Monday, July 21, 2014

Jevons, The Mystery of the Invisible Hand

Wittgenstein, a passionate reader of detective stories, famously said that “more wisdom is contained in the best crime fiction than in conventional philosophical essays.” Marshall Jevons’ The Mystery of the Invisible Hand (Princeton University Press, forthcoming September 7) may not measure up to Wittgenstein’s lofty standard since it imparts knowledge rather than wisdom, but it’s still a worthwhile, enjoyable read.

Marshall Jevons is the pen name of William L. Breit and Kenneth G. Elzinga, professors of economics at Trinity University and the University of Virginia. They write mysteries that mix economics lessons with murder. I’m not sure what this hybrid genre is called, but let me—for lack of a better term—dub it didactic detective fiction. The reader learns some basic principles of economics as he sorts through motivations for murder. In this case, the Coase conjecture takes center stage.

This is the third Henry Spearman mystery. The fictional Spearman, a professor of economics, is the incarnation of Kenneth Arrow’s (somewhat dubious) statement that “an economist by training thinks of himself as the guardian of rationality, the ascriber of rationality to others, and the prescriber of rationality to the social world.”

Spearman speaks the language of economics: “That doesn’t seem to fit any rational cost-benefit analysis” and “… everybody’s better off, no one’s worse off. Sounds Pareto-optimal to me.” He explains to his dismissive neighbor: “… the term ‘dismal science’ was coined by Carlyle, and he didn’t mean that the subject was dismal to learn. Carlyle disliked economics because he saw free markets as a threat to the social structure in England that kept blacks and others in their place. He was a bigot who worried that a market economy would reduce the authority of the English ruling class.” And he thinks such unromantic thoughts as “In his case, marriage was a husband and wife having interdependent utility functions: one spouse deriving more utility by increasing the utility of the other.”

Economics is central to solving The Mystery of the Invisible Hand, but inevitably it also gets in the way of free-flowing prose. I suppose that’s just the nature of the hybrid beast. Still and all, for anyone wanting to nail down some basic principles of economics, and have fun doing it, it’s a “rational solution.” It would make superb supplementary reading for an introductory econ course.

Thursday, July 17, 2014

Brooks, Business Adventures

Resurrecting a 45-year-old book, Bill Gates included Business Adventures: Twelve Classic Tales from the World of Wall Street on his 2014 summer reading list. His enthusiasm (“Warren Buffett recommended this book to me back in 1991, and it’s still the best business book I’ve ever read”—and claims it’s Warren Buffett’s favorite business book, too) was contagious. With prodding by Gates’s team, the out-of-print book was reissued as an e-book by Open Road, and as I write this post it’s Amazon’s #1 best seller in commerce and #2 in books.

John Brooks originally published these business stories in The New Yorker, so it goes without saying that they are well written. Describing the stock market as “the daytime adventure serial of the well-to-do,” Brooks devotes the first chapter to a blow-by-blow account of the “little crash” and rapid recovery that occurred in the last week of May 1962. On Monday the Dow dropped more than it had on any day except October 28, 1929. By Thursday, after the Wednesday Memorial Day holiday, it closed “slightly above the level where it had been before all the excitement began.”

The infrastructure in place at the time could not cope with the overwhelming trading volume. On Tuesday, May 29, “there was something very close to a complete breakdown of the reticulated, automated, mind-boggling complex of technical facilities that made nationwide stocktrading possible in a huge country where nearly one out of six adults was a stockholder. Many orders were executed at prices far different from the ones agreed to by the customers placing the orders; many others were lost in transmission, or in the snow of scrap paper that covered the Exchange floor, and were never executed at all. … By a heaven-sent stroke of prescience, Merrill Lynch, which handled over thirteen per cent of all public trading on the Exchange, had just installed a new 7074 computer—the device that can copy the Telephone Directory in three minutes—and, with its help, managed to keep its accounts fairly straight. Another new Merrill Lynch installation—an automatic teletype switching system that occupied almost half a city block and was intended to expedite communication between the firm’s various offices—also rose to the occasion, though it got so hot that it could not be touched. Other firms were less fortunate, and in a number of them confusion gained the upper hand so thoroughly that some brokers, tired of trying in vain to get the latest quotations on stocks or to reach their partners on the Exchange floor, are said to have simply thrown up their hands and gone out for a drink. Such unprofessional behavior may have saved their customers a great deal of money.” (p. 17)

The first chapter alone is worth the price of the e-book, but Brooks has eleven more. He writes about the fate of the Edsel, the federal income tax, insiders at Texas Gulf Sulphur, Xerox, the Haupt crisis, non-communication at GE, a company called Piggly Wiggly, David E. Lilienthal, annual meetings and corporate power, the trial of Goodrich v. Wohlgemuth, and the pound sterling.

