Holiday season is upon us and I thought I would take a little break from the world of finance and economics to wander off into some interesting territories. I had bought this collection of Akira Kurosawa movies. Of this I finally got around to watching Rashomon. It is a great movie no doubt. Here's a humble attempt to analyse it.
The movie is narrated by a wood-cutter to a common man who has come to share a shelter named Rashomon during a heavy downpour. There is a priest as well. It transpires that the woodcutter and the priest had come to testify in a court for a crime of rape and murder by a bandit against a samurai and his wife. The woodcutter however recounts (from what he hears at the court as told by the witnesses) three different stories to the commoner - each of which are different in their reasons and details. These are accounts of the crime as told by the bandit, the wife and the samurai. The starting set-up, ending state and some of the major chunks of events are same in each story. The motives and specific actions by each of the three however are quite different.
Just as they are wondering which of the stories is correct, the woodcutter goes further to narrate his version of the story as well - supposedly the closest to the truth. As it turns out, the best availble version of the 'truth' has its own flaws as well. The commoner represents the utterly cynical worldview while the priest stands for the idealist variant. The woodcutter seems quite disturbed by his observation of the limitations of human nature.
The central theme of the movie is quite disturbingly accurate of the limits of the truth available to human beings. For one, it focuses on how truth gets deformed by the individual agendas and aspirations the observer has. This is shown through the three stories of the bandit, the samurai and the wife. Secondly the movie goes into the more disturbing exploration of whether there is any absolute truth whatsoever which is without any coloring by the observer. This is brought out in the slightly distorted version of the events produced by a supposedly unbiased woodcutter. One is almost tempted to revisit the principle of quantum mechanics that the observer invariably influences the observed and thus can never provide the accurate description of "things as they are". Rashomon seems to bring out a similar intertwining of the observer and observed in the moral plane.
Sunday, December 26, 2010
Wednesday, December 15, 2010
Current account deficit - how big a deal?
Several observers have expressed concern about India's rising current account deficit. In recent months, the deficit has indeed been on rise.
However, contrary to popular perception this need not cause the same degree of alarm it used to say 10 years ago.
In general a widening current account deficit is a negative. In India’s case however, it is almost acting as the counterweight to the hot money flows and is helping RBI avoid the nasty problem of either letting the currency appreciate (if it does not intervene by buying dollars) or increasing the money supply (it if does intervene). Contrary to a widely held belief, the hot money flows are not only equity markets driven. A good portion of this is also invested in debt in India and that is primarily driven by the differential in interest rates across developed economies and India. Since that is likely to last for a while owing to quantitative easing by the Fed, I would think the hot money flows are unlikely to abate in a significant way in the near future.
Structurally of course it is dangerous to have this fragile equilibrium for long. Hopefully some pick up in global economy would support exports growth from India and reduce the deficit. On the other hand, one can hope that the break up of the capital inflows moves towards more stable FDI. In fact, in one of the recent articles, The Economist highlights the so called 'Delhi Consesus' which in essence is about letting the capital inflows happen as a positive and much needed outcome of superior economic growth in emerging economies vis-a-vis developed ones. Following is an interesting graph from that article.
Even portfolio investments are made out to be much more volatile, bigger and potent villains than they really are. In a country like India sitting on over $280bn of forex reserves, a capital flight out of India of hot money can hardly bring about macroeconomic instability.
However, contrary to popular perception this need not cause the same degree of alarm it used to say 10 years ago.
In general a widening current account deficit is a negative. In India’s case however, it is almost acting as the counterweight to the hot money flows and is helping RBI avoid the nasty problem of either letting the currency appreciate (if it does not intervene by buying dollars) or increasing the money supply (it if does intervene). Contrary to a widely held belief, the hot money flows are not only equity markets driven. A good portion of this is also invested in debt in India and that is primarily driven by the differential in interest rates across developed economies and India. Since that is likely to last for a while owing to quantitative easing by the Fed, I would think the hot money flows are unlikely to abate in a significant way in the near future.
Structurally of course it is dangerous to have this fragile equilibrium for long. Hopefully some pick up in global economy would support exports growth from India and reduce the deficit. On the other hand, one can hope that the break up of the capital inflows moves towards more stable FDI. In fact, in one of the recent articles, The Economist highlights the so called 'Delhi Consesus' which in essence is about letting the capital inflows happen as a positive and much needed outcome of superior economic growth in emerging economies vis-a-vis developed ones. Following is an interesting graph from that article.
Even portfolio investments are made out to be much more volatile, bigger and potent villains than they really are. In a country like India sitting on over $280bn of forex reserves, a capital flight out of India of hot money can hardly bring about macroeconomic instability.
Sunday, November 28, 2010
Too big to fail - a revisit
The troubles facing Ireland have brough to fore yet again an uneasy compromise policymakers and the populace had come to live with. This concerns the issue of private profits, public losses that emerged in the financial crisis. The main theme underlying the issue is the bailing out of several errant financial institutions by their respective governments during the crisis, using tax-payer's money. By not allowing these institutions to fail, the governments essentially let the owners of these companies keep the profits they made while committing the follies which drove them to the failure in the first place. The argument for doing this was that these institutions were too big to fail and letting them go through the well deserved failure would have undermined the stability of the entire financial system - with very dire repurcussions for the real economy as well. The failure of Lehman Brothers is often cited as the case in point for this. I believe part of this argument is indeed valid. I have so described in my book as well - in a box on "The Logic of Too Big to Fail".
In the short term this argument is quite acceptable. While firefighting, one does not look to punish the errant who started the fire immediately. However, this need not become the norm in the modern financial world. If financial institutions realize that they have a free hand to engage in any risk taking as long as they remain big enough (or interrelated to the rest of the financial system in complex enough ways) they will be bailed out, one does not need a crystal ball to guess what path they will choose.
