Wednesday, September 21, 2016

Keohane, Capital and the Common Good

Sometimes, even when there is agreement that a project is pressing and that money should be allocated to it, traditional public and philanthropic funding is insufficient. In addressing major challenges, “our aspirations” may be “deeper than our pockets.”

We have witnessed a horrendous example of how financial engineering, by creating deceptive financial products, can encourage people to let their aspirations outstrip their means. But if financial innovation can get the world into serious trouble, innovative finance can help solve its problems. With “a kind of creative and ‘visible hand’ … that corrects for market failure and provides for the public good,” innovative finance can be a powerful social force. What is new here is “not the engineering, but the application.”

In Capital and the Common Good: How Innovative Finance Is Tackling the World’s Most Urgent Problems (Columbia University Press, 2016) Georgia Levenson Keohane looks at climate change, healthcare, financial inclusion and access to capital, disaster finance, and U.S. community and economic development.

Innovative finance is definitely not charity. Firms that engage in innovative finance expect a return on their investment. For instance, LeapFrog, a private equity firm, has invested in “companies providing insurance, savings, pensions, and payment services to customers earning less than $10 a day. According to the company, the current portfolio showed a 40 percent increase in operating revenue and a 39 percent rise in profitability in 2013.” Admittedly, these figures aren’t especially meaningful in isolation, but I assume that LeapFrog is, as they say, doing well by doing good.

Keohane gives example after example of how finance can be applied creatively for the public good. For instance, “an expert in securitization who translates future development aid pledges into vaccines today; an entrepreneur who turns a mobile phone into pay-as-you-go solar electricity; the conversion of pay-for-success contracts from bridges and roads to affordable housing, early childhood education, and maternal health.”

This book may not be an antidote to the constant barrage of attacks on the financial industry, but it shows that finance can be, and often is, allied with the interests of the public good.

Sunday, September 18, 2016

Derman & Miller, The Volatility Smile

Options traders know about, but often don’t know what to do about, the volatility skew/smirk/smile. In The Volatility Smile (the word “practitioners have persisted in using … to describe the relationship between implied volatilities and strikes, irrespective of the actual shape”) Emanuel Derman and Michael B. Miller take us into the weeds, but by their own accounting not too deep into the weeds. The book, over 500 pages long, with the expected math, offers “an accessible, not-too-sophisticated introduction to models of the volatility smile.”

The Black-Scholes-Merton options pricing model “assumes that a stock’s future return volatility is constant, independent of the strike and time to expiration of any option on that stock. Were the model correct, a plot of the implied BSM volatilities for options with the same expiration over a range of strikes would be a flat line.” This is in fact what implied volatilities, at least in equity index option markets, looked like before the stock market crash of 1987. After that fateful day traders realized that they should pay more for low-strike puts than for high-strike calls. The flat line began to slope and curve. And the Black-Scholes model, never in perfect accord with reality, was now seen to be decidedly imperfect.

Researchers thus set out to create a options pricing model that could explain the volatility smile. As might have been expected, they came up with not one but many models, each of which explains some aspects of the volatility smile, but none of which is “perfect” enough to replace BSM as the dominant pricing model. Don’t despair, the authors advise: “Models not only change the pattern of trading in existing markets, but make possible trading in new, previously unimagined markets. Thus, new and improved models lead to new markets which lead to newer models, ad infinitum.” Financial engineers won’t be joining a bread line any time soon.

If you’re a trader, do you care that the BSM model is wrong? In most cases, if you’re trading very liquid options, the answer is no. “The model is merely a quoting convention.” However, “the model becomes critical for vanilla options, even liquid ones, when you want to hedge them, because even if the option price is known, the option’s hedge ratio is model-dependent. … The model is also critical if you want to trade illiquid exotic options, whose prices are not obtainable from a listed market. In that case, you have no choice but to use a model to estimate both the price and a hedge ratio.”

And so the authors delve into models that are consistent with the smile: local volatility models, stochastic volatility models, and jump-diffusion models.

Although there are nuggets in this book that the retail options trader might find useful, the book is really written for professional traders and budding financial engineers. For those using the book as a self-study guide, there are end-of chapter problems with answers.

Thursday, September 15, 2016

Walker, Matter Over Mind

Elaine Walker has written a book that most people will both learn from and argue with. Which makes it a worthwhile read. Matter Over Mind: Cosmos, Chaos, and Curiosity (Dog Ear Publishing, 2016) is a grand tour, guided primarily by chaos theory, through the cosmos, consciousness, society, morality, longevity, and curiosity.

