Designing better futures

Calling all Quants.....

Warning this is for quants only.  If you understand the problems of leptokurtosis in options pricing or the nature of gamma risk read on.....

I have recently been reading the Black Swan, which any serious quant will have finished a long time ago.  Thinking about black swans etc. the inherent failures of Black Scholes variants to work as a good pricing mechanism got me to thinking.....

If one converts a vol point on a curve into a probability or likely hood event, then one can also construct a time likelihood etc. easily, ie. this is a in 10 trillion year event (See Goldman Sachs alpha fund et al for details.)   The post fact analyst and pundit always can say that common sense made it obvious such and such was a falsehood.

I think a more interesting way to step out of the fallacy of pricing extreme events or price variants is to step outside of the price box altogether and to posit a regime type question.  ie. how long has this phenomenon existed.  Then using the work of Gott, one could arrive at the probability of it not existing.  Here is an example instead of pricing AAA CDO's based on a finite time series of a few years and then assessing the shift outside of say 2 stdev's.  My suggestion would be to use Gott's theorem pose the question how long has this instrument been priced below/above X.  Then convert the time back into a probability to use in pricing the instrument.

Now this approach has flaws in that, the answer will vary on the way the question is framed.  I would posit however that the naive approach of only using previous price is also only a singular frame of reference to assign value. 

The major thesis is to not diminish VaR, and BS theory but rather to add an infinite number of ways to assess the framework of price and value and to free valuation from the context only of price and potentially put valuations into a wider framework of analysis.

Any comments...?

Scary financial stuff

demon of our own design is an interesting look at the world of financial risk.

The Author is a practitioner and academic who provides a welcome perspective on the area of contemporary finance and the environment of financial risk. 
The book is a bit heavy going for the lay person who may not be comfortable with options and and basis points, but for the market practitioner it is a must read.

The author put forth a very reasonable account of the foibles and mistakes that have been made in recent areas of finance.  He articulates the theory of Normal Accidents and how they relate to finance in a great way.  Normal accidents, are a phenomenon of design whereby a complex system, be it a nuclear reactors, airplane safety procedures or any complex system is designed to fail.  This design for failure of course isn't intentional but unfortunately due to complexity of interaction the system fails in an un-intended but wholly preventable way, 3 mile island, Chernobyl and about any financial accident you can think of falls within this group.

The author does a good job of explaining why there really is no such thing as a hedge fund and also posits a few interesting questions about the half life of a trading strategy and the usefulness of ever more esoteric instruments.  As he states, just because you can swap out a cash flow based on a state variable doesn't mean you should.

The clarity, candor and perspective in this book are refreshing.  My own personal concerns in terms of financial risk were only re-enforced.  The current credit crunch articulated in this blog will grow in size significantly but most likely not pose any systemic threat on a global basis. 

The current credit issue will be acute not chronic a $2-4 trillion mess at most.  Looming in 3-5 years will be a crisis which will ultimately be attributed to the Basel II capital accords.  This will be chronic and most likely caused by the safety mechanism of the Capital accords which are being put into place to mitigate risk. 
My sincere hope is that more people read this book and think about the dangers inherent in layering on ever more esoteric risk management systems with finer models thus allowing ever greater financial "innovation".  Gamma risk will look like nothing compared to Basel II model risk when it is fully realized.  Innovation is rarely a good thing in finance and banking especially when it involves ever more esoteric ways of "deriving" value by seperating an asset from the fundamental information or sources of it value creation.

and now for a little Swedish cheese

My wife and I spent a summer living in Sweden and loved it, I have worked in Denmark and spent a lot time there.  If I am good in this life, I will probably come back re-incarnated as a Scandinavian designer.  Our friends are still there here is a little something for them.

5 reasons iphone 1.x is the Apple Lisa.

The iphone is strikingly similar to the lisa in many ways.

1. The Lisa and iphone were both revolutionary for design and look at the time.
2. The iphone and Lisa were both overpriced relative to other products for their functionality, but made up for it with design.
3. The iphone and Lisa both provide a closed view of the world with limited functionality relative to competing offerings.
4. The iphone and Lisa both appeal more to apple fans than regular people, check out the European reception which was luke warm.  Please remember the U.S. is 2-3 years behind the world in smart phones technology,(thanks AT&T, Verizon, insert your Carrier and FCC here).
5. The iphone will fade away like the Lisa fairly rapidly and its 2nd or 3rd incarnation will be truly meaningful.