In India in particular, we have the luxury of time and learning from the west's regulatory and policy mistakes. It would be a terrible waste if we ignore this phenomenon of too big to fail till a similar crisis hits us. There are various mechanisms to prevent individual companies from becoming systemically important enough to warrant a bail-out with public money. This need not smack of the relic of "Prevention of Monopolies Act". At the heart of the too big to fail argument lies the interconnections of various firms in finance. This is unlike other sectors. In finance competitors deal with each other lot more than those in any other sector. Hence any large enough firm tends to become too big to fail. The correct policy intervention here would be to make sure that the ways in which financial institutions do business with each other is adequately secure. One example is the regulation of OTC derivatives. While in theory one can argue that two firms can decide the risks they would like to take on their own books, in practice this is a sure-shot mechanism of transmitting a bankruptcy of one firm to another. More needs to be researched on this front. In general though, transperancy, promoting centralized clearing of transactions and keeping an eye on finanical sector innovations should be the general intent of policy making.
In the short term this argument is quite acceptable. While firefighting, one does not look to punish the errant who started the fire immediately. However, this need not become the norm in the modern financial world. If financial institutions realize that they have a free hand to engage in any risk taking as long as they remain big enough (or interrelated to the rest of the financial system in complex enough ways) they will be bailed out, one does not need a crystal ball to guess what path they will choose.
In India in particular, we have the luxury of time and learning from the west's regulatory and policy mistakes. It would be a terrible waste if we ignore this phenomenon of too big to fail till a similar crisis hits us. There are various mechanisms to prevent individual companies from becoming systemically important enough to warrant a bail-out with public money. This need not smack of the relic of "Prevention of Monopolies Act". At the heart of the too big to fail argument lies the interconnections of various firms in finance. This is unlike other sectors. In finance competitors deal with each other lot more than those in any other sector. Hence any large enough firm tends to become too big to fail. The correct policy intervention here would be to make sure that the ways in which financial institutions do business with each other is adequately secure. One example is the regulation of OTC derivatives. While in theory one can argue that two firms can decide the risks they would like to take on their own books, in practice this is a sure-shot mechanism of transmitting a bankruptcy of one firm to another. More needs to be researched on this front. In general though, transperancy, promoting centralized clearing of transactions and keeping an eye on finanical sector innovations should be the general intent of policy making.
Saturday, November 20, 2010
G20, Currency Wars, Economic Imbalances and the general mess that goes with the present International Monetary System
Last three decades have not been very forgiving for the global monetary system. There have been numerous sovereign defaults, many large bank failures, several local currency and banking crises and then one mega-crisis along with the deepest recession in last 70 years. When did life become so complicated?
At the risk of oversimplification I am going to suggest a date! 15th August 1971. That was the date on which President Nixon of US announced the abolishing of Gold Standard under the Bretton Woods system. This day onwards, currencies started floating freely against each other. The initial reaction of most countries was one of the two. Large economies were fine with letting their currencies float since the volatility in the exchange rate was not significant - this included Germany, UK, Japan etc. Smaller countries chose to peg their currency to one of the major currencies - mostly driven by the currency of choice for their largest trading partners. Majority chose USD, some went with Pound Sterling.
Over a period of time, the policy makers in the emerging economies discovered the strategy of currency management for export promotion. A very interesting analysis of this strategy has been done in a paper by Prof. Sebastian Morris of IIM Ahmedabad. Parallely, as capital became more mobile globally in the 80s and 90s, many emerging economies started seeing significant movement of capital in and out. Some discovered to their peril the footloose character of large part of these flows - also termed "hot money". The Asian Financial Crisis of 1997 was a testimony to this. Coupled with the cheap currency led export promotion and the need to have large forex reserves in the wake of the crisis, most Asian economies built massive piles of reserves (now running into trillions of dollars).
The world is now divided into three camps - monetarily speaking! Many of the advanced economies which run current account deficits and capital account surpluses in one camp, some advanced economies and many large economies which run currency account surplus and capital account deficits and the rest of the world. US and UK lead the first camp, Germany/Japan amongst advanced economies and China/East Asia amongst emerging economies lead the second camp. The second camp accumulates reserves or has depreciating currencies. The first camp has an ever increasing issuance of government debt to the reserve accumulators. (India belongs to the third camp - it accumulates reserves only when there is massive capital account surplus, else the moderate capital surplus typically balances out its almost always positive current account deficit.)
The funny (or tragic depending on your beliefs in fairness, human nature and geopolitics!) thing is that this state of affairs is thoroughly unstable. Whatever equillibrium the global financial system achieves is always likely to be very fragile since the actors in the above state of affairs are soveriegn states with very limited influence on each other! Consider the US-China exchange on the currency management by China and loose monetary policy of US Fed. Neither can directly control what the other is going to do to its internal monetary policy but both are likely to be strongly affected by it. It almost seems like one needs to coin a new phrase to describe this phenomenon of politics getting intertwined with monetary policy - "moneto-politics" maybe (along the lines of "geopolitics").
There is no easy way out of this. Central banks and governments across the world will keep managing their monetary policies and currencies independently. That may not always be the optimal outcome for everyone concerned. However, till most of the participants see more benefits of coordinated action than the to-each-his-own policies, the instability remains an inherent feature of the modern monetary system. Maybe one should do a game-theory analysis of monetary policy conduct of major economies!