She contrasts two paradigms, abstract thought and nature, which she sometimes describes mathematically as Euclidean geometry and chaos theory. Although she recognizes the necessity of abstract thought, she wants to restrain it. You can see where she is going with these pairings: “chaos theory and Euclidean geometry, truth and superstition, evolution and creationism, freedom and bureaucracy, a libertarian society and a totalitarian regime, equal opportunity and forced equality, individuality and mandated behavior.” You may not opt for the first alternative in every case even though you probably would not embrace the second. You may want an alternative that lies somewhere in between. But Walker doesn’t deal in nuance or compromise. She extends her model as far as she can. And sometimes it sheds light on old problems.

Wednesday, September 14, 2016

Poundstone, Head in the Cloud

Ever since I read Fortune’s Formula I have been a fan of William Poundstone’s work. He has the ability to take topics I would dismiss in a couple of paragraphs and create page-turning books out of them. Head in the Cloud: Why Knowing Things Still Matters When Facts Are So Easy to Look Up (Little, Brown), his latest effort, deals with a subject I touched on in my review of A Field Guide to Lies. It’s a tricky subject, one that inevitably leads to charges of elitism. But these charges are misplaced. Knowing stuff really does matter.

Public ignorance is so well documented that it has become a staple of late-night comedy. Who’s the vice president of the United States? In 2010 41% of adult Americans didn’t know (and this finding came from a poll by the Pew Research Center, not a test for dementia).

Poundstone undertook his own research into what the typical American (at least one with an Internet connection) does and does not know. He used Internet panel surveys, which means that theoretically participants could cheat, although he requested that they not look up answers. “But,” he writes, “most of the surveys were filled out quickly, scarcely allowing time to research answers. The overall results—which often show a shockingly low state of public knowledge—argue against cheating being much of a factor.” (For readers who want to know if they’re “smarter than …,” most of the book’s chapters include sample questions.)

The book is divided into three parts: the Dunning-Kruger effect, the knowledge premium, and strategies for a culturally illiterate world.

From the section on the Dunning-Kruger effect (which, if you don’t know, says that “those most lacking in knowledge and skills are least able to appreciate that lack”) I’ve selected one example of the consequences of ignorance, which also showcases Poundstone’s style. In 2014, as Russians were entering Crimea, three political scientists ran a survey asking Americans to locate Ukraine on a world map. Only one in six clicked within Ukraine’s borders.

Other guesses were, literally, all over the map. There were clicks in every populated continent, with a cluster in Greenland and a few within the continental United States. There were a few clicks in the world’s oceans. They weren’t on an island. Either the clickers imagined Ukraine to be some lost Atlantis or they couldn’t tell which part of a world map was water and which was land.

Here’s the upshot. The researchers found that, the farther a person’s guess was from the actual location of Ukraine, the more likely it was that that person supported a US military intervention in Ukraine.

There’s a reason why war rooms have maps. Geography helps determine whether a military occupation is essential to national security or immaterial to it; feasible or ruinously costly. A decision about sending troops to war in Ukraine ought to be informed by wonkish details such as whether Ukraine is in the United States or is a foreign country and whether Ukraine is on land or under water.

Okay, people are often frightfully ignorant, but, one might ask, so what? We’re not going to name someone who doesn’t know where Ukraine is secretary of defense. (Although we’ve had and continue to have our fair share of political candidates whose knowledge of the world is, shall we say, somewhat deficient.)

Poundstone found that there is a strong correlation between income and performance on quizzes of general knowledge and some correlations between income and specialized areas of knowledge. (If you want to know what you can skip learning about and not have your income suffer, try grammar, slang, sex, and religion.) And “general factual knowledge has an effect above and beyond educational level in predicting income.”

As is usually the case, the section of the book on strategies for dealing with ignorance is the weakest. But it’s a critically important issue to confront. In one of the starkest examples, Poundstone asked his panelists whether they would push a button that made them a billionaire but killed a random stranger, assuming no one knew they were responsible for the death. “Nearly one in five Americans said they’d push that button. Those who scored low on a general-knowledge quiz were more likely to push the button, and yes answers were almost twice as common (36 percent) among those who couldn’t name the year of the 9/11 World Trade Center attacks.” If you were that random stranger, wouldn’t you want the person with the button to have broad general knowledge? Think about it the next time you say, “I don’t have to know x or y, I can just look it up.”

Sunday, September 11, 2016

Harrington, Capital without Borders

I first encountered Brooke Harrington’s work in an article she wrote for the Atlantic and was sufficiently intrigued that I resolved to read her book when it was published.

