Wednesday, July 25, 2012

Hull, Risk Management and Financial Institutions, 3d ed.

Most people in the world of finance know John C. Hull of the Joseph L. Rotman School of Management, University of Toronto from his classic Options, Futures, and Other Derivatives, now in its eighth edition. Risk Management and Financial Institutions, 3d ed. (Wiley, 2012) overlaps the material covered in the book on derivatives but includes much that is new. It is a paperback of over 650 pages intended to be used as a textbook—I trust by very gentle page turners. It has practice questions and problems, with answers at the end of the book, and further questions, where the reader is on his own.

Although Hull’s book has its fair share of math, much of it surprisingly elementary, the focus of the book is not on the math but on the context in which it is used. Readers seeking a quant-heavy book should turn elsewhere.

After some preliminary chapters that cover banks, insurance companies and pension plans, mutual funds and hedge funds, trading (primarily derivatives), the credit crisis of 2007, how traders manage their risks using the Greeks, and interest rate risk, Hull moves on to key concepts in risk management: VaR, volatility, and correlations and copulas. He then deals with bank regulation (Basel in its several iterations and Dodd-Frank). The following nine chapters are devoted to various kinds of risk and risk measurement: market risk VaR (historical simulation approach and model-building approach), credit risk, counterparty credit risk in derivatives, credit VaR, scenario analysis and stress testing, operational risk, liquidity risk, and model risk.

Hull includes business snapshots that show real-life examples of the principles he discusses—including instances in which financial institutions managed to get things very wrong. I want to share one snapshot here because, although I read about the Joseph Jett story in 1994, I had no idea exactly what went wrong. And no wonder. The New York Times reported what I remember: that “There were virtually no genuine profitable trades. Joseph Jett, Kidder, Peabody’s former bond-trading star, simply made up trades and marked them down as having made money. In the meantime, his few real trades consistently lost money.”

Hull sets the record straight. “Investment banks have developed a way of creating a zero-coupon bond, called a strip, from a coupon-bearing Treasury bond by selling each of the cash flows underlying the coupon-bearing bond as a separate security. Joseph Jett … had a relatively simple trading strategy. He would buy strips and sell them in the forward market. The forward price of the strip was always greater than the spot price, and so it appeared that he had found a money-making machine! In fact, the difference between the forward price and the spot price represents nothing more than the cost of funding the purchase of the strip. … Kidder Peabody’s computer system reported a profit on each of Jett’s trades equal to the excess of the forward price over the spot price…. By rolling his contracts forward, Jett was able to prevent the funding cost from accruing to him. The result was that the system reported a profit of $100 million on Jett’s trading (and Jett received a big bonus) when in fact there was a loss in the region of $350 million. This shows that even large financial institutions can get relatively simple things wrong!” (p. 476) Indeed!

Risk Management and Financial Institutions is a good text for those who, as Thomas S. Coleman draws the distinction, aspire to manage risk but who will most likely leave risk measurement to others. In brief, it’s a business school textbook.

Monday, July 23, 2012

Pompian, Behavioral Finance and Investor Types

We know from the extensive literature on behavioral finance that investors suffer from cognitive and emotional biases that can undermine wise decision-making. Moreover, Michael J. Pompian argues in Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions (Wiley, 2012), investors are also constrained by their personality types. Combining insights from behavioral finance and personality theory, the author offers guidelines to help self-reflective individual investors and, perhaps more aptly, to help investment advisors deal with their clients.

The author identifies four primary behavioral investor types: preserver, follower, independent, and accumulator. Let’s say you’re an independent investor, that is, you are “engaged in the investment process and opinionated on investment decisions.” You’re likely to pursue an active investing style, with an above average risk tolerance (though not as high as aggressive investors). You’re also prone to cognitive biases such as confirmation bias, availability bias, self-attribution bias, conservatism bias, and representative bias. Pompian provides diagnostic quizzes to help identify particular biases.

After ascertaining that you’re an independent investor and that you’re likely to fall victim to particular biases, what would a financial advisor do with this information? “Independents can be difficult clients to advise due to their independent mindset, but they are usually grounded enough to listen to sound advice when it is presented in a way that respects their independent views. … A good approach is to have regular educational discussions during client meetings. … Because Independent biases are mainly cognitive, education on the benefits of portfolio diversification and sticking to a long-term plan is usually the best course of action.” (p. 133)

Pompian’s book is simple in its approach but is based on solid research. As long as financial advisors have clients who are willing to fill out the appropriate questionnaires and take little quizzes (would that both the questionnaires and the quizzes were more sophisticated and less obvious), they should be able to offer tailored advice goes beyond a client’s age and financial situation.