At the risk of oversimplification I am going to suggest a date! 15th August 1971. That was the date on which President Nixon of US announced the abolishing of Gold Standard under the Bretton Woods system. This day onwards, currencies started floating freely against each other. The initial reaction of most countries was one of the two. Large economies were fine with letting their currencies float since the volatility in the exchange rate was not significant - this included Germany, UK, Japan etc. Smaller countries chose to peg their currency to one of the major currencies - mostly driven by the currency of choice for their largest trading partners. Majority chose USD, some went with Pound Sterling.
Over a period of time, the policy makers in the emerging economies discovered the strategy of currency management for export promotion. A very interesting analysis of this strategy has been done in a paper by Prof. Sebastian Morris of IIM Ahmedabad. Parallely, as capital became more mobile globally in the 80s and 90s, many emerging economies started seeing significant movement of capital in and out. Some discovered to their peril the footloose character of large part of these flows - also termed "hot money". The Asian Financial Crisis of 1997 was a testimony to this. Coupled with the cheap currency led export promotion and the need to have large forex reserves in the wake of the crisis, most Asian economies built massive piles of reserves (now running into trillions of dollars).
The world is now divided into three camps - monetarily speaking! Many of the advanced economies which run current account deficits and capital account surpluses in one camp, some advanced economies and many large economies which run currency account surplus and capital account deficits and the rest of the world. US and UK lead the first camp, Germany/Japan amongst advanced economies and China/East Asia amongst emerging economies lead the second camp. The second camp accumulates reserves or has depreciating currencies. The first camp has an ever increasing issuance of government debt to the reserve accumulators. (India belongs to the third camp - it accumulates reserves only when there is massive capital account surplus, else the moderate capital surplus typically balances out its almost always positive current account deficit.)
The funny (or tragic depending on your beliefs in fairness, human nature and geopolitics!) thing is that this state of affairs is thoroughly unstable. Whatever equillibrium the global financial system achieves is always likely to be very fragile since the actors in the above state of affairs are soveriegn states with very limited influence on each other! Consider the US-China exchange on the currency management by China and loose monetary policy of US Fed. Neither can directly control what the other is going to do to its internal monetary policy but both are likely to be strongly affected by it. It almost seems like one needs to coin a new phrase to describe this phenomenon of politics getting intertwined with monetary policy - "moneto-politics" maybe (along the lines of "geopolitics").
There is no easy way out of this. Central banks and governments across the world will keep managing their monetary policies and currencies independently. That may not always be the optimal outcome for everyone concerned. However, till most of the participants see more benefits of coordinated action than the to-each-his-own policies, the instability remains an inherent feature of the modern monetary system. Maybe one should do a game-theory analysis of monetary policy conduct of major economies!
Friday, November 12, 2010
Dealing with FPOs
There is a spate of follow-on public offerings in the offing - Power Grid is already behind us, SAIL, ONGC and some other PSUs are to follow. FPOs are an interesting animal. Unlike IPOs, FPOs already have a traded security in the market. The price discovery hence is already done. Unlike the IPO the issue price can be benchmarked to something real. For investors this is a good indicator of whether they should buy in the follow on issue or simply from the secondary markets - something dependent on the degree of the discount offered in the issue.
Since the issuer would want investors to subscribe to the issue despite the availability of the same shares in the secondary markets, it is understandable that FPOs would typically happen at a discount to the prevailing market price. While this is a small positive for the long term investor, it is potentially a very interesting opportunity for the short term investor. Inherent to the discount is an arbitrage opportunity. Since the FPO is likely to be in discount to the open market price, one can short the futures of the underlying security in the secondary markets and bid for the issue. When the allocation happens, one can square off the futures position as well as sell the alloted shares. This would lock in the price differential. Of course one needs to estimate the allocation amount. Given this, one can even use leverage to further boost the returns - especially since this strategy is relatively free of market risk.
Since the issuer would want investors to subscribe to the issue despite the availability of the same shares in the secondary markets, it is understandable that FPOs would typically happen at a discount to the prevailing market price. While this is a small positive for the long term investor, it is potentially a very interesting opportunity for the short term investor. Inherent to the discount is an arbitrage opportunity. Since the FPO is likely to be in discount to the open market price, one can short the futures of the underlying security in the secondary markets and bid for the issue. When the allocation happens, one can square off the futures position as well as sell the alloted shares. This would lock in the price differential. Of course one needs to estimate the allocation amount. Given this, one can even use leverage to further boost the returns - especially since this strategy is relatively free of market risk.
Sunday, October 31, 2010
Hedging against FII outflow driven market correction
Considering that there seems a general consensus regarding the source of the currency rally in Indian equity markets, one would wonder how sustainable it is. Further quantitative easing in US may push things even further up. What can one do to hedge against an FII outflow driven market correction in Indian equity?
Today's business standard has an interesting article on a related topic. It contains an interesting idea. One can short Rupee in the currency futures markets to hedge against a sharp pullout of FIIs from Indian markets. Of course the cost of this is that the gains driven by FII inflows will get dampened somewhat by the losses on the futures side since Rupee will continue to appreciate in that case. However, considering potential RBI intervention in forex markets to keep Rupee from appreciating too much may work in favor of this strategy. On the other hand a sudden pullout by FIIs will certainly push Rupee down. The gains from that will partially offset the losses in the equity portfolio.
Why not simply buy a put on the index? For one it would be costlier. For two, it does not address the specific issue of volatility of FII inflows. A dollar rupee futures contract does just that. One can even use an option - out of the money call on Rupee (or put of Dollar) - as an alternative. In this case the upside from further FII inflows remains fully untouched in return for the option premium. This is best done in one or two month one off cases. For a regular hedge futures are likely to be more effective.
A multi-asset portfolio can also benefit from the above. Bonds are affected by the FII flows as well - albeit to a lesser extent. Gold of course is an entirely different topic. More on that later!
