Financial Crises - Contagion - and Complexity - July 19 FINAL

Financial Crises, Contagion, and Complexity
The Challenges of an Interconnected World

CQF Extra July 19, 2010
The Lecture
Part I: An Overview of Financial Crises - Manias, Panics, and Crashes through the ages Part II: The Best of Times, The Worst of Times - select financial and economic timelines, trends, and case studies
Part III: Complexity 1: The Globalization of Finance

Part IV: Complexity 2: Technological Innovation in Finance
Part V: The Garden of Forking Paths: Finance and Economics

Part IV: The Fire Next Time: Where will the next crisis come from?
CQF Lecture, Copyright PHE, 2010 2
A Note on Style and Format

The Disclaimer: Attempting to cover a lot of ground risk of going a mile wide and an inch thick Wide range of readings selected from popular press and biographies to specialized finance, economics, market philosophy Mix of stories, data, open questions, focus on diverse perspectives Therefore, Conflicts of Opinion are encouraged Embracing Logical Difficulties
In philosophy, an aporia is a philosophical puzzle or a seemingly insoluble impasse in an inquiry, often arising as a result of equally plausible yet inconsistent premises.
Aporias
There, in sum, in this place of aporia, there is no longer any problem. Not that, alas or fortunately, the solutions have been given, but because one could no longer even find a problem which would constitute itself and that one could keep in front of oneself, as a presentable object or project, as a protective representative or a prosthetic substitute, as some kind of border still to cross or behind which to protect oneself.
Jacques Derrida, Aporias
Part 1: An Overview of Financial Crises

Anatomy of a Crisis Varieties
Manias and Bubbles Panics Crashes
Regulatory Responses US - Up to WWII US - Post-War Boom
CQF Lecture, Copyright PHE, 2010
Anatomy of a Crisis
The Minsky Moment In prosperous times, corporate cash flow rises beyond what is needed to pay off debt A speculative euphoria develops Soon, debts exceed what borrowers can pay from their revenues This produces a financial crisis Banks and lenders tighten credit, even to companies that can afford loans The economy contracts The Financial Instability Hypothesis: A fundamental characteristic of our economy is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles. - Hyman Minsky, 1974 Taxonomy Hedge finance Speculative finance Ponzi finance
Manias and Bubbles: Defined

Mania, is a state of abnormally elevated or irritable mood, arousal, and/ or energy levels. The word derives from the Greek " (mania), "madness, frenzy"and the presence of which is a criterion for certain psychiatric diagnoses. An economic or financial bubble is characterized by trade in high volumes at prices that are considerably at variance with intrinsic values. People are quite creative and also quite forgetful You know what happens to those who forget history
Top Ten Bubbles

1. Dutch Tulip Mania, 1636 2. South Sea Bubble, 1720 3. Mississippi Bubble, 1720 4. Late 1920s Stock Market Bubble, 1927-9 5. Bank Loans to Mexico & other devel. countries, 1970s 6. Real Estate and Stocks in Japan, 1985-9 7. Real Estate and Stocks in Scandinavia, 1985-9 8. Real Estate and Stocks in Thailand, Malaysia, Indonesia and other Asian Countries, 1992-7 9. Foreign Investment in Mexico, 1990-3 10. OTC Stocks , esp. Technology, in US, 1995 - 2000
Tulip Mania, 1634 early 1637

1593 botany professor brings Turkish plants to Leyden Mosaic virus produces flames and bizarres Bulb merchants predicting demand for certain styles and stockpiling hot ones Call options on bulbs Upon crash, government sought to settle contracts at 10% of face value, dropped further
South Sea Company, 1711-20

1711 government offers SSC monopoly over all trade to region Directors had no experience w/ S. American trade Insider trading immediately New issue in 1720, offered on payment plan Gains rapid momentum; further issuance, plans Bubble Cards, ridicule Even Isaac Newton lost money. Motions of the spheres, not the madness of crowds.
Panics: Defined
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent. As a bank run progresses, it generates its own momentum, in a kind of self-fulfilling prophecy (or positive feedback); as more people withdraw their deposits, the likelihood of default increases, and this encourages further withdrawals. This can destabilize the bank to the point where it faces bankruptcy. A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time. A systemic banking crisis is one where all or almost all of the banking capital in a country is wiped out. The resulting chain of bankruptcies can cause a long economic recession.
Top Bank Panics