Thursday, July 19, 2012

Peterson, Investment Theory and Risk Management

Steven P. Peterson is the director of research and senior risk officer for the Virginia Retirement System; he has also taught at Virginia Commonwealth University’s School of Business for over twenty years. His teaching experience shines through in this book. Although Peterson purports to be writing not only for graduate students but for CFAs and experienced portfolio managers as well, Investment Theory and Risk Management (Wiley, 2012) is essentially a quantitative finance textbook. A very good textbook, I might add.

The author presumes that the reader/student has a grasp of the basic mathematical and statistical tools necessary for quantitative finance. He then shows how these tools can be used to solve real problems in the real world—from retirement planning to portfolio optimization, from dealing with pricing anomalies to hedging portfolio risk.

Normally in my reviews I highlight a chapter or two to give a sense of the book. Well, I tried to do this and failed miserably. I even opted for the chapter entitled “Incorporating Subjective Views.” Without the math, the text seemed to lose its purpose, so I deleted my summary; it would have been a disservice to the author. You’ll have to take it on faith that Peterson has written a smart, engaging textbook.

The book claims to have a companion website, but its url seems to be a well-kept secret. At least I couldn’t find it in the book. The best I could do is the "downloads" link from Wiley’s book description.

Tuesday, July 17, 2012

Klein, Dalko, and Wang, Regulating Competition in Stock Markets

In recent years many individual investors have lost faith in the financial markets and their credentialed professionals. From the financial crisis to the flash crash, from Madoff to Wasendorf, and now of course the Libor scandal, there is a relentless flow of damaging headline news.

Regulating Competition in Stock Markets: Antitrust Measures to Promote Fairness and Transparency through Investor Protection and Crisis Prevention, edited by Lawrence R. Klein, Viktoria Dalko, and Michael H. Wang (Wiley, 2012) tackles one aspect of the problem, using data from both U.S. and international markets.

Before the authors propose remedies, however, they look at the human toll of the 2008 global financial crisis. They surveyed 335 young professionals who were former graduate students of the authors and found that the crisis “had a measurable and detrimental impact on health and happiness.” Their sample was far from random, and therefore it is a bit disingenuous to compare the emotional health impact of the 9/11 attack on people not living in the vicinity of the attack (within half a year) to the impact of the financial crisis on the survey participants in the fall of 2008. But about twice as many people in the second group were worried and had problems with sleeping. And 35% reported worse physical health in the spring of 2009 than in the previous fall.

Since stock market crises are so devastating, it is critical to understand how they can be prevented. The authors find an answer in regulation: regulating shareholding concentration, trade-based price-lifting, earnings manipulation, trading by corporate insiders, information manipulation by sell-side analysts, information-based manipulation, and news reporting that cultivates long-run manias and triggers short-run panics.

Let’s look very briefly at one of the areas that need regulation: trade-based price lifting. It includes, but is not limited to, pump and dump schemes. Trade-based manipulation tactics include self-dealing (wash sale) and cross-dealing (matched orders), advancing the bid, marking the close, and fake trading (a characteristic of much high-frequency trading). The first pair of tactics, which the authors dub fictitious trading, is frequently seen in China, Hong Kong, India, and Japan, rarely in the U.S. (or at least rarely investigated by the SEC). The U.S. markets, on the other hand, specialize in fake trading.

Few of the authors’ proposals for dealing with trade-based price lifting are likely to be incorporated into U.S. financial regulations any time soon. For instance, they propose a daily volume limit and time constraints—that “the time interval between two consecutive orders by any investor cannot be less than 10 minutes at any given time during a trading day” or that the minimum interval between any two consecutive voluntarily canceled orders be set at one hour. (pp. 106-107) Yes, minutes and hours, not nanoseconds. Of course, the authors leave it up to the discretion of the regulators of individual markets to adjust and implement their suggestions.

Each of the seven chapters dealing with financial regulation was presented as a paper at a 2011 conference. Two of the conferences were held in China, two in Taiwan, one in Brazil, one in Greece, and one in the U.S. International venues, with recommendations for stock markets worldwide. Even though the financial crisis was largely made in the U.S.A., I suspect that the authors’ recommendations will resonate more with regulators of markets who don’t have such a long history of price manipulation, and regulatory response, as do the U.S. markets.

