tag:blogger.com,1999:blog-228626992024-03-26T09:03:23.358+00:00The Econophysics BlogThis 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.The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.comBlogger112125tag:blogger.com,1999:blog-22862699.post-14061122536871599922008-01-27T21:28:00.000+00:002008-01-28T00:18:37.197+00:00Smoke & 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 <a href="http://www.nytimes.com/2008/01/26/business/worldbusiness/26bank.html?ex=1359090000&en=41279261b362a286&ei=5124&partner=permalink&exprod=permalink">may have been related</a>.)<br /><br />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.<br /><br />For those of you who are not cinephiles (movie lovers), <span style="font-style: italic;">The Pink Panther</span> (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.<br /><br />Originally, <span style="font-style: italic;">The Pink Panther</span> 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.<br /><br />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.<br /><br />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 <span style="font-style: italic;">Grandes Ecoles</span>!'<br /><br />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 <span style="font-style: italic;">Grandes Ecoles</span> 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.<br /><br />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 <span style="font-style: italic;">chanteusse</span> 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 <a href="http://www.bbc.co.uk/mediaselector/check/player/nol/newsid_7200000/newsid_7207600?redirect=7207646.stm&news=1&nbram=1&bbram=1&nbwm=1&bbwm=1&asb=1">interview with the BBC</a> that was surprisingly candid and detailed.)<br /><br />As for the final point, it's true that he didn't attend a <span style="font-style: italic;">Grandes Ecoles</span>, 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.<br /><br />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 <span style="font-style: italic;">Glengarry Glen Ross</span> for the current troubles, but what about <a href="http://www.nytimes.com/2008/01/27/business/yourmoney/27kim.html?ex=1359090000&en=487eadb273125104&ei=5124&partner=permalink&exprod=permalink">the higher-ups who are pocketing huge bonuses and/or severance packages and will land on their feet</a> despite fubar-ing away billions if not trillions of dollars (all the while people are losing jobs and losing their homes)?<br /><br />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.<br /><br />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?<br /><br />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 <span style="font-style: italic;">Grandes Ecoles</span>, the Ivy Leagues, etc., that got our leaders and regulators to look the other way.<br /><br />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.<br /><br />The mess that we are in is because we believed in a mirage, a possibility suggested in <a href="http://www.nytimes.com/2008/01/23/business/23leonhardt.html?ex=1358830800&en=b7104b1711a642b9&ei=5124&partner=permalink&exprod=permalink">an excellent article by David Leonhardt</a> 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.<br /><br />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 <span style="font-style: italic;">the spreading of the crisis</span>. 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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br />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.<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0273704745&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691118507&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=B0009S4J3C&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0805075100&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0471227277&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691133611&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=1400063515&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0521592712&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691120668&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-21815905863472459072008-01-16T22:41:00.000+00:002008-12-09T14:35:20.937+00:00VIX Shows Greater Sense of Uncertainty in the MarketsI 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.<br /><br />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.<br /><br />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.<br /><br /><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjvNAmv7NZgzwwCRZPBEjxkY1nkUPeOgVppjbfsUADetXftUXQPPsSmfvvyyqxdBtAkUjezofes5C5tzqtiCLVgEO4RS94f__aeXETjjSN8rtEVXcdB2NY87ci8RyVrRLohkfxX/s1600-h/VIX+04-Jan808chart.jpg"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjvNAmv7NZgzwwCRZPBEjxkY1nkUPeOgVppjbfsUADetXftUXQPPsSmfvvyyqxdBtAkUjezofes5C5tzqtiCLVgEO4RS94f__aeXETjjSN8rtEVXcdB2NY87ci8RyVrRLohkfxX/s400/VIX+04-Jan808chart.jpg" alt="" id="BLOGGER_PHOTO_ID_5156209258003074850" border="0" /></a>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-69382644114236331932008-01-13T19:45:00.000+00:002008-01-13T20:56:26.105+00:00Google vs. New Hampshire: Prediction Markets & NetworksAs 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 <a href="http://www.nytimes.com/2008/01/10/us/politics/10media.html?ex=1357707600&en=1aaffc59d791a901&ei=5124&partner=permalink&exprod=permalink">how the pundits were surprised by Hillary Clinton's surprise victory over Barack Obama despite polls to the contrary</a>, 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.<br /><br />Google <a href="http://www.nytimes.com/2008/01/07/technology/07link.html?ex=1357362000&en=1463e04f4f11c7b9&ei=5124&partner=permalink&exprod=permalink">encourages it's employees to use a prediction market</a> 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, <a href="http://bocowgill.com/GooglePredictionMarketPaper.pdf">Using Prediction Markets to Track Information Flows: Evidence From Google</a>, 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).<br /><br />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 <a href="http://tierneylab.blogs.nytimes.com/2008/01/09/number-crunching-the-2008-election/index.html?hp">blog</a> 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.)<br /><br />A less sanguine blog post was written by another New York Times columnist, David Leonhardt. In his post, <a href="http://thecaucus.blogs.nytimes.com/2008/01/09/primary-predictions-popped/">Primary Predictions Popped</a>, 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.<br /><br />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, <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FWhy-Stock-Markets-Crash-Financial%2Fdp%2F0691118507%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1200257358%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Why Stock Markets Crash: Critical Events in Complex Financial Systems</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" /> [you can read my review of that book <a href="http://econophysics.blogspot.com/2007/12/book-review-why-stock-markets-crash.html">here</a>]).<br /><br />The New York Times article, <a href="http://www.nytimes.com/2008/01/10/us/politics/10media.html?ex=1357707600&en=1aaffc59d791a901&ei=5124&partner=permalink&exprod=permalink">Analyzing the New Hampshire Surprise</a> (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.<br /><br />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.<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691128715&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0452284392&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691122024&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0804745099&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691118507&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0393325423&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-53905857985489972452008-01-01T01:07:00.000+00:002008-01-01T01:36:46.323+00:00Putting a Face on the Victims of Credit DerivativesI came across an extremely interesting New York Times article this Sunday by Gretchen Morgenson: <a href="http://www.nytimes.com/2007/12/30/business/30loan.html?ex=1356757200&en=8a01853293a595cd&ei=5124&partner=permalink&exprod=permalink">The Debt Crisis, Where It’s Least Expected</a> (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.<br /><br />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.<br /><br />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 <span style="font-style: italic;">schadenfreude</span>.<br /><br />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.<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0273704745&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0140278796&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-49522752831436537112007-12-16T23:23:00.000+00:002007-12-16T23:42:38.805+00:00Follow up to Mind TimeI noticed an article -- <a href="http://www.livescience.com/health/071211-time-slow.html">Why Time Seems to Slow Down in Emergencies</a> at Live Science (11 December 2007) -- that serves as an interesting follow-up to my previous blog post on <a href="http://econophysics.blogspot.com/2006/04/mind-time-market-time.html">'mind time'</a>.<br /><br />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.<br /><br />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 <a href="http://www.livescience.com/php/video/player.php?video_id=071211-FreeFall">video</a> of the experiment.<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=067401846X&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0393329372&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0465092942&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-49992459200090766502007-12-09T23:28:00.000+00:002007-12-10T01:40:34.102+00:00Book Review: Why Stock Markets Crash: Critical Events in Complex Financial SystemsI have to admit that when I first (which was about 5 years ago) heard of UCLA geophysicist, <a href="http://www.ess.ucla.edu/faculty/sornette/">Didier Sornette</a>, and his book, <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FWhy-Stock-Markets-Crash-Financial%2Fdp%2F0691118507%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1197243231%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Why Stock Markets Crash: Critical Events in Complex Financial Systems</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" />, I was skeptical. In deciding to write this book review, I reflected back on why I had that first impression. One of the reasons was that (and, recall, that this was before I moved to the UK from the US) I first heard about this book on the local tv news ... a highly unusual event since the local tv news normally covers car chases and celebrity punch-ups rather than sending their well-groomed reporters to chat up geophysics professors. Since television reporters --local or national -- are usually not renowned for their expertise in disseminating the research of physicists and mathematicians to the general public, the local news did a poor job of explaining in a 30 second sound-bite the monumental importance of this outstanding book.<br /><br />In fairness to the local tv 'journalists,' they focused on an aspect of the book that made me skeptical then and, to some extent, makes me skeptical now: the last chapter of the book (chapter 10). But if we (temporarily) ignore the last chapter, Didier Sornette's book is the best book in the still nascent discipline of econophysics and one of the greatest contributions to the scientific understanding of markets that has ever been written.<br /><br />The best one-line endorsement (although I will give a detailed review below) I can give this book is the following: Replace "stock" with any word you like ... "credit" or "mortgage" or "real estate" or "tulip" ... and you pretty much get a rock solid scientific explanation of why markets crash and why, like the geological faults that criss-cross California, they will inevitably rupture.<br /><br />In this review, I will try to do what the local tv reporter should have done ... focus on chapters 1 to 9. I will deal with chapter 10 in due course.<br /><br />---<br /><br />A large portion of the early part of the book is spent on describing financial markets and how traditional financial economics models have failed to properly explain and predict market crashes. This may not sound too original since other books, more or less, have done the same thing. What is very original in this book is that -- rather than a lot of handwaving and limiting itself only to historical anecdotes -- it is not afraid to employ maths (sorry, British English) and physics to scientifically analyze the nature of crashes.