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Archive for November 2005

Yield curve inverts

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The 5 yr yield was briefly below the 2 yr yield today. Is the market predicting a recession? I guess historically the Fed always overtightens…

Imagine you want to model interest rate fluctuations. You have to have a decent model for fluctuations at all maturities. Are there any reasonable constraints? How far can the curve invert? How likely is that? What are the self-consistency constraints? How do we incorporate current option prices into the analysis? A well-known practitioner once told me that modeling the yield curve is to modeling equity prices as quantum field theory is to ordinary quantum mechanics!

See here for Derman’s explanation of the BDT (Black, Derman, Toy) yield curve model. I discussed a nice bio of Fischer Black here, and Derman’s book here.

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Written by infoproc

November 29, 2005 at 8:18 am

Posted in finance

Ben Stein on globalization

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Ben Stein is most likely familiar to you as a comedian in movies and on TV. Earlier in life he attended Yale Law School and worked in the Nixon White House as a speechwriter. Below he gives the positive spin on globalization. However, at the very end he addresses the winners and losers issue, and his description of losers sounds a lot more like the average american than his description of winners!

China: Friend or Foe?
Wednesday, November 23, 2005

A few nights ago, I had the pleasure of speaking to and MC’ing the annual dinner of the Semiconductor Industry Association (SIA). Attending were the major players in the chip world, the Texas Instruments, AMDs, National Semiconductors, and — well, you get the picture. Very successful, super smart men and women filled the room — real geniuses who did things like create programs that read and check immense software codes written in India, only do it in real time over the internet. These are people who started and run incredibly complex and productive businesses.

You might have thought it would be a rollicking good time, but it was not at all.

The three main speakers — George Scalise, head of the SIA; Charlene Barshefsky, formerly Clinton’s Special Trade Representative; and Byron Wien, a major power at Morgan Stanley — were deeply worried about Far Eastern competition in the chip world. It is simple enough: China, Taiwan, Thailand, and India have far lower labor costs than we do. They have up-to-date machinery and a highly trained, well motivated labor force. They can make chips for less, and they are starting to become players in a big way — not just in chip manufacturing (or “fabbing,” as they say) but in design, which was formerly an American fiefdom.

Trees Do Not Grow to the Sky

The three main speakers showed charts and graphs pointing out Asian inroads and the declining U.S. share of production and design. And one speaker expressed doubt that we would see our kids live as well as we do because of Asian competition.

This prompted several thoughts in my wooly head.

First of all, we start out very far ahead of China in wealth and income. The per capita GDP of the U.S., depending on how you measure it, is as much as 40 times Chinese per capita GDP and not less than 12 times by any measurement.

Yes, China is growing much faster than we are, at roughly 10 percent per year. If current trends last, China will overtake the U.S. in per capita GDP sometime this century. But current rates for China are extremely high. No nation has ever been able to sustain the rates China is experiencing for very long. History argues that China will not be able to do so either. Put simply, trees do not grow to the sky.

However, the Chinese are an amazing, intelligent, hard working, well disciplined people. Possibly they will be able to enjoy super high growth rates for a prolonged period. It would be a historical anomaly, but maybe it will happen.

Is What’s Good for China Good for the U.S.?

Even if China became much richer than it is now though, that would not necessarily make us poorer. China is a prodigious buyer of foods and resources, and we have a lot of both. Chinese industry will be partly owned by U.S. investors, and Chinese prosperity will (if no fraud is involved) make them much richer. The fact that a very large nation like China becomes rich makes individual American workers who compete with China worse off, but it does not make America as a nation worse off.

Next, is it not interesting that China, in a state of brutal totalitarian rule, was really not a threat to us except in fiction? But under capitalism, China is making us all run around screaming in fear. I am really not sure what we have to fear from China. The country is our partner in prosperity, not our enemy. The earlier we work out a durable framework of respect and cooperation in trade and policy, the better off everyone will be.

But the main thing I want to express, as I did to the SIA, is that China is getting rich because its people are getting well educated, because they are working hard, because they are saving, and because they are investing. These are exactly the same things that made America rich. And these are exactly the same things that are allowing Hispanic and Asian immigrants to America to move up the economic ladder.

Who Wins, Who Loses?