I admit that I haven’t quite finished reading the book, but since any review I could write would pale in comparison to Gates’s and Buffett’s endorsement, I considered it sufficient to add my voice to those calling attention to these essays.

Wednesday, July 16, 2014

Carey, How We Learn

Benedict Carey, a science reporter for The New York Times, has written a fast-paced, well-structured book that should have broad appeal. How We Learn: The Surprising Truth About When, Where, and Why It Happens (Random House, forthcoming September 9) not only summarizes a wide range of research findings that challenge traditional views but offers useful tips for both teachers and students.

For instance, most people do better if they break out of routines—if, for example, they vary their study or practice locations. Distributed study time is more effective than concentrated study time. Mixing multiple skills in a practice session sharpens our grasp of all of them. Forgetting is critical to learning. And sleep—well, we all know the value of sleep to learning and creating.

Of particularly interest to traders may be the chapter entitled “Learning Without Thinking: Harnessing Perceptual Discrimination.”

Baseball stars (hitters) and chess masters both have what Carey calls a good eye, and none of them is able to describe exactly what that is. “Their eyes, and the visual systems in their brains, are extracting the most meaningful set of clues from a vast visual tapestry, and doing so instantaneously.” (p. 152)

Carey takes the reader back to the doodle experiment of Eleanor Gibson and her (unnamed) husband. Gibson showed that the brain perceives to learn; “it takes the differences it has detected between similar-looking notes or letters or figures, and uses those to help decipher new, previously unseen material.”

As Carey clarifies a key passage from Gibson’s 1969 book Principles of Perceptual Learning and Development, perceptual learning “is active. Our eyes (or ears, or other senses) are searching for the right clues. Automatically, no external reinforcement or help required. We have to pay attention, of course, but we don’t need to turn it on or tune it in. It’s self-correcting—it tunes itself. The system works to find the most critical perceptual signatures and filter out the rest. Baseball players see only the flares of motion that are relevant to judging a pitch’s trajectory—nothing else. The masters in Chase and Simon’s chess study considered fewer moves than the novices, because they’d developed such a good eye that it instantly pared down their choices, making it easier to find the most effective parry.” (pp. 156-57)

And good traders? They presumably have developed a similarly good eye. For those who want to train future traders Carey describes how to construct a basic perceptual learning module to build perceptual intuition. Success not guaranteed; by definition, in every field there are only a handful of people at the top of their game.

Monday, July 14, 2014

Lombardo, Better Than Perfect

Perfectionism as it is usually understood can be a terrible curse, especially for a trader. It leads a person to act out of fear rather than passion—and sometimes not to act at all (why bother? I’ll botch it anyway). The perfectionist has both an “incessant drive to control the future” and “the unsatisfying feeling that, no matter how hard [he tries, he] will always come up short.” (p. 7)

In Better Than Perfect: 7 Strategies to Crush Your Inner Critic and Create a Life You Love (Seal Press, forthcoming September 23) Elizabeth Lombardo, a clinical psychologist and author of the national bestseller A Happy You, tackles the problems perfectionists create for themselves and suggests ways to overcome them.

For the most part Lombardo’s solutions involve reframing attitudes and motivations. Take the fear/passion dichotomy. “When you are fueled by fear, you focus on what you don’t want. Your goal is to do everything in your power to reduce the possibility of an undesired outcome. … Just by switching your perspective from one of fear to one of passion—working toward a desired outcome instead of avoiding an unwanted result—you can begin to feel more motivated, engaged, positive, and hopeful.” (p. 50)

Perfectionists are inclined to compare themselves to others and to judge themselves negatively. Of course, it’s not only perfectionists who do this; they are simply more intensely competitive. As Lombardo says, “Perfectionists don’t just want to ‘keep up with the Joneses,’ they want to kick the Joneses’ butts!” (p. 185) Well, that sounds more like trader talk; maybe a dose of perfectionism is actually a good thing, at least professionally. Lombardo admits that “many champion athletes, prominent scientists, and celebrities demonstrate perfectionist traits.” (p. 6)