The first i-pod was panned on release and looks very dated.
The future will be quite interesting for apple, but the phone game is very different and the pace is much more rapid in the phone world than the PC world.  My guess is the Mac OS and the eventual dominance of Solid State Hard drives will mean that the MAC OS has a 15-20%  install base in the next 5 years.   The line between PC and Phone will blur as people will use monitors and printers as generic devices, data that counts (media, messages and mwork) will be stored on portable devices that sync to environments and interfaces.  i-tunes should become more of a data bridge and remote desktop proxy if Apple want to make real headway.

Forget winCE and Palm doesn't really seem to be getting their Linux version out in time.  Google's android move looks smarter and smarter.  Apple will need to get open faster otherwise, may be an also ran.  The rest of the world's 2 billion phone users will be leaping ahead with WiMax and Linux or Symbian.
 

a little thougt project

Happy Thanksgiving.  Here is a great video for a little food for thought for the holidays, if you really pay attention your head may hurt a little after watching this and you will forget about that belly full of Turkey you are carrying around.

Storm King Sculpture Garden

Storm King is a 500 acre sculpture garden about 1.2 hours outside of New York.  It is fantastic, my wife and I went with our freinds Ludwig, Silvana and their 2 year old Enzo.  It was a great day and a great place.

Good design and a great lay out for the park meant we walked and discovered new thing for hours.  Here is a flickr stream to check out.

bank debt is the new iceberg.

I didn't like the subprime market in June and july, see early posts and I like it even less now.    See original posting here in July.  Expect the new heads of Citibank and Merrill Lynch to report huge losses in Q4.  It is the one chance they have to "blame it on the last guy" and move on.  If they are smart they will get all of the banks to do it.

The banking sector is in serious trouble.  Globally the USD is as popular as a fart in church.

A more worrying point, Citibank with $2.3 trillion in positions is below its 8% in risk capital.  This basically means one of the world's largest banks is low on capital.   

Here is what Forbes has to say.

Oh and here is that picture worth 1,000 words.
This is AAA rated paper that is trading for $0.70 on the dollar.  In theory this could be in money market fund.  Thanks Moody's and S&P.  Here is the source.

China week, rising fast, don't know where they are headed.

China had a big week,  its satellite circled the moon, petro china arguably became the first >USD$1 trillion companies.  China holds more than $1 trillion in US reserves and grows in importance by the day. 
On the flipside of the coin, they arrest journalists, environmentalists etc. run a totalitarian regime and have been labeled the first 21st century fascist nuclear state.

starfish economics and inflation

ok folks time to make up words. My new made up word is "starflation".  No before you start dropping this at dinner parties with a knowing look let me explain the concept. 

Inflation as most people understand it is the fact that prices either increase or the purchasing power of a your currency has declined.   Your big mac which used to cost $3 is now $4.  Assuming you are paid in $'s your purchasing power has now decreased by 25% and the cost of everything just went up 33%.  Let me explain.  The price went up 33% (inflation) and you can now only afford 75% of that big mac with your $3.  Economists hint if you see 75% of a big mac laying on a park bench, don't eat it, there really is no such thing as free lunch.

Now there is also something known as Stagflation which like Disco was very in vogue in the US in the 70's.  Stagflation as defined by the wikipedia is inflation without economic growth.  See here.

Inflation is usually measured in aggregate by trying to capture the cost of everything an average person or family would need to subsist on.  In general inflation is measured so that appropriate monetary and taxation policy may be enacted to provide stability and economic growth, thus maximizing happiness in the long term for a country or groups of people.

This was pretty simple to measure and assess when economies were closed, money flows were limited and a basket of goods didn't change much over time.  In 1950 you lived in the US, rarely travelled, bought a loaf of bread, drove your car and paid the mortgage at the local bank.  Pretty simple and a fairly closed and hermetic system, easily managed by your friendly central banker.