Young Americans who study hard, learn serious subjects, do not lose themselves in computer games, avoid doomed industries, learn good work habits, save prudently, and invest sensibly will be well off no matter what happens in China or Taiwan or India.

Americans who are slothful, do not pay attention to economic trends, learn no useful skills, do not save, and do not invest wisely will roll downhill fast.

But for the disciplined among us who learn from the Chinese the keys to wealth as the Chinese learned from us and we learned from all of history, the future is bright.

Written by infoproc

November 29, 2005 at 7:10 am

Posted in globalization

China book reviews

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From The NY Review of Books. I briefly mentioned both of these books in earlier posts here and here.

Three Billion New Capitalists: The Great Shift of Wealth and Power to the East
by Clyde Prestowitz
Basic Books, 321 pp., $26.95

China, Inc.: How the Rise of the Next Superpower Challenges America and the World
by Ted C. Fishman
Scribner, 342 pp., $26.00

The “rise” of China has suddenly become the all-absorbing topic for those professionally concerned with the future of the planet. Will the twenty-first century be the Chinese century, and, if so, in what sense? Will China’s rise be peaceful or violent? And how will this affect the United States, the current “hyperpower”? In fact, China has been “rising” for some time (after several hundred years of “fall”), but for many years its claim to notice was obscured by more exciting events. Attention in the 1990s concentrated on the fall of Soviet communism, “globalization,” the spread of democracy, and the high-tech revolution. These developments, which left America as the world’s sole economic and political superpower, seemed to belie Paul Kennedy’s prediction in 1987 of relative US decline and “more of a multipolar system.”[1]

The attack on the World Trade Center in 2001, together with the concurrent collapse of the high-tech bubble, exposed America’s fragility, but this was masked by the hyperactivity of the Bush administration. The “war on terror” planted American armies in Afghanistan and Iraq; the Clinton surpluses were succeeded by the Bush deficits to shore up the economy and finance the military operations. However, as the Iraq escapade foundered and the deficits ballooned, the sense of relative decline reasserted itself. Unlike in 1987, there was now a clear candidate for the succession: China. This was especially so as the US economy became dependent on China’s bankrolling its huge trade deficit. The dream of an “American century” receded, to be replaced by the nightmare of a “Chinese century.”

Focus on China is overdue. For the last quarter of a century its economy has been growing by over 9 percent a year, increasing eightfold. However, it is not just this long-sustained hyper-growth rate that amazes and alarms the observer. It is the size of the economy which is growing. China’s population is officially estimated at 1.3 billion, but is probably larger—one fifth of all the people in the world. This makes its rise much more important than that, say, of Japan in the 1960s. From the economic point of view its cheap labor is much more abundant, so its cost advantage will not quickly be eliminated. The size of an economy obviously matters, too, in measuring power. The Chinese economy, in terms of the purchasing power of the Chinese people, is about two thirds the size of the US economy.[2] If it continues to grow at 9 percent a year, it will overtake the US by 2014. Lee Kwan Yu of Singapore believes that the rise of China will shift the balance of power back to the East for the first time since Portuguese caravels arrived there in the sixteenth century.

China’s growth, simply because of its size, is bound to create problems both for itself and others. From the Chinese leadership’s point of view, the main problem is how to maintain social cohesion amid the vast socio-economic upheavals going on. Apart from the environmental degradation and rampant corruption, China’s pell-mell, and largely uncontrolled, economic growth is disturbing its domestic stability in a profound way: there is a huge floating population without settled jobs or abodes, and a development and income gap between the coastal and inland areas which is as big as between the United States and North Africa. According to one estimate, 30 percent of China’s urban workforce, or 200 million people, is currently unemployed or underemployed. The livelihood of another 100 million agricultural workers is threatened as World Trade Organization rules increase China’s dependence on foreign food supplies. The specter of chaos frightens the rulers in Beijing.