<br /><br />I should note at this point that the level of mathematics knowledge required to understand this book is somewhere near a good American high school level of math. Sornette, unlike other physicists who have written 'popular' books, doesn't subscribe to the apocryphal story about Stephen Hawking being told by his publisher that each equation that is added to his book leads to some proportionate drop in book sales (although Sornette's book is nowhere near as popular as <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FBrief-History-Time-Stephen-Hawking%2Fdp%2F0553380168%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1197245784%26sr%3D1-2&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">A Brief History of Time</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" /> ... although <span style="font-style: italic;">it should be!</span>). That having been said, one can safely ignore most of the maths and still get a lot of insights from the book.<br /><br />Having said that, if you happen to be comfortable with mathematics, then all the better because there is a lot of beautiful and interesting mathematics and physics in this book. Sornette is a real scientist rather than a mercenary that happens to use (quasi-) scientific tools in the pursuit of filthy lucre. Reading his book, one gets the sense that Sornette really loves maths and science, because he talks about things like Polya urn models, Benford's law, evolutionary psychology, and computer simulations of 'artificial life' that others writing in the field of quantitative finance either don't care to write about or write about carelessly.<br /><br />He invests time in introducing the reader to the ideas of complexity theory and econophysics. Fractals, power laws, critical phenomena, etc., are carefully described in this part of the book. The fact that Didier Sornette is a geophysicist by training is perfect for studying market crashes since there are many fruitful analogies that can be drawn between earthquakes -- which can be best understood in the light of complexity theory -- and market tremors.<br /><br />What I found useful in this part of the book is the critique of how econometricians have tried to deal with what are clearly non-Gaussian aspects of financial market data. Sornette is right to criticize GARCH (Generalized Autoregressive Conditional Heteroskedasticity -- for you nerds out there) because the fat tails that model tries to pick up aren't fat enough. Sornette is also right to point out that most of the <span style="font-style: italic;">linear</span> correlations useful for arbitrage have been arbitraged away (and the only linear correlations useful for arbitrage involve such short time intervals that the costs doesn't justify chasing after them). What are really interesting then are <span style="font-style: italic;">non-linear</span> 'correlations' (really, they're not correlations or covariances, but some sort of inter-relationships that are happening at higher statistical moments ... presuming 'moments' are even meaningful in that context) that manifest themselves when markets exhibit complex, critical behavior (i.e., there is some dynamic 'attractor' where financial agents are either bidding up towards, or -- in the current credit crises -- bidding down towards -- in a non-linear way).<br /><br />Having laid the intellectual groundwork, in the middle to later parts of the book, Sornette uses these concepts -- along with other tools from econophysics -- to develop models to predict crashes. Let me repeat that: Sornette comes up with models that almost precisely predict crashes! And, it seems to work pretty well (so far). What Sornette does is to fit and calibrate financial market data to a highly non-linear model. These predictive models seem to have done a decent job of predicting market downturns in a timely manner.<br /><br />What's more, these models are not described in a hand-waving, 'black box' manner in the book. He prints them (or at least the non-proprietary version) in the book. That alone should make people run out, digging into their wallets, to buy this and other books by Sornette.<br /><br />But this is where the skeptic in me awakens. In Nassim Nicholas Taleb's <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FBlack-Swan-Impact-Highly-Improbable%2Fdp%2F1400063515%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1197247686%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">The Black Swan</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" />, the careful reader may have noticed an 'inside joke' when Taleb -- who heartily endorses Sornette's book(s) (as I am doing as well) -- suggests that people not tell Sornette about Taleb's skepticism about predictive models so that Sornette won't stop creating his interesting models.<br /><br />Let me throw in my 2 pence into that discussion among intellectual comrades ... Yes, I think Sornette and his models are brilliant and they are probably right and even useful, but almost any non-Gaussian model would do a better job than Gaussian methods of calibrating predictive models based on financial data. Sornette's models are probably a lot better than the other non-Gaussian or pseudo-non-Gaussian models out there (like GARCH, stochastic volatility, etc.) but -- like most models -- there is probably some model risk with Sornette's models as well and their overuse will -- as Fischer Black noted with the Black-Scholes option pricing model -- lead to noise trading and model breakdowns.<br /><br />Which leads me to chapter 10. In chapter 10 -- which, if you will recall, is what the local tv reporter exclusively focused in on -- is where Sornette 'predicts' that the year 2050 is when the era of economic growth will end. This seems vaguely reminiscent of Nostradamus or the Book of Revelations in the Bible. Unlike Nostradamus or St. John, Sornette uses equations, time series data, and ideas from self-organized criticality to make his bold prediction.<br /><br />Is he right? I don't know. Maybe he's right. Maybe he's wrong. That was what bothered me 5 years ago. Honestly, it still bothers me ... but much less so, and certainly not enough to give this book anything less than my highest endorsement and praise.<br /><br />Why? Because this book and its author goes against the grain.<br /><br />Look at all of the so-called 'quants' that were terribly wrong about credit derivative models. They used rubbish pseudo-science in a mercenary way, dressed it up with things like AAA ratings that weren't worth the paper they were printed on, and then went off and bought luxury yachts while the rest of us are left holding the bag. When confronted with their failures, they inevitably turn defensive. There is no genuine humility there. The same folks (or people who will be virtually indistinguishable from them) will lead us into another round of financial catastrophes. It may not be mortgages next time. Maybe it will be inflation linked derivatives. Maybe it will be commodity linked derivatives. Whatever. It will happen. To borrow a phrase from a Jarvis Cocker song, they will kill again.<br /><br />But Sornette is different. He is a real scientist. Every page of his book is embued with a sense that this man loves science. He is applying genuine science -- physics, math, etc. -- to scientifically examine a phenomena that is often more earth-shaking and causes more damage than the earthquakes that a geophysicist is usually concerned with ... market crashes. Maybe he will be wrong. He is willing to risk it and be honest about it. He has the genuine humility of a genuine scientist. If his models don't work out, then he will acknowledge that and work to improve it rather than cynically 'putting lipstick on a pig.'<br /><br />I own all of his books and I believe that they will be useful to me in my attempts to understand uncertainty. But if his models don't work out ... well, that's science. Sornette, as a real scientist, is willing to risk failure to <span style="font-style: italic;">know</span> ... to <span style="font-style: italic;">understand</span> ... to learn how the world works. When I finally put my initial skepticism aside and read the book, I got that feeling as well. Not only do I take solace in that, I am inspired by it.<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691118507&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=354027264X&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=3540308822&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-47597749324673061322007-12-06T23:40:00.000+00:002007-12-07T02:41:23.658+00:00Goldie Gets The Porridge (Everyone Else Will Get Lawsuits)Regulars to this blog will recognize that -- very early on in the current credit crises -- I <a href="http://econophysics.blogspot.com/2007/08/credit-derivatives-meltdown-book-review.html">diagnosed and laid out the problems</a> and predicted how this crises would play out. Sadly, everything I foresaw happening has come to pass.<br /><br />Anyone who doubts that credit derivatives (for the most part, mortgage backed securities) helped to inflate the bubble -- and are now magnifying the downturn to almost cataclysmic levels -- should read a recent New York Times article: <a href="http://www.blogger.com/@http://www.nytimes.com/2007/12/06/business/06hedge.html?ex=1354683600&en=7e2f5552cf8666eb&ei=5124&partner=permalink&exprod=permalink%22">Wary of Risk, Bankers Sold Shaky Mortgage Debt</a> (Dec. 6, 2007). The part that I found most interesting -- but not surprising -- was that many prominent investment banks paid inflated prices to buy into mortgage deals that they could turn around and repackage into CDOs and sell to now embittered investors (which includes those banks themselves).<br /><br />My next prediction: Lawsuits. It will be based on legal concepts like <span style="FONT-STYLE: italic">uberrima fides</span> (utmost good-faith, in Latin) from insurance law. Banks relied on high-priced legal opinions from their favorite law firms -- not having case law and/or statutes to support their lucrative business of selling credit derivatives while washing their hands of being treated like insurers or guarantors of default risks -- to do what they did. Those legal opinions -- along with other practices of banks related to the credit derivatives business that can be challenged by lawyers -- <span style="FONT-STYLE: italic">will be</span> challenged.<br /><br />My advice to the I-banks: Don't believe your own bluffs. They shouldn't have loaded up on risk the way that they did. They should have hedged earlier and more earnestly. They shouldn't have bought at bloated prices mortgages that weren't worth the paper they were printed on while they were turning around and selling the same garbage. It's bad enough to sell rubbish, it's even worse to buy, basically, the same rubbish (at inflated prices no less)! Many banks suckered regulators, rating agencies, and investors, but they (also) wound up suckering themselves. Now, lawyers will come and sucker them all.<br /><br />I suppose there is a bit of a bright spot in this atmosphere of gloom (at least, if you're fortunate to work for them). There was one bank who 'got it' and didn't sucker themselves: Goldman Sachs. According to the above cited article and an earlier article in The New York Times -- <a href="http://www.nytimes.com/2007/11/19/business/19goldman.html?ex=1353474000&en=c5d415dd01b5ce34&ei=5124&partner=permalink&exprod=permalink">Goldman Sachs Rakes In Profit in Credit Crisis</a> (Nov. 19, 2007) -- 'Goldie' is the one I-bank that, as the article puts it, "made more money in the boom and, at least so far, has managed to keep making money through the bust."<br /><br />How did they do it? One reason is that Goldman Sachs -- unlike so many of their competitors as well as hedge funds -- takes risk seriously. As a Merril Lynch (which is facing turmoil because they didn't do what Goldman Sachs did) analyst admits, “The risk controllers are taken very seriously ... They have a level of authority and power that is, on balance, equivalent to the people running the cash registers. It’s not as clear that that happens everywhere.” In fact, unusually, risk managers are given legitimate opportunities to make the kind of money that traders and corporate bankers make. That shows how seriously Goldie takes risk!<br /><br />As one Goldie alumn put it, Goldman Sachs has a 'culture of success.' It's hard for people who talk about risk during booms (when the bubble is being created and inflated) to be taken seriously -- i.e., actually given authority to affect change. Goldman Sachs is one of the few places that -- against the grain -- has enough 'humility' (at least when it comes to the possibility of losing money ... but I suppose not when it comes to making it) to take the 'fearmongers' seriously and give them backing from upper management to affect change.