Notes

Anomaly - The True Architects of the Economic Crisis?
Those of you who followed Nouriel Roubini during the Asian Currency crisis over a decade ago* should have already recognized the similarity between that crisis and this one. Roubini was recently interviewed and gave his opinion: "The U.S. has been living in a situation of excesses for too much time. Consumers were out spending more than their income and the united states was spending a lot more than its income, running up large current-account deficits. Now we have to tighten our belts and save more. The difficulty is that higher savings in the medium term are positive, but in the short run a consumer cutback on consumption makes the economic contraction more serious."

That's the paradox of thrift. But we have to save more as a country, and we must channel more resources to elements of the economy that are more productive. And when you have way too many financial engineers rather than as many computer engineers, you have a problem......I think this country needs more people who find themselves going to be entrepreneurs, more folks in manufacturing, more people going into sectors that will lead to long-run economic growth. When the best minds of the united states are all likely to Wall Street, there exists a distortion in the allocation of human capital for some activities that become excessive and finally inefficient." However, Nobel laureate Robert Merton of the Harvard Business School has a different perspective:

we are in need of more financial engineers, not fewer risk and innovation, including derivatives, aren't going away, and we are in need of senior managements, boards, and regulators of finance institutions who understand them." Who are the Financial Engineers? And What the Hell Are They Talking About? I received my Master of Science in Financial Engineering degree back in 2002 and still to this day no one knows what the hell which means. Ok, Financial Engineers tend to be "rocket scientists" (literally) that are hired by large banks and multinational corporations to create sophisticated mathematical models with the intention to predict the likelihood of risky events, to supply valuations for instruments that are traditionally hard to price, and to create synthetic securities for the hedging risk (and sometimes for speculating).

"As LBO specialist Ted Stolberg once told Inc. Magazine, 'Financial engineering is like building a bridge. You can build it anyway you like as long as it doesn't collapse when heavy trucks stepped on it and you will add additional lanes when you want more traffic to debate it. So when it's all done, it must be an engineering marvel, just like the Golden Gate'" (Warsh, 1993, p. 296). These "quants", as they are lovingly called, tend to be lured from poor paying academic jobs by Wall Street to high paying jobs in London, New York, Chicago, or California. The organization executives that hire these Quants often prefer to remind their investors that everything will be alright because of the brilliant minds they will have on the payroll. Unfortunately, there are two large problems in financial engineering which have emerged in hindsight. First, finance is ultimately about human beings and their relationships to one another.

Real finance bears little resemblance to the logical order of math and physics. Most models in finance start out with the basic assumption of "Homo Economus", the assumption that man is a rational being. This has largely been proven to be a faulty assumption because of the recent research of cognitive neuroscience. Second, the output from the financial models is misinterpreted by your choice makers in senior level management. As Alfred Korzybski said, "The map is not the territory". Much too much decision making has been based upon these models, providing them with much too much weight. Senior executives seem all to wanting to confirm their successes and deny their failures, it is human nature after all. Financial Models: CURRENCY MARKETS Rationality or Irrationality? "It is greater than a metaphor to describe the price system as a kind of machinery, or a system of telecommunications which enables individual producers to view merely the movement of several pointers, as an engineer might watch the hands of a few dials, as a way to adjust their activities to changes of which they may never learn than is reflected in the purchase price movement." - F.A. Hayek The efficient market hypothesis is fairly appealing conceptually and empirically, which accounts for its enduring popularity.

In a nutshell, efficient stock markets are generally thought of as equilibrium markets where security prices fully reflect all relevant information that's available about the "fundamental" value of the securities (Tangentially, Benjamin Graham, well-known for co-authoring the fundamentalist treatise Security Analysis with David L. Dodd, was quoted as saying shortly before his death, "I'm no longer an advocate of elaborate techniques of security analysis and discover superior value opportunities... I doubt whether such extensive efforts will create sufficiently superior selections to justify their costs... I'm on the side of the 'efficient market' school of thought..." [Malkiel, 1996, p. 191]). Despite its popularity, efficient capital markets theory has weathered some very appropriate criticisms. Since a theory is a model of reality rather than "reality" itself, anomalies arise where theory does not mirror reality and the idea of efficient capital markets is not any exception.

