Notes

Anomaly - THE REAL Architects of the Economic Crisis?
Those of you who followed Nouriel Roubini through the Asian Currency crisis over ten years 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 surviving in a predicament of excesses for too much time. Consumers were out spending more than their income and the country was spending more than its income, running up large current-account deficits. Now we have to tighten our belts and save more. The trouble is that higher savings in the medium term are positive, however in the short run a consumer cutback on consumption makes the economic contraction more serious."

That is the paradox of thrift. But we have to 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 too many financial engineers rather than as many computer engineers, you've got a problem......I believe this country needs more people who find themselves going to be entrepreneurs, more people in manufacturing, more folks going into sectors that are going to result in long-run economic growth. When the best minds of the country are all going to Wall Street, there exists a distortion in the allocation of human capital to some activities that become excessive and eventually 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 need senior managements, boards, and regulators of financial 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 that 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, also to create synthetic securities for the hedging risk (and sometimes for speculating).

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

Real finance bears little resemblance to the logical order of math and physics. Most models in finance start out with the essential assumption of "Homo Economus", the assumption that man is a rational being. This has largely been proven to be a faulty assumption thanks to the recent research of cognitive neuroscience. Second, the output from the financial models is misinterpreted by the decision 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, giving them 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 really is more than a metaphor to describe the purchase price system as a kind of machinery, or perhaps a system of telecommunications which enables individual producers to watch merely the movement of several pointers, as an engineer might watch the hands of a few dials, to be able to adjust their activities to changes which they may never learn than is reflected in the price movement." - F.A. Hayek The efficient market hypothesis is quite appealing conceptually and empirically, which accounts for its enduring popularity.

The bottom line is, efficient stock markets are generally regarded as equilibrium markets where security prices fully reflect all relevant information that's available about the "fundamental" value of the securities (Tangentially, Benjamin Graham, famous for co-authoring the fundamentalist treatise Security Analysis with David L. Dodd, was quoted as saying shortly before his death, "I'm no more an advocate of elaborate techniques of security analysis in order to find superior value opportunities... I doubt whether such extensive efforts will generate sufficiently superior selections to justify their costs... I'm privately of the 'efficient market' approach..." [Malkiel, 1996, p. 191]). Despite its popularity, efficient capital markets theory has weathered some very appropriate criticisms. Since a theory is really a model of reality rather than "reality" itself, anomalies arise where theory will not mirror reality and the theory of efficient capital markets is no exception.

Ray Ball's article The Theory 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 due to the "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 recently available study by Fama and French provides evidence that there is no relationship between historical betas and historical returns which has lead many to trust the equilibrium-based CAPM, developed greatly as a result of enormous quantity of empirical data on efficiency, has failed. (Not contained 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 buying a stock which has performed poorly for days gone by two years will most likely give you above average returns through the next two years (Malkiel, p. 198), thereby allowing contrarians to take a profit once again.) 5) There are seasonal patterns to be found in the info on stock returns or small firms, such as the "January effect", where stock prices are unusually higher during 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 evidence 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 have a tendency to provide higher returns (Malkiel, pp. 204 -207). Where Ball's article differentiates itself from most 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 currency markets efficiency of the processing and acquisition costs of information. This neglect could be the reason for the anomalies, such as 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 need 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 referred to as "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 could be justified by historical variance in actual dividends) by challenging Shiller's usage of a continuing market expected return in nominal terms. Since CAPM assumes a constant without risk rate of return and a continuing market risk premium it is impossible to determine 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 will not claim to dismiss the trend for periods of relatively high returns to be accompanied 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 very quickly answers, "I don't believe 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 can be an important assumption of the efficient market hypothesis and when it is not true, it may explain why the anomalies exist. Work in prospect theory by Allias, Kahneman and Tversky provides important evidence that the standard 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 sum of "utilities," dependant on a function of true probabilities 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, read more omits the common practice of financial economists to categorize the idea of the stock market efficiency into three types which, from least to most 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. The strong Form holds that everything known or even 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. In support of the weak and semi-strong forms, the results of Ball and Brown's mid-1960's study (Ball, p. 35) of the way the currency markets actually responds to announcements of annual earnings suggests that the marketplace anticipates approximately 80% of the brand new information within annual earnings before the earnings were actually announced.