<br /><br />That's what happened: When they saw warning signs -- as early as 2006 (last year) -- that 'mortgage risk' was on the rise, they cut their positions and hedged their risks. The results: While their competitors were trying to dump toxic waste (along with valuable holdings that they had to sell below value to raise liquidity), Goldie's hedges were profitable.<br /><br />Goldman Sachs is an example of how one can profit from being cautious and wary of <a href="http://econophysics.blogspot.com/2007/05/black-swan-well-thats-life.html">Black Swan</a> type risks. We all have to take risks. Life is, in many ways, like poker. But we have to know when to fold 'em and know when we shouldn't bluff ... or, at least, to not believe the bluffs.<br /><br /><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0684869683&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0470192739&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><br /><br />(NB: Both Lisa Endlich & Emanuel Derman are Goldman Sachs alumni.)The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-72771875014026726862007-12-03T10:22:00.000+00:002007-12-03T10:45:34.547+00:00The O.C. of the Arctic (or The Global Reach of the Credit Crunch)If anyone had any doubts -- or wishful thoughts (forlorn hopes) -- about how far the (mostly) American credit crises can reach, here is an article that should dispell any lingering doubts about how inter-connected financial markets are.<br /><br />The New York Times has an article -- <a href="http://www.nytimes.com/2007/12/02/world/europe/02norway.html?ex=1354338000&en=678c1440d1f25479&ei=5124&partner=permalink&exprod=permalink">U.S. Credit Crisis Adds to Gloom in Norway</a> (December 2, 2007) -- describing how Narvik -- a remote Norwegian town north of the Artic Circle -- has been harmed by investments in "complex securities investments" (i.e., credit derivatives). Here is a brief excerpt from the article:<br /><blockquote>Norway’s unlucky towns are the latest victims — and perhaps the least likely ones so far — of the credit crisis that began last summer in the American subprime mortgage market and has spread to the farthest reaches of the world, causing untold losses and sowing fears about the global economy.<br /><br />Where all the bad debt ended up remains something of a mystery, but to those hit by the collateral damage, it hardly matters.<br /><br />Tiny specks on the map, these Norwegian towns are links in a chain of misery that stretches from insolvent homeowners in California to the state treasury of Maine, and from regional banks in Germany to the mightiest names on Wall Street. Citigroup, among the hardest hit, created the investments bought by the towns through a Norwegian broker.<br /><br />For Ms. Kuvaas, being in such company is no comfort. People here are angry and scared, fearing that the losses will hurt local services like kindergartens, nursing homes and cultural institutions. With Christmas only weeks away, Narvik has already missed a payroll for municipal workers.<br /><br />Above all, the residents want to know how their close-knit community of 18,000 could have mortgaged its future — built on the revenue from a hydroelectric plant on a nearby fjord — by dabbling in what many view as the black arts of investment bankers in distant places.<br /><br />“The people in City Hall were naïve and they were manipulated,” said Paal Droenen, who was buying fish at a market across the street from the mayor’s office. “The fund guys were telling them tales, like, ‘This could happen to you.’ It’s a catastrophe for a small town like this.”<br /><br />Now, the towns are considering legal action against the Norwegian brokerage company, Terra Securities, that sold them the investments. They allege that they were duped by Terra’s brokers, who did not warn them that these types of securities were risky and subject to being cashed out, at a loss, if their market price fell below a certain level.</blockquote> All of the familiar themes are there: relatively unsophisticated investors getting sold complex derivatives -- where these naivetes were the ones who were, in effect, 'writing' the derivatives ... i.e., they receive higher yields but expose themselves to tremendous losses (or as Nassim Nicholas Taleb so eloquently puts it, stepping in front of steamrollers to grab pennies), angry citizens that range from old age pensioners to kindergarteners, and threats of lawsuits. It happened with Orange County, California. While no one will mistake Narvik (in the winter) for 'the O.C.', the underlying problems are the same: unscrupulous derivatives salesmen and gullible, unsophisticated investors that get lured by higher yields without realizing that they are exposing themselves to Black Swan type risk.<br /><br />Here is a bet I'm willing to make ... I'll bet that this sort of thing will happen again and again. Maybe next time it won't be credit derivatives or derivatives linked to municipal debt ... it'll probably be some other 'fancy' financial instrument ... but the same thing will happen again and again. The names and faces (and models) may change, but some things are constant: human greed, hubris, and gullibility.The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-50799886898736183652007-11-25T00:11:00.000+00:002007-11-25T00:59:03.031+00:00Forecaster as Entrepreneur (or How Do You 'Know' Without Knowing)I came across a very interesting article in the Economics Focus feature of The Economist: <a href="http://www.economist.com/finance/displaystory.cfm?story_id=10172461">A new fashion in modelling: What to do when you don't know everything</a> (22 Nov. 2007). The article describes the work of NYU economist, Roman Frydman. In his new book, <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FImperfect-Knowledge-Economics-Exchange-Rates%2Fdp%2F0691121605%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1195949806%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Imperfect Knowledge Economics</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" />, Prof. Frydman makes the case for using predictive models that are more intuitive and qualitative than those traditionally favored by economists.<br /><br />As the article notes, Prof. Frydman starts from a very interesting proposition: "The forecaster is like an entrepreneur. He uses quantitative methods, but he also studies history, and relies on intuition and judgment." From this brilliantly crafted idea (and I am very sympathetic to this viewpoint), he crititques traditional methods of economic forecasting -- using exchange rates as a case study (of sorts). The method that comes under the most scrutiny is the dominant approach of the 'rational expectations' school. Much to -- what I can safely forecast -- the chagrin of the adherents of rational expectations, Prof. Frydman compares them to communist idealogues who insisted, to the bitter end, that communism could be made to work.<br /><br />The problems with rational expectations -- which is so dominant in economics that even its critics essentially fall under its spell -- are legion and isn't worth detailing here. But there is one fact that best encapsulates its failings: Predictions of currency movements using rational expectations type approaches are usually worse than flipping a coin!<br /><br />Someone who follows the bloodsport of the endless debates within economics and finance faculties between different schools of thought might think that Prof. Frydman might favor 'behavioural economics.' Surprisingly, although he does give behaviourialists credit when they critique rational expectations, Prof. Frydman is critical when behaviouralists turn around and try to 'precisely' forecast human behaviour (which, if you will recall, is what I call falling into the 'rational expectations trap.')<br /><br />Prof. Frydman doesn't just cast stones; he offers solutions. What Roman Frydman proposes will be familiar to intellectually oriented traders -- mixing (or 'mashing,' as kids now a days would call it) quantitative methods with the spotting of qualitative regularities (or irregularities) that only a 'forecasting entrepreneur' (e.g., thinking traders and investors like George Soros, Warren Buffets, Nassim Nicholas Taleb, etc.) can do. Prof. Frydman's approach to uncertainty is essentially Bayesian as opposed to 'frequentist' -- i.e., it is inherently subjective. (See the latest book by financial theorist, Riccardo Rebonato: <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FPlight-Fortune-Tellers-Financial-Differently%2Fdp%2F0691133611%2F&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Plight of the Fortune Tellers: Why We Need to Manage Financial Risk Differently</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" />. In that book, Rebonato also advocates a Bayesian approach.)<br /><br />The 'problem' with Prof. Frydman's -- and, I suppose, Riccardo Rebonato's or Nassim Nicholas Taleb's -- approaches are that the forecasting models that they are advocating will not be as 'precise' as the models advocated by the mainstream. My response to that: Good! What is the point of having precisely wrong models of reality (other than for falsification)? If we can get more accurate models of reality, we should be glad to sacrifice false precision.<br /><br />In light of the recent credit crises, the closing comments in the article seem especially important:<br /><blockquote>Messrs Frydman and Goldberg are now turning their attention to the troubled subprime-mortgage markets, and the performance of the rating agencies. The rating agencies, argues Mr Frydman, have generally been better at rating corporate bonds than rating asset-backed collateralised-debt obligations. Why? One reason is that the rating agencies used both a mathematical model and the judgment of their in-house specialists when forecasting the default probabilities of corporate bonds; on subprime-related securities, they could only use mathematical models, not least because the instruments were so new. “They had no experience, no intuition, no entrepreneur,” he says. That is “empirical proof that relying on models alone is not wise.”</blockquote><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691121605&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691133611&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=026262205X&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-13249724629789949332007-11-10T12:54:00.000+00:002008-12-09T14:35:21.319+00:00Finally Waking Up to the Credit Derivatives MessRegulars to The Econophysics Blog know that, since day one of the current crises, I've been pointing out the role that credit derivatives have played in creating and worsening the credit/mortgage crises -- a fact that was obscured or under-reported by the mainstream financial press and 'experts.' There is an article in The Economist that basically confirms the case I've been making -- along with some new fears -- about the toxicity of credit derivatives: <a href="http://www.economist.com/finance/displaystory.cfm?story_id=10113339">CDOh no!: With trades scarce and losses mounting, it is going to be a harsh winter</a> (Nov. 8, 2007).<br /><br />According to the very interesting and comprehensive article, the AAA tranches of CDOs (collaterised-debt obligations: a vehicle used to package credit derivatives) have been substantially downgraded in value (see the chart of the ABX index -- and index of credit derivatives -- below) with fears of more downgrades to come. This would wreak havoc on already shaky financial markets.<br /><br /><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEitoKBa2oZnBeMESJPLMed-hRKH_XMa_jQ1ths2p2VO7MsNo7QAUBH3fWxuNKXUPID7j3sZxY8741YFGBpGFh2WzBbj47N0FRYUOXHzMcCTDd_cV7akK4otqB1Hpz4kZCBvYAK6/s1600-h/ec+cdo+abx.gif"><img style="margin: 0px auto 10px; display: block; text-align: center; cursor: pointer;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEitoKBa2oZnBeMESJPLMed-hRKH_XMa_jQ1ths2p2VO7MsNo7QAUBH3fWxuNKXUPID7j3sZxY8741YFGBpGFh2WzBbj47N0FRYUOXHzMcCTDd_cV7akK4otqB1Hpz4kZCBvYAK6/s400/ec+cdo+abx.gif" alt="" id="BLOGGER_PHOTO_ID_5131196721087237858" border="0" /></a><br />There is also the question of accounting for these credit derivatives. The recommended method is to stick it in a category called "Level 3" which assesses "fair value" using "assumptions that market participants would use." But is that a good way to assign "fair value"? This situation is made worse by the fact that Level 3 securities have grown so much that they "now exceed shareholder equity" of many banks. No wonder many investment and commercial banks (as well as insurers, hedge funds, etc.) have been accused of not marking down their credit derivatives sufficiently.