Ray Ball's article THE IDEA of Stock Market Efficiency: Accomplishments and Limitations (Ball, 1994, p. 40) presents a mostly balanced perspective and illuminates some interesting anomalies: 1) A study by French and Roll suggests that prices overreact to new information which is then accompanied by a correction, allowing contrarian investors to take profits. 2) Excess volatility of prices as a result of "extraordinary delusions and madness of crowds". 3) Prices underreact to quarterly earnings reports, which alone seems an anomaly in the tendency of prices to overreact to new information. 4) A recent study by Fama and French provides evidence that there surely is no relationship between historical betas and historical returns which has lead many to believe the equilibrium-based CAPM, developed greatly as a result of enormous quantity of empirical data on efficiency, has failed. (Not included in Ball's article, but told in Malkiel's A Random Walk Down Wall Street may be the story of how Fama and French also determined that investing in a stock which has performed poorly for days gone by two years will often give you above average returns through the next 2 yrs (Malkiel, p. 198), thereby allowing contrarians to have a profit once again.) 5) There are seasonal patterns found in the info on stock returns or small firms, including the "January effect", where stock prices are unusually higher through the first few days of January or the "weekend effect" where average stock returns negatively correlated from closing on Friday to closing on Monday.

Anomalies missing from Ball's article include: 1. the evidence that firms with low price-earnings ratios outperform people that have higher P/E ratios. 2. the data that stocks that sell with low book-value ratios have a tendency to provide higher returns. 3. the data that stocks with high initial dividends tend to provide higher returns (Malkiel, pp. 204 -207). Where Ball's article differentiates itself from almost every other summaries of the trials and tribulations of the theory of efficient capital markets is in a section titled "Defects in 'Efficiency' as a Style of Stock Markets" (Ball, p. 41 - 46) where he discusses the overall neglect within the theoretical and empirical research on stock market efficiency of the processing and acquisition costs of information. This neglect could be the reason for the anomalies, including the "small firm effect", the tendency of small cap stocks to supply higher returns. He also criticizes the assumption in the efficient markets hypothesis of investor "homogeneity" and suggests the necessity for a fresh research program. Ball also considers the role of both transactions costs in the efficient markets theory literature "largely unresolved" and the result of the actual market mechanism on transacted prices, also called "market microstructure effects".

He defends efficient markets theory from Robert Shiller's argument (that the historical variance of stock prices has been a lot more volatile than can be justified by historical variance in actual dividends) by challenging Shiller's use of a constant market expected return in nominal terms. Since CAPM assumes a continuing without risk rate of return and a constant market risk premium it really is impossible to find out a "correct" quantity of variance in the market index. Ball also defends market efficiency from Shiller and other behavioralists in maintaining that the mean-reversion in stock returns will not necessarily imply market irrationality. CAPM does not claim to dismiss the trend for periods of relatively high returns to be followed by periods of relatively low returns. In fact, such cyclical patterns may be the result of rational responses by investors to political/economic conditions and corporations to changes in investor demand for stocks.

Ball then grants more space to Shiller and the behavioralists by ending his piece with the rhetorical question "Is 'behavioral' finance the answer?" He rapidly answers, "I don't think so" (Ball, p. 47). I'd rephrase the question so it reads "Does 'behavioral' finance yield useful answers?" and my answer will be "yes." Whether or not investors behave rationally, that is, whether investors accurately maximize expected utility is an important assumption of the efficient market hypothesis and if it isn't true, it could explain why the anomalies exist. Work in prospect theory by Allias, Kahneman and Tversky provides important evidence that the typical assumption of expected utility maximization assumed by most financial economists may not furnish accurate representations of human behavior (prospect theory states that folks are better represented as maximizing a weighted amount of "utilities," dependant on a function of true probabilities which gives zero weight to extremely low probabilities and a weight of 1 to extremely high probabilities). While such evidence is not damning, it really is troubling to say minimal (Shiller, 1997).

Interestingly enough, Ball's article omits the common practice of financial economists to categorize the idea of the stock market efficiency into three types which, from least to many orthodox, are as follows: 1. The weak form states that the annals of stock price movements contains no useful information enabling investors to consistently outperform a buy-and-hold portfolio management theory. 2. The semi-strong form maintains that no available published information will help security analysts select "undervalued" securities. 3. read more holds that everything known as well as knowable about a company is reflected in the price tag on the stock. Statistical evidence lends credibility to the weak and semi-strong forms, and discounts the strong form revealing that corporate insiders have earned excess profits trading on inside information. To get the weak and semi-strong forms, the results of Ball and Brown's mid-1960's study (Ball, p. 35) of the way the stock market actually responds to announcements of annual earnings suggests that the marketplace anticipates approximately 80% of the new information within annual earnings before the earnings were actually announced.