Wednesday, July 11, 2012

Book sale

As I wrote yesterday, I'm desperately short on bookshelf space. It's time for some serious culling.

Here’s the deal. I will sell the books on the first list for half the current official Amazon U.S. price plus the cost of domestic media mail—figure between $3 and $3.50 for a single title, less per book for multiple titles. (I’m willing to ship outside the U.S., but shipping charges can be prohibitive.) Books on the second list I’ll part with for a third of the Amazon price. Orders that total over $100, excluding shipping, will be eligible for an additional 10% discount.

The books are officially used because, yes, I read them. But I have one of the tiniest “book footprints” on the planet; my used books look better than most new books at the local bookstore. No dog ears, no coffee—or, in my case, tea—spills, no visible fingerprints.

In deference to the publishers who so kindly supply me with review copies, I am not offering anything I have reviewed in the last three months. If, however, you’re interested in a more recent title, I’ll be happy to put it aside for you. Just ask.

If you would like to buy any of these books, please email me at My preferred method of payment is PayPal. I’ll fill “orders” on a first come, first served basis.

So, here goes with


Anson et al., The Handbook of Traditional and Alternative Investment  Vehicles
Beder & Marshall, Financial Engineering
Byers, Blind Spot (stamped “review copy not for resale” on bottom    edge)
Caliskan, Market Threads (stamped “review copy not for resale” on  bottom edge)
Connors, How Markets Really Work
Deemer, Deemer on Technical Analysis
Derman, Models.Behaving.Badly
Esperti et al., Protect and Enhance Your Estate, 3rd ed. (paper)
Fogarty & Lamb, Investing in the Renewable Power Market
Frush, All About Exchange-Traded Funds (paper)
Hassett, The Risk Premium Factor
Katsenelson, The Little Book of Sideways Markets
Koesterich, The Ten Trillion Dollar Gamble
Kolb, Financial Contagion
Kroll, The Professional Commodity Trader
Kroszner & Shiller, Reforming U.S. Financial Markets
Lack, The Hedge Fund Mirage
Light, Taming the Beast
Lindzon et al., The StockTwits Edge
Malz, Financial Risk Management
Marston, Portfolio Design
Martin, A Decade of Delusions
Osband, Pandora’s Risk
Oxley, Extreme Weather and Financial Markets
Page, Diversity and Complexity (paper)
Palicka, Fusion Analysis
Phillipson, Adam Smith
Ponzi, The Rise of Mr. Ponzi (paper)
Rahemtulla, Where in the World Should I Invest?
Redleaf & Vigilante, Panic
Scharfman, Private Equity Operational Due Diligence
Schmidt, Financial Markets and Trading
Schneeweis et al., The New Science of Asset Allocation
Schwager, Market Wizards (paper, crease in back cover)
Sklarew, Techniques of a Professional Commodity Chart Analyst
Smith & Shawky, Institutional Money Management
Standard and Poor’s 500 Guide, 2012 ed. (paper)
Staddon, The Malign Hand of the Markets
Stoken, Survival of the Fittest for Investors
Swope & Howell, Trading by Numbers
Wagner, Trading ETFs, 2d ed.
Wyckoff, Wall Street Ventures & Adventures through Forty Years


Au, A Modern Approach to Graham & Dodd Investing
Ayache, The Blank Swan
Bern, Investing in Energy
Bhuyan, Reverse Mortgages and Linked Securities
Biggs, A Hedge Fund Tale of Reach and Grasp
Diacu, Mega Disasters (stamped “review copy not for resale” on top  edge)
Dobson & Reimer, Understanding Spreads (paper)
Fraser, Wall Street: America’s Dream Palace (paper)
Harstad, Live It Up! But Don’t Outlive Your Income (paper)
Isbitts, The Flexible Investing Playbook
Labuszewski et al., The CME Group Risk Management Handbook
Levinson & Horowitz, Guerrilla Marketing Goes Green (paper)
McGinn, Tail Risk Killers
Sorkin, Too Big to Fail
Standard & Poor’s 500 Guide, 2011 ed. (paper)
Trahan, The Era of Uncertainty
Triana, The Number That Killed Us
Wasendorf, The Secret Keys to Smart Investing (paper)

Tuesday, July 10, 2012

Upcoming half-price book sale

Once again, more books than space. Within the next day or two I’m going to offer some of the books I’ve reviewed in the past three years for half the listed Amazon price and, to prevent the walls from closing in on me, others at an even deeper discount. Stay tuned.

