at least for no limit hold'em in large tournaments; other types of poker may have a larger skill component). As the article concludes about the Gini coefficient of poker, "It's far enough from zero to make skill obvious, but far enough from one to keep you humble ..."

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