Basically, investors were mostly deprived of future opportunities to profit from the new information since stock prices had already processed the info released in the annual earnings reports. It appears to me investors and "Quants" alike would do well 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 at home, there are no success and failures, only outcomes or results. All that emerge are data points that let you know if 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 world. In capital markets, the real risk of experimentation such as this can lead to people not eating. What's Risk and Where Does Financial Engineering Come In? Well, we can intuitively say there appears to be a confident relationship between risk and uncertainty. The more certain we are able to be of a particular outcome, the less risky it is. However, in a dynamic world such as for example ours where we can barely (and usually inaccurately) predict the weather five days from now, how can a financial manager, farmer, or any interested party expect to predict, say, the cost of tea in China weeks, months, or even years from now?

This is where the beautiful asymmetric nature of a financial instrument named an "option" will come in: "A call option may be the right to buy a specified quantity of some underlying asset by paying a specified exercise price, on or before an expiration date. A put option may be the to sell a specified level 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, as the potential profit is unlimited. So although it could be impossible to predict the near future price of tea in China, it is possible to set a floor for the quantity of loss allowed to occur without setting a ceiling on the gains reaped. Options participate in a class of financial instruments called derivatives, aptly named since they derive their value from something else. Options, for example, derive their value from an underlying asset. Other derivatives include interest and exchange rate futures and swaps, whose values depend on interest and exchange rate levels (some parties exchange cash payment obligations because they may prefer somebody else's payment stream), commodity futures, whose value be determined by commodity prices, and forward contracts, which are similar to future contracts except that the commodity under contract is in fact delivered upon a specified future date. But how can we use these instruments to reduce our exposure to risk?

" read more may be the usage of financial instruments to restructure an existing 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 achieve 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 the straight security and the synthetic portfolio are equivalent, then any difference in the present market values of the two is an arbitrage opportunity. An arbitrage is trade where one buys something at one price and simultaneously sells basically the same thing at an increased price, in order to make a riskless profit (Within an efficient market such opportunities ought to be rare, and when the wily investor took benefit of it the process should drive the cost of what they are buying up and the price of what they're 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 number of different security combinations (synthetic securities) used 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 is the straight security + sign denotes a long position, or a lending posture - sign denotes a short position, or 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 regularly and therefore float, these are called floating rate notes.

Collars + Collar = + Cap - Floor "Caps" and "Floors" are option contracts that guarantee the maximum [cap] and minimum [floor] rate which might be reached. Caps and floors are essentially interest rate insurance contracts that insure against losses from the interest levels 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 who are bullish on bond prices and expect interest levels to drop. This can be 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 finished 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 many who seek to an easy knowledge 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 can be invaluable guards against risk, however if used to take a position, they are able to invite unnecessary risks. Also, hubris can be devastating as sometimes the payoffs could be too complex to totally understand. Unintended consequences can be quite a bitch (see credit default swaps) The United States Government = The Paleo-Financial Engineers "Blessed will be the young, for they shall inherit the national debt" -Herbert Hoover Let's look at the most complicated financial engineering schemes ever, the relationship between your United States Treasury and the Federal Reserve system. The Federal Reserve is really a privately owned corporation. In other words as the popular phrase goes, "The Federal Reserve is really 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 america the last century has been among deficits and debt.

To put it simply, a deficit occurs whenever you spend more than you have. Each and every time the government spends 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 exchange for this interest payment, the Federal Reserve literally creates money (mostly electronically and completely out of nothing) through manipulated ledger accounts. What a lot of people neglect to recognize is that the primary way Treasury generates the revenue to pay off it's debt to the Federal Reserve is through taxation. Simply put, our income taxes goes directly to bankers. A more sobering simple truth is this, to get an idea of how much the U.S. owes to bondholders (i.e., the Federal Reserve banking cartel) simply take a glance at the National Debt. It towers at over $11 trillion (remember a trillion is really a thousand billion, and a billion is a thousand million, and million is a thousand thousand.