18th century Panic of 1792 Panic of 17961797 19th century Panic of 1819, a U.S. recession with bank failures; culmination of U.S.'s first boom-to-bust economic cycle Panic of 1825, a pervasive British recession in which many banks failed, nearly including the Bank of England Panic of 1837, a U.S. recession with bank failures, followed by a 5-year depression Panic of 1847 Panic of 1857, a U.S. recession with bank failures Panic of 1866 Panic of 1873, a U.S. recession with bank failures, followed by a 4-year depression Panic of 1884 Panic of 1890 Panic of 1893, a U.S. recession with bank failures 20th century Panic of 1907, a U.S. economic recession with bank failures
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Bank Panic, 1907

Triggered by failed attempt to corner United Copper Company Lenders include Knickerbocker Trust, which falls Banks runs in NYC, then around the country Speculative side bets in bucket shops NYSE falls close to 50% from previous year JP Morgan steps in (there is no Central Bank at this time) Follow on TC&I JPM steps in again, via US Steel Federal Reserve created in 1913
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Crashes: Defined
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative bubbles. Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell. Generally speaking, crashes usually occur under the following conditions: a prolonged period of rising stock prices and excessive economic optimism, a market where P/E ratios exceed long-term averages, and extensive use of margin debt and leverage by market participants. There is no numerically specific definition of a stock market crash but the term commonly applies to steep double-digit percentage losses in a stock market index over a period of days. Crashes are distinguished by panic selling and abrupt, dramatic prices declines.
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Select Crashes
Paris Bourse, January 19, 1882 Wall Street 1929
Black Thursday - October 24, 1929 Black Monday - October 28, 1929 Black Tuesday - October 29, 1929
1973-4 UK stock market crash October 19, 1987 Friday the 13th Mini-Crash, October 13, 1989 Asian Contagion Mini-Crash, October 27, 1997 Dot-com Bubble and Crash, peak, March 10, 2000 Flash Crash May 6, 2010
Crash of 1929: Black Monday
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Black Thursday - October 24, 1929 Black Monday - October 28, 1929 Black Tuesday - October 29, 1929 Intense Duration: 4 years Leverage already in use: The bursting of the speculative bubble in shares led to further selling as people who had borrowed money to buy shares had to cash them in, when their loans were called.
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Crash of 1929
600 500 400 300 200 100 0 3-Mar- 3-Sep- 13-Nov- Low 1928 1929 1929 1932
AT&T Bethlehem Steel General Electric Montgomery Ward National Cash Register RCA
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Regulatory Responses to 1929

Public outcry and political will brings massive reform and legislation to the financial sector. The Rise of Central Authority: The SEC was created to regulate the stock market and prevent corporate abuses relating to the offering and sale of securities and corporate reporting. It was given the power to license and regulate stock exchanges, the companies whose securities traded on them, and the brokers and dealers who conducted the trading.
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Regulatory Responses
The SEC was created by section 4 of the Securities Exchange Act of 1934 and was empowered to enforce the following : The Securities Act of 1933 The Trust Indenture Act of 1939 The Investment Company Act of 1940 The Investment Advisers Act of 1940 And since that time: The Sarbanes-Oxley Act of 2002 The Credit Rating Agency Reform Act of 2006
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Up to World War II
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Post WWII: Boom
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Part II: Modern Events

The Best of Times and the Worst of Times The Tools of the Trade: Modern Methods Investment Timelines and Trends Regulation to 1980 and beyond Case Studies:
The Roaring 90s The Credit Crisis 2007 2009
The Great Hangover Seeking Solutions: An Engine not a Camera

Top Banking Crises

18th Century Crisis of 17721773 in London and Amsterdam, begun by the collapse of the bankers Neal, James, Fordyce and Down. 19th Century Australian banking crisis of 1893 20th century Panic of 1907, a U.S. economic recession with bank failures Great Depression, the worst systemic banking crisis of the 20th century Secondary banking crisis of 19731975 in the UK Savings and loan crisis of the 1980s and 1990s in the U.S. Finnish banking crisis of 1990s Swedish banking crisis (1990s) 1997 Asian financial crisis 1998 Russian financial crisis Argentine economic crisis (19992002) 21st century 2002 Uruguay banking crisis Financial crisis of 20072010, including: Subprime mortgage crisis in the U.S. starting in 2007 2008 United Kingdom bank rescue package 20082009 Belgian financial crisis 20082009 Icelandic financial crisis 20082010 Irish banking crisis 20082009 Russian financial crisis 20082009 Spanish financial crisis 20082009 Ukrainian financial crisis
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The Tools of the Trade

