Monday, March 26, 2007

Asset prices and the Fed

The conundrum the Fed faces with financial and real asset prices continues.  In order to effectuate the "goldilocks" economy, the Fed must manage inflation expectations whilst turning another eye to asset prices.  This behavior has some interesting side effects, the most prominent of which is what the REcapitualtor believes is an unhealthy regard for defacto central planning.

From Mishkin's latest speech, in which he all but states the management of the "correct" inflation expectations is the aim of the Fed:

"Although solidly anchored inflation expectations are indeed highly
desirable, they could pose a bit of a problem for monetary policy if
they were at a level somewhat above or below the rate preferred by
policymakers. Under such circumstances, the central bank would likely be
interested in shifting the public’s expectations in a more favorable
direction. Whether such adjustment would be easy or difficult is,
unfortunately, quite uncertain because we do not understand the
expectations-formation process very well"

Expectations are a "problem" if they are above or below the rate "preferred" by the Fed.

Mechanical inflation targeting (something that I abhor) is looking better all the time...

Tuesday, March 20, 2007


This lovely term is more affectionately known by statisticians as "fat tails", and describes probability distributions that assign more liklihood to extreme rare events.

There is a veritable ocean of literature regarding this subject, and the REcapitulator, as always, directs the diligent reader to the excellent SSRN site for further reading:

However, the REcapitulator would like to make a somewhat narrow comment. A normal distribution, or even most of the distributions that exhibit "fat tails" make the assumption that VARIANCE, the spread of possible values in relation to the expected value of a given variable, is STABLE. This is not true, as volatility in markets (as measured by the VIX) is also volatile.

If we have a normal distribution, we should also expect to see an additive generator of random variables.
But this is not what we actually see. In periods of high volatility, the generator is multiplicative.

In other words, whenever you see any statistic in markets that has a normal distribution as its intellectual lynchpin, be very skeptical of any conclusions derived therefrom.

Monday, March 19, 2007

A good example...

...of the capital markets at work, distributing risk in the appropriate manner and forcing innovation as to how risk is allocated.  As stated in the last post regarding Buffet, the risks to Hurricane-prone areas have "increased", or at least the perception of that risk has increased with Katrina.  Rating agencies who cover REinsurance companies are going to assess risk based on recent experience (the "availability" heuristic as popularized by Kahneman and Taversky's brilliant work on how humans actually make decisions).  Rates increase.

Solutions will present themself...if government will allow them to.  Finite risk, contingent capital solutions, etc.  Perhaps a private homeowners captive will sprout out of the Keys.

Of course, global warming (or the perception of same) only serves to increase the risk, something risk providers (REinsurance companies) will be happy to provide for a price.

Buffet's gambit

Berkshire profits up 56% year on year.  Impressive.

However, the REcapitulator, would like to simplify the way Mr. Buffet makes his money.

1.  Sell thousands of out of the money binary put options.  In the insurance lexicon this means sell property and hurricane exposure policies with defined policy limits.

2.  Price said options using a one-year history of data, with that year containing the worst hurricane in 100 years.  As an aside, The REcapitulator is aware of the non-gaussian and epistemological difficulties with the weather, but he is merely describing 
methodology here.  Take advantage of the historical tradition of offering exposure to ONE year of negative events.  In other words, double the price based on a rare event.

3.  Invest the premium from all those options/polices into the global financial markets.  Then hope (pray?) that another 100-year rare negative event does not occur.  

In other words, short the rare 100-year event, go long the global finance markets, which have a 70% liklihood of increasing year on year.  This is good risk taking.


Tuesday, March 13, 2007


The REcapitulator believes the S&P will "correct" (readers will note I hate that the market "incorrect" when some participants are long and some are short?) down to this level.  We should then see improvement in June/July.  If we do not, Greenspan's "33.3% probability", as if such precision was possible, of recession may turn out to be about 60 points too low.

Monday, March 12, 2007


The onerous (and some would say ruinous) and hastily passed Sarbanes-Oxley regulation that has eroded the competitive virtues of listing on the 
major American exchanges, and provided a windfall to consulting, legal, and auditing firms, organized resistance is forming.