Today's business standard has an interesting article on a related topic. It contains an interesting idea. One can short Rupee in the currency futures markets to hedge against a sharp pullout of FIIs from Indian markets. Of course the cost of this is that the gains driven by FII inflows will get dampened somewhat by the losses on the futures side since Rupee will continue to appreciate in that case. However, considering potential RBI intervention in forex markets to keep Rupee from appreciating too much may work in favor of this strategy. On the other hand a sudden pullout by FIIs will certainly push Rupee down. The gains from that will partially offset the losses in the equity portfolio.
Why not simply buy a put on the index? For one it would be costlier. For two, it does not address the specific issue of volatility of FII inflows. A dollar rupee futures contract does just that. One can even use an option - out of the money call on Rupee (or put of Dollar) - as an alternative. In this case the upside from further FII inflows remains fully untouched in return for the option premium. This is best done in one or two month one off cases. For a regular hedge futures are likely to be more effective.
A multi-asset portfolio can also benefit from the above. Bonds are affected by the FII flows as well - albeit to a lesser extent. Gold of course is an entirely different topic. More on that later!
Sunday, September 26, 2010
Cheap money at the gates!
Indian equity markets have staged an impressive rally in the past couple of weeks. One major reason for this was the rather subdued growth in equity markets in last 6 months after the initial recovery. Once the markets caught up to the fundamentals (and probably went a little further), suddenly everyone seemed to be looking around for reasons to justify higher levels. There were not many and that showed in the range bound markets for last 6 months.
Interestingly nothing major has happened in the last month either. Domestically that is. Of course the monetary policy stance is becoming less aggressive, inflation is waning, IIP is rising and GDP forecasts are getting better. But none of this is 'news' and to that extent has largely been factored in the markets. The real change in my view is on the foreign investors' front. Many investors in the developed economies seem to be over their fears now and are back into the hunt for returns. The other thing that works in India's favor is the a robust economic growth through the crisis and absence of any obvious signs of bubble (unlike China). Thus the cheap money is at our gates again!
Is it a problem? Not now, not necessarily in future either. But it can be worrying for us in two ways. For one, the returns that foreign investors are willing to settle for are lesser than what we may demand as investors standalone. This forces domestic investors to also settle for the same returns or lead to inflated asset values. Secondly, the return of this money in troubled times rocks our asset markets more than they deserve to on the back of their performance. This is simply the "curse of shallow but attractive asset markets". We will continue to have it till the size of our economy and asset markets grows to a few times its current level (at current growth rate, maybe another 10 years).
What do we watch out for? There is no easy way to make money by second guessing FIIs. A more realistic strategy would be to avoid making losses due to their behavior. That means avoiding entering markets in a euphoria driven by non-domestic factors (US employment data, good results of stress tests in EU etc) and more importantly avoiding booking losses in a fall driven by FII exit due to non-domestic factors. Summary: let the investors be domestic or foreign, make your decisions domestic!
Interestingly nothing major has happened in the last month either. Domestically that is. Of course the monetary policy stance is becoming less aggressive, inflation is waning, IIP is rising and GDP forecasts are getting better. But none of this is 'news' and to that extent has largely been factored in the markets. The real change in my view is on the foreign investors' front. Many investors in the developed economies seem to be over their fears now and are back into the hunt for returns. The other thing that works in India's favor is the a robust economic growth through the crisis and absence of any obvious signs of bubble (unlike China). Thus the cheap money is at our gates again!
Is it a problem? Not now, not necessarily in future either. But it can be worrying for us in two ways. For one, the returns that foreign investors are willing to settle for are lesser than what we may demand as investors standalone. This forces domestic investors to also settle for the same returns or lead to inflated asset values. Secondly, the return of this money in troubled times rocks our asset markets more than they deserve to on the back of their performance. This is simply the "curse of shallow but attractive asset markets". We will continue to have it till the size of our economy and asset markets grows to a few times its current level (at current growth rate, maybe another 10 years).
What do we watch out for? There is no easy way to make money by second guessing FIIs. A more realistic strategy would be to avoid making losses due to their behavior. That means avoiding entering markets in a euphoria driven by non-domestic factors (US employment data, good results of stress tests in EU etc) and more importantly avoiding booking losses in a fall driven by FII exit due to non-domestic factors. Summary: let the investors be domestic or foreign, make your decisions domestic!
Sunday, September 05, 2010
Book review - When Genius Failed
This book on the LTCM debacle is by no means either new or contemporary. I just happened to dig it out from Landmark one evening and finished reading it today.
LTCM i.e. Long Term Capital Management, was a hedge fund promoted by a clutch of bond traders on Wall Street along with a few academicians (including Scholes and Merton of Black-Scholes-Merton fame). At its peak it had equity capital of more than $ 4 bn and assets of more than $ 100 bn.
The book covers the rise and fall of LTCM in great detail - in a very human rather than analytical way. It is written for lay persons and that shows. A good read for lay persons for sure, but also for the practitioners of modern finance, all the more so in emerging economies like India's. It is not implausible to expect an LTCM like debacle in India within next 5 years. As the complexity of the financial system grows, crises of LTCM variety are more and more likely to occur.
So what exactly happened? LTCM started out as purely a bond arbitrage portfolio with $ 1.5 bn in capital. It borrowed about 25 times that and invested in bonds of various types. It was not a directional bet on the bond prices though. It dealt in what is called convergence trades i.e. narrowing of spreads between two bonds. For whatever reasons if the spreads between two bonds are out of whac with the usual levels, an opportunity to make relatively low risk return arises. One needs to short the costlier bond and long the cheaper one. Over time, as the spreads do narrow, one squares off both the positions and makes a tidy profit. This is market neutral trade since absolute price levels of either of the two positions is not relevant for the profit and loss of the trade. Only the spreads matter.
