Showing posts from September, 2009

Excellent Video On The Health Care Debate

I try not to post too many political things on the blog because 1) I have a mostly finance readership, and 2) It brings out the moonbats (from both sides). But sometimes you find something too good to pass up. Recently Will Ferrell put up a video of celebrities chiming in on the health care debate. It was a masterpiece of typical Hollywood arrogance. As an aside, I often find myself upset when I hear some celebrity preaching to us normal mortals on one topic or another. Just remember - in reality, these are people whose main claim to fame is that they can convincingly read lines written by someone else (can you tell I don't care for celebrity "messages"?). Well, here's the rejoinder to Ferrell's piece. Whichever side of the debate you fall on, you have to appreciate the level of snark that they use to lampoon the celebrities (or maybe not - but I liked it, and it's my blog).

Bubbles and Scale Invariance

In yesterday’s post I mentioned that bubbles were exponential, scale-invariant and self-similar, making it virtually impossible to time their collapse. Let’s flesh out this assertion by looking at a particular market index. For the first 17 years of its existence, this index had a mean of 100 and a standard deviation of 56. (Prices have been scaled to avoid easy recognition). That’s a pretty stable time series. Then something happened. Over the next 8.5 years, the index went from a starting value of 200 (already near the upper end of its previous range) to a value of 700. What’s more, this rise took on exponential, maybe even super-exponential characteristics, as the graph below makes clear. Would you sell? If you did, you’d be out of luck. Because over the next 25 months, the index went from 700 to 1100. Once again the rise looked exponential or better: (Note that this graph has the same start date as the previous one, but different scales on each axis). Would you sell? If you

Bubbles and the Rational Trader

A few weeks ago, Paul Krugman wrote a lengthy essay on the history of macroeconomic thought for the New York Times Magazine. His article prompted a flood of commentary both pro and con; I do not propose to add to this deluge. I do however want to take issue with one particular assumption that runs through both the original article, and through many of the responses to it (from both left and right). This assumption has to do with the relationship between rationality and bubbles. One group of economists argues that traders are rational and markets are efficient; hence bubbles (if they do arise) are likely to be short-lived and self-correcting. Since markets are largely self-regulating, the role of government is to intervene as little as possible 1 . Another group argues that traders are often irrational and markets are often inefficient; hence bubbles may last a long time before eventually (and painfully) bursting. Since markets cannot be trusted 100%, the role of government is to

Can't You Bump My Grade Up?

At the end of the semester, I often get a student or two who want to protest their grades. Not too many, because I make a lot of preemptive moves explaining how their grade is determined, and I try to be very explicit in my syllabus. In addition, I teach mostly upper-level courses with almost all finance majors, so most of my student can actually do the simple computation necessary to figure out their grades. Finally, I think they get the sense that trying to work me for a grade simply won't be worth the effort. Still, it happens - often because "they need to get a "C" to graduate" (or some variation involving a scholarship, Dean's list, or so on). Rate Your Students has a pretty good piece on this topic that nails it. You can read the whole thing here , but the money quote comes at the: Up until now, I was always suckered into actually engaging in the debate. But this fall I'm going to try a new tactic, and anyone out there who wants to is free to a

A Wet Hilly Ride

I just did the a bikeathon for The Hole In The Wall Gang Camp . Today would have been Jonathan's 11 th birthday, so being able to do a fundraiser for the camp had special meaning. I had initially planned on riding the 60-mile course, but they canceled that ride due to inclement weather(it was raining heavily, and riding for 4 hours soaking wet and doing 15-20 mph could lead to hypothermia). So, I did the 30 miler instead. It started with a 3 mile, 6% downgrade in the pouring rain. By the bottom of the hill, my feet were soaked, my butt was frozen from the water thrown off by the rear tire, and my glasses were completely covered with water. Since it wandered through Northeast Connecticut, the course was extremely hilly (close to 10 hills of over a quarter mile and greater than 5% grade), and rained most of the way. Since they mismeasured the course, it turned out to be more like 38 miles than 30. Still, it was a blast. I'm actually glad they cancelled the 60 miler.