Monday, July 9, 2012

Brown, Mastering Elliott Wave Principle

Mastering Elliott Wave Principle: Elementary Concepts, Wave Patterns, and Practice Exercises (Bloomberg/Wiley, 2012) is the first of a two-book project designed to teach Constance Brown’s unique method of analyzing charts and projecting future price movement. Although the focus is on wave patterns, Brown also incorporates insights from Gann, Fibonacci levels, and oscillators in her work.

Despite the fact that she refers to this book as elementary, I would categorize it as an intermediate-level text, best read by those who have at least a passing acquaintance, however flawed, of Elliott waves. Or by those who have tried to use waves in their trading and have come up short. For them it’s time for some serious remedial education.

The three central chapters of Mastering Elliott Wave Principle deal with patterns that describe trending market movement, patterns that describe corrective market movement, and diagonal triangles (wedges). Bookending these chapters is one that introduces the reader to balance and proportion in market price data and a summary chapter with study flash cards for patterns, rules and guidelines, and practice and final exams.

The book is interactive in the sense that the author regularly challenges the reader to perform certain learning tasks and then points out where he might have gone astray. For instance, “Draw a box to show the complete unit we call wave (3). Are there five waves inside the box? NO? Fix it! You will have to start over.” (p. 34)

The only way to read this book is to be engaged and to take the mini-quizzes scattered throughout the central chapters. By proceeding conscientiously the reader should begin to understand both the basic concepts and some of the subtleties of the Elliott Wave Principle.

Where is the reader by the time he has successfully completed the final exam? He is not yet ready to do his own wave interpretations with any reasonable probability of success. He is a critic, not a creator: he “will have the skill to understand others’ charts and recognize when the application of another’s wave interpretation violates the basic tenets of the Wave Principle.” (p. 103) In his quest for proficiency the reader will have to wait for the companion book, Advanced Elliott Wave Analysis: Complex Patterns, Intermarket Relationships, and Global Cash Flow Analysis.

Thursday, July 5, 2012

Coleman, Quantitative Risk Management

The title of Thomas S. Coleman’s book—Quantitative Risk Management: A Practical Guide to Financial Risk (Wiley, 2012) probably conjures up an image of pages of complex formulas, a book that only a true quant would ever want to read. That image would be wrong. Although the second half of the book deals with risk measurement and has its fair share of math, Coleman is writing for both those who manage risk and those who measure risk. He wants to bring managers and quants together so that each understands in plain language what the other is doing and how they both contribute to the firm’s profit and financial stability.

He argues that “managers cannot delegate their responsibilities to manage risk, and there should no more be a separate risk management department than there should be a separate profit management department.” Risk measurement may well be the mandate of a separate department, but managing risk “must be treated as a core competence of a financial firm and of those charged with managing the firm.” (p. 5)

Since Coleman is writing for practitioners, he refuses to get tripped up over theoretical niceties. For instance, he maintains that “we can often ignore any distinction between frequency-type (objective) and belief-type (subjective) probability. … The future is uncertain, subject to randomness that is not simply replication of a repeated game. But we have to make decisions, and probability theory is such a useful set of tools that we have to use it. The utility of treating frequency-type and belief-type probabilities as often interchangeable outweighs any problems involved in doing so.” (pp. 58-59)

Probability, however, is not intuitive. “The fact is that dealing with probability and randomness is hard and sometimes just plain weird.”(p. 24) There’s the classic birthday problem: What is the probability that if you enter a room with 20 people, two of them will share the same birthday? Over 41%. “And it only takes 56 people to raise the probability to more than 99 percent.” (p. 25)

Or there’s the matter of clustering, or bunching, in a random sequence that often appears to our intuition to be nonrandom. “The random shuffle on an iPod has actually been adjusted so it appears to us as more random.” (p. 25) Similarly, Bill Miller’s run at Legg Mason could easily have happened purely as a matter of luck.

In the financial world both risk and luck play critical roles. Risk, “the interaction of the uncertainty of future outcomes with the benefits and costs of those outcomes,” can be studied and modified. Luck, “the irreducible chanciness of life,” cannot be controlled, but it can be managed. (p. 64)

Coleman devotes a chapter to the “fiendishly difficult” business of managing risk, which involves managing people, processes, and projects. And, the author adds, learning more about measuring risk.