<br /><br />Things can get much worse: AAA rated securities are relied on by a diverse range of investors -- from old age pensioners and municipal goverments to high flying hedge funds and banks. If AAA rated securities take a bigger hit because of their links to credit derivatives -- and/or other type of credit linked instruments (linked to consumer loans, for example) start sliding -- things can get really ugly ... much uglier than it is now.<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0273704745&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0470821590&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0470821760&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-88921312992409362352007-11-04T17:34:00.000+00:002007-11-04T18:46:39.313+00:00Book Review: The Mathematics of Natural CatastrophesI haven't written a pure book review blog post since coming to the UK, so I thought I would write one reviewing a book by a British author. Gordon Woo -- the author of <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2Fdp%2F1860941826%3Ftag%3Deconophysicsb-20%26camp%3D0%26creative%3D0%26linkCode%3Das1%26creativeASIN%3D1860941826%26adid%3D14E5RBMX7RX8AW2CR3F6%26&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">The Mathematics of Natural Catastrophes</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" /> -- was a senior wrangler in the <a href="http://en.wikipedia.org/wiki/Cambridge_Mathematical_Tripos">Maths tripos</a> as an undergraduate at <a href="http://www.cam.ac.uk/">Cambridge University</a>. He went onto a PhD in theoretical physics at Cambridge as well (while taking a detour through MIT and Harvard). He is currently on the staff of <a href="http://www.rms.com/">RMS</a> (a risk management consultancy) doing research on catastrophic risk and the risks of terrorism.<br /><br />The title of Dr. Woo's book is slightly deceptive (but in a good way). Yes, it is literally about the mathematics of natural catastrophes, but it's a lot more than that. It is an insightful yet accessible guide to the philosophy of risk and chance.<br /><br />Although the book has its share of mathematical formulae and equations, the book -- despite the title and the academic background of its author -- is less about maths (British English) in the colloquial sense (i.e., complicated symbolics) and more about maths in its true sense, a logical way of tackling problems. In that way, the book is highly readable and should be accessible to people with even rudimentary mathematical backgrounds, yet remaining sophisticated enough for people with more formal training in maths.<br /><br />The types of natural disasters discussed in the book focuses on examples from geology and meteorology, but the discussion can easily be extended to other types of events (including terrorism). Not surprisingly, given Dr. Woo's background, the author applies the tools of mathematics, statistics, probability theory, physics, geology, meteorology, engineering, and actuarial methods, in order to get a grip on these thorny issues.<br /><br />But he doesn't stop there; he also demonstrates -- in the framework of Isaiah Berlin's <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FHedgehog-Fox-Essay-Tolstoys-History%2Fdp%2F1566630193%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1194200379%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">The Hedgehog and the Fox</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" /> -- a certain intellectual 'foxiness.' Dr. Woo incorporates history, philosophy, and even literature into his analysis of catastrophic risk. For those interested in the increasingly important links between natural catastrophes and financial instruments, Dr. Woo devotes a chapter to financial issues (including Cat bonds) and other chapters to issues relevant to the insurance industry and the 'management' of extreme risk.<br /><br />The most fascinating aspect of this book, beyond the purely practical (and there are definitely practical aspects to this book), are the philosophical aspects of the book. As a mathematician philosophizing about the nature of probability, Dr. Woo reminds me of another Cantabrigian mathematician (unfortunately, known more as an economist), John Maynard Keynes (especially in his magisterial, <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FTreatise-Probability-John-Maynard-Keynes%2Fdp%2F1596055308&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">A Treatise on Probability</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" />). Dr. Woo's book has not received as much attention as Nassim Nicholas Taleb's <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FBlack-Swan-Impact-Highly-Improbable%2Fdp%2F1400063515&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Black Swan</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" /> (my book review can be found <a href="http://econophysics.blogspot.com/2007/05/black-swan-well-thats-life.html">here</a>), but I strongly believe that fans of the Black Swan will enjoy reading The Mathematics of Natural Catastrophes.<br /><br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=1860941826&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-37788399146146642162007-10-27T02:29:00.000+01:002007-10-27T03:19:50.033+01:00Twilight of the Quants (or yet another reason for the current financial turmoil)Over the last few months, I've tried to offer some analysis about the recent market turmoil that I feel has not been fully understood by the financial press and so-called expert commentators (e.g., the role of credit derivatives in the current crisis). It turns out that there is another contributing factor to the recent turmoil in the markets: quantitative hedge funds.<br /><br />The most recent <a href="http://www.economist.com/finance/displaystory.cfm?story_id=10026288">Buttonwood</a> column in The Economist (25 Oct. 2007), sheds light on how 'quants' have been adding risk to the market because of their strategies. These quant funds are staffed by mathematicians, physicists, etc., that are suppose to come up with ultra-sophisticated models that should, they promise, lead to higher returns. But the problem is that other funds also hire quants that use similar models. This leads to a kind of feeding frenzy (or a vicious cycle) where an increasing number of very smart people are chasing ever shrinking opportunities for genuine arbitrage profits, which causes them to either ratchet up risks and/or try ever more esoteric strategies (which are copied almost as soon as there is any profit to be made), which, in turn, lead them further down the slippery slope.<br /><br />For that reason, as well as others, these funds -- just as recently foreclosed home owners and their subprime mortgage lenders (who, presumably, didn't do PhDs in maths, physics, or engineering) -- loaded up on leverage (either directly or indirectly via derivatives, etc.). When the markets turned against the quants, they tried to offload their now toxic investments (in credit derivatives, etc.). Of course they couldn't find buyers, so they had to unload more liquid and valuable investments in order to meet margin calls and/or stay in business. But all this did was to cause a stampede among quant funds to get rid of assets that they really shouldn't have gotten rid of but HAD TO because of margin calls, the need to delta hedge their positions, plain desperation, etc.<br /><br />This is the story of so many financial bubbles bursting -- except on a high tech, post-modern level. This, according to Buttonwood, is what happened during August. It seems that no one on Wall Street or in the City has a memory beyond their last bonus. Didn't we go through this with LTCM? Program trading in October 1987? Yet we are told that ever more sophisticated models or ever faster execution of orders will lead to greater returns. But what these 'geniuses' don't realize is that the world doesn't always fit their 'sophisticated' models. Common sense should have told them that strategies and assets that weren't correlated before will become correlated once everyone else with a PhD in Computational Chemistry decides to sell similar things at the same time! The rules of the game are the same whether you are a down-on-your-luck homeowner or an over-educated quant.<br /><br />But to be fair, quants shouldn't shoulder all the blame. Yes, it's true that, as the article points out, "instead of providing liquidity in a crisis, the quants added to the instability." But the same could be said for those who participated in the dotcom bubble, tulip-mania, the Roaring 20s, and a whole host of financial fads and fashions that went awry. The problem is not that we are too sophisticated or that we are not sophisticated enough; the problem is arrogance. The problem is being willfully blind to 'Black Swans.' I doubt that any amount of rigorous modelling, algorithmic trading, statistical arbitrage, or improvements in order executions will solve that problem.<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691118507&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=1400063515&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0470091398&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-43375135805063594282007-10-15T00:55:00.000+01:002007-10-15T01:16:13.332+01:00Why some people won't stop teaching others how to lose money (or Still Getting Fooled by Randomness)Apologies for not updating more frequently. I have been trying to adjust to life in the U.K., so I haven't had much free time.<br /><br />I wanted to put up a quick blog post about an interesting thing I experienced last week. I went to a presentation by a prominent finance academic (he holds posts in some top programs ... programmes in British English ... in finance, and has written a well known book about quantitative investing). He presented the results of a theoretical paper he wrote extending some of the standard neoclassical financial models in what I hoped would be interesting directions. Instead, this chap seemed to be making some of the same mistakes -- and, in some cases, introducing new errors into already flawed models -- that had been made before by some of the (unfortunately) leading figures in quantitative finance.<br /><br />I politely asked him how his model related to the types of difficulties we have just faced (i.e., the credit crisis, real estate bubble bursting, Northern Rock, etc.) -- and his model, as advertised, should have had <span style="font-style: italic;">something</span> of substance to say about it. Sadly, he and his cohorts (mildly) dismissed my musings. Their rationale was that their simplistic linear model couldn't cope with the non-linearity of the way real financial markets work (aside: actually, even based on linear type maths -- vector spaces, independence, etc. -- I and a few others doubted that the presenter's model was valid). Rhetorical questions: Isn't that the point? Why claim that you have a model of how financial markets should work when it doesn't and probably won't work that way?<br /><br />I wanted to respond by saying something like: "Sorry for bringing in a dose of reality and spoiling the fun of building models of fantasy worlds." But, prudently, I didn't say anything of the sort.<br /><br />But what this incident goes to show is that -- despite a cold slap to the face by the <span style="font-style: italic;">true</span> nature of uncertainty (not continuous, but extremely discrete; not linear, but non-linear) by events that are barely a month old -- there are still people teaching finance to impressionable minds that refuse to incorporate some degree of humility and reality into a subject that can use quite a lot of both.The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-69479721480236688032007-09-30T00:28:00.000+01:002007-09-30T01:05:42.839+01:00Game Theory and the Kyoto ProtocolI thought I'd take a break from depressing news about the financial markets and tackle depressing news about the environment. I just read an article in the Economics Focus section of The Economist: <a href="http://www.economist.com/finance/displaystory.cfm?story_id=9867020">Playing games with the planet</a>, Sep 27, 2007. In that article, The Economist discusses research that analyzes the current impasse over the Kyoto Protocol from the perspective of Game Theory.