I have the feeling that there are in fact a lot of perfectionists in the trading world—not basket case, paralyzed perfectionists but highly driven, competitive perfectionists. Consider the following excerpt, which in its broadest strokes is a reasonable trading strategy, at least if the tradeoff is favorable. “Comparisons affect not only how we feel but also what we do to try to feel better. People will actually give up something positive in order to have someone else receive less. In one experiment, for example, participants were given the opportunity to get rid of other participants’ money—though if they did they had to give up some of their own money, too. The result? More people chose to have others lose money, resulting in the depletion of their own funds.” (p. 187)

Lombardo’s world has limitless possibilities—limitless potential for money, health, prosperity, and abundance. By contrast, “perfectionists have a scarcity perspective: me vs. them.” (p. 186) In some markets perfectionists have it right; they’re playing a zero sum game.

I started Lombardo’s book believing that perfectionism (and, I admit, I have it in spades) is on balance a negative that should somehow be transcended. But by the end I was feeling pretty good about myself (although Lombardo might conclude that I’m in denial). Some perfectionist traits may get in the way of optimal performance, but others propel people to extraordinary heights.

Wednesday, July 9, 2014

Ugeux, International Finance Regulation

Georges Ugeux, founder of Galileo Global Advisors and adjunct professor at the Columbia Law School where he teaches a course on European banking and finance, has had a long career in international financial markets. He has worked at Soc Gen, Morgan Stanley, Kidder Peabody, the European Investment Fund, and the NYSE. He draws on that experience as well as his training as an economist and lawyer to tackle a daunting topic: International Finance Regulation: The Quest for Financial Stability (Wiley, 2014).

Ugeux challenges the model that views “the history of finance as a stable one agitated by external periodic disruptions.” Instead, he suggests, “financial markets are never in a stable situation because the environment in which they operate is not stable.” (p. xiv) Financial regulators would do well to learn from volcanologists who “monitor the forces that could provoke eruptions and take preventive actions to limit the consequences of this eruption” since “the world is similar to a volcano. It is a huge magma of tectonic forces that constantly collide more or less strongly. The energy spent in focusing on new rules that aim at avoiding a repetition of the previous crisis would be better applied at monitoring and understanding the global forces that can affect the financial system today.” (p. xviii)

Backward-looking rules are only one problem with current financial regulation. Another is its fragmentation, especially across national borders. As a senior bank executive in charge of regulation said, “It’s a bloody nightmare. The regulators have no respect for one another at all. Each country is looking after itself.” Ugeux finds everyone guilty. “Germany implemented its hedge fund regulation the day after a European framework had been discussed, ignoring the discussions. France implemented a banking regulation while the European banking union was being launched. The United States implemented a derivative system that contradicted the agreement it had with Europe four months before.” (p. 185)

Despite the “tens of thousands of regulatory texts that have been written by lawmakers and regulators over the past five years,” many issues remain unresolved. Ugeux highlights fourteen, among them: “Financial institutions do not genuinely embrace global financial regulation.” That is, “despite statements to the contrary, their mind-set has not changed.” It remains “a cat-and-mouse fight.” (p. 189)

Moreover, as yet “no effort has been made to disconnect risks and remunerations. While Europe has put together a limit to the bonus system, it has only led to an increase of base salaries and, rather than reducing the risks associated with some high-powered activities, is effectively making financial institutions more vulnerable to market fluctuations as a result of the increase in fixed costs.” (p. 191)

And, as critics of the Federal Reserve argue, “central banks have lost independence by becoming lenders. … By losing their independence to become supports of their overindebted governments and banks, they are changing the game, as well as capital markets, in a way that is financially unsound and creates exit problems.” (p. 192)

Ugeux is not especially hopeful that we can resolve the problems that stand in the way of global financial stability. In fact, if the volcano model is apt, stability itself is a chimera. Undeterred, however, Ugeux soldiers on, claiming that “it will require a combination of courage and competence that has, so far, not been displayed by a nationally obsessed political class.” He concludes with a stolid quotation from William I, Prince of Orange. (Known as William the Silent, he seems to have been more taciturn than silent.) “It is not necessary to hope in order to undertake, Nor to succeed in order to persevere.” (p. 193)

Monday, July 7, 2014

Edwards, Risk Management in Trading

It is a commonplace that risk management is critical to trading success. What constitutes good risk management, however, is anything but commonplace knowledge. Was VaR the number that killed us, as Pablo Triana claimed, or is it a useful, perhaps even indispensable, tool? Should risk management teams have their separate turf or should they be integrated with the trading desks? And what do you have to know to be a risk manager?