Modern Methods
Fundamental Analysis Technical Analysis Quantitative Analysis
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Modern Methods: Fundamental Analysis

Graham and Dodd Security Analysis The Intelligent Investor Benjamin Graham The Sage of Omaha: Warren Buffett The top-down investor starts his analysis with global economics, including both international and national economic indicators, such as GDP growth rates, inflation, interest rates, exchange rates, productivity, and energy prices. He narrows his search down to regional/industry analysis of total sales, price levels, the effects of competing products, foreign competition, and entry or exit from the industry. Only then he narrows his search to the best business in that area. The bottom-up investor starts with specific businesses, regardless of their industry/region. Stock Valuation methods focused on company, management, sector, Balance Sheet, Income Statement, Statement of Cash Flows
Debt-to-equity P/E ratio Price Earnings Growth
Drilling down deep on companys position, its competitors, and future prospects
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Modern Methods: Technical Analysis

Technical analysis employs models and trading rules based on price and volume transformations, such as the relative strength index, moving averages, regressions, inter-market and intra-market price correlations, cycles or, classically, through recognition of chart patterns. Technical analysis ignores the nature of the company, market, currency or commodity and is based solely on "the charts,: price and volume information and other indicators. Head and Shoulders Triangle Top/Bottom Resistance Support Breakout
Beware, the Black Swan
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Modern Methods: Quantitative Analysis

Financial Modeling;
The Greek Paradise and many hot pricing models
BlackScholes model Black model Binomial options model Monte Carlo option model Implied volatility, Volatility smile SABR Volatility Model Markov Switching Multifractal Finite difference methods for option pricing Optimal stopping (Pricing of American options) Interest rate derivatives Short rate model HullWhite model CoxIngersollRoss model Chen model LIBOR Market Model HeathJarrowMorton framework
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Investment Timeline: 1950s - 1960s

So how does all that play out in the market? November 23, 1954: the US stock market from the Great Crash 1946: Launch of American Research and Development first Venture Capital fund 1957: ARD Invests in Digital Equipment Corporation ($70,000) 1968: DEC goes public, valued at $355 million; 500x and 101% ARR 1962: Launch of Fidelitys Magellan Fund 1969: Launch of the first Money Market Fund Boom of new issues between 1959 1962 and through the decade
Growth stocks Concept stocks Lure of technology, e.g. DEC, Control Data, IBM, TI, Varian Associates
Generous p/e multiples

Investment Trends: 1950s - 1960s

Dawn of the Space Age Optimism in US Europe is rebuilding, with Marshall Plan Popular Press Social Revolution International Travel the Jet Set is expanding
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Investment Timeline: 1970s

1971: End of the Gold Standard 1973-4: Oil Crisis, OPEC story 1975: First index fund launched 1979: Iranian Revolution Oil Crisis revisited 1974-80: Speculation on Silver Period characterized by stagflation: high unemployment and high inflation U/E peak of 9% in May 1975 and GDP fell by 3.2% Recession from 1973-5 in UK as well
Investment Trends: 1970s

Oil Silver Nifty Fifty Business Journals gaining readership
Forbes Fortune Business Week
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Elites Weave Webs with Silver Threads
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Cornering the Silver Market
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Among the Gold Bugs
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Regulation to 1980 and Beyond