LTCM did good business in first four years of its operation. However, its success prompted many others to enter the bond arbitrage business. This put the firm in a quandary. It was getting more investors but fewer opportunities. The firm reacted by diversifying into newer areas of convergence trade - including merger arbitrage, volatility spreads and so on. This however was a much more tricky turf than bond arbitrage. Owing to a blind faith in the validity of their lognormal price models and a financial storm precipitated by the Russian bond default of the 1998, LTCM found that the spreads in most of its trades were diverging rather than converging. Owing to its excessive leverage, this proved to be far too much for it to handle. The fund had to be rescued by a consortium of investment banks.
The efficient market hypothesis has turned out to be more a neat modeling tool rather than reliable predictive framework. The book repeatedly refers to fat tails and the ridiculous implicit expectation in normal distribution models that events of 1998 should occur no more than once in the lifetime of the universe! In reality, such events happen once in 25-50 years; and are occuring more frequently in recent decades.
An interesting meta-inference i could draw was as follows. The accuracy of the efficient market hypothesis itself is a market dependent variable. Think of it as the volatility of the volatility. During normal times, the normal distribution (no pun intended) holds much more accurately than during turbulent times. I recall my lessons as an aerospace engineer. In fluid mechanics we always specified whether our models were dealing with laminar flow or turbulent flow (when you open a tap just a little, its water stream is laminar, if you open it fully and the water pressure is good, it becomes turbulent). The models, one would guess, differed significantly. Something similar should apply to the financial world as well. The laminar models are already in place. The turbulent ones need to be developed. (Jump diffusion for option pricing is an interesting start.)
LTCM i.e. Long Term Capital Management, was a hedge fund promoted by a clutch of bond traders on Wall Street along with a few academicians (including Scholes and Merton of Black-Scholes-Merton fame). At its peak it had equity capital of more than $ 4 bn and assets of more than $ 100 bn.
The book covers the rise and fall of LTCM in great detail - in a very human rather than analytical way. It is written for lay persons and that shows. A good read for lay persons for sure, but also for the practitioners of modern finance, all the more so in emerging economies like India's. It is not implausible to expect an LTCM like debacle in India within next 5 years. As the complexity of the financial system grows, crises of LTCM variety are more and more likely to occur.
So what exactly happened? LTCM started out as purely a bond arbitrage portfolio with $ 1.5 bn in capital. It borrowed about 25 times that and invested in bonds of various types. It was not a directional bet on the bond prices though. It dealt in what is called convergence trades i.e. narrowing of spreads between two bonds. For whatever reasons if the spreads between two bonds are out of whac with the usual levels, an opportunity to make relatively low risk return arises. One needs to short the costlier bond and long the cheaper one. Over time, as the spreads do narrow, one squares off both the positions and makes a tidy profit. This is market neutral trade since absolute price levels of either of the two positions is not relevant for the profit and loss of the trade. Only the spreads matter.
LTCM did good business in first four years of its operation. However, its success prompted many others to enter the bond arbitrage business. This put the firm in a quandary. It was getting more investors but fewer opportunities. The firm reacted by diversifying into newer areas of convergence trade - including merger arbitrage, volatility spreads and so on. This however was a much more tricky turf than bond arbitrage. Owing to a blind faith in the validity of their lognormal price models and a financial storm precipitated by the Russian bond default of the 1998, LTCM found that the spreads in most of its trades were diverging rather than converging. Owing to its excessive leverage, this proved to be far too much for it to handle. The fund had to be rescued by a consortium of investment banks.
The efficient market hypothesis has turned out to be more a neat modeling tool rather than reliable predictive framework. The book repeatedly refers to fat tails and the ridiculous implicit expectation in normal distribution models that events of 1998 should occur no more than once in the lifetime of the universe! In reality, such events happen once in 25-50 years; and are occuring more frequently in recent decades.
An interesting meta-inference i could draw was as follows. The accuracy of the efficient market hypothesis itself is a market dependent variable. Think of it as the volatility of the volatility. During normal times, the normal distribution (no pun intended) holds much more accurately than during turbulent times. I recall my lessons as an aerospace engineer. In fluid mechanics we always specified whether our models were dealing with laminar flow or turbulent flow (when you open a tap just a little, its water stream is laminar, if you open it fully and the water pressure is good, it becomes turbulent). The models, one would guess, differed significantly. Something similar should apply to the financial world as well. The laminar models are already in place. The turbulent ones need to be developed. (Jump diffusion for option pricing is an interesting start.)
Saturday, September 04, 2010
Index investing and quantitative strategies
I was reading the buttonwood blog in economist - regarding bond indices. A side argument there pointed me to an interesting thought. Index investing has picked up in a big way (at least in terms of mindspace) in the developed economies. It is finding some favor with indians as well. This was no doubt a reaction to the exhorbitant asset management fees charged by managers who ultimately ended up underperforming the index. The thought pioneered by Vanguard and the likes was that lower cost model of index investing is likely to be remunerative in the medium term since no one can sustainably outperform the index anyway.
Leaving aside that reaction, if one were to explore the world of quantitative rules driven investing as against index investing, one reaches the same conclusion sooner or later - index investing is an oversimplified quant strategy! The rules are deceptively simple - in fact so simple that they do not appear to be rules at all! Invest in stocks in the same proportion they form in the index and stick to it. Invest/divest when index constitution changes. Period. A quant model can be extremely complex or relatively simple. The simplest of them can start to look very similar to index investing. And then one realizes that index investing is also a quant strategy - the difference is one of degree and not of nature.