In international relations, the issue is whether China’ impact on the world will be peaceful or violent. Th debate here follows disciplinary lines. “Those who focus on economics tend to see partnership, cooperation and reasons for optimism despite tensions, while security experts are more pessimistic and anticipate strategic conflict as the likely future for two political systems that are so different,” writes one commentator [3]. Both views can claim some evidence in their favor…

Written by infoproc

November 26, 2005 at 9:35 pm

Posted in globalization

Google click to call

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This is the next step in Internet advertising. Among the text ads that come with your search results you might see a little telephone icon. If you click it and enter your phone number, Google will connect a representative from the advertiser to you via VOIP. (Your phone will ring, and voila, you can discuss how the refrigerator gets delivered or whether the plasma screen is glare resistant. Guess what part of the world the call center rep will be working from 🙂 This sort of thing is already out there using IM-type clients, but here the user only needs an ordinary phone. Google does not tell the advertiser your phone number, so your anonymity is protected. Very nice!

I’m very envious of the Google people because they actually have the opportunity to implement all of these nifty ideas.

Written by infoproc

November 25, 2005 at 8:10 pm

Posted in Uncategorized

Simons, Thorp and Shannon

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Nice article on Jim Simons and Renaissance in Saturday’s Times. Part of me wants to get into the new fund (fees are pretty reasonable compared to Medallion), but then again they are embarking on something new, so it’s no sure thing. See earlier posts here and here. Most impressive about Medallion is their consistency — no down years since 1988 and only a single down month in the last 5 years!

BTW, I’ve received my copy of Fortune’s Formula and it’s quite good. I learned a number of tidbits about Thorp (the mathematician who wrote Beat the Dealer and invented a system for counting cards in blackjack), Shannon (the father of information theory) and others from this book. Apparently, Thorp and Shannon’s investment returns (Thorp ran an early hedge fund called Princeton-Newport, while Shannon invested his own account) rivalled those of the best managers like Buffet and Soros. Buffet and Thorp actually knew each other early on, and had very high opinions of each other. The stories of Thorp testing his card counting system in Nevada are hilarious — the level of detail after all these years suggests a phenomenal memory!

The bit about optimizing geometric vs arithmetic returns (a subject of controversy between math/physics guys like Kelly, Shannon, Thorp and economists such as Samuelson, and the origin of the title of the book) seems not so interesting to me, as the answer depends on what one wants to achieve. On the subject of hedge funds, it appears everyone is starting one, including information theorist Thomas Cover and former physicist turned AI researcher Eric Baum (author of What is Thought?, the best book I’ve read on AI).

NYTimes: $100 Billion in the Hands of a Computer

By JOSEPH NOCERA
PEOPLE ask me all the time: What’s your secret?” James Simons said. We were sitting in an office in Manhattan that Mr. Simons uses when he’s not at the Long Island offices of Renaissance Technologies, the money management firm he founded in 1982. He was wearing an elegant shirt and tie, and loafers with no socks. He took a drag from a cigarette, the second of three he would smoke in the course of a long interview.

I had indeed come to ask him what his secret was. In the hedge fund world, that’s what everybody wants to know.

Mr. Simons, 67, who rarely talks to journalists, is hardly a household name like Warren E. Buffett. But Mr. Simons, who got into the hedge fund business after abandoning a stellar career in mathematics, has a track record that is jaw-dropping. This summer, word leaked out that he was starting a new fund – people took to calling it the “$100 billion fund” because its marketing materials say that it could conceivably grow to that enormous size. Not surprisingly, that has caused Wall Street types to be even more curious about him.

Here are Mr. Simons’s numbers: from 1990 to 2004, Renaissance’s primary hedge fund, called Medallion, has delivered annualized returns of 33.21 percent. (The Standard & Poor’s 500-stock index has returned, on average, 10.98 percent during those same years.) Since the end of 2002, the fund, which has $5 billion under management, has disbursed $4.9 billion to its investors – with another $1.5 billion to be delivered at the end of this year.

And these returns are after Medallion’s 5 percent management fee and 44 percent share of the profits – surely the highest hedge fund fees in the land. Medallion’s returns, and its fees, have helped make Mr. Simons a very wealthy man, with a net worth that Forbes estimates at $2.7 billion.

When I showed Mr. Simons’s returns to a hedge fund friend, he looked startled. “Nobody has numbers like those,” he said. But here’s the real eye-opener: no one outside the firm’s 200 or so employees has a clue how he does it.