With an estimated population of the United States of 305,367,770, which means that each United States citizen's share of the outstanding public debt is nearly $40K at this writing. The tricky part is this, if the growth of your debt is constant and greater than the rate of growth of average real income, then what should we expect the government to accomplish when tax revenues are no longer sufficient to cover the interest on the debt? Then once the money (again, which was created out of thin-air) trickles down back into the economy because the government spends it, and finds its in the past in to the private banks. Once there, the true inflation begins through the magic of fractional reserve banking. That is all documented in the Federal Reserves' own manual entitled "Modern Money Mechanics". In a nutshell, given that they only maintain a fraction of the specific 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 can take; repudiate, hyperinflate, or liquidate. I favor the liquidation of governmental assets (non-essential governmental properties just 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 once we know it. Repudiation would shock the economy, interest levels would skyrocket, and bond prices would plummet; an excessive amount of 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 living in a situation of excesses for too much time. Consumers were out spending more than their income and the united states was spending more than its income, running up large current-account deficits. We now have to tighten our belts and save more. The difficulty is that higher savings in the medium term are positive, however in the short run a consumer cutback on consumption makes the economic contraction more severe.

That is the paradox of thrift. But we must save more as a country, and we must channel more resources to parts of the economy which are more productive. And when you have way too many financial engineers and not as much computer engineers, you've got a problem......I believe this country needs more those people who are likely to be entrepreneurs, more people in manufacturing, more folks going into sectors that are going to result in long-run economic growth. Once the best minds of the country are all going to Wall Street, there exists a distortion in the allocation of human capital to some activities that become excessive and eventually inefficient." I wholeheartedly agree that the solution is based on entrepreneurship. However, the quote is bookended by the idea of "excess" and associates it with our economic crisis. This begs the question though, that are the true architects of the excess, the Financial Engineers alone or will be the Federal Reserve and the U.S. Treasury complicit aswell?

REFERENCES
Hayek, F. A. (September, 1948). The utilization 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). Boston, MA. Shiller, R. J. (1997). Human Behavior and the Efficiency of the Financial System. [online]. Available: [http://www.econ.yale.edu/~shiller/handbook.html].
Warsh, D. (January 17, 1988). After the Crash (financial engineering). economic principals.
New York, N. Y. Figlewski, S. and Silber, W. L. (1990).
financial options: from theory to practice. New York, N. Y. Galitz, L.C. (1995).
financial engineering: tools and techniques to manage financial risk. Burr Ridge, Illinois. Smith, D. J. (1999). The Arithmetic of Financial Engineering. In D. H. Chew, Jr. (Ed.), The new corporate finance; where theory meets practice (pp. 535 - 543). Boston, MA. (June 20, 1999).

*The Lessons of the Yen (I wrote this back in 1998 for the Golden Gate University student newspaper, in the event that you substitute "Japan" for "America" it may be true today) Less than ten years ago it had been thought that America's unemployment and growth rates could not become more appealing than those of Japan's. Such thinking has proven wrong, and the sting is being felt around the globe. What effect, if any, do problems in a single the main world have on the others? Well, the 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 will be the most immediately affected. Erina Ishikawa (MBA, entrepreneurship) and Dongil Yun (masters, computer information systems), have both felt the effects 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 holds true," said Yun. Anticipating economic problems in Japan and noticing higher interest levels in the US, Misa Aoki (MA, PR) changed her Yen savings to dollars over a year ago. While not influenced by the threat of waning purchasing power due to her foresight, she still worries about getting a job after graduating and returning to Japan. Such fears are not 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 crisis. Each of them said that they were concerned for future years of Japan's economy, but they ultimately do not believe that the existing crisis is that big of a deal. Jiro Ushio, chairman of the powerful Japan Association of Corporate Executives echoes the same sentiment, "[t]he realities of Japan's economy aren't as bad because the world thinks." The president of the American Chamber of Commerce in Japan, Glenn S. Fukushima, said, "[f]undamentally it boils down to the point that people in Japan generally don't believe that things are so very bad that they have to have fundamental change." Even some in Japan believe that the US expects its bubble economy to pop soon and is only searching 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 marketplace work. The bad loans take into account 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 some say that Japan's April deregulatory "Big Bang" liberalization program will ultimately pay off over time. Whether the "big bang" or perhaps a more Schumpeterian "evolutionary" course is taken, with last week's resignation of Prime Minister Hashimoto, the future is uncertain.

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