If that be so, can we think of outperforming the index using quantitative strategies? The above-mentioned article in economist spoke of synthetic bond indices which do not over-weight more indebted borrowers unlike the commonly used ones. Thus they end up performing better than the conventional index. Likewise a 'remixed Nifty' ETF launched by one of the new AMCs in India is an attempt to redefine the allocation within Nifty stocks using factors other than market value. Both approaches merit attention. Leaving aside the special status accorded to the index, these discussions are akin to evaluation of two alternate quant strategies. Clearly one with market cap as the sole basis of weightage (i.e. the index) seems less sound than one with some other parameters that incorporate attractiveness of stocks/bonds.
What factors? That remains the holy grail of quantitative strategists! More on that later.
Leaving aside that reaction, if one were to explore the world of quantitative rules driven investing as against index investing, one reaches the same conclusion sooner or later - index investing is an oversimplified quant strategy! The rules are deceptively simple - in fact so simple that they do not appear to be rules at all! Invest in stocks in the same proportion they form in the index and stick to it. Invest/divest when index constitution changes. Period. A quant model can be extremely complex or relatively simple. The simplest of them can start to look very similar to index investing. And then one realizes that index investing is also a quant strategy - the difference is one of degree and not of nature.
If that be so, can we think of outperforming the index using quantitative strategies? The above-mentioned article in economist spoke of synthetic bond indices which do not over-weight more indebted borrowers unlike the commonly used ones. Thus they end up performing better than the conventional index. Likewise a 'remixed Nifty' ETF launched by one of the new AMCs in India is an attempt to redefine the allocation within Nifty stocks using factors other than market value. Both approaches merit attention. Leaving aside the special status accorded to the index, these discussions are akin to evaluation of two alternate quant strategies. Clearly one with market cap as the sole basis of weightage (i.e. the index) seems less sound than one with some other parameters that incorporate attractiveness of stocks/bonds.
What factors? That remains the holy grail of quantitative strategists! More on that later.
Sunday, August 29, 2010
Tracing excess money in the economy!
The post below about Friedmand's claim regarding inflation being always a monetary phenomenon has already introduced the question of this post. Let me restate still: when the money supply in an economy increases, where does it go and thus what effects does it have?
Insofar as 'inflation' in Friedman's claim is restricted to consumption goods and does not include changes in the prices of assets such as real estate and equity stocks, the above claim though true is only half-accurate. While the only explanation of inflation is increase in money supply, not all increases in money supply cause inflation. Inflation as a phenomenon is the subset of all the effects of increased money supply. Why is this important to highlight? That is because monetary policy decisions would be faulty if it is assumed that any expansion in money supply will eventually lead to inflation for sure.
Hence the need to trace the money. To be more precise - increased money supply. The mechanisms of increase in money supply are not directly controlled by one entity. There are several participants who respond to not only the regulatory fiat of the central banks but also the market realities of credit and money markets. Hence it is difficult even for the central banks to directly control money supply - they are probably the biggest influencers but that is that. Let us consider the simplest example of growth in money supply. The central bank reduces interest rates and the demand for money goes up. The banking system starts to lend out more. The multiplier comes into picture and the total amount of money in the economy goes up. This happens through a combination of extension of more credit, higher incomes, more projects and so on. This is expected to push the prices of the goods and services up. Herein lies the catch.
The prices of goods and services will increase if the increased money supply has found its way to the wage earning individuals AND they have decided to use most of their increased nominal wages for higher consumption. Both of these assumptions are valid only ocassionally. Also there co-occurance is another matter of debate. The first assumption is not trivial. Increased money supply reaches spending individuals directly through retail credit and indirectly through the negotiations for higher wages in labor intensive industries. The elasticity of retail credit to price of money remains to be evaluated. Also the frequency of wage changes in labor intensive industry needs to be ascertained. For the second assumption, one needs to be cognizant of the further stratification of incomes and thus find out which income groups the increased money supply is going to. The savings rate tends to rise very sharply at some point in the income spectrum of the middle class. Increased money supply to individuals above this level would typically not increase their consumption by much - and in effect will divert the money into asset markets.
The excess money in the hands of individuals who are not very keen to spend most of it eventually finds its way into asset markets through debt, equity or real estate. This should have very limited direct impact on the prices of goods and services. On the other hand, the asset prices are likely to move up. Which assets move up in particular will depend on the risk perceptions prevalent in the economy then. The regulators then need to watch out for the asset price inflation as much as the goods and services inflation. The former can adversely affect the economy by introducing a random variable in future monetary policy decisions. More on that later.
Another noteworthy point is the implication of monetary policies on the way we think about our wealth. While the wisdom of inflation eating into the purchasing power of one's wealth is widely discussed and agreed upon, it seems to miss the same point as above of asset price inflation. One can argue that the asset price inflation directly positively affects one's wealth. However, depending on which assets inflate by how much and how reliably and what is the balance between goods and services inflation and asset price inflation, one needs to fine tune the investment strategy in the long term.
Insofar as 'inflation' in Friedman's claim is restricted to consumption goods and does not include changes in the prices of assets such as real estate and equity stocks, the above claim though true is only half-accurate. While the only explanation of inflation is increase in money supply, not all increases in money supply cause inflation. Inflation as a phenomenon is the subset of all the effects of increased money supply. Why is this important to highlight? That is because monetary policy decisions would be faulty if it is assumed that any expansion in money supply will eventually lead to inflation for sure.