Medallion, you see, is a quantitative fund. In quant funds, trading activity is generated by complex computer models rather than human judgment. Most quants are secretive about the algorithms that drive their models; after all, that’s their investing edge. But of the handful of big-time “black box” investors, as they’re often called, Mr. Simons’s box may well be the blackest.

HERE’S what we do know. Medallion’s portfolio contains literally thousands of stocks and other financial instruments that it trades in rapid-fire fashion. The firm’s scientists are constantly searching for repeatable patterns, and other signals, in the enormous amounts of data they compile. The computer models they devise tell them when to make trades based on those signals.

As Mr. Simons put it – and this is about as specific as he would get – “Certain price patterns are nonrandom and will lead to a predictive effect.” He also told me that Medallion sticks with highly liquid securities that trade in public markets around the world. Why? “Because there is a lot of data on such instruments, and we’re very statistically oriented,” he said. He stays away from exotic derivatives.

Not even Mr. Simons’s investors know much more than I’ve just described. “We trust Jim and we think he’s smart,” said one longtime Medallion investor. “So we stopped caring what the computer was doing.” When this investor began describing Mr. Simons’s investing approach, he admitted he was guessing.

Mr. Simons shrugged when I suggested to him that his firm’s lack of “transparency,” as they say in the business, was bound to make people nervous. Humans fail in the market all the time, but somehow we are willing to keep giving our money to human beings to manage because we understand investing based on human judgment. Or at least we think we do. But black box investing feels different. It feels scary somehow, precisely because it is not something most of us can understand.

“How any great investor does it isn’t in the least obvious,” Mr. Simons responded. “How we do it isn’t any more mysterious than how a great fundamental investor does it. In some ways it is less mysterious because what we do can be programmed.” Then he stopped, took another drag from his cigarette, and let out a small chuckle. “Well,” he conceded, “it’s less mysterious to us.”

Mr. Simons wasn’t always a quant. A former crypt analyst – a code breaker, that is – he did important work in mathematics that helped lay the foundation for string theory. When he began managing money in the 1970’s, he did it the same way most investors did: he used his own judgment. “At first,” he said, “I didn’t think about investing in a scientific fashion. But I was trading currencies, and it gradually occurred to me that there might be some way to create models that would allow you to predict currency movements.”

Although Mr. Simons and a partner made an absolute killing in the currency markets the old-fashioned way – they made huge bets that turned out to be right – he began surrounding himself with scientists who developed models for all sorts of tradeable securities. “By the end of the 1980’s,” he said, “I was a model man, and didn’t want to do fundamental analysis.” One advantage, he said, is that “models can lower your risk.” Another, though, is that “it reduces the daily aggravation.” With old-fashioned stock picking, he said: “One day you feel like a hero. The next day you feel like a goat. Either way, most of the time it’s just luck.”

Indeed, trading the way he does, making thousands of small trades aimed at capturing small price movements, doesn’t generate the kind of “10 bagger” that investors love. But when done well, quant investing is less likely to have the kind of disaster that is always the danger when one bets big on a stock.

To those who point to Long-Term Capital Management as an example of the dangers of black box investing, Mr. Simons’s defenders point out that his fund has far less leverage than Long-Term Capital, and that in any case, while Long-Term Capital had several Nobel laureates on board, human bets were what caused it to go awry.

Clifford Asness, another well-known quant hedge fund manager, said that while he knew no more about Mr. Simons’s methods than anyone else, “It’s hard to believe that there isn’t a measure of safety in Jim’s approach.

“Presumably, he’s got a highly diversified portfolio, high turnover, and he’s capturing small inefficiencies. It’s hard to lose a ton of money doing that. It is always possible that someday his models might stop working. But that’s different from ‘blowing up.’ “

“You know,” Mr. Asness added, “human beings have a black box, too. It’s called the brain.”
As for the new “$100 billion fund,” Mr. Simons was even more constrained than usual, thanks to regulatory restrictions that limit what he can say publicly while the fund is raising money. People are buzzing about it nonetheless, for it seems to be a major departure from Medallion. Medallion’s investors were almost all wealthy individuals; the new fund, called the Renaissance Institutional Equities Fund, has a $20 million minimum investment and is aimed at institutions. It has a much lower fee structure. It will invest in – or sell short – only publicly traded equities. Instead of making rapid-fire trades, it will be much closer to a buy-and-hold portfolio. And so on.