Since actions of 1930s sluggish economy in 1970s new policies Employee Retirement Income Security Act of 1974, created minimum standards for pension plans in private industry and provides for extensive rules on the federal income tax effects of transactions associated with employee benefit plans. ERISA was enacted to protect the interests of employee benefit plan participants and their beneficiaries by requiring the disclosure to them of financial and other information concerning the plan; by establishing standards of conduct for plan fiduciaries; and by providing for appropriate remedies and access to the federal courts. The institutionalization of investment
For the Common Man: Diversification ~ Mutual Funds Pension Funds now have a mandate
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Regulatory Recap
1933 Securities Act of 1933 1934 Securities Exchange Act of 1934, governing the secondary trading of securities 1938 Establishment of the Temporary National Economic Committee 52 Stat. 705 1939 Trust Indenture Act 1940 Investment Company Act 1940 Investment Advisers Act 1964 Securities Act Amendments PL 88-467 1968 Williams Act (Securities Disclosure Act) PL 90-439 1975 Securities and Exchange Act PL 94-29 1980 Depository Institutions and Deregulation Money Control Act PL 96-221 1982 GarnSt. Germain Depository Institutions Act PL 97-320 1984 Insider Trading Sanctions Act PL 98-376 1988 Insider Trading and Securities Fraud Enforcement Act PL 100-704 1989 Financial Institutions Reform, Recovery, and Enforcement PL 101-73 1999 Gramm-Leach-Bliley Act PL 106-102 2000 Commodity Futures Modernization Act of 2000 2002 Sarbanes-Oxley Act 2007 Regulation NMS
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1980 Bayh-Dole Act stimulates innovation in universities and small companies by protecting IP and inventions developed through the course of government funded research
Patents and startups, especially biotechs, begin boom
1982 Launch of the first Emerging Markets Fund 1984 Reform of mortgage-backed bonds
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New Issues Biotech Stocks Mid-1980s - High yield bonds aka Junk
Drexel Burnham Lambert Michael Milken and the fallen angels
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Black Monday refers to Monday, 19 October, 1987, when stock markets around the world crashed, shedding a huge value in a very short time. The crash began in Hong Kong, spread west through international time zones to Europe, hitting the United States after other markets had already declined by a significant margin. The Dow Jones Industrial Average dropped by 508 points to 1738.74 (22.61%). By the end of October, stock markets in Hong Kong had fallen 45.5%, Australia 41.8%, Spain 31%, the United Kingdom 26.4%, the United States 22.68%, and Canada 22.5%. New Zealands market was hit especially hard, falling about 60% from its 1987 peak, and taking several years to recover.
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Crash of 1987
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Alternative Explanations
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Market Reactions: Modeling Wild Randomness

In 1991, the Options Clearing Corporation decided to change the probability models employed to calculate margin requirements. This was a direct consequence of Black Monday. The OCC switched to the Levy distribution, which endows rare events with a much higher probability of existence than the Normal distribution. A Levy distribution allows for Wild randomness. The OCC liked the fact that under a Levy regime, a 99% confidence interval would cover five or six standard deviations, whereas under the Normal distribution only three standard deviations are so covered. This was desirable, not just on account of representative fairness, but also as a survival mechanism for the OCC and the individual exchanges that cleared with it. - Pablo Triana, Lecturing Birds on Flying
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January 1990 Crash of Japan leads to the yen carry trade September 1992 Sterlings Black Monday spurs foreign exchange as an asset class 1994-5 - Financial Crisis in Mexico December 1996 Alan Greenspan warns against irrational exuberance 1997 Asian crisis prompts Asian countries to build up reserves of dollars

March 1998 Citigroup and Bank of America mergers create banks that are too big to fail August 1998 Russia defaults on debt and Long-Term Capital Management melts down 1999 IPOs and existing tech stocks go up and up and up
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Black Box Trading Real Estate Internet Mania
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Case Study: The Roaring 1990s

Dotcom Bubble Massive Inflows of Money to Alternative Investment Everyone wants alpha Early Warnings: Irrational Exuberance 1996 The Results
NASDAQ numbers
Factors in the Tech Bubble