<br /><br />Basically, the Kyoto Protocol resembles the Prisoner's Dilemma -- a game where players should cooperate from the perspective of globally optimal payoffs, but the players have incentives that would cause them to defect from cooperation and lead to mutually harmful payoffs. The Prisoner's Dilemma can be ameliorated by converting it from its static form to a repeated game. In the repeated Prisoner's Dilemma, players can see what the other players did during previous rounds and 'punish' them for defection.<br /><br />As <a href="http://en.wikipedia.org/wiki/Robert_Axelrod">Robert Axelrod</a> (an American political scientist -- who took the science part seriously) and others have demonstrated, the best strategy that emerges for repeated PDs is the so-called 'tit-for-tat' strategy. In most cases, that strategy recommends that (a) players should start by cooperating, (b) if some subset of players defect, then they should be punished by the cooperating players but that this punishment should last no more than the time or magnitude required to get players back in line, and (c) hopefully, all players will return to cooperation.<br /><br />Michael Liebreich, of New Energy Finance, argues that -- while the current impasse over Kyoto seems to be more like the static PD -- the situation should be seen as being more like the repeated PD. Mr. Liebreich offers hope that, with some alterations to the Kyoto and post-Kyoto attempts to control global warming, something akin to 'tit-for-tat' can bring about a global regulatory mechanism to combat global warming.<br /><br />Although I admire Mr. Liebreich's no doubt good intentions, I think he is being too optimistic. The flaw with his thinking is that there is another framework to consider beyond Game Theory: externalities. As The Economist cheekily points out:<br /><blockquote>At any given summit on climate change, it is never long before some politician declares how “urgent” or “vital” or “imperative” it is to stop the planet from overheating. And yet few governments are willing to tackle the problem by themselves. In practice, what these impassioned speakers usually mean is that it is urgent—no, vital!—no, imperative!—for all countries but their own to get to grips with climate change.</blockquote> This quote nicely sums up the problem with economic externalities (aka, external costs and benefits): The benefits of controlling global warming would be shared with countries not cooperating, but the costs will be borne only by those who cooperate. In other words, countries like the U.S. that refuse to cooperate with global warming treaties will free-ride off the countries that are doing something about global warming.<br /><br />The logic of repeated PD and 'tit-for-tat' rests on the fact that, in those idealized scenarios, players can monitor defection and can adequately punish defectors. But with externalities, it would be difficult to monitor who benefits even though they are free-riding, and it would be even more difficult to punish free-riders without causing serious lasting damage to both the cooperators and defectors.<br /><br />For example, let's say Denmark decides to punish America for not cooperating on Kyoto or Kyoto-like global warming control schemes. How would it do that? Dump toxic waste to get back at America? But that would cause lasting damage to not only America and Denmark but to the global environment itself ... precisely what they were trying to avoid!<br /><br />Unlike 'tit-for-tat' of laboratory repeated Prisoner's Dilemma, in the real world global warming game, it would be hard to limit the punishment so that it would send a strong enough signal to cooperate but not so strong as to be destructive to everyone involved.<br /><br />Back to the drawing board, I guess, for utilizing Game Theory for negotiating global warming treaties.<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0465005640&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691015678&fc1=000000&IS2=1&lt1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-28204905814440069072007-09-20T08:31:00.000+01:002007-09-20T00:31:22.499+01:00Northern Rock and Betting on StormsI apologize to regular readers of this blog for not updating for a while. The reason why I haven't updated is that I recently moved to the UK. I've been busy settling in so I haven't had time to update the blog.<br /><br />The last couple of blogs I wrote were regarding the 'credit crunch' that was unfolding in America (where I just left a few weeks ago). It seems like trouble has followed me across the Atlantic, because Northern Rock -- a British mortgage bank -- has basically suffered a run on it in the last few days. The 'queue' (or, as we Americans call it, a line) outside the local branch of Northern Rock (it was actually more like a scrum) of depositors trying to pull their money out of Northern Rock reminded me of photos of similar scenes during the Great Depression. The BBC has adequate coverage of the <a href="http://news.bbc.co.uk/1/hi/business/7003304.stm">situation</a>.<br /><br />As I've written before, so-called 'expert' commentators are missing the point about the 'credit crunch': The heart of the matter is that there are a bunch of credit derivatives contracts out there that are still toxic right now. I fail to see how even a large drop in rates by the Fed or the Bank of England priming the monetary pumps will solve the problem of derivatives run amok.<br /><br />Speaking of derivatives and storms, Michael Lewis wrote an article for the New York Times Magazine a few weeks ago that talks about quants trading in catastrophe bonds: <a href="http://www.nytimes.com/2007/08/26/magazine/26neworleans-t.html?ex=1345694400&en=bb621a3cf0c0103c&ei=5124&partner=permalink&exprod=permalink">In Nature’s Casino </a> (Aug. 26, 2007). You may recall I had a blog post about <a href="http://econophysics.blogspot.com/2007/08/catastrophe-bonds.html">catastrophe bonds</a> a while back. Michael Lewis is a great writer and I thought his article was very interesting and stimulating. Frankly, though, I wish John Seo would have stuck with math (or 'maths' in British English) rather than getting involved with derivatives trading. The article has a great quote from Dr. Seo's father when he chewed out his son for leaving academic science for Wall Street by saying, "The devil has come to you as a prostitute and has asked you to lie down with her." Apparently the senior Seo has Wall Street experience!The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-33968234553009203282007-08-27T00:19:00.000+01:002007-08-27T00:24:17.563+01:00More on the Credit CrunchHopefully, all of you have read my last blog post -- <a href="http://econophysics.blogspot.com/2007/08/credit-derivatives-meltdown-book-review.html">Credit Derivatives Meltdown & Book Review of 'Traders, Guns & Money'</a> (Aug. 16, 2007). In that blog post (among other things), I outline a major factor in the credit crisis and market fall that is being ignored (or misunderstood) by most commentators -- credit derivatives.<br /><br />I found several articles in the most recent New York Times that relate to the current crisis in the credit and real estate markets (and their knock-on effects to the financial markets in general). I don't think they get to the heart of the matter (credit derivatives), but they do talk about issues that are nonetheless important to any attempted explanation of what is going on now.<br /><br /><a href="http://www.nytimes.com/2007/08/26/business/26housing.html?ex=1345867200&en=38a8000720a117b1&amp;amp;amp;amp;amp;amp;amp;amp;amp;amp;ei=5124&partner=permalink&exprod=permalink">Drop Foreseen in Median Price of U.S. Homes</a> by David Leonhardt and Vikas Bajaj (Aug. 26, 2007) : In the last few years, almost every real estate 'expert' dismissed the idea of a nationwide decline in housing prices across the U.S. Guess what? ... It's happening!<br /><br /><a href="http://www.nytimes.com/2007/08/26/business/yourmoney/26country.html?ex=1345780800&en=a3245b14209bf8a3&amp;amp;amp;amp;amp;amp;amp;amp;amp;ei=5124&partner=permalink&exprod=permalink">Inside the Countrywide Lending Spree</a> by Gretchen Morgenson (Aug. 26, 2007): With many mortgage banks/lenders at deaths door (either closing down or dramatically reducing their mortgage lending operations), Countrywide's recent bailout from other banks ($11.5 billion credit line had to be drawn down 2 weeks ago and Bank of America recently took a 16% stake in Countrywide for $2 billion) is emblematic of the recent crisis in the credit and real estate markets.<br /><br /><a href="http://www.nytimes.com/2007/08/26/business/yourmoney/26view.html?ex=1345780800&en=f22bc73ddd26445e&amp;amp;amp;amp;amp;amp;amp;amp;ei=5124&partner=permalink&exprod=permalink">A Psychology Lesson From the Markets</a> by Robert J. Shiller (Aug. 26, 2007): Yale financial economist and author of <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FIrrational-Exuberance-Robert-J-Shiller%2Fdp%2F0767923634%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1188169399%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Irrational Exuberance</a><img style="border: medium none ; margin: 0px;" alt="" src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" border="0" height="1" width="1" /> comments on what is happening in the most recent market crisis.<br /><br /><a href="http://www.nytimes.com/2007/08/26/business/yourmoney/26deal.html?ex=1345780800&en=592f8b6f11007e99&ei=5124&partner=permalink&exprod=permalink">Will the Credit Crisis End the Activists’ Run?</a> by Andrew Ross Sorkin (Aug. 26, 2007): Speculates that credit crisis will reduce the ammunition needed by activist hedge funds to ply their trade.<br /><br /><a href="http://www.nytimes.com/2007/08/26/business/yourmoney/26stra.html?ex=1345867200&amp;en=1e71c55fb941c8f1&amp;amp;amp;ei=5124&partner=permalink&exprod=permalink">Just How Contagious Is That Hedge Fund?</a> by Mark Hulbert (Aug. 26, 2007): Hulbert cites <a href="http://papers.ssrn.com/sol3/papers.cfm?abstract_id=884202">research</a> by 3 financial economists (the most prominent being Rene Stulz of Ohio State University) arguing that hedge fund strategies may be correlated with each other. This is flies in the face of hedge funds' advertised goals of using strategies that are unique and distinct from one another. What this means is that if the strategies of a few hedge funds fail, then there is a good chance that others will fail as well. To some extent, we are seeing some of this with the credit derivatives bets made by some hedge funds.<br /><br /><br /><iframe style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0767923634&fc1=000000&IS2=1<1=_blank&amp;amp;amp;lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><iframe style="width: 120px; height: 240px;" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0470821590&fc1=000000&IS2=1<1=_blank&amp;amp;amp;lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-65673289566120685862007-08-16T20:47:00.001+01:002007-08-17T00:21:05.845+01:00Credit Derivatives Meltdown & Book Review of 'Traders, Guns & Money'Regulars to this blog may be familiar with my preference to not comment on contemporaneous events occurring in the markets. The basic reason for this is that I'd prefer to let the dust settle before I say anything about movements in the financial markets (if I have anything to say about it at all). I am making an exception to this general 'rule,' because the credit market meltdown that we are currently experiencing in the global financial markets just happens to coincide with a book review I wanted to write for a long time.<br /><br />So what is this book I wanted to review that seems ironically (or, perhaps, appropriately) to be <em>the</em> perfect companion to the bursting of the credit/real estate bubble? The book I want to review today is titled <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FTraders-Guns-Money-unknowns-derivatives%2Fdp%2F0273704745%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1187294216%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Traders, Guns & Money (Knowns and Unknowns in the Dazzling World of Derivatives)</a><img style="BORDER-RIGHT: medium none; BORDER-TOP: medium none; MARGIN: 0px; BORDER-LEFT: medium none; BORDER-BOTTOM: medium none" height="1" alt="" src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" width="1" border="0" /> written by financial derivatives expert and veteran trader, <a href="http://www.wilmott.com/blogs/satyajitdas/index.cfm/2007/6">Satyajit Das</a>.