In one critical way, though, it is similar to Medallion. As the marketing document, which I obtained from a person unconnected to Mr. Simons, put it: “The company’s risk control, variance and covariance estimation, execution techniques, slippage models, and predictive signals are all derived from those employed by the managing member in trading the Medallion Funds.”

In other words, Mr. Simons believes that computer models similar to those that have worked for Medallion will also work for a fund that can hold $100 billion worth of stocks over long periods of time. It is absolutely audacious.

What interested me most of all was: why? At an age when most men are contemplating retirement, with more money than he can count, why was Mr. Simons still at it? “I enjoy the challenge,” he replied.

He then began describing a demonstration he saw recently of a new nuclear accelerator at the Brookhaven National Laboratory, where he is on the board. Two atoms hurtled toward each other, colliding with great force. “A huge number of particles are thrown out,” he said, “and the job is to analyze everything that results from the collision.”

“Watching the spray of particles on the screen made me think of the stock market,” he continued. Every trade, even of a hundred shares of a company, affects every other trade. And every day there are thousands upon thousands of such trades, all of them affecting the rest of the market. His work, as he sees it, is to analyze that incredibly complex mosaic and try to figure out how it all fits together.

“The subject may not be the most important in the world,” he concluded, “but the dynamics of the market are really interesting. It’s a serious question.”

I suddenly understood the motivation behind Mr. Simons’s new fund. He’s doing it because he wants to see if it can be done. Once a scientist, always a scientist.

Written by infoproc

November 20, 2005 at 9:16 pm

Posted in finance

The new white flight

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Instead of white students fleeing academically weak school districts dominated by disadvantaged blacks and hispanics, in Silicon Valley white students are fleeing overly strong school districts dominated by Asians. Who needs all that math and science anyway?

See related post on Asians and affirmative action here.

WSJ: CUPERTINO, Calif. — By most measures, Monta Vista High here and Lynbrook High, in nearby San Jose, are among the nation’s top public high schools. Both boast stellar test scores, an array of advanced-placement classes and a track record of sending graduates from the affluent suburbs of Silicon Valley to prestigious colleges.

But locally, they’re also known for something else: white flight. Over the past 10 years, the proportion of white students at Lynbrook has fallen by nearly half, to 25% of the student body. At Monta Vista, white students make up less than one-third of the population, down from 45% — this in a town that’s half white. Some white Cupertino parents are instead sending their children to private schools or moving them to other, whiter public schools. More commonly, young white families in Silicon Valley say they are avoiding Cupertino altogether.

Whites aren’t quitting the schools because the schools are failing academically. Quite the contrary: Many white parents say they’re leaving because the schools are too academically driven and too narrowly invested in subjects such as math and science at the expense of liberal arts and extracurriculars like sports and other personal interests.

…In the 1960s, the term “white flight” emerged to describe the rapid exodus of whites from big cities into the suburbs, a process that often resulted in the economic degradation of the remaining community. Back then, the phenomenon was mostly believed to be sparked by the growth in the population of African-Americans, and to a lesser degree Hispanics, in some major cities.

But this modern incarnation is different. Across the country, Asian-Americans have by and large been successful and accepted into middle- and upper-class communities. Silicon Valley has kept Cupertino’s economy stable, and the town is almost indistinguishable from many of the suburbs around it. The shrinking number of white students hasn’t hurt the academic standards of Cupertino’s schools — in fact the opposite is true.

…white students represented 20% of [Monta Vista’s] 29 National Merit Semifinalists this year.

At Cupertino’s top schools, administrators, parents and students say white students end up in the stereotyped role often applied to other minority groups: the underachievers. In one 9th-grade algebra class, Lynbrook’s lowest-level math class, the students are an eclectic mix of whites, Asians and other racial and ethnic groups.

“Take a good look,” whispered Steve Rowley, superintendent of the Fremont Union High School District, which covers the city of Cupertino as well as portions of other neighboring cities. “This doesn’t look like the other classes we’re going to.”

On the second floor, in advanced-placement chemistry, only a couple of the 32 students are white and the rest are Asian. Some white parents, and even some students, say they suspect teachers don’t take white kids as seriously as Asians.

