Archive for October, 2008

why no damping factors?

Stories like this about the sudden unwinding of the yen carry trade had me thinking.

Financial markets are some kind of dynamical system. This system has stable and unstable modes. Clearly, the unstable modes are best not to be touched, yet there are few (or not enough) regulations or systematic constraints to keep a path from falling into those.

Common experience from systems design seems to say that you have to be willing to give up some efficiency in exchange for stability. That’s why there are currency pegs (or trading bands), reserves ratios, and interest rate targets. But these are too crude. There needs to be systematic tools in all markets to damp system dynamics to a time constant on the same order as that of economic reality. You cannot have capital flooding in and out of markets and currency flooding in and out of countries at rates that cannot be absorbed or sustained by the national economies. Sure, that is “efficient”, but it also makes no sense. This is the point at which free market and market efficiency fundamentalists need to take a step back and look at the big picture and see where they are so obviously wrong.

Iceland recruiting day

Don’t mean to pick on Iceland, but this admittedly hungover photo of a poster for recruitment is just… untimely.

mind games

This is interesting:, but it’s already over.

lock up quantitative risk managers

This article is hilarious:

As a trader turned philosopher, Taleb has railed against Wall Street risk managers who attempt to predict market movements. Even so, Taleb said he saw the banking crisis coming.

“The financial ecology is swelling into gigantic, incestuous, bureaucratic banks — when one fails, they all fall,” Taleb wrote in “The Black Swan: The Impact of the Highly Improbable,” which was published in 2007. “The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup.”

Taleb is angry that Wall Street is continuing to use traditional tools such as value at risk, which banks use to decide how much to wager in the markets.

“We would like to society to lock up quantitative risk managers before they cause more damage,” Taleb said.

This being recruiting season, there was a guy from the risk management division of a certain big bank here talking up his job and company. (The week after that, their stock was halved and last week it was even in the single digits. That’s another story.)

He wasn’t very specific but I got an impression of the very crude and non-rigorous method of “value at risk”, something like the 90th percentile loss value based on some unverifiable model, but not an actual hard bound. So what do you get? Obviously everybody builds up their portfolio right up against the 90th percentile and a digital waterfall effect at the boundary becomes that much more likely. There is nothing wrong with quantitative risk management. There is something wrong with bad ideas even if they are “quantitative”… Probably worse, because it gives the layman a false sense of invincibility.

A different kind of straddle with etf’s?

A simple thought experiment. Some index ETF’s apparently have an inverse or 2X inverse “short” version. For instance, SPY and SDS.

Ignoring the expense costs, suppose the inverse ETF’s do what they aim to do: maintain the inverse or twice-inverse daily percentage moves of the reference index, then they are good for a particular kind of straddle strategy. Suppose you believe the daily prices of the reference index going forward are strongly directional (that is, if it goes up one day, then it may go up for several days afterwards, or if it goes down, then it may go down for several days). But, you don’t know which way it will be.

Then one way to get a potential gain from this is to take a purchase of both the forward and inverse ETF’s at the same exposure. That would mean 2 units of SPY and 1 unit of SDS, for example. Several days later, if the assumption is correct, then there will be a net gain, because the absolute gains coming from the “winner” ETF will be larger and larger with compounding, while the absolute losses from the “loser” ETF will be smaller and smaller. In the extremal case, the winner ETF goes to infinity and the loser ETF goes to 0.

Of course there is a cost for violating the assumption. The cost comes from the daily rebalancing of the inverse ETF’s. That would mean a path of reference index prices that fluctuates around the initial one. In that case, the inverse ETF loses value gradually, depending on the size of the moves. The 2X inverse ETF would lose even more. But if the realistic alternatives are small daily fluctuations or a few days of big directional moves, then this strategy wins. This seems especially appropriate for the current period.

ridiculously antiquated banking system

For an advanced economy with advanced electronic banking systems, it is embarassing that there is no bank that has branches in all parts of the country and no electronic funds clearing other than on “business days”. Computers don’t have geographic boundaries nor do they take breaks. Why can’t money be available everywhere (without resorting to a middle-man cash machine network) and be freely transferable 24/7?

For that matter, what is the fear of a central bank? In some countries, banks are like utilities and post offices — public services provided by the government. The First and Second National Banks were killed because people did not trust the government with their money. Well, it seems like big commercial banks can be trusted even less. Also, it’s not like anything would function with just community banks. It’s not a country of farmers any more…

I mean, capital allocation decisions can still be locally made and subject to market forces, as they should, but banking infrastructural issues like described here (and regulatory ones, some say) should have no reason not to be national, am I wrong?

triangular pursuit

Here’s a problem posed to me by a friend:

Consider an equilateral triangle ABC with edge length 1. At each vertex is an object that is capable of movement at exactly speed 1. Beginning at time 0, each of the three objects moves toward its initial adjacent neighbor object, as in a game of pursuit. Of course, by symmetry, the objects will meet at the incenter of ABC. The question: how far will they have traveled?
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