<br /><br />The most succinct endorsement (obviously, I will give a more detailed endorsement below) I can give to this book is by comparing this book to two of the books -- <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FFooled-Randomness-Hidden-Chance-Markets%2Fdp%2F0812975219%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1187294624%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Fooled By Randomness</a><img style="BORDER-RIGHT: medium none; BORDER-TOP: medium none; MARGIN: 0px; BORDER-LEFT: medium none; BORDER-BOTTOM: medium none" height="1" alt="" src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" width="1" border="0" /> and <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FBlack-Swan-Impact-Highly-Improbable%2Fdp%2F1400063515%3Fie%3DUTF8%26qid%3D1187294624%26sr%3D1-1&tag=econophysicsb-20&amp;amp;amp;amp;amp;amp;linkCode=ur2&camp=1789&creative=9325">The Black Swan</a><img style="BORDER-RIGHT: medium none; BORDER-TOP: medium none; MARGIN: 0px; BORDER-LEFT: medium none; BORDER-BOTTOM: medium none" height="1" alt="" src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" width="1" border="0" /> -- written by one of my favorite authors, Nassim Nicholas Taleb. In a nutshell, Das' book takes many of the ideas developed and espoused in NNT's books and applies them, in a clinical and detailed (but accessible) way, to the world of financial derivatives.<br /><br />But a stronger one-line endorsement of this book was given by Frank Partnoy (author of <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FFiasco-Inside-Story-Street-Trader%2Fdp%2F0140278796%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1187295181%26sr%3D1-2&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">FIASCO: The Inside Story of a Wall Street Trader</a><img style="BORDER-RIGHT: medium none; BORDER-TOP: medium none; MARGIN: 0px; BORDER-LEFT: medium none; BORDER-BOTTOM: medium none" height="1" alt="" src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" width="1" border="0" /> and <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FInfectious-Greed-Corrupted-Financial-Markets%2Fdp%2F0805075100%3Fie%3DUTF8%26qid%3D1187295181%26sr%3D1-2&tag=econophysicsb-20&amp;amp;amp;amp;amp;linkCode=ur2&camp=1789&creative=9325">Infectious Greed</a><img style="BORDER-RIGHT: medium none; BORDER-TOP: medium none; MARGIN: 0px; BORDER-LEFT: medium none; BORDER-BOTTOM: medium none" height="1" alt="" src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" width="1" border="0" />) : "When 'derivatives' and 'f******' appear together on every other page, you know someone has written the truth about financial innovation." (It's worth noting that Partnoy exaggerates the amount of profanity used in the book ... but his basic point is well put.)<br /><br />In <em>Traders, Guns & Money</em>, Satyajit Das dissects and analyzes almost every aspect of the derivatives industry with the same level of skill and care as an expert crime scene investigator combs through the scene of a crime. No part of the derivatives world escapes the attention of Das. Sell side, buy side, over-the-counter (OTC) derivatives, risk (mis-)management, 'quants,' structured products, equity derivatives, credit derivatives (much more on this later), and even more exotic derivatives (like weather and carbon emission derivatives) are covered in this fascinating book.<br /><br />Das uses several underlying themes or frameworks throughout this book. One of these themes/frameworks is his use of semi-fictionalized narrative -- presumably, based on his own long career in the derivatives industry -- to highlight the dark side(s) of the derivatives world. This is reminiscent of the style used in NNT's books (Das even has his own 'Nero'; although Das' Nero is more like NNT's Fat Tony ... in fact Das' Nero would make Fat Tony look like a debutante). Das' 'war stories' are salacious, but, more importantly, they serve the purpose of exposing the real world workings of the derivatives industry to <em>naifs.</em><br /><br />Another theme/framework Das employs throughout his book is a somewhat Popperian one: 'knowns' and 'unknowns.' Das categorizes the workings of financial derivatives into one of four categories based on permutations of knowns and unknowns. There are the 'known knowns' -- things that we know that we know and, thus, can have a high degree of certainty about. The second category is 'known unknowns' -- things that we don't know but we <em>know</em> that we don't know them; this adds a degree of uncertainty but it is manageable uncertainty (similar to NNT and Benoit Mandelbrot's "mild uncertainty").<br /><br />The third category is rather fascinating to me when I first heard it: 'unknown knowns.' These are things that we know but we <em>do not realize</em> (or, many times, we <em>don't want to</em> realize) that we know it! This may sound far-fetched, but I think Das is correct to articulate this category. An example that Das cites to illustrate 'unknown knowns' is the idea of greed and fear that underlies the derivatives game. No matter what people may say (and even believe, to some extent) about derivatives as a tool to hedge risk, add liquidity to markets, etc., the almost unsaid truth is that the motivation behind trading derivatives is greed and the fear of missing out on greed. This is an 'unknown' known because the players have incentives to not admit this to others (or even to themselves) because it is, at the very least, impolitic to 'know' this known.<br /><br />The last category are the 'unknown unknowns' -- the "things that you did not know you did not know" (p. 12). This is the most problematic category because the degree of uncertainty in this category is virtually unbounded. This is like NNT's "Black Swan" (or "wild randomness").<br /><br />Lest one is tempted to think this is all idle philosophizing, as the book highlights along the way, both the 'unknown knowns' and 'unknown unknowns' seems to pervade the derivatives industry.<br /><br />One of the 'unknown knowns' that Das book does a great job of exploring is the mythology of financial 'engineering.' Many business schools and economics departments would like to beatify quantitative finance by removing the messy realities of the real world and 'cleaning' (over-simplifying) it up so that it resembles something like civil engineering. Academic and industry <em>naifs</em> would like people to believe that Black-Scholes, Cox-Rubenstein, Miller-Modigliani, etc., turn derivatives valuation into something akin to bridge building (and, as the recent tragedy in Minnesota shows us, even bridge building is a lot messier in the real world than in textbooks).<br /><br />Das does a lot to explode these myths. Yes, Das would concede, fancy quantitative models can help, but there are serious weaknesses with copulas, implied correlations, dynamic delta hedging, etc. In other words, model risk, basis risk (basically, comparing apples to oranges), marking-to-model or to a market when there is no liquid market for the instrument, liquidity risk and flight-to-quality, etc., will forever doom even the geekiest and 'greekiest' models to getting blind-sided by negative Black Swans.<br /><br />Along the same lines is how Das' book exposes the dark underbelly of many derivatives contracts. Many (if not all) the textbooks and technical literature on derivatives seem to think that derivatives are created and structured by Mother Theresa's Sisters of Mercy. These other books/papers will describe vanilla call, put, forward/futures, swap contracts but will have next to nothing on 'exotic' derivatives, structured products, special purpose vehicles, credit derivatives, etc. Even books/papers that touch on OTC and exotic products tend to take an unrealistic and unworldly view of things; i.e., they seem to unskeptically accept the propaganda of sell side traders/derivatives salesmen that they are 'client-centric' and that they would 'never' try to hide anything or slip in financial equivalents of ticking time bombs into their derivatives products.<br /><br />Fortunately, Das -- having been on both the buy and sell side of the business -- doesn't believe that derivatives salesmen and traders have taken a vow of chastity. Das exposes many of the hidden details in real world -- as opposed to the idealized models one sees in textbooks -- derivatives contracts/products. And, not surprisingly, these details show that derivatives aren't the seemingly innocent ways to make markets more 'efficient' as we've been led to believe. There is sketchy accounting, hidden leverage (often massive), outlandish terms, and other ugly and sordid details.<br /><br />For example, one semi-fictional example of contractual shenanigans that Das gives is almost comical (if you have a mathematical bent) if billions of dollars weren't at stake. One swap contract would have had a near-bankrupt company pay $4 million <em>a month</em> to a dealer in exchange for the investment bank paying the company an amount based on the following formula/algorithm (adapted from pp. 10-11):<br /><br />Max[0; $600 million * {7 * [(LIBOR^2 * 1/LIBOR) - (LIBOR^4 * LIBOR^-3)]} * days in the month/360]<br /><br />If you know basic algebra, then you would realize that this term will always equal zero! [Hint: The LIBOR terms.]<br /><br />There are many other aspects of this book that I can highlight and praise, but the remainder of this post will focus on the intersection between Das' book and the current turbulence in the markets: namely, credit derivatives. The current market meltdown -- as summarized in the <a href="http://www.economist.com/finance/displaystory.cfm?story_id=9659784">current issue of The Economist</a> -- revolves around collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and mortgage backed securities (MBS) [for the purposes of our discussion, we can consider all three to be virtually interchangeable]. It just so happens that Das' book contains <em>the best</em> overview of credit derivatives that I am aware of.<br /><br />The problem that credit derivatives products are causing right now in the markets are complex and hard to describe in the limited space of this blog. However, I can very briefly outline the problems below:<br /><br />(1) Credit derivatives, like CDOs, are causing problems right now, in part (again, it's much more complex than what I can get into at this point), because they are basically untradeable and unhedgeable at this point. Why? Because the assets underlying these credit derivatives -- for the most part real estate mortgages (but there are other kinds of debt, like corporate debt, at play here too) -- have tanked in value because of the rising levels of defaults and the increase in the (subjective) probability of defaults.<br /><br />(2) That's not the only problem. The other problem is that investments in these credit derivatives vehicles/products are structured into what are called <em>tranches</em>. That is a fancy way of saying that different classes of investors in credit derivatives will get paid in different ways. The 'equity' and 'mezzanine note' holders are taking a bath on this freefall in the CDO 'market' (I use that term loosely, since much of this is OTC) since they had lower priority in cases where some of the holdings in the credit derivatives portfolio defaulted (i.e., they took the risk in return for the rewards, and the chickens have come home to roost). The catch here is that senior note holders who had the highest priority are also taking a beating. This came as a surprise to them (but, according to Das and to my way of thinking, maybe it shouldn't have been) because most of these CDOs are structured so that the senior notes will get the highest possible ratings by credit rating agencies -- AAA. Now, the senior note holders are finding that AAA might as well be FFF.<br /><br />(3) To make matters even worse -- and this happens in virtually every market crash (bursting of asset pricing bubbles) -- investors, banks, etc., are compelled to sell assets in order to limit losses and/or hedge risk. The problem is that this is either hard to do and/or makes things even worse. Obviously, they want to get rid of non-performing and/or illiquid assets, but they can't right now (if ever) because they're heading toward worthlessness. So they have to sell off 'good' assets, which means that prices of assets that at first blush seems to have little to do with CDOs, MBSs, mortgages, lending, banking, etc., also fall precipitously. I.e., correlations are created when there was little or none before!<br /><br />(4) To top it all of, there is a LOT of leverage involved (both explicit and implicit). Leverage makes downturns even worse. For example, the need to meet margin calls is what is causing the sell off that I described in point (3).