# Information Processing

Just another WordPress.com weblog

## Archive for February 2005

Investors are familiar with the concept of risk-adjusted return. A fund which takes large risks to obtain higher returns might be judged inferior to another fund with lower risk and return. We should apply the same kind of thinking to the economic status of families in the US. While incomes have risen in recent decades, so has volatility in income. Families earn more on average than in the past, but also suffer larger swings in income (most likely due to layoffs and unemployement).

The personal risk-adjusted performance of our economy is not nearly as impressive as the simple GDP numbers. The 3-part LA Times series covering this is available here (their internal name for it is appropriately “new deal over”).

I discussed this issue previously here.

Written by infoproc

February 28, 2005 at 6:40 pm

Posted in Uncategorized

## LTCM (and the *real* smart guys)

When Genius Failed : The Rise and Fall of Long-Term Capital Management
by ROGER LOWENSTEIN

Inventing Money : The Story of Long-Term Capital Management and the Legends Behind It
by NICHOLAS DUNBAR

Long Term Capital Management was the hedge fund founded (1994) by legendary Salomon bond trader John Meriwether together with Robert Merton and Myron Scholes, the Nobel prize-winning academics behind options pricing theory. Meriwether was one of the first on Wall St. to see the value of quants, building a talented team which he took to LTCM. After several years of superb returns (over 40% in one year), the fund blew up in the wake of the Russian debt default and had to be bailed out by a consortium of banks organized by the Fed (1998).

If you are interested in the details of the LTCM story, the two books listed above are the place to start. (There was also a lengthy article in RISK magazine years ago, but you’ll have to dig that out of your library.) Lowenstein is a business writer (formerly of the WSJ), who has also written a nice biography of Warren Buffet. His treatment is more readable for the average person, although frustratingly short on the details necessary to understand LTCM’s actual trades and positions. Dunbar was a grad student at Harvard in applied physics, so understands the technical details better. He even gives a nice history of derivatives and option pricing.

Central Bank of Volatility: One of LTCM’s big trades was a bet that future realized vol would resemble historical vol. They did so much business that London equity derivatives traders nicknamed them the Central Bank of Volatility. Historical vol was about 15% for European markets, but in 1997 the implied vol was 23%. LTCM was willing to sell vol (long dated options) at that price. Even larger positions in fixed income and mortgage-backed securities were also based on the assumption that markets would approach equilibrium. The question, as always: how long before mean reversion? Can you stay solvent longer than the market can stay “irrational”?

In their case, the answer was no, but the consortium of banks that bailed them out (buying out their portfolio) eventually made money. There was an issue of LTCM’s counterparties front-running them on trades, but I don’t think this was the main reason for their demise, and ultimately their positions came back.

The Economist reports that hedge fund assets under management have reached $1 trillion, even while returns have diminished. Only qualified investors (an SEC classification) are eligible to invest – the requirement is$1M in net worth or $300K per year of family income. I guess most physics profs are stuck with mutual funds, which might not be so bad given the 2/20 fee structure charged by hedge funds 😉 If your kid is mathematically gifted, I suggest pointing him (or her 🙂 to the nearest “relative value arbitrage” fund, rather than grad school in physics 🙂 With the glut of money heading into hedge funds, I’ve been told that the number one shortage is in investment ideas! You can see this in the graph below – the variation in returns is going down as more and more funds pile onto similar strategies. Institutional Investor’s obsessively read list of most-highly-paid hedge-fund managers starts with familiar names (George Soros:$750m), but 16 others made at least $100m in 2003… Successful managers become rich, possibly too rich to care about work, in just a few years. I’ve discussed the role these funds are playing in the bond market, plying the carry or curve-flattening trades: sell the short end and buy the long end of the yield curve. Hedge funds are the third largest holders of US Treasury debt after Japan and China. Written by infoproc February 23, 2005 at 5:44 pm Posted in Uncategorized ## First FX domino? with 8 comments Just as predicted by game theory critics of Bretton Woods II, Korea may be the first to defect from the currency regime, seeking to protect the value of its reserves by diversifying into a basket of currencies. Note, however, that BoK has merely floated this as a proposal to parliament. Korean companies may have something to say about whether the won should be allowed to rise against the dollar. Not long ago at the ASEAN meeting Korean President Roh expressed concern about the rising won and declared pan-Asian currency solidarity. Can the Koreans take the pain necessary to move to a basket? Bloomberg: “The dollar fell the most in more than four months against the yen and dropped versus the euro, Korean won and at least 30 other currencies after the Bank of Korea said it plans to increase its non-dollar reserves. South Korea’s central bank, which has a total of$200 billion in reserves, said in a Feb. 18 report to a parliamentary committee it will increase investments in assets denominated in currencies such as the Australian and Canadian dollars. The country’s reserves are the world’s fourth biggest, behind Japan, China and Taiwan, according to data compiled by Bloomberg.”

Brad Setser caught this as well.

UPDATE: From Bloomberg this evening, South Korea’s central bank, which holds the world’s fourth-largest foreign currency reserves, said it has no plan to sell dollars from those holdings and no plan to change the current portfolio of currencies in its reserves.

“The Bank of Korea will not change the portfolio of currencies in its reserves due to short-term market factors,” the central bank’s said in a press release e-mailed to all media this morning after the Korean won rose past 1,000 against the dollar for the first time since November 1997.

But not before the dollar plunged and US equity markets tanked…

Written by infoproc

February 22, 2005 at 5:27 pm

Posted in Uncategorized

## "Easy Al" Greenspan

From Barrons: “The accompanying chart, which comes to us by grace of Trey Reik, of Clapboard Hill Partners, a New York-based investment outfit, shows one of the singular effects of Mr. Greenspan’s eagerly accommodating reign at the Fed. It tells the story of credit in this fair land from 1916 through the present. Keeping in mind that Mr. G took over in 1987, you can readily see the trajectory picks up altitude abruptly from then until now.

Mr. Reik observes that for the past 100 years, the nation’s credit-market debt has averaged between 140% and 160% of gross domestic product. The principal exceptions came in 1929, when the stock market went bananas, and in 1933, during the traumatized period that followed the Great Crash, when four years of the Depression (GDP shrank by an awesome 45%) hoisted the ratio to 287%, prompting a devaluation of the dollar. That was the all-time peak, never approached again until the remarkable rise that began in the 1980s and has resolutely continued ever since, lifting the ratio to today’s astonishing 304%.”

Written by infoproc

February 21, 2005 at 9:13 pm

Posted in Uncategorized

## Finance for beginners

I recently discovered the Web site of John Norstad. According to his fascinating bio, John was an Iowa boy like me, who had a little too much interest in math when growing up. He now works in software development at Northwestern University, but has taken time out recently to write a number of expository papers on topics in modern finance, ranging from portfolio theory to options pricing.

Particularly nice is his note on “two-state options,” a kind of toy-model world that helps develop intuition. One thing that always used to bother me was how the price of an option could really be independent of the assumed “drift term” in the Black-Scholes model (you can find this debated by real practitioners here). An explicit model in which one can replicate the derivative using cash and shares of the underlying security makes this more transparent. The deep insight is that all expectations about future returns on the underlying are contained in the instantaneous price. This also clarifies the observation that derivatives can be priced in a risk-neutral way, as I mentioned in my post on path integrals.

I haven’t looked at all of his papers, but they seem just right for someone with a background in math or physics who wants a clear, concise, but theoretically sophisticated introduction to this subject. I usually tell people to read John Hull’s introductory textbook, but I think a stop at Norstad’s site might be very worthwhile.

Written by infoproc

February 21, 2005 at 1:01 am

Posted in Uncategorized