Written by infoproc

November 19, 2005 at 9:03 am

Posted in Uncategorized

Outsourcing at Conexant

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The handwriting is on the wall…

NYT: Dwight Decker, Conexant’s chief executive, said that half the semiconductor design and other high-tech engineering work is now done at Conexant India, the division in Hyderabad.

The operation there employs 700 engineers, nearly as many as headquarters does. That is up from 10 percent of such work last year, and Mr. Decker says that figure will jump to 65 percent by the end of 2006, leaving just one-third of the work to be done by the engineers in the United States.

“We are placing a very large bet on our ability to shift a significant part of our development to Asia,” Mr. Decker said. “We are doing that more aggressively than any semiconductor company.” He emphasizes that no layoffs are planned for Newport Beach, where engineers will work on the “innovation and architecture” of the firm’s semiconductor systems.

Conexant’s step is enormous, proportionate to its middling size. Giants like General Electric and 3M routinely assign high-tech research to laboratories they own in India and China. And the sprinkling of such work among their global systems is increasing. But most of their research remains in the United States.

Conexant is a fraction of their size, with only 2,400 employees and $900 million in sales of computer and communications equipment last year. Yet it is a technological powerhouse – the inventor 50 years ago of the computer modem – and a major investor in research and development.

Conexant will spend about $250 million this year on research and development because it must keep coming up with new microelectronic wonders for demanding customers like Samsung Electronics, DirecTV and others that are striving to bring movies, music, medical diagnoses and every conceivable service via Internet television to the digital home. Conexant is a strong and rising competitor in the electronics that make possible broadband Internet reception through D.S.L. telephone lines.

In 1955, as a division of North American Aviation, Conexant developed the transistor modem for communicating data over telephone lines, under a contract from the Defense Department. In the early 1980’s, as part of Rockwell International, it brought out high-speed fax modems, and in 1996, it introduced high-speed Internet connectivity.

“We have adapted time and again,” said Mr. Decker, who has led Conexant since it was spun off from Rockwell in 1999. “And we will continue to adapt and play our part in an expanding world market as long as we innovate.” Conexant is putting emphasis on India to keep ahead of it main competitors, the Broadcom Company and the Swiss-based giant, ST Microelectronics Group, said Mr. Decker, a physicist and mathematician with degrees from McGill University in Montreal and a doctorate in math from the California Institute of Technology.

Mr. Decker said that besides financial reasons the export of research jobs is motivated by a looming dearth of engineering talent in the United States. Engineers in India earn one fourth of the pay of their American counterparts, roughly $25,000 a year in salary and benefits, compared with $100,000.

“If we can get two-thirds of our product development at one-fourth the cost, we come close to cutting our overall costs in half,” Mr. Decker said. In the first year of large-scale work in India, he said, Conexant reduced costs by $36 million.

Conexant may be a harbinger of developments at corporate research departments across America. “There is a lot more research work being done in India these days,” said Shivbir Grewal, a lawyer in Irvine, Calif., who works with companies in America and India.

The attraction is “the huge pool of talent” from the Indian Institutes of Technology – seven major institutions established over the last 54 years – and regional engineering colleges, Mr. Grewal said. But “visas to the United States have been extremely restricted since 9/11,” Mr. Grewal said, “so the graduates are staying home and finding work in India.” The increase in research overseas is arousing concerns in the United States. The fear is that good jobs will migrate to India and China and that the innovative wellspring of new technology will slowly dry up in the United States.

Terry Opdendyk, a venture capitalist, disagrees with the second concern, but concedes the first.

“It is extremely difficult to achieve and manage innovation in collaborations across oceans and time zones,” said Mr. Opdendyk, who has backed more than 100 start-ups as head of Onset Ventures, a Silicon Valley firm he founded in 1984. “But I worry because we’re educating too few engineers in America and I don’t see us pursuing change-the-world ideas as we used to,” Mr. Opdendyk said.

Mr. Decker agrees that at fewer than 60,000 new engineers a year, the United States may not have enough skilled people to handle all the work to be done. However, he said, the United States still leads in information technology, and “we can sustain our world leadership if we continue to innovate.”

Written by infoproc

November 17, 2005 at 7:25 am

Posted in Uncategorized