Friday, February 27, 2009

Exchange rates - goods or assets?

The NBER looks at the issue of exchange rates and prices. Betts and Kehoe find that the ratio of tradable to non-tradable prices are affected by nominal exchange rates. However,

When the authors include China, for which the data is annual rather than quarterly and only dates back to 1985, the results change very little. But for the United States and its European trading partners, the relationship is dramatically weaker. Fluctuations in the relative price of non-traded-to-traded-goods account for only 7 percent of the fluctuations in the bilateral U.S./EU real exchange rates when measured in four-year differences using a variance decomposition. By contrast, these relative price fluctuations account for 29 percent of the fluctuations in U.S./non-EU real exchange rates and 39 percent of the fluctuations in U.S./Canada and U.S./Mexico real exchange rates. The authors suggest that the lower ratio for the United States and the EU nations may be attributable to the relatively low importance of trade, compared to the size of these economies. They note that just because there's a relationship between exchange rates and domestic prices, it does not follow tha! t one drives the other.

This provides further evidence that it is the capital flows that dominate the exchange rate trading.

Variable risk premia as a cause of volatility

Peel and Minford look at variable risk premia as an explanation of market volatility that some suggest means that there is inefficient incorporation of information. Thanks to Chris Dillow for the pointer amidst a review of Akerlof and Shillers' Animal Spirits.

Price discrimination

More on price discrimination as Which finds that the ticket for European train journeys is much higher on English-language versions of train operators' websites.

Researchers found that on some European sites, for example, fares were up to 60% more on the English version of the sites than on the native language version, while the sites were also difficult to navigate in order to find key information on pricing. On the Spanish version of, the Spanish rail operator, a second-class adult single ticket from Madrid to Barcelona was €43.80 (£39.30) - but €109.50 on the English version.

Sunday, February 22, 2009

Dell, competition and the life cycle

Lex looks at the demise of Dell.

There are a number of ways to look at this but the most important appears to be the life cycle of the process. Dell once had an advantage, now the way that they used to do things is commoditised. This article also points the way to valuation with the combination of PE ratio and what a regular discount factor implies for future earnings.

However, such hopes are not needed to build an investment case, because Dell’s shares are so cheap. Exclude the $6.5bn net cash pile and the interest income that it generates and Dell trades on just four times prospective earnings, according to Citigroup figures. Alternatively, to get a discounted cash flow valuation to the level implied by the current share price demands that investors assume operating margins decline to 2 per cent, from the 5 per cent expected this year, and that sales growth never returns. Struggling to run, the market is pricing Dell as if it has been put out to pasture.

Saturday, February 21, 2009


The FT has a look at the problems at HBOS.

HBOS lent in retailing and property, often taking equity stakes as well as providing debt. This model was devised back in 2000 and developed by Mr Cummings.

It helped lift profits at the corporate division – the unit accounted for 40 per cent of HBOS profits in the first half of 2007 – but is now blamed for much of HBOS’s woes.

Providing debt and equity, such as in a 2001 hotel venture with Sir Rocco Forte, allowed the corporate lending team to establish a niche that set it apart from rivals.

It seems that there are no fancy derivatives or opaque assets. According to this, it is just good, old-fashion, bad lending.

Friday, February 20, 2009

Bankers and risk and compensation

Jamie Whyte looks at government plans to change banking compensation. I think that he has it right here:

The financial crisis was caused not by bankers’ incentive plans but by a systematic failure to price risk correctly. Without accurately priced risk, there is no way of giving bankers the right incentives, however long the period over which their performance is measured. And with accurately priced risk, there is no incentive problem to be solved.

As he says, a lot of the incentives are already fairly long-term; the problem appears to have been in the price of risk. The huge flow of liquidity into US and UK financial systems seems to have distorted all pricing and affected risk assessment. The bonus payments were there a long time before the risk premia started to collapse. There may have been a monemtum in the bonus payments and the risk-taking, but this does not seem to be the fundamental problems to me.

For another look at banking compensation see The Epicurean Dealmaker for an overview of the development of bonus culture or Chris Dillow.

The fact that excess leverage and risk-taking came across the system suggests that this was not the major feature. The relatiionship between risk-taking in the US and UK and the bonus culture seems to be confounded by the fact that the inflow of liquidity to these major financial centres meant that they were sure to suffer the most when the tide went out again.
Let's get control over the amount of money in the financial system as a whole rather than start a witch-hunt.