Hence the need to trace the money. To be more precise - increased money supply. The mechanisms of increase in money supply are not directly controlled by one entity. There are several participants who respond to not only the regulatory fiat of the central banks but also the market realities of credit and money markets. Hence it is difficult even for the central banks to directly control money supply - they are probably the biggest influencers but that is that. Let us consider the simplest example of growth in money supply. The central bank reduces interest rates and the demand for money goes up. The banking system starts to lend out more. The multiplier comes into picture and the total amount of money in the economy goes up. This happens through a combination of extension of more credit, higher incomes, more projects and so on. This is expected to push the prices of the goods and services up. Herein lies the catch.
The prices of goods and services will increase if the increased money supply has found its way to the wage earning individuals AND they have decided to use most of their increased nominal wages for higher consumption. Both of these assumptions are valid only ocassionally. Also there co-occurance is another matter of debate. The first assumption is not trivial. Increased money supply reaches spending individuals directly through retail credit and indirectly through the negotiations for higher wages in labor intensive industries. The elasticity of retail credit to price of money remains to be evaluated. Also the frequency of wage changes in labor intensive industry needs to be ascertained. For the second assumption, one needs to be cognizant of the further stratification of incomes and thus find out which income groups the increased money supply is going to. The savings rate tends to rise very sharply at some point in the income spectrum of the middle class. Increased money supply to individuals above this level would typically not increase their consumption by much - and in effect will divert the money into asset markets.
The excess money in the hands of individuals who are not very keen to spend most of it eventually finds its way into asset markets through debt, equity or real estate. This should have very limited direct impact on the prices of goods and services. On the other hand, the asset prices are likely to move up. Which assets move up in particular will depend on the risk perceptions prevalent in the economy then. The regulators then need to watch out for the asset price inflation as much as the goods and services inflation. The former can adversely affect the economy by introducing a random variable in future monetary policy decisions. More on that later.
Another noteworthy point is the implication of monetary policies on the way we think about our wealth. While the wisdom of inflation eating into the purchasing power of one's wealth is widely discussed and agreed upon, it seems to miss the same point as above of asset price inflation. One can argue that the asset price inflation directly positively affects one's wealth. However, depending on which assets inflate by how much and how reliably and what is the balance between goods and services inflation and asset price inflation, one needs to fine tune the investment strategy in the long term.
Sunday, August 08, 2010
Friedman's claim for inflation
Milton Friedman has famously claimed once - inflation is everywhere and without exception a monetary phenomenon. Many have agreed, many have disagreed and a small subset on either side have understood. I don't know which group i belong to!
In theory, it is quite straightforward to understand that if the money supply in the economy is growing at the same rate as the output, the average price level in the economy will be constant - zero inflation. Hence any economy wide price increase has to be attributed to the prevalence of more money than that is needed to buy all the goods and services produced. The issue becomes perpelxing when one thinks of the so-called supply side inflationary shocks. If the oil price goes through the roof, prices of most things tend to go up. This is also easy to understand and in fact to see in practice. What happens to money supply in this case? As in, if money supply were constant and the price of a key commodity went up due to supply side issues, what explains the resultant inflation?
One can go back to first principles and device a thought experiment. Say a closed economy has wheat as the primary commodity and a host of manufactured goods and services. For simplicity let us assume that the economy is not growing in real terms and has constant money supply. Hence one can effectively point to the total amount money in the market (including notes, coins and bank deposits). Now if the wheat harvest of one year turns out to be quite bad and the stocks dwindle. The demand for wheat has remained same and hence by the laws of supply and demand, the price of wheat will go up. Insofar as there is no change in the money supply, one would expect a deflationary pressure on the price of other commodities. As in the haircuts and electricity should become cheaper since more money is now being sent the way of purchasing wheat. Would it happen in real life? If not, where would the excess money to pay for more wheat come from?
In a real life scenario, there might be a linkage to the asset markets and credit generation. Ultimately money supply is primarily affected by the rate of credit growth in the economy. If the supply shock leads to change (effectively increase) of the credit in the economy, it can lead to inflation through a forced change in money supply. Forced in the sense that it comes from outside the monetary policy controller of the economy (central bank). In this sense Friedman may be right in the final observation - it is through the money supply route that the supply shocks also get to increase inflation. But the statement has been often abused by monetary policy critics who directly translate that statement into a blame for all inflation onto monetary policy. That is clearly not the case.
One can only say that supply side or demand side, inflation comes through increase of money supply. Not always can the increased money supply be attributed to the monetary policy. However only active monetary policy can quell the increased money supply.
Another important factor in considering the impact of money supply on inflation is the growth rate in asset markets. It is not only goods and services that are purchased with money. Equities, bonds and real estate are as well. Hence the linkage of money supply to inflation is not complete without understanding the balancing figures of asset price changes. More on that later.
In theory, it is quite straightforward to understand that if the money supply in the economy is growing at the same rate as the output, the average price level in the economy will be constant - zero inflation. Hence any economy wide price increase has to be attributed to the prevalence of more money than that is needed to buy all the goods and services produced. The issue becomes perpelxing when one thinks of the so-called supply side inflationary shocks. If the oil price goes through the roof, prices of most things tend to go up. This is also easy to understand and in fact to see in practice. What happens to money supply in this case? As in, if money supply were constant and the price of a key commodity went up due to supply side issues, what explains the resultant inflation?
One can go back to first principles and device a thought experiment. Say a closed economy has wheat as the primary commodity and a host of manufactured goods and services. For simplicity let us assume that the economy is not growing in real terms and has constant money supply. Hence one can effectively point to the total amount money in the market (including notes, coins and bank deposits). Now if the wheat harvest of one year turns out to be quite bad and the stocks dwindle. The demand for wheat has remained same and hence by the laws of supply and demand, the price of wheat will go up. Insofar as there is no change in the money supply, one would expect a deflationary pressure on the price of other commodities. As in the haircuts and electricity should become cheaper since more money is now being sent the way of purchasing wheat. Would it happen in real life? If not, where would the excess money to pay for more wheat come from?