In other words, investors were mostly deprived of future opportunities to benefit from the brand new information since stock prices had already processed the info released in the annual earnings reports. It seems if you ask me investors and "Quants" alike would prosper never to to swallow anybody approach whole, warts and all, but to carefully weigh the evidence of all different approaches. In scientific experimentation, where Quants feel in the home, you can find no success and failures, only outcomes or results. All that emerge are data points that let you know in the event that you hypothesis is correct or not. Unfortunately, in capital markets, if an "experiment" is leveraged enough, it is possible to bankrupt entire countries, and today, perhaps even the planet. In capital markets, the true risk of experimentation such as this can lead to people not eating. What's Risk and Where Does Financial Engineering CAN BE FOUND IN? Well, we are able to intuitively say there appears to be a positive relationship between risk and uncertainty. The more certain we can be of a specific outcome, the less risky it really is. However, in a dynamic world such as for example ours where we are able to barely (and usually inaccurately) predict the weather five days from now, how can a financial manager, farmer, or any interested party be prepared to predict, say, the cost of tea in China weeks, months, or even years from now?

This is where the stunning asymmetric nature of a financial instrument called an "option" will come in: "A call option is the right to buy a specified level of some underlying asset by paying a specified exercise price, on or before an expiration date. A put option may be the right to sell a specified quantity of some underlying asset for a specified exercise price, on or before an expiration date" (Figlewski and Silber, 1990, p. 4). An investor's potential loss is bound to the premium, while the potential profit is unlimited. So although it could be impossible to predict the future price of tea in China, you'll be able to set a floor for the amount of loss permitted to occur without setting a ceiling on the profits reaped. Options belong to a class of financial instruments called derivatives, aptly named because they derive their value from another thing. Options, for instance, derive their value from an underlying asset. Other derivatives include interest and exchange rate futures and swaps, whose values be determined by interest and exchange rate levels (some parties exchange cash payment obligations since they may prefer somebody else's payment stream), commodity futures, whose value be determined by commodity prices, and forward contracts, which act like future contracts except that the commodity under contract is really delivered upon a specified future date. But how can we use these instruments to minimize our exposure to risk?

"Financial engineering may be the use of financial instruments to restructure a preexisting financial profile into one having more desirable properties" (Galitz, 1995, p. 5). Quite simply, it's the province of the financial engineer to create "synthetic" securities to accomplish desired risk-return results. You take combinations of option, futures, swaps, etc. and create new securities to mitigate unforeseen risks. Let's assume that the cash flows between your straight security and the synthetic portfolio are equivalent, then any difference in the present market values of both is an arbitrage opportunity. An arbitrage is trade where one buys something at one price and simultaneously sells fundamentally the same thing at a higher price, to make a riskless profit (In an efficient market such opportunities ought to be rare, so when the wily investor took benefit of it the very process should drive the price of what they are buying up and the price of what they are selling down).

A Simple Exemplory case of How Financial Engineering Actually Works In his article, The Arithmetic of Financial Engineering (Smith, 1999, p. 534) Donald J. Smith uses simple arithmetic and algebra to illustrate the relationships of a variety of different security combinations (synthetic securities) utilized by financial engineers to generate these unique risk-return trade-offs. His basic explanatory formula looks like this; A + B = C where, A + B comprise the synthetic portfolio C may be the straight security + sign denotes an extended position, or perhaps a lending posture - sign denotes a short position, or perhaps a borrowing posture Utilizing the arithmetic outlined above, Smith can illustrate the relational structure of such synthetic securities as; Interest rate swaps + Interest Rate Swap = + Unrestricted Fixed Rate Note - Floating Rate Note The coupon for some bonds is fixed ahead of time, hence the name fixed-income securities, but many issues have coupons which are reset frequently and therefore float, these are called floating rate notes.

Collars + Collar = + Cap - Floor "Caps" and "Floors" are option contracts that guarantee the utmost [cap] and minimum [floor] rate that can be reached. Caps and floors are essentially interest insurance contracts that insure against losses from the interest rates rising above or falling below determined levels. Mini-Max Floater + Mini-Max Floating Rate Note = + Typical Floating Rate Note - Cap Inverse Floaters - Inverse Floater = - Two Fixed Rate Notes + Unrestricted Floating Rate Note -Cap Inverse floaters appeal to those investors that are bullish on bond prices and expect interest levels to drop. It is the synthetic security that Robert Citron used wrongly and ended up bankrupting Orange County, California when the Federal Reserve sharply raised interest rates in 1994. This folly ended up costing Orange County $1.7 billion in 1994 dollars! Participation Agreements + Participation Agreement = + Cap - Floor This simple arithmetic formula wields great explanatory power for those who seek to a straightforward understanding of the complexities of financial engineering.