Wednesday, February 18, 2009


Robert Stavins, while discussing environmental economics, provides a very good overview of what makes markets work and what gets in the way.

Economists in business schools may be particularly fond of identifying markets where the necessary conditions are met, where many buyers and many sellers operate with very good information and very low transactions costs to trade well-defined commodities with enforced rights of ownership. These economists regularly produce studies demonstrating the efficiency of such markets (although even in this sphere, problems can obviously arise).

For other economists, especially those in public policy schools, the whole point of the first welfare theorem is very different. By clarifying the conditions under which markets are efficient, the theorem also identifies the conditions under which they are not. Private markets are perfectly efficient only if there are no public goods, no externalities, no monopoly buyers or sellers, no increasing returns to scale, no information problems, no transactions costs, no taxes, no common property, and no other distortions that come between the costs paid by buyers and the benefits received by sellers.

Therefore, we must focus on:
1) Public goods - the stability of the financial system itself.
2) Externalities - network effects, macroeconomic well being.
3) Large financial monopolies in certain markets, the government and central banks.
4) Increasing returns to scale and financial concentration.
5) Huge informational issues.
6) Other costs of involvement that lead to instiutional dominance.

Monday, February 16, 2009

Price discrimination and innovation

Ultimi Barbarorum looks at the business behind the iPhone

Problem: 4 to 6 months after release, you have run out of early adopters, and now you need to penetrate the more price sensitive punter. Volume starts falling. No matter, you cut the price 10% to 20%. This would be bad for gross margins but for the natural tendency for material costs to come down. “Price down” is like a law of the tech supply chain. Memory prices have been coming down for years, for instance, passive and mechanical bits like the keypad and casing become cheaper to make as they scale up, and one’s engineers are always coming up (or should be) with new ways of making the industrial design more efficient. So gross margins drop only a bit, to 35% to 40%, but your volume goes up again so your operating margin can even increase.

Thursday, February 05, 2009

Hedge funds (2)

All About Alpha gives a great overview of the latest thinking on hedge funds. There is a huge amount here about difficult times. One interesting point:

According to Douglas, Asian markets are more informationally-inefficient because most investors there are of the non-professional persuasion. Douglas says that hedge fund managers often end up trading alongside individual investors, not large pensions and mutual funds as in North America.

Tuesday, February 03, 2009

Hedge funds

Felix Salmon uncovers the difference between a public company and a partnership by what happens when you take a hedge fund public.

Consider the fight between Carl Icahn and fund manager Warren Lichtenstein. Lichtenstein had a bright idea when his hedge fund -- full of illiquid assets -- faced a lot of redemption requests: he'd take it public, and investors could then sell their investments at whatever price the market put on them, without the fund itself having to liquidate. Investors might have to take a very low price -- but Lichtenstein himself would continue to collect his management fee in perpetuity.

The exit risk is removed, but at the expense of taking 20% of the upside (maybe).

Monday, February 02, 2009

Dealing with bad loans

The FT reports on the latest efforts to deal with bad loans and comes to two methods of vauing these assets:

It would acquire securities that had already been heavily marked down by financial institutions, probably using a valuation model rather than an auction-based process to determine pricing.

There is huge uncertainty over the price of assets. How do we pick the correct value? No body knows. As a result, there is no market.

Sunday, February 01, 2009

Global imbalances and financial crisis

Caballero and Krishnamurthy:

The U.S. is currently engulfed in the most severe financial crisis since the Great Depression. A key structural factor behind this crisis is the large demand for riskless assets from the rest of the world. In this paper we present a model to show how such demand not only triggered a sharp rise in U.S. asset prices, but also exposed the U.S. financial sector to a downturn by concentrating risk onto its balance sheet. In addition to highlighting the role of capital flows in facilitating the securitization boom, our analysis speaks to the broader issue of global imbalances. While in emerging markets the concern with capital flows is in their speculative nature, in the U.S. the risk in capital inflows derives from the opposite concern: capital flows into the U.S. are mostly non-speculative and in search of safety. As a result, the U.S. sells riskless assets to foreigners, and in so doing, it raises the effective leverage of its financial institutions. In other words, as global imbalances rise, the U.S. increasingly specializes in holding its "toxic waste.