Capital without Borders: Wealth Managers and the One Percent (Harvard University Press, 2016) is an innovative approach to addressing a problem that is even more pressing than income inequality—wealth inequality. Recognizing that the wealthy are “notoriously difficult to study,” Harrington, a sociologist, decided to focus instead on wealth managers. In some ways, however, they are even less accessible. As professionals, they are constrained by privacy considerations. Moreover, as a group they have come under attack for being “agents of money laundering and tax evasion” and are thus suspicious of outsiders. To overcome this barrier to access, Harrington trained for two years to gain certification by STEP (Society of Trust and Estate Practitioners) as a wealth manager herself. Between 2008 and 2015 she conducted 65 interviews with wealth managers in 18 countries.

Fortunately, Capital without Borders is not simply a collection of interviews. It is a well-designed study that proceeds along two lines: (1) Who are wealth managers and what do they do? (2) What are the social and economic ramifications of wealth management as it is currently practiced?

The distinction between income and wealth is central to Harrington’s analysis. As opposed to income, which is measured in the short term and can fluctuate significantly, wealth “confers privilege along multiple, mutually reinforcing dimensions. … While there is some intergenerational continuity of income, the stability of wealth levels across generations is far higher. This is because wealth comes with special economic and political privileges that enable the wealthy to protect and increase their assets better than others.” The top one percent in the U.S. “have captured 17 percent of the nation’s income but 35 percent of its wealth.” And this wealth gap is growing. According to one recent estimate, it doubled between 2003 and 2013.

The primary objective of most wealth managers is to protect and conserve the wealth of their clients. Protecting and conserving wealth entails, among other things, that clients pay as little tax as possible, escape the reach of creditors, and navigate the shoals of divorce and spendthrift heirs. Wealth managers use trusts, corporations, and foundations to “liberate clients from the rule of law.” When legislative action onshore is detrimental to their clients, they take advantage of offshore opportunities.

By protecting clients’ income, steering surplus income toward investment opportunities, and ensuring that their wealth passes as smoothly as possible to subsequent generations, wealth managers “set in motion a kind of perpetual moneymaking machine. Wealth grows, protected by trusts and offshore vehicles, generating more income, feeding more economic resources into the system.” And wealth inequality grows as well.

I have summarized only the main thrust of Harrington’s book here. But the book is rich in fascinating detail, from the historical roots of wealth management to a description of a state system that might be called the “parasitic twin” of the Westphalian model.

Capital without Borders is a book that everyone who cares about fairness, the rule of law, and equal opportunity should read. Even if, or perhaps especially if, you’re in the “one percent.”

Thursday, September 8, 2016

Bandy, Foundations of Trading

Howard B. Bandy is best known as the AmiBroker guru. As a result, traders who used other platforms sometimes ignored his earlier work. But as Foundations of Trading: Developing Profitable Trading Systems Using Scientific Techniques makes clear, they do that at their peril. There’s so much twaddle passing for proven fact in the trading community that it’s refreshing to read a sober discussion of just how hard it is to become a profitable systematic trader. And to get a detailed account of the elements that must be integral to any successful trading system.

The text of Foundations of Trading is only 160 pages long, but it is packed with insights. Bandy, a former professor of mathematics and computer science, seems to approach writing as he would a computer program—his prose is precise, succinct, efficient.

Two seemingly intractable problems confront any trading system developer. First, he must find a weak signal amidst all the noise. Second, he is subject to the constraints of stationarity. For a trading system to be profitable, “the distribution of signals must be stationary over the combined length of the in-sample and out-of-sample period.” The problem is that financial time series data are notoriously non-stationary. So the longer the holding period, the more likely it is that “conditions change, stationarity is lost, and profitability drops.”

Trading system development is a straightforward, if demanding, process. It involves “an extensive in-sample data mining and (hopefully) learning process” in which the developer “generates many alternative trading systems (ATS), each based on a specific model-data combination; evaluates each ATS, giving each a score computed by the objective function; and ranks the ATSs, preferring those with high scores, selecting one.” This is followed by “limited (ideally one time only) testing of the selected system using out-of-sample data to validate that the system has learned.” The objective function that Bandy uses is CAR25 (a lower limit for 75% of the distribution), "the credible value of expected equity growth associated with the risk-normalized forecast of a trading system.”

Foundations of Trading includes a lengthy chapter on risk in which Bandy explains how to quantify one’s personal level of risk tolerance. That is, to define the point at which the drawdown of the system is such that, when exceeded, the trader accepts that “the system is broken and must be taken offline.” In the process he introduces the notion of safe-f, the maximum position size for the next trade.

Here I have shared only a couple of points from Bandy’s book. It contains ever so much more—the distinction between impulse and state signals, traditional system development platforms vs. machine learning, and I could go on and on. It’s a book that every trader should read and re-read. And, even then, recognize that, as Bandy concludes his chapter on trading system development, “There is always a best. It is not always tradable. Even when it is, it may not be good enough.”