However, the financial engineer should be cautious with the double edged sword of derivative instruments. When used to hedge, derivatives could be invaluable guards against risk, however if used to speculate, they can invite unnecessary risks. Also, hubris can be devastating as sometimes the payoffs can be too complex to fully understand. Unintended consequences can be quite a bitch (see credit default swaps) AMERICA Government = The Paleo-Financial Engineers "Blessed will be the young, for they shall inherit the national debt" -Herbert Hoover Let's look at one of the most complicated financial engineering schemes of all time, the relationship between the United States Treasury and the Federal Reserve system. The Federal Reserve is a privately owned corporation. Basically as the popular phrase goes, "The Federal Reserve is as 'federal' as Federal Express". The biggest stock holders of the Federal Reserve bank are the 17 largest banks on earth. As a matter of record, for the United States the final century has been one of deficits and debt.

To put it simply, a deficit occurs once you save money than you have. Each time the government spends a lot more than it has it must issue a debt instrument or I.O.U., usually a U.S. Treasury bond, to cover the expenses. The Federal Reserve banking cartel buy these bonds (with paper currency literally created out of thin-air) on the promise that the federal government can pay the Federal Reserve back both the principal and a set rate of interest. In trade for this interest payment, the Federal Reserve literally creates money (mostly electronically and completely out of nothing) through manipulated ledger accounts. What most people fail to recognize is that the main way Treasury generates the revenue to pay off it's debt to the Federal Reserve is through taxation. To put it simply, our income taxes goes right to bankers. A far more sobering simple truth is this, to get a concept of how much the U.S. owes to bondholders (i.e., the Federal Reserve banking cartel) just take a look at the National Debt. It towers at over $11 trillion (remember a trillion is a thousand billion, and a billion is really a thousand million, and million is really a thousand thousand.

Having an estimated population of the United States of 305,367,770, that means that each United States citizen's share of the outstanding public debt is nearly $40K as of this writing. The tricky part is this, if the growth of the debt is constant and greater than the rate of growth of average real income, then what should we expect the government to do when tax revenues are no more sufficient to cover the interest on the debt? Then once the money (again, that was created out of thin-air) trickles down back to the economy because the government spends it, and finds its in the past into the private banks. Once there, the real inflation begins through the magic of fractional reserve banking. This is all documented in the Federal Reserves' own manual entitled "Modern Money Mechanics". The bottom line is, since they only maintain a fraction of the actual reserves on-hand (while their ledgers falsely say they will have the complete amount) the currency is inflated and the risk of bank runs are ever present.

There are only three basic courses of action the government may take; repudiate, hyperinflate, or liquidate. I favor the liquidation of governmental assets (non-essential governmental properties like the FDA, FCC, or the IRS) over repudiation or hyperinflation simply because liquidation of governmental assets may be the surest solution to end big government as we know it. Repudiation would shock the economy, interest levels would skyrocket, and bond prices would plummet; too much risk involved. Hyperinflation would only devalue the currency and impoverish everyone concerned. In Conclusion All this brings me back full circle to Nouriel Roubini's quote again: "The U.S. has been surviving in a situation of excesses for too long. Consumers were out spending a lot more than their income and the country was spending a lot more than its income, running up large current-account deficits. Now we have to tighten our belts and save more. The difficulty is that higher savings in the medium term are positive, but in the short run a consumer cutback on consumption makes the economic contraction more severe.

That's the paradox of thrift. But we must save more as a country, and we have to channel more resources to parts of the economy that are more productive. And when you have way too many financial engineers rather than as much computer engineers, you have a problem......I believe this country needs more people who find themselves likely to be entrepreneurs, more folks in manufacturing, more people going into sectors that will result in long-run economic growth. When the best minds of the united states are all going to Wall Street, you will find a distortion in the allocation of human capital to some activities that become excessive and eventually inefficient." I wholeheartedly concur that the solution is based on entrepreneurship. However, the quote is bookended by the idea of "excess" and associates it with our overall economy. This begs the question though, that are the true architects of the excess, the Financial Engineers alone or are the Federal Reserve and the U.S. Treasury complicit aswell?