Risk comes in many stripes. Within firms (idiosyncratic risk) managers have to defend against fraud. They must also try to prevent normal business activity from going wrong. Coleman briefly describes some of best known cases of trading losses (he, of course, finished his book before the J.P.Morgan loss) and offers suggestions for combating financial disasters.

Coleman rounds out the first part of his book with an excellent chapter on practical risk techniques and a few pages on the uses and limitations of quantitative techniques. He focuses on volatility and VaR to measure the size of risk and marginal contribution and best hedges to understand the composition of risk.

And then it’s on to part two, measuring risk, which fleshes out in over 300 pages the material introduced in his chapter on practical risk techniques as well as credit risk and liquidity and operational risk.

Quantitative Risk Management is an exceedingly well crafted book that gets “the right balance between vagueness and precision.” For, as Coleman explains, “Using and understanding quantitative tools requires a careful balance between too much vagueness (where we can’t say anything useful) and false precision (where we can be very precise about things with no connection to the real world).” (pp. 142-43) Everyone who manages risk, at whatever level, could profit from reading this book.

Monday, July 2, 2012

The CRB Commodity Yearbook 2012

The Commodity Research Bureau has been publishing its yearbook, an invaluable resource for traders and investors who appreciate historical data, for over 70 years. It is an expensive book and is sold exclusively through the CRB, so don’t expect the Amazon-style discounting that we’ve all become accustomed to. But for your money you get 384 8 ½” x 11” pages chock full of charts and tables. And there’s data on 104 commodities, interest rates, and stock index futures, from aluminum to zinc—including some commodities you may never have heard of.

This is, of course, not a book you read from cover to cover. Personally, I look at the data for commodities in which I am interested and I also scan the book for some “things you should have learned in school (had you been paying attention).” For instance, I—who often make flaxseed whole wheat bread—didn’t know that flaxseed is also called linseed, as in linseed oil, used to finish furniture. Linseed oil is, of course, subjected to chemical treatment and not safe to consume. Flaxseed bread is delicious.

Or think, preferably not too long or hard, about all the varieties of tallow and grease: edible tallow, lard, top white tallow, all beef packer tallow, extra fancy tallow, fancy tallow, bleachable fancy tallow, prime tallow, choice white grease, and yellow grease. Edible tallow products, derived from rendering the fat of cattle, include margarine and cooking oil.

Then there’s fertilizer. The three primary ingredients that fertilizers provide are nitrogen, potassium, and phosphorus. Since most farmers don’t make their own fertilizer from manure, bones, and wood ash, they rely on commercially produced ammonia (nitrogen), phosphate rock, and potash. In 2011 U.S. consumption of potash rose 20.4% yy/yr, and imports, primarily from Canada, accounted for 83% of U.S. consumption.

I suppose that since I’m on a food kick here I might as well choose a commodity, corn, that has been in the news of late to illustrate the kind of data the CRB yearbook provides. As Bloomberg reported recently, the price spread between U.S. corn futures for July and December deliveries plunged to a 20-month low as traders bet the biggest annual planting in 75 years will be crimped by drought in Iowa and Illinois.

Most of the corn figures in the CRB yearbook are from 2002 thru 2011. Where appropriate, the data are broken down by month. Tables offer information on the world production of corn or maize, world supply and demand of coarse grains, acreage and supply of corn in the U.S., production of corn (for grain) in the U.S. by state, quarterly supply and disappearance of corn in the U.S., corn production estimates and cash price in the U.S., distribution of corn in the U.S., average cash price of corn (no. 2 yellow) in central Illinois, average cash price of corn (no. 2 yellow) at gulf ports, weekly outstanding export sales and cumulative exports of U.S. corn, average price received by farmers for corn in the U.S., corn price support data in the U.S., U.S. exports of corn by country of destination, stocks of corn (shelled and ear) in the U.S., volume of trading of corn futures in Chicago, and average open interest of corn futures in Chicago. In 2011-12, by the way, the value of the U.S. corn crop was a whopping $76.464 billion.

There’s an astonishing amount of data in the 2012 CRB Commodity Yearbook, a book by the way that is of value not only for commodity traders. Those who are interested in macro trends as well as investors in search of stock ideas could also profit from the careful data collection of the CRB. There’s a lot of meat (and little fat) here.