<br /><br />That's a nutshell description of what is happening now in the financial markets. Like I said, it is much more complicated than that I'm sure, but if you can follow what I just wrote, then you're probably more knowledgeable than the vast majority of the people who bought and sold CDOs over the years.<br /><br />Getting back to Das and how his book relates to the current tremors in the markets ... Das' book is the only book that I'm aware of that gives an accessible account of the workings and structure of credit derivatives, including both financial and legal issues surrounding them. Chapter 9 of his book -- considering the mess we're in -- is well worth the price of the book in it of itself (although the rest of the book is just as great if not better)! I would go so far as to say that Das essentially predicted the current crisis over a year ago (the book was published last year, 2006).<br /><br />The intersection between Das' book and the market meltdown brings us back to the theme of knowns and unknowns. Goldman Sachs has admitted that its hedge funds -- keep in mind that hedge funds have been big buyers of credit derivatives -- have been "hit by moves that its models suggested were 25 standard deviations away from normal" (from The Economist article). This is, in terms of standard Gaussian mathematical statistics, akin to saying that it was impossible for these losses to take place. Guess what ... the losses took place!<br /><br />Apologists for hedge funds, investment banks, credit agencies, and investors may claim that these are what Das might call 'unknown unknowns.' How can anyone think that a (negative) 25 sigma event would take place? How can anyone know that credit rating agencies' grades are not worth the paper they're printed on when you need to count on them the most? Etc.<br /><br />The problem with this line of argument is that these 'unknown unknowns' were actually <em>known</em> .. we just didn't want to admit that to ourselves. Nassim Nicholas Taleb, Benoit Mandelbrot, and -- as this blog post outlines -- Satyajit Das, have been warning us about these kinds of Black Swans for quite a while. Chance of a 25 sigma event taking place? Impossible from a 'normal,' bell curve perspective. Quite likely, from the Black Swan way of thinking.<br /><br />The lesson we can learn from the NNTs and Das-es of the world -- those rare individuals who can combine sincere humility with the courage to face and embrace inconvenient truths -- are that the 'unknown unknowns' are really 'unknown knowns.' We actually <em>know</em> that 'impossible' events can take place because we should know that our pretentious models and heuristics are vulnerable to the messiness of the real world. The problem is that we don't know -- or, more accurately, we <em>don't want</em> to know -- that we know. That kind of self-knowledge is too painful to our ego, too inconvenient, and too humbling.<br /><br />But ask yourself the question: Isn't it better to feed yourself humble pie rather than having it hurled at your head as is happening to so many traders and bankers now?<br /><br /><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0273704745&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0812975219&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=1400063515&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><br /><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0140278796&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0805075100&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0470821590&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-41898557505113175872007-08-09T03:33:00.000+01:002007-08-11T20:14:42.119+01:00Catastrophe BondsCatastrophe bonds -- or "cat" bonds -- are bonds (normally issued by insurance companies) that have high yields but lose their value when natural disasters (such as earthquakes, floods, hurricanes / typhoons, etc.) take place. In the past, the vast majority of cat bond investors were large institutional investors like pension funds and hedge funds. Recently, however, <a href="http://www.economist.com/finance/displaystory.cfm?story_id=9600122">a mutual fund has allowed retail investors an 'opportunity' to gain exposure</a> to this seemingly exotic alternative asset class.<br /><br />The benefits of investing in cat bonds is that (a) it has yields that are substantially higher than most junk bonds and the sovereign debt of emerging countries, and (b) it (supposedly) has low correlation with other asset classes (of course, those touting cat bonds are tacitly assuming that natural catastrophes are not linked to market catastrophes). The problem is that these benefits come with a high price: Investors in cat bonds are implicitly writing (selling) options to insurance companies when they buy cat bonds.<br /><br />If you know anything about financial options, you should know that the writers (sellers) of options -- which, counter-intuitively in this case, aren't the issuers of cat bonds, but the investors of cat bonds -- can lose their entire investment, and, in some cases, have virtually unlimited losses. If investments in cat bonds involve a lot of leverage -- which would not be surprising given that cat bonds are essentially another form of exotic financial derivatives -- then losses for investors can get quite ugly.<br /><br />Cat bonds is another example of exotic derivatives and financial products that are finding their way to retail investors. Creators and marketers of these products are increasingly motivated to offer these products to the retail market because: (a) they have access to greater liquidity (thousands of 'little old ladies from Pasadena' can rival institutional investors when it comes to chasing liquidity), and (b) they provide a way to further (re-)distribute risk.<br /><br />More on point (b) ... re-insurers -- who provide insurers with insurance against catastrophic risk -- are the obvious alternative to cat bonds. Unfortunately for insurance companies, re-insurers (and, for that matter, insurance companies) are like Mark Twain's proverbial bankers: "They give you an umbrella when it's sunny, but take it away when it's raining." In other words, re-insurance is plentiful when there aren't too many natural catastrophes, but they tend to dry up when it is most needed.<br /><br />Cat bonds -- especially if retail investors get in on the act -- can be a way for insurance companies to obtain more 're-insurance' than they otherwise could. Unfortunately, for retail investors, these cats may not have nine lives when disaster strikes.The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-15881943462840046602007-08-03T00:42:00.000+01:002007-08-05T19:05:08.121+01:00International Investing and China in the NBER DigestI came across a couple of interesting items in the July issue of the National Bureau of Economic Research's <em>NBER Digest</em>.<br /><br />The first item that caught my eye was <a href="http://www.nber.org/digest/jul07/w12697.html">The Declining Gain from International Portfolio Diversification</a> (by Les Picker). That article describes a NBER Working Paper by Karen Lewis, a financial economist at Wharton, where she examines the puzzle of why investors tend to disproportionately weight their investment portfolios to domestic securities and assets. This tendency is a 'puzzle' because this tendencymeans that investors forego the possible gains -- including lower correlated risks, higher returns from riskier foreign investments, etc. -- from international diversification.<br /><br />Prof. Lewis finds that (a) international equity markets have become more correlated over the years (although she didn't find them to be as highly correlated as others have suspected them to be), and (b) foreign stocks that are listed on U.S. exchanges have become highly correlated with the U.S. market(s) over time. Thus, the potential gains from international portfolio diversification have been declining, and there seems to be relatively little to be gained in the way of diversification from investing in domestically listed foreign stocks.<br /><br />The second item of interest in the <em>NBER Digest</em> is <a href="http://www.nber.org/digest/jul07/w12755.html">The Return to Capital in China</a> (also by Les Picker). This article discusses research by professors Bai, Hsieh, and Qian, on what affects (if any) China's high investment rate (over 40% of GDP) has on returns to capital. The researchers found that (adjusted for various factors) China has relatively high returns to capital. It should be noted that this is an interesting finding because high investment rates can often mean <em>lower</em> returns to capital.<br /><br />One of the plausible reasons why China's return to capital seems to be higher is -- despite misallocation of capital in many cases -- that China's economy has been moving rapidly toward more capital-intensive industries and techniques and away from purely labor-intensive industries of the past.The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-16925399490045066762007-07-27T00:09:00.000+01:002007-07-27T02:08:28.055+01:00Derivatives, Leverage, and the Case of the Vanishing Bond Market VigilantesA recent article in The Economist -- <a href="http://www.economist.com/finance/displaystory.cfm?story_id=9516621">Vanishing vigilantes: Why the markets may be undermining central banks</a> (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.<br /><br />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.The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-31397002441071018772007-07-18T09:51:00.000+01:002007-07-18T10:12:50.436+01:00Do Investors Have Too Much Information?A recent <a href="http://www.economist.com/finance/displaystory.cfm?story_id=9482952">Buttonwood</a> 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.<br /><br />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.<br /><br />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.The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-18182056750606823942007-07-04T07:24:00.000+01:002007-07-04T08:02:18.278+01:00Success 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 <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2Fo%2FASIN%2FB0009RNZC4%3Fpf%5Frd%5Fm%3DATVPDKIKX0DER%26pf%5Frd%5Fs%3Dcenter-1%26pf%5Frd%5Fr%3D03FPH4GJ385BRQQS4KD0%26pf%5Frd%5Ft%3D101%26pf%5Frd%5Fp%3D292858701%26pf%5Frd%5Fi%3D507846&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Bluff magazine</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&amp;amp;amp;amp;amp;l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" /> written by <a href="http://www.eraider.com/">Aaron Brown</a> 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: <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FPoker-Face-Wall-Street%2Fdp%2F0470127317%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1183530567%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">The Poker Face of Wall Street</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&amp;amp;amp;l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" />. Brandon Adams has written a couple of books dealing with similar themes: <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FBroke-Poker-Novel-Brandon-Adams%2Fdp%2F0595377297%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1183530717%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Broke: A Poker Novel</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&amp;amp;l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" /> and <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FStory-Behavioral-Finance-Brandon-Adams%2Fdp%2F0595396909%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1183530717%26sr%3D1-2&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">The Story of Behavioral Finance</a><img src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&amp;amp;l=ur2&o=1" alt="" style="border: medium none ! important; margin: 0px ! important;" border="0" height="1" width="1" />.<br /><br />What was interesting to me about their article, <span style="font-style: italic;">Luck and Skill in Poker</span>, 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 Betfair.com 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 Betfair.com); in effect, they use Betfair.com and the odds it quotes as a predictive market. Using this probability function, they applied the <a href="http://en.wikipedia.org/wiki/Gini_coefficient">Gini coefficient</a> -- 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.<br /><br />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.<br /><br />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 ..."