Davis W. Edwards addresses all of these questions, with particular emphasis on the third, in Risk Management in Trading: Techniques to Drive Profitability of Hedge Funds and Trading Desks (Wiley, 2014). The book is a useful self-study guide for those who aspire to become risk managers; each chapter ends with a set of questions to test the reader’s knowledge, and there is an answer key at the back of the book. It also goes a long way toward satisfying the curiosity of those who want to know just what it is that risk managers really do. It does not, however, directly address the concerns of the individual trader who wants to incorporate sound risk management principles into his business model.

After three preliminary chapters (on trading and hedge funds, financial markets, and financial mathematics) Edwards gets to the heart of the matter. He discusses backtesting and trade forensics; mark-to-market accounting; value-at-risk; hedging; options, Greeks, and non-linear risks; and credit value adjustments (CVA).

To give you a better sense of the level of the book—and so you can test your own skills—here are a few questions from the quizzes.

“Chang, a trader at a hedge fund, is examining two trading strategies. Strategy A has a 2.0 Sharpe ratio, Strategy B has a -0.1 Sharpe ratio, and the strategies have a -1.0 correlation. What is the best combination of strategies?” (p. 119)

“Angela, a risk manager at a mining company, wants to hedge the output of copper ore using exchange traded copper futures. What is the minimum variance hedge ratio if both copper and copper ore have 17 percent volatility and are 85 percent correlated?” (p. 195)

“Richard, a risk manager at a bank, wants to estimate the loss caused by owning a long put option given a $2 per unit rise in price of the underlying. The option is for 100,000 units, the delta is -0.6, gamma is 0.1, and interest rates are zero. Using a second-order approximation (a delta/gamma approximation) what is the expected profit or loss?” (p. 235)

“Benjamin, a credit analyst at a hedge fund, is trying to calculate the default probability of a company that doesn’t have traded CDS spreads. The company issued bonds at 6 percent. At the time of issuance, risk-free rates were 3.5 percent and the spread for liquidity risk was 50 basis points. The estimated recovery rate in event of a default is 40 percent.” (p. 264)

I’m not providing the answers. If you’re either supremely confident in your responses or you haven’t a clue, this book probably isn’t for you. If, however, you’re somewhere in between, Edwards’ book may help you gain some skills.

Tuesday, July 1, 2014

Kelly, The Secret Club That Runs the World

I don’t understand why so many CNBC reporters feel compelled to write books, but they do. The Secret Club That Runs the World: Inside the Fraternity of Commodities Traders (Portfolio/Penguin) is actually Kate Kelly’s second book. Her first, Street Fighters: The Last 72 Hours of Bear Stearns, written when she was a reporter for the Wall Street Journal, was a New York Times bestseller (which probably explains why she decided to keep the franchise going). I doubt The Secret Club will enjoy such success.

I’m not saying that the book is terrible; it’s just not a page turner. There are no major revelations about the alleged secret club that runs the world, in part because commodity traders neither belong to a secret club nor run the world. And the book is disjointed; some characters disappear only to reappear many pages later as Kelly returns to their story, others are unceremoniously discarded.

Kelly’s cast of characters includes executives, traders, and regulators from BlueGold Capital Management, Glencore, Morgan Stanley, the CFTC, Delta Air Lines, Goldman Sachs, Xstrata, and the Qatar Investment Authority—an unwieldy bunch to manage in under 200 pages. They do deals, make trades, and cross paths with regulators, Senate investigators, and sometimes clients. They even have private lives, often gratuitously described for the 99+% of us who didn’t hire Elton John to give a live concert at our (collective) wedding.

There are a few tabloid-like tidbits that add to the otherwise forced secrecy theme. For instance, in Goldman’s tenth-floor conference center “china and sea-kelp-scented soap created an elegant atmosphere. Meeting rooms were so private that their doors were fitted with covered peepholes.” (p. 141)

Even though I was not taken with this book, it still makes decent summer reading. If you’re stuck at a boring Fourth of July picnic, you can always settle down in a far-off corner and whip out your Kindle.