Wednesday, December 31, 2008

Gathering complacency

The Big Picture draws attention the item in The Washington Post that reports on the first moves by AIG into the CDS market. The first steps appear to be rather mundane and cautious. However, it is likely that each subsequent step, supported by the lack of collapse in the previous period, just adds (no multiplies) the level of risk that is being taken.

Noise-trader risk

A return to noise trader risk with a look at experiments in trading.

Here is the experiment.

Thursday, December 25, 2008

Currncy returns

Richard Levich and Valerio Poti assess 'Predictability and 'Good Deals' in Currency Markets'

The abstract
This paper studies predictability of currency returns over the period
1971-2006. To assess the economic significance of currency
predictability, we construct an upper bound on the explanatory power
of predictive regressions. The upper bound is motivated by "no
good-deal" restrictions that rule out unduly attractive investment
opportunities. We find evidence that predictability often exceeds
this bound. Excess-predictability is highest in the 1970s and tends
to decrease over time, but it is still present in the final part of
the sample period. Moreover, periods of high and low predictability
tend to alternate. These stylized facts pose a challenge to Fama's
(1970) Efficient Market Hypothesis but are consistent with Lo's
(2004) Adaptive Market Hypothesis, coupled with slow convergence
towards efficient markets. Strategies that attempt to exploit daily
excess-predictability are very sensitive to transaction costs but
those that exploit monthly predictability remain attractive even
after realistic levels of transaction costs are taken into account
and are not spanned by either the Fama and French (1993) equity-based
factors or the AFX Currency Management Index

Wednesday, December 24, 2008

Monday, December 22, 2008

Using order flow

It is usually the case that if it looks too good to be true, then it probably is....However, in the Madoff case, there was a clear explanation for his reported returns. The FT reports on the explanation that Union Bancaire Privee gave to its clients.

“We were assured that he had some visibility as to the momentum of the markets...due to his significant volume size as a broker/dealer,” the UBP letter said.

“The perceived edge was Madoff’s ability to gather and process market-order flow information and use this information to time the implementation of the split-strike options strategy.”

This is also the base for accusations that were made at Madoff that he was front-running (dealing before a large order that he had on the books).

Friday, December 19, 2008

More intielligent soldiers die

Interesting research that shows that the more intelligent soldiers appear to have greater risk of death than their less intelligent colleagues.

Being dumb has its benefits. Scottish soldiers who survived the second world war were less intelligent than men who gave their lives defeating the Third Reich, a new study of British government records concludes.

The 491 Scots who died and had taken IQ tests at age 11 achieved an average IQ score of 100.8. Several thousand survivors who had taken the same test - which was administered to all Scottish children born in 1921 – averaged 97.4.

The unprecedented demands of the second world war – fought more with brains than with brawn compared with previous wars - might account for the skew, says Ian Deary, a psychologist at the University of Edinburgh, who led the study. Dozens of other studies have shown that smart people normally live longer than their less intelligent peers.

"We wonder whether more skilled men were required at the front line, as warfare became more technical," Dear says.

Journal reference: Intelligence (DOI: 10.1016/j.intell.2008.11.003)

Wednesday, December 17, 2008


NBER research on the elasticity of fleet fuel economy to oil prices.

The authors estimate that a 10 percent increase in gasoline prices from 2005 levels will generate a 0.22 percent increase in fleet fuel economy in the short run and a 2.04 percent increase in the long run - ten times the short-run effect. The $4 per gallon gasoline prices observed in early 2008 could result in a sizable increase in fleet fuel economy - that is, an increase in average fleet miles per gallon, or MPG - of 3.27, or 14 percent, relative to 2005. There also would be a large accompanying reduction in gasoline consumption if these high prices were to remain permanent

Tuesday, December 16, 2008

Spanish regulation

The FT reports on Spanish banks and finds two important regulations that have insulated them from some of the problems that have hit other banks.

But Spain’s bankers agree that they were kept virtuous largely by the stern regulators at the Bank of Spain. The central bank achieved this in two ways. It made it so expensive for financial institutions to establish off-balance sheet vehicles – of the sort that subsequently sunk banks elsewhere – that few Spanish banks bothered. It also demanded in the good years that banks set aside “generic” bad loan provisions in addition to provisions for specific risks, a sensibly counter-cyclical regime that has been much remarked on abroad since the crisis began. Santander, for example, has built up more than €6bn of generic loan loss provisions.

These are regulations that are likely to be adopted in other countries.

The music business

The Guardian looks at the music business. Major changes in the business model.

Twenty-eight years ago, those west London desperadoes the Clash released an exhausting triple album called Sandinista!. It included Hitsville UK, a tribute to a new breed of cottage industry record labels which blithely bypassed the fact that the Clash were signed to CBS and mapped out a new, non-corporate utopia. In the world to come, they claimed, there would be "no expense accounts, or lunch discounts, or hyping up the charts" - nor any need for "slimy deals with smarmy eels".

This brings together new technology, 2 and 3 way business models and the nature of the consumer.

Saturday, December 13, 2008

A silver lining

The FT reports on the opportunities for pension funds in the convertible bond market.

Convertible bonds were hurt more than other markets because hedge funds were the main buyers, owning the bonds as a way of arbitraging the value of the implied option to convert them into equity. But as banks cut back their leverage – from 5.5 times a year ago to virtually nothing now – and investors tried to withdraw money, hedge funds became forced sellers. As a result many investors believe that there is an opportunity to make relatively low-risk double-digit returns without needing to use leverage or complex hedging strategies.

Though hedge funds were forced sellers, this opens the way for other funds to cover some of their losses in other markets.

Thursday, December 11, 2008

Illiquid assets

The FT looks at the weight of illiquid assets that can not be sold and are hard to value.

Already, level-three assets are many times bigger than the market cap of the banks. The US Treasury had planned to buy these using the $700bn troubled asset relief programme but changed tack and has used some funds for capital injections.

Saturday, December 06, 2008


Brad DeLong provides the balanced view of Greenspan: it is not just free market; it is also a strong belief in the power of the central bank to correct mistakes.
Fundamentally, the Greenspanist combination of massive skepticism of government intervention with overwhelming confidence in the power of the all-knowing and benevolent masters of monetary policy seems strange and unsustainable. But it is, of course, easier to sustain if you yourself are the central planner.

Friday, December 05, 2008

Importance of FX flexibility

Amidst increased talk that the UK will be forced to join the EMU, it is important to note that the last time there was a similar international economic dislocation, exchange rate flexibility was a certain advantage.

As Bernanke says in 'Essays on the Great Depression',

Second, for reasons that were largely historical, political, and philosophical rather than purely economic, some governments responded to the crises of the early 1930s by quickly abandoning the gold standard, while others chose to remain on gold despite adverse conditions. Countries that left gold were able to reflate their money supplies and price levels, and did so after some delay; countries remaining on gold were forced into further deflation. To an overwhelming degree, the evidence shows that countries that left the gold standard recovered from the Depression more quickly than countries that remained on gold. Indeed, no country exhibited significant economic recovery while remaining on the gold standard. The strong dependence of the rate of recovery on the choice of exchange-rate regime is further, powerful evidence for the importance of monetary factors.

This raises the question of whether the mechanism was just a relaxation of the constraint on monetary expansion or something that came from changes in relative prices.