REFERENCES
Hayek, F. A. (September, 1948). The Use of Knowledge in Society.
The American Economic Review, XXXV, No. 4. Malkiel, B. G. (1996).
A random walk down wall street. New York, N.Y. Ball, R. (1994).
The theory of currency markets efficiency: accomplishments and limitations. In D. H. Chew, Jr. (Ed.),
The new corporate finance; where theory meets practice (pp. 35 - 48). more info , MA. Shiller, R. J. (1997). Human Behavior and the Efficiency of the ECONOMIC CLIMATE. [online]. Available: [http://www.econ.yale.edu/~shiller/handbook.html].
Warsh, D. (January 17, 1988). Following the Crash (financial engineering). economic principals.
NY, N. Y. Figlewski, S. and Silber, W. L. (1990).
financial options: from theory to apply. New York, N. Y. Galitz, L.C. (1995).
financial engineering: tools and ways to manage financial risk. Burr Ridge, Illinois. Smith, D. J. (1999). The Arithmetic of Financial Engineering. In D. H. Chew, Jr. (Ed.), The brand new corporate finance; where theory meets practice (pp. 535 - 543). Boston, MA. (June 20, 1999).

*The Lessons of the Yen (I wrote this back 1998 for the Golden Gate University student newspaper, in the event that you substitute "Japan" for "America" it could be true today) As little as ten years ago it was thought that America's unemployment and growth rates would never become more appealing than those of Japan's. Such thinking has proven wrong, and the sting is being felt around the world. What effect, if any, do problems in one part of the world have on others? Well, check here sinking Japanese economy, the most recent of the Asian Tigers to be struck by the Asian currency crisis iceberg is cause for concern for a few Golden Gate University students in SAN FRANCISCO BAY AREA. International students receiving funds from Japan are the most immediately affected. Erina Ishikawa (MBA, entrepreneurship) and Dongil Yun (masters, computer information systems), have both felt the consequences of an unfavorable exchange rate because the decline of the Yen.

"When I came (to America) a decade ago, things were much cheaper for us in Japan, now the contrary is true," said Yun. Anticipating economic problems in Japan and noticing higher interest levels in the US, Misa Aoki (MA, Public Relations) changed her Yen savings to dollars over a year ago. While not impacted by the risk of waning purchasing power due to her foresight, she still worries about finding a job after graduating and time for Japan. Such fears aren't unfounded. The rising unemployment rate of 4.1% may be the highest in Japan since World War II. Fortunately, none of those interviewed knew of anyone who has had to drop out of school and return to Japan due to the crisis. They all said they were concerned for future years of Japan's economy, but they ultimately do not believe the current crisis is that big of a deal. Jiro Ushio, chairman of the powerful Japan Association of Corporate Executives echoes exactly the same sentiment, "[t]he realities of Japan's economy are not as bad as the world thinks." The president of the American Chamber of Commerce in Japan, Glenn S. Fukushima, said, "[f]undamentally it comes down to the fact that people in Japan generally don't believe that things are so very bad that they need to have fundamental change." Even some in Japan believe that the US expects its own bubble economy to pop soon and is only looking for a scapegoat.

Obviously, there were problems enough for Secretary of the Treasury, Robert Rubin, to intervene to prop up the falling Yen in mid-June. His multi-billion dollar gamble paid off in the short run, reversing the Yen's slide by 8% within one day. Critics of Japan's government maintain that the under guidance by the Ministry of Finance, Japanese banks made bad loans to weak companies instead of letting the market work. The bad loans take into account a lot more than $600 billion, a quantity larger than the complete economy of China, the world's most populated country. Surprisingly however, japan people overwhelmingly re-elected the current government. Prescriptions for recovery are everywhere, MIT's Paul Krugman suggests that Japan's central bank should inflate the amount of money supply and lower interest rates to stimulate domestic demand, while others say that Japan's April deregulatory "Big Bang" liberalization program will ultimately pay off in the long run. If the "big bang" or perhaps a more Schumpeterian "evolutionary" course is taken, with last week's resignation of Prime Minister Hashimoto, the near future is uncertain.

Read more in the highly anticipated new book 'Anomaly: Revolutionary Knowledge In Everyday Life' and join the 'Anomaly Newsletter' at [http://anomalynow.com/].
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