Although it is difficult to extract exact causalities from the data regarding the propensities for
firms to list here in the U.S., the follwing paper by Luigi Zingales (of the REcapitulators alma mater, the  University of Chicago...which everyone knows is the greatest institution for higher
learning this side of Proxima Centauri) does support the simple logic of another one of my professors, the great Robert Aliber, who said:

"If the cost of regulation is greater than the cost of avoidance...the regulation will be avoided"

And here is a preliminary rejoinder from the political sector:

March 13, 2007

THE US Chamber of Commerce is calling for an end to quarterly earnings
guidance from companies, proposing that auditing firms be allowed to seek
private shareholders, and urging legislation allowing the Securities and
Exchange Commission to ease the burden of Sarbanes-Oxley on foreign

The recommendations come in a report that is the third high-level effort to
raise alarm about the competitiveness of US capital markets in four months,
as the issue garners attention on both sides of the Atlantic.

In January, New York Mayor Michael Bloomberg and Democratic Senator Chuck
Schumer co-authored a report warning that New York risked losing its
position as the world's financial capital to rivals such as London.

Tuesday, March 06, 2007

Mortality Derivatives

Mortality derivatives is an interesting subject, and the REcapitulator will be publishing a paper (more of a primer on the subject than delving into problems of conditional probability and mortality modeling) that will be available here.  Some excerpts from the paper are given below.

The REcapitulator is also privy to information regarding the launch of Hurricane derivatives, but he doubts that these will catch on as there is major basis risk.  The contracts (initiated by the CME) hedge against hurrican landfall (frequency), but not the severity of a given landfall.  What is an insurance company to do if the severity of a hurricane is not a price factor?  This initial attempt will hopefully spawn new innovation.

Anyway, some excerpts from the opening comments of the forthcoming paper:

The exposure of pension and insurance companies to unexpected decreases in mortality is an important risk, and one that has been increasingly difficult to predict. Actuarial assumptions regarding populations do not take into account secualar increases in life spans. To the extent that this risk can be transferred to the capital markets, it would create a more definable and predictable set of cash flows (and potentially reducing the cost of capital) for insurance and pension concerns.
While insurance companies can internally hedge their exposure to long-tail life insurance contracts through the writing of annuities, this presupposes the ability to sell annuities, a more or less contsant distribution of population, (assuming further that annuity purchasers do not buy life insurance products) and introduces other forms of risk to the overall insurance profile such as interest rate risk.

Mortality Derivatives may also be a more efficient way to price life and annuity contracts. Derivatives markets attract sophisticated participants who may have access to better information and/or more predictive financial models. This phenomenon has not been lost on the Federal Reserve, which routinely scans deriviatives markets and their corresponding implied expectations of the future in order to make policy decisions.  This “tail wagging the dog” effect, due in large part to increased leverage than cash markets,could also provide valuable informational flow with regards to pricing the primary obligations of pension and insurance companies.  These firms would have a competitive advantage versus their peers with mere active partcipation into the mortality derivatives markets.  Information garnered in this fashion could be used for capital allocation and internal hedging purposes, in addition to providing a competitive advantage to firms participating in the mortality derivatives markets by acting as the proverbial “canary in the mineshaft” in detecting unexpected events that effect mortality rates.

Saturday, March 03, 2007

Right and wrong...

But never "correct" (in the epistemological sense of the term), the REcapitulator is looking back on the last week.  Red is everywhere on financial data websites.

Volatility has indeed spiked over (in VIX terms) 20.  I was wrong about the short-term prospects for the dollar/Yen, as everyone has blamed the yen carry trade for contributing to the decline.  

And what a decline it was.  The S&P declined from 1458 to 1398 in a matter of 4 days.  Analysts at major banks (of course) bleat on about the "fundamentals" being "positive" and such.  How would they know?  Do the fundamentals change when massive selling causes inflation, stagflation, or deflation?  The Recapitulator reminds his audience that the accuracy of forecasts by bank analysts is no better than random.  Their compensation structure is entirely based on how convincing their forecasts are, not upon ex ante or ex post accountability.

So risk spreads are beginning to loosen.  Other risks are also coming to fore.  Insider trading is one such risk.  Not everyone will be caught, but it will have a chilling effect on the more "aggressive" trades.  Legal risk, like volatility in the markets, tends to cluster. Recall the flurry of activity Spitzer inititated in the early part of this century. (This is not unlike many revolutions.  The new government presents offending parties to the 
gallows.  The public enjoys an emotional catharsis, which is short-lived.  The now established
government then proceeds to do precisely what the old "evil" government did.)

So risk is increasing everywhere.  Not as serene an environment as those bank "equity strategists" would have you believe.