In a real life scenario, there might be a linkage to the asset markets and credit generation. Ultimately money supply is primarily affected by the rate of credit growth in the economy. If the supply shock leads to change (effectively increase) of the credit in the economy, it can lead to inflation through a forced change in money supply. Forced in the sense that it comes from outside the monetary policy controller of the economy (central bank). In this sense Friedman may be right in the final observation - it is through the money supply route that the supply shocks also get to increase inflation. But the statement has been often abused by monetary policy critics who directly translate that statement into a blame for all inflation onto monetary policy. That is clearly not the case.
One can only say that supply side or demand side, inflation comes through increase of money supply. Not always can the increased money supply be attributed to the monetary policy. However only active monetary policy can quell the increased money supply.
Another important factor in considering the impact of money supply on inflation is the growth rate in asset markets. It is not only goods and services that are purchased with money. Equities, bonds and real estate are as well. Hence the linkage of money supply to inflation is not complete without understanding the balancing figures of asset price changes. More on that later.
Wednesday, July 21, 2010
Sovereign defaults - the next big thing!
Much of 2008 was marked by a speculation about which big company was to fail next! After the Bear Sterns rescue, people started guessing who was next to disappear - through failure or takeover. Citi, UBS, AIG, Lehman, Merrill were all in the fray. Finally Lehman went bankrupt and Merrill was acquired while the rest survived to see another day. As the fears of a catastrophic global meltdown receded, a certain optimism justifiably took root amongst investors. Not too long though! As Euro area problems boiled over through the PIIGS and a few others, a new specter has started to hang over the global economy - sovereign defaults.
In short sovereign defaults are failures of a government to repay its debt obligations. It is not new to the modern global economy. Argentina defaulted in the 90s, several smaller countries defaulted through second half of 20th century and so on. However it is probably the first time since second world war that some of the developed economies are the candidates for default - in this case most notably Greece and Portugal and to a lesser extent Spain, Italy and Ireland.
Sovereign defaults are imminent when the government of a country runs into debt trap - a state of affairs when one needs to keep borrowing ever increasing debts to simply keep repaying the earlier ones. The obvious reason this starts to happen is because the governments in question spend more than they earn - leading to budget deficits. But then that is the modus operandi of most governments in the present world. Why the sudden change of fortunes? The problems arise when the deficits grow too large for the government's current and expected income as well as when the interest payments go up as the investors in that government's debt start demanding a higher interest rate on their lending. Unfortunately most often these two trends coincide. Investors start to get wary of spendthrift governments - especially those with economies growing slowly or not at all. The increase interest payments on the debt then pushes these governments to start borrowing more, which further unnerves the investors and the cycle continues. Often it is broken in its early stages by belt tightening by government thereby reducing actual deficits as well as by creating more faith amongst investors - thus reducing interest payments on further borrowings.
Will Greece default? Will any of the other PIIGS default? The likelihood of Greece defaulting is low but not insignificant. The likelihood of any others defaulting is indeed quite low. Greece is a much more classic case than the rest, of a government spending too much for its own good with the hope that the buoyant global economy of the pre-2007 era would keep its problems under control. Thus the crisis hit it the hardest. The others are better managed in comparison - though no models of austerity!
While the world worries about the spendthrift governments in southern Europe, there are voices of concern over a frugal Germany as well! It might almost sound contradictory to see experts crow over over-spending and under-spending at the same time for countries in the same monetary union. There is some merit to it, but there are deeper questions raised about the structure of global economy in the process. The rabit-hole may indeed go much deeper, but more on that later!
In short sovereign defaults are failures of a government to repay its debt obligations. It is not new to the modern global economy. Argentina defaulted in the 90s, several smaller countries defaulted through second half of 20th century and so on. However it is probably the first time since second world war that some of the developed economies are the candidates for default - in this case most notably Greece and Portugal and to a lesser extent Spain, Italy and Ireland.
Sovereign defaults are imminent when the government of a country runs into debt trap - a state of affairs when one needs to keep borrowing ever increasing debts to simply keep repaying the earlier ones. The obvious reason this starts to happen is because the governments in question spend more than they earn - leading to budget deficits. But then that is the modus operandi of most governments in the present world. Why the sudden change of fortunes? The problems arise when the deficits grow too large for the government's current and expected income as well as when the interest payments go up as the investors in that government's debt start demanding a higher interest rate on their lending. Unfortunately most often these two trends coincide. Investors start to get wary of spendthrift governments - especially those with economies growing slowly or not at all. The increase interest payments on the debt then pushes these governments to start borrowing more, which further unnerves the investors and the cycle continues. Often it is broken in its early stages by belt tightening by government thereby reducing actual deficits as well as by creating more faith amongst investors - thus reducing interest payments on further borrowings.
Will Greece default? Will any of the other PIIGS default? The likelihood of Greece defaulting is low but not insignificant. The likelihood of any others defaulting is indeed quite low. Greece is a much more classic case than the rest, of a government spending too much for its own good with the hope that the buoyant global economy of the pre-2007 era would keep its problems under control. Thus the crisis hit it the hardest. The others are better managed in comparison - though no models of austerity!
While the world worries about the spendthrift governments in southern Europe, there are voices of concern over a frugal Germany as well! It might almost sound contradictory to see experts crow over over-spending and under-spending at the same time for countries in the same monetary union. There is some merit to it, but there are deeper questions raised about the structure of global economy in the process. The rabit-hole may indeed go much deeper, but more on that later!
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