New Excel Video

Since students in all three of my classes will need to do a data table in Excel at some point, I decided to put together a short video on 1 and 2-variable data tables. Teaching three preps has been much more time consuming than I'd expected. Luckily, I'm almost through the most time consuming parts of my classes - in one, the most technical material comes first, and the other two (the case course and the student-managed fund) require a lot of "setup" at the beginning of the class. So, I'm hoping that crunch time will shortly be over. In any event, here are the videos click here for the video file in MPEG-4 format, and here if you want it in MOV format. It takes time to make these, but it should save me a fair bit of time in the long run. For example, I won't need to spend class time on teaching my students the basics of data tables any more. They'll still have questions after viewing the video, I'm sure, but they can review it multiple times, a

Implicit Regulatory Arbitrage: The Puts-Payers Trade

Yesterday’s post revealed how (and why) a large portion of the financial industry’s revenues came to depend on explicit regulatory arbitrage. This is fairly common knowledge, and should come as no surprise to industry observers. What’s not so well known is that many ‘classic’ arbitrages, which appear at first glance to be regulation-independent, also depend implicitly on regulatory asymmetries to work. The textbook example is bond futures arbitrage. While anyone can buy bonds, some market participants are forbidden to sell bonds short. To express a bearish view, this latter group has to sell bond futures. This makes bond futures systematically cheap relative to cash bonds. Arbitrageurs have only to take the opposite side of this transaction to make easy money. Of course, the classic bond futures arbitrage no longer exists (‘”too many eyeballs”), but other, subtler examples abound. Consider a trade that was very popular with fixed income arbitrageurs earlier this decade: the puts

Why Is Regulatory Arbitrage So Attractive?

When the histories of today’s very interesting times are finally written, I suspect that the phrase ‘regulatory arbitrage’ will feature prominently. One may point to the housing bubble or the bubble in finance as proximate causes; or to unsustainable global macro imbalances as a more distant cause. But the grease that lubricated the wheels of the runaway train was regulatory arbitrage. Why was regulatory arbitrage so prevalent during the boom? There are several reasons. First, regulatory arbitrage is easy . It’s certainly easier than trying to beat the market in ‘legitimate’ ways, as many retired traders can testify. What’s more, this state of affairs is likely to persist. Regulatory agencies in the USA are notoriously understaffed; their few workers are notoriously underpaid. Anyone competent enough to understand the complexities of modern financial instruments (which, incidentally, are often designed specifically to avoid or evade regulatory scrutiny) would waste little time i

Introduction: About Myself

This may have been true in the early days of the web, but these days people are smarter and more cynical. These days, people assume that you’re a dog unless you can prove otherwise. Much as I would like the ideas on this blog to stand on their own, I fear I will have to provide some shamelessly self-promotional biographical detail. So, a few words about myself: I joined a hedge fund at the age of 21. By 23 I was a junior trader; by 25 I had my own portfolio; by 27 I was a millionaire; and by 30 I had retired. I closed out the last of my positions on my 30th birthday and walked away with my winnings intact. A large chunk of my success can be put down to simply being in the right place at the right time, but I like to think that skill played a small part too. This was a few years ago. Since then, I have traveled the world, played a great deal of tennis, and become a father. I still follow the markets constantly, partly so that I can invest my own money productively, but mostly be

Introduction: The Meta Finance Blog

Welcome to the Meta Finance Blog. As the name suggests, this is a blog about what lies beneath the edifice of modern finance. In this blog, instead of addressing the what and how, or even the when and how much, I will focus on the why of financial markets. The bedrock of any study of finance has to be individual transactions (‘trades’), which suggests the first ‘why’: Why are certain traders / trades / trading styles more successful than others? Under this heading I will talk about competing trading philosophies; the design and analysis of trading strategies; various sources of trading returns; the concept of premium capture (especially risk premium); the measurement of trading performance; arbitrage, its implications and its limitations; modeling and meta-modeling; market-making and price-taking; risk management schemes; and so on. Of course, traders don’t operate in a vacuum; they are typically funded by (and hence beholden to) institutions. This brings us to the second ‘why’: Wh