Wednesday, September 7, 2016

Trevelyan, The Winchester

I am not keen on guns, but I do like a good business story. The Winchester: The Gun That Built an American Dynasty (Yale University Press, 2016) documents the rise and fall of the Winchester Repeating Arms Company of New Haven, Connecticut. The author, Laura Trevelyan, is the great-great-great-granddaughter of the company’s founder, Oliver Winchester.

Winchester, who remembered being “always hungry and always cold” as a child, was apprenticed to a carpenter at the age of 14 and soon excelled at church building. But, after only a few years, he abandoned carpentry and opened a men’s clothing store in Baltimore. Ten years later he sold his business and turned his attention to the design and manufacture of men’s dress shirts. He was granted a patent for a shirt with a curved seam to “avoid a pull on the neckband.” He left Baltimore for New Haven and, with a partner from New York, formed a company to make men’s shirts. Initially, seamstresses did piece work by hand at home. With the invention of the sewing machine in 1852, however, the manufacture of shirts moved to the company factory, which produced 40,000 dozen shirts a year.

By the time Oliver Winchester was 45, he was looking for investment opportunities. He bought shares of New Haven’s Volcanic Arms Company, formed by Horace Smith and Daniel B. Wesson, later known for the Smith & Wesson revolver, and became the company’s first president. Unfortunately, the company, which made inferior firearms that used the repeating action, soon became insolvent. Undaunted, Oliver bought up the company’s inventory and persuaded its shareholders to join him in a new venture, the New Haven Arms Company. The company tried to sell its 16-shot Henry repeating rifle to the Union army, to no avail. The company was also plagued with production problems and quality control. Still, between 1862 and 1865 the company sold more than 10,000 rifles.

When Oliver was in Europe drumming up business, the disgruntled inventor of the rifle the New Haven Arms Company was selling, Benjamin Tyler Henry, tried to change the name of the company to the Henry Repeating Rifle Company. In response, Oliver cabled his bankers to call in all the mortgages and liens he and his son held against the New Haven Arms Company, thereby threatening it with bankruptcy. And on July 1, 1865 he signed the articles of association to establish the Winchester Arms Company, with a view to developing an improved version of the rifle he had been selling. And thus was born the Winchester rifle, “the gun that won the West.” (It was also the gun used to massacre the U.S. Army at Little Bighorn and a gun that foreign armies used with devastating effect.)

Oliver Winchester died at the age of 70, in 1880. Although he had envisaged his son Wirt succeeding him, Wirt died of tuberculosis the following year. The job therefore fell to Tom Bennett, husband of Oliver Winchester’s daughter. Bennett was a shrewd businessman, “either outsmarting or vacuuming up his opponents.” He continued to pursue international markets, selling to the Ottoman Empire, China, Haiti, and Morocco. And the Winchester gained even more fame in the United States when Buffalo Bill pronounced “your improved Winchester the boss” and when Annie Oakley used a Winchester in her sharp shooting act. More than a million of the Model 1892 repeater rifles were sold, and over seven million of the Model 1894.

By the start of 1913, however, as a prewar recession was taking hold in the U.S., Winchester’s gun business was slowing down. It took some huge orders from the British military to buoy the fortunes of the company. But these orders, as well as eventual orders from other countries, also took their toll. The company needed to expand, and management, under the short-lived leadership of Tom Bennett’s frail son Win, had to turn to New York banks for financing. The war contracts with the Allies were supposed to be quite profitable, but with “the extraordinary rise in costs resulting from the increase in labor rates and the rising price of raw materials, coupled with the fixed price contracts negotiated with the Allies” the company made practically nothing.

Once the United States entered the war, the future of the company looked brighter. But a profiteering tax, which took 80% of the company’s profits over 8%, left the company still in debt and “quite poor.” It had more production capacity than it could use and more debts than it could pay.

Enter Louis K. Liggett, who persuaded management that Winchester should manufacture hardware and sporting goods and sell them through dealerships. The company would use the Winchester brand to sell razors, ice skates, washing machines, and metal household goods, as well as guns—an idea that was a total disaster.

By 1931, “the famous name of Winchester, which had ‘meant defense to those in peril, succor to those in need, vengeance to the wronged, health and sustenance to those far from civilization, pleasure and happiness to the sportsman, creative joy to those who, generation after generation, have devoted themselves to designing and making epoch-making firearms’ went quietly and humiliatingly into receivership.” Its “tattered remnants” were purchased for $8.1 million.