<br /><br /><iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0470127317&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=B0009RNZC4&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe> <iframe src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=1886070253&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" style="width:120px;height:240px;" scrolling="no" marginwidth="0" marginheight="0" frameborder="0"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-37869879095094873312007-06-26T01:27:00.000+01:002007-06-26T01:47:15.173+01:00Algorithmic Trading'Algorithmic trading' is trading done by computer programs (algorithms) that pick up on trade-worthy bits of information from streams of market data and financial news. According to a recent <a href="http://www.economist.com/finance/displaystory.cfm?story_id=9370718">article</a> in The Economist, algorithmic trading accounts for a third of share traded in the U.S. and analyst project that algorithmic trading in some form or fashion will grow to account for a majority of trading in the coming years.<br /><br />One of the advantages to algorithmic trading is sheer speed. In trading, especially in 'statistical arbitrage,' even a few milliseconds can mean the difference between exploiting a profitable opportunity or missing it altogether.<br /><br />There are problems with this type of trading. One of the problems is that the algorithms may mis-interpret data or not have enough or the right kinds of information to make the proper trading decision. For example, as the article points out, does "surprise" mean the price is going up or down? One solution to this is to make sure that algorithms properly combine pieces of information (e.g., matching "surprise" found in a news piece with relevant price data). Another solution is tagging the news items fed into the computers (but then how do you know whether the tags are correct?) -- which is being done by financial news providers like Dow Jones.<br /><br />I believe that there are more profound and more troubling problems than those pointed out by the article. First, we might wind up seeing similar problems that we got with 'programed trading' (which is not necessarily the same as algorithmic trading) that contributed to the October 1987 crash that rocked the financial market; i.e., you can get massive herding effects since many algorithms (even if superficially different from one another) will often behave in similar ways to each other.<br /><br />The second problem is that algorithmic trading is essentially data mining. Now, most people in the business world think that data mining is a good thing. In some cases, it can be on a practical level. But, to thinking mathematical statisticians, data mining is a highly dubious practice. As Nassim Taleb might put it, algorithmic trading might be mining data to confirm whatever 'white swans' that one hopes will provide trading profits. But what if a black swan happens? It's doubtful that trading algorithms can pick up on black swans any better than their human trading compatriots can.<br /><br />A third problem -- which I won't elaborate on since there are mountains of books written on this subject -- are the ones faced by anyone working in artificial intelligence ... which algorithmic trading is sort of aiming at.The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-23172398647951045492007-06-22T21:15:00.000+01:002007-06-22T23:00:50.599+01:00Thin Sliced ElectionsThe NBER (National Bureau of Economic Research) Digest's latest issue (June 2007) has an article -- <a href="http://www.nber.org/digest/jun07/w12660.html">TV Appearance and Electoral Success</a> -- that I found both fascinating and disturbing at the same time. In their paper, <a href="http://home.uchicago.edu/~jmshapir/thinslice102306.pdf">Thin-Slice Forecasts of Gubernatorial Elections</a>, Daniel Benjamin and Jesse Shapiro, conducted an experiment on a group of Harvard students to see whether or not the physical appearance of political candidates alone could lead to correct predictions of the outcome of elections. These subjects were shown 10 second clips of televised debates of candidates for governors in several U.S. states. Some subjects were shown clips without sound while others were either shown clips with muddled sounds or with full audio.<br /><br />The researchers found that those who saw silent videos had greater success at predicting who would win the elections (58% of picks actually won their elections) compared to most other factors used to make electoral predictions. The students who made their predictions after seeing the videos either with muddled or full sounds could do no better than had they randomly guessed who would win (ranging from 52 to 48% success rates). Furthermore, purely visual forecasts were considerably more accurate than electoral predictions based on other measures such as per capita income, unemployment rates, and state fiscal health.<br /><br />The results of this research is consistent with similar experiments carried out on subjects outside the U.S. to find out what factors people actually used when picking their political leaders. For example, two studies carried out in Europe (Romania and Finland) found that subjects basing predictions based on physical appearance tended to do better than those who had based their predictions on other seemingly more 'politically correct' factors such as competence in economic and policy matters.<br /><br />Contrary to expectations, adding policy information to the predictive mix seems to <em>worsen</em> the chances of making correct predictions. The findings of this body of research may explain why 'experts', "who are highly informed about and attentive to policy matters, are often found to perform no better than chance in predicting elections" (and, frankly, experts often do worse than chance in making predictions and this mis-predictive 'ability' is applicable to other fields as well).<br /><br />These findings are consistent with the idea of 'thin-slicing' which was popularized by journalist, <a href="http://www.gladwell.com/">Malcolm Gladwell</a>, in his best-selling book, <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FBlink-Power-Thinking-Without%2Fdp%2F0316010669%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1182546118%26sr%3D1-2&tag=econophysicsb-20&linkCode=ur2&camp=1789&creative=9325">Blink</a><img style="BORDER-RIGHT: medium none; BORDER-TOP: medium none; MARGIN: 0px; BORDER-LEFT: medium none; BORDER-BOTTOM: medium none" height="1" alt="" src="http://www.assoc-amazon.com/e/ir?t=econophysicsb-20&l=ur2&o=1" width="1" border="0" />. Malcolm Gladwell's contention is that making rapid, intuitive decisions are often not much worse than -- and may often be superior to -- making more deliberate decisions. Although I really admire Malcolm Gladwell and, to some extent, agree with this idea, this is the part that I (and I'm sure others) find somewhat disturbing. As I recently wrote up in a blog post on the <a href="http://econophysics.blogspot.com/2007/06/travelers-dilemma-irrational-game.html">Travelers' Dilemma</a>, those who make snap decisions tend to make more emotional or random rather than rational or strategic decisions. Thus, while in a positivist sense 'thin-slicing' may be the method used to make decisions in political elections (and in other situations), in a normative sense this type of decision-making is a recipe for choosing incompetent and disastrous leaders.<br /><br />Benjamin and Shapiro's research seems to contradict econometric models of elections done by researchers like <a href="http://fairmodel.econ.yale.edu/">Ray Fair</a>, who found that economic and other policy factors can play significant roles in making electoral predictions. Having said that, all three economists agree that incumbency is the factor with the most predictive power in trying to forecast electoral results. (Campaign spending is another factor that has great predictive power.)<br /><br />The research discussed in the NBER Digest both complements and contradicts research carried out by Philip Tetlock, a political scientist at U.C. Berkeley. Prof. Tetlock -- most recently in his book, <a href="http://www.amazon.com/gp/redirect.html?ie=UTF8&location=http%3A%2F%2Fwww.amazon.com%2FExpert-Political-Judgment-Good-Know%2Fdp%2F0691128715%3Fie%3DUTF8%26s%3Dbooks%26qid%3D1182547945%26sr%3D1-1&tag=econophysicsb-20&linkCode=ur2&amp;amp;amp;amp;amp;amp;camp=1789&creative=9325">Expert Political Judgment: How Good Is It? How Can We Know?</a> -- eloquently debunks the predictive 'abilities' of experts. Tetlock's research seems consistent and complementary to Benjamin and Shapiro's findings in that all three would agree that experts are bad at making predictions. Tetlock's research is at odds with the reasoning laid out in the Digest in that Tetlock, as Isaiah Berlin would have put it, believes that 'foxes' -- those who are intellectually curious and have wide-ranging interests (i.e., knows at least a little about a lot of things) -- tend to do better than 'hedgehogs' -- those who are focused on a few matters (i.e., knows (a little? a lot?) about a few things ... usually one thing) -- in making predictions. Benjamin, Shapiro, et al., seem to suggest that such a distinction may not matter at all -- i.e., it really doesn't matter whether or not an expert is Berlin's intellectual fox; in fact, narrow-minded hedgehogs -- so long as they are focused on the right 'few' things (such as visual cues of personal appeal in this case) -- may make better predictions than Tetlock's foxes.<br /><br />Perhaps the most fascinating aspect of Benjamin and Shapiro's findings -- beyond how the electorate is susceptible to making snap decisions based on 'looks' -- is the complexity of how people thin-slice during elections. Although the experimental subjects did predict better with purely visual cues (without sound or policy information), these visual-based predictions do not seem to be simplistically correlated to factors that are obviously associated with physical attractiveness.<br /><br />Instead, there seems to be a sense of some intangible quality -- we can call it 'charisma' -- that somehow can be picked up visually (and perhaps is muddied a bit when we start considering the substance of what the candidates have to say) that seem to be the key factor in the predictive success of those who based their decisions on silent videos. Thus, personal charisma of a candidate -- as vague a concept as that may seem -- is a superior to the predictive power (or lack thereof) of more concrete factors like policy matters and competence.<br /><br />As Benjamin and Shapiro aptly conclude, "Adding policy information to the video clips by turning on the sound tends, if anything, to worsen participants' accuracy, suggesting that naïveté may be an asset in some forecasting tasks."<br /><br /><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0316010669&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0804745099&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691128715&fc1=000000&IS2=1<1=_blank&lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0tag:blogger.com,1999:blog-22862699.post-41787126162190998612007-06-16T00:26:00.000+01:002007-06-16T00:27:03.341+01:00eBay 'Sniping' and the Power Law'Sniping' -- where a bidder waits until the last moments of an auction to place a bid -- is a tactic used by some eBay auction aficionados to gain an upper hand in bidding for an item.<br /><br />According to an <a href="http://www.newscientisttech.com/article/dn9398">article</a> (June 23, 2006) in the New Scientist, two South Korean physicists, Byungnam Kahng and Inchang Yang, found that a power law equation explained the observed patterns in eBay auction bidding. The power law reflects the fact that most of the bidding for items tend to take place near the end of an auction. Thus, according to their <a href="http://phya.snu.ac.kr/~kahng/ebay_rate.pdf">article</a> in <em>Physical Review E</em> (vol. 73, p 067101, 2006), 'sniping' is a rational strategy to employ in eBay bidding.<br /><br />This research builds on the work of experimental economist / game theorist, Alvin Roth. His <a href="http://kuznets.fas.harvard.edu/~aroth/papers/eBay.veryshortaer.pdf">article</a> in the <em>American Economic Review</em> (vol 92, p 1093, 2002) came to similar conclusions.<br /><br /><iframe style="WIDTH: 120px; HEIGHT: 240px" marginwidth="0" marginheight="0" src="http://rcm.amazon.com/e/cm?t=econophysicsb-20&o=1&p=8&l=as1&asins=0691127131&fc1=000000&IS2=1<1=_blank&amp;lc1=0000FF&bc1=000000&bg1=FFFFFF&f=ifr" frameborder="0" scrolling="no"></iframe>The Econophysics Bloghttp://www.blogger.com/profile/04545180427862150305noreply@blogger.com0