William Gibson the science fiction writer once quipped, the future is already here, has just arrived in different places at different rates.  For example travel to Niger, Africa and you can set your clock back in some villages pre-agrarian times.  In the US we use phones that are 2-3 years behind the Koreans and 1-2 years behind the Europeans.  The future arrives in a spikey format. 

Money and the phenomonan we call inflation is now "spikey" like that.  Old inflation indicators aggregate a basket of goods you or I consume and compare today's cost with yesterday's, the difference is inflation. 

Remember the Hamburger.
What if instead of a hamburger, I mentioned your computer.  You can get 1,000 times the computer power today for the same price you bought a computer 10 years ago.  How do we account for inflation in such a scenario.  Are you 1,000 times better off?  Imagine if you could 1,000 hamburgers for $4.  That would be a little more simple.  Today your mortgage may be held in a half dozen currencies around the world.  Your gas may be more expensive, but you can travel the world and have access to more information than anyone ever alive.  Measuring the "aggregate" basket of goods that you consume and assessing your purchasing power is getting more difficult.   The increase in variances brought about by technology an incredibly sophisticated monetary system which is multi-currency means that inflation is "spikey" high in places and yet lower in others.  If you spend more on gas and buy the 40" plasma TV instead of the 50", is there really consumer inflation? 

My opinion is that there isn't really a shift.  The aggregate benefits derived by the individual relative to their labors has only slightly shifted.  Most likely without technologies, shift the person would have kept the old TV anyway.  Hint: economists hate and have always hated technology, it is tough to measure and causes exceptions in models.

My argument is that we are in a period of Starflation.  Starflation is what occurs when a structural rule set (political/cultural) shifts the game to push out some asset or economic component like the arms of a star.  In 90's Japanese industrial policy pushed the asset arms of real estate and big corporates at the expense of a consumer culture.  The impacts have been profound unhappiness and economic stagnation for the 90's and 2000's in Japan.

Inflation in and of itself is a monetary phenomonon and not necessarily debilitating assuming the rate no matter what level is fixed and spread evenly. i.e. all arms of the economy shrink or grow at relatively similar rates.  Many countries have survived inflation "albeit" miserably with high levels of inflation, while Japan, had extremely low inflation in the 90's and asset deflation. 

My thesis is that it is the rate of shift in various arms of an economy that causes pain.  Imagine an economy to be starfish with lots of arms, growing and getting larger, stronger based inputs from the brain and resources at the center.

The arms of the Starfish could be (housing, equities, debt, corporate debt, govt debt, cash, consumer debt, and inventories including (health, education, materials etc.)

   The US along with many countries was so enamored with creating a structural environment for home ownership (fixed) that a cult of fixed ownership took over.  The UK equivelant is the myth of the property ladder. 

A spike in one arm of the starfish makes it unstable.  Most economies have a degree of fluidity that requires a mix ownership, rental, leasing, and couch surfing.  By trying to game the system for a "social good", home ownership, many developed countries have altered a market and swollen a starfish arm beyond the abilities of the arms to maintain balance.

We have created a Star out of an asset class, namely Housing, in the 70's it was consumer goods and auto's.  The starflation is worst in fixed goods and will have a painful period of retrenchment.  An unbalanced starfish can be rebalanced in 1 of 2 ways, grow the whole starfish (inflation via monetary policy), or let the arm recede to a natural level.  My guess is that we will see a mix of both of these things.  My personal prediction is inflation exceeding 10% in some components of CPI for the next 5 years with a composite CPI of 4-6% over the period as we substite cheaper goods.  There will also be a shrinking of the starfish arm called consumer housing, by 15% in the next 2 years.  It will hurt.

My real concern is the next form of starflation, namely health care, it is 15% of GDP and coming on strong in terms of growth. The US demographics are pushing for a solution and fast.  Health care is an open ended service with strong social externalities.  Expect the Starflation of housing which was created by a policy of tax free mortgage payments and the 1031 treatments to be replaced rapidly with starflation of healthcare.  The mix of policy and monetary policy could be painful for 7-10 years out.  The Japanese never did really figure out how to rebalance.  Some real-estate prices are only no back to their 1989 figures.  Commercial real-estate  crashed by 80%.  The  economy still hasn't come back in terms of growth in 17 years.  Please comment using the magic words, that always leave bankers on the rocks....it's different this time.