A Brief Update

I survived the first week of the semester at Unknown University. This is my first time ever teaching three preps, and it's tougher than I expected. I'm about 1 1/2 weeks ahead in my classes, so I'm not running around playing catch up (another first, it seems). But, it's still no cake walk. On a different note - I just got an email from a coauthor. It contained a graph with some absolutely kick-hiney (that's a technical term) results. Times like this remind me what I love about this job - finding out interesting new things. I've got great hopes for this project - not only that it'll place in a good journal but that it'll be the start of a new stream of research. Time will tell, but for now, I'm excited. Ah well - time to give the Unknown Baby Boy his last bottle for the night, and then turn in. updates the next day - even more good new results. Woo Hoo!

Blogging Has Been Light

Blogging's been light lately for a couple of reasons (and probably will continue to be for a while). School just started up at Unknown University and anyone in academia knows that the beginning of the semester is always crazy. In addition, I have THREE preps this fall (I typically have two preps, but one of the faculty went on sabbatical, and I got his class - a new prep). Most important, I've come to the conclusion that I have to focus more on my research. I have a number of project that are "close" to completion, but it's better to have ONE completed and submitted than THREE that are "close". So, for the fall semester, I'm trying to work on only one project at at time until it (or at least my part of it) is done. I've tried to "juggle" projects in the past, but that ends up with me spinning my wheels. For me, multitasking just doesn't work. To give you an idea as to what's on my plate: I just finished a paper to submit

You Can't Measure Alpha Independent of Risk

When I teach investments, there's always a section on market efficiency. A key point I try to make is that any test of market efficiency suffers from the "joint hypothesis" problem - that the test is not tests market efficiency, but also assumes that you have the correct model for measuring the benchmark risk-adjusted return. In other words, you can't say that you have "alpha" (an abnormal return) without correcting for risk. Falkenblog makes exactly this point: In my book Finding Alpha I describe these strategies, as they are built on the fact that alpha is a residual return, a risk-adjusted return, and as 'risk' is not definable, this gives people a lot of degrees of freedom. Further, it has long been the case that successful people are good at doing one thing while saying they are doing another. Even better, he's got a pretty good video on the topic (it also touches on other topics). Enjoy.

The Summer Winds Down

It's been a busy week here in Unknownville. Unknown University starts up next week (we start later than most), so we've had a rash (or is that a plague?) of meetings. I'm still juggling several papers (writing a lit review for one, doing data work for another, and some polishing/editing for a third) and sequentially disappointing my coauthors. Ah well - them's the breaks. But I have to be nice, since coauthors on each paper read the blog. So fear not, coauthors - my parts will be done in good time. Along those lines, I just received a bunch of results from one coauthor, some of which are pretty interesting. It's an area that I had an unsuccessful paper in several years ago, and she usues s new and difficult data set that allows us to revisit the topic in a very new way. WE've got a good story and good results, and it'll gp to the head of the pile, since we're sending the paper to an upcoming conference (the Eastern Finance Association annu

What to Use as the Equity Risk Premium?

I'm teaching Corporate Finance again this semester. In the class, we spend a fair bit of time on the CAPM (yes, I know - it's not perfect. But it is a still pretty good). One of the big issues is what to use as the Market Risk Premium (or, as it's sometimes called, the "Equity Risk Premium). Looks like I'll be using this piece as background: The Equity Risk Premium in 100 Textbooks by Pablo Fernandez of the University of Navarra. Here's the abstract: I review 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and find that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages. Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premi