WWW, Nov 1993 Mosaic, Feb 1994 Regulation & deregulation, Telecomms Act of 1996, Glass-Steagall Users reaching critical mass, 1997 End of Cold War, triumphalism, yet global instability, foreign crises Rep. Congress, cap gains tax cuts 28 20%, 1997 Growth of mutual funds and also rise of discount brokers, day traders; attitudes towards risk Cultural change - business success touted and expansion of media reporting of business news Analysts increasingly optimistic and visible forecasts: Blodgett, Meeker, Cramer; opinion leaders Taleb: this period filled with narrative fallacy
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Dot Bomb
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2000 Dot-com bubble bursts 2001 Emerging markets rebranded BRICs 2004 Commodities become an asset class 2005 Default risk becomes an asset class More International action hot money
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Hot Money
In economics, hot money refers to funds which flow into a country to take advantage of a favorable interest rate, and therefore obtain higher returns. They influence the balance of payments and strengthen the exchange rate of the recipient country while weakening the currency of the country losing the money. These funds are held in currency markets by speculators as opposed to national banks or domestic investors. As such, they are highly volatile and will be shifted to another foreign exchange market when relative interest rates make this more profitable. Hot money is a major factor in capital flight, illicit financial flows, and the ability of developing nations to finance their debt. As large sums of money can move very quickly to take advantage of small fluctuations in interest rates and currency values, countries which have difficulty raising money through the sale of long-term bonds are particularly susceptible to short-term interest rate pressure, particularly during periods of rapid inflation.

Chasing Alpha Venture Capital Overhang/Hangover
Life of the fund GP v. LP High Water Marks Where are the exits?
Private Equity Credit Crunch Rise of the Machines

Patterns
Case Study: Credit Crisis 2007-2009

June 7, 2007 Ten-year Treasury yields hit 5.05 percent June 19, 2007 Bear Sterns Hedge Fund appeals for help August 3, 2007 Jim Cramer declares Armageddon in the credit markets August 7-9, 2007 Big quant hedge funds suffer unprecedented losses August 9, 2007 European Central Bank intervenes after BNP Paribas money fund closes
Credit Crisis 2007 2009

August 17, 2007 Federal Reserve cuts rates after Countrywide Financial funding crisis September 13, 2007 The run on Northern Rock October 31, 2007 World stock markets peak November 1, 2007 Fear of losses at Citigroup prompts a sell-off March 16, 2008 Bear Stearns rescued by JP Morgan July 14, 2008 Oil and the dollar rebound the end of the decoupling trade September 7, 2008 Fannie Mae and Freddie Mac nationalized
Credit Crisis 2007 2009

September 15, 2008 Lehman Brothers goes bankrupt September 18, 2008 AIG is rescued, Reserve Fund breaks the buck, money market panics September 29, 2008 Congress votes down the TARP bailout package October 6-10, 2008 Global correlated crash October 24, 2008 Emerging markets hit bottom as China rolls out stimulus package
Credit Crisis 2007- 2009

What Happened to Quants August 2007? Andrew Lo http://web.mit.edu/alo/www/Papers/august07.pdf
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The Big Short

Quote by Michael Lewis ~ All of Washington is reading this book, but I am not an Investment Banker
Credit Crisis beneficiaries

The Publishing Industry thrives Sampling of books, note S. Das reviews on Wilmott.com Rolling Stone and Vanity Fair emerge with high quality financial reporting
The Big Short Michael Lewis

It is unreal, because basically all of the people you mentioned all swallowed a general view of Wall Street, which was that it was a useful and worthy master class, that these people basically knew what they were doing and should be left to do whatever they wanted to do. And they were totally wrong about that. Not only did they not know what they were doing, but the consequences of not knowing what they were doing were catastrophic for the rest of us. It was not just not useful; it was destructive. We live in a society where the people who have squandered the most wealth have been paying themselves the most, and failure has been rewarded in the most spectacular ways, and instead of saying we really should just wipe out the system and start fresh in some way, there is a sort of instinct to just tinker with what exists and not fiddle with the structure. And I dont know if thats going to work. When you look at what Alan Greenspan did, or what Larry Summers did, or what Bob Rubin did, there are individual mistakes they made, like for example not regulating the credit default swap market, preventing that from happening. But the broader problem is just the air they breathe. The broader problem is just the sense they all seem to have that whats good for Goldman Sachs is good for America.
Michael Lewis, Interview with Christopher Lydon
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The Great Hangover

Joseph Stiglitz: Capitalist Fools: Five Key Mistakes that Led Us to the Collapse, Jan 2009, Vanity Fair Systemic failure, not a single decision point, but a cascade
Firing the Chairman Volcker v Greenspan, 1987
Ronald Reagan. Under Volcker inflation went from 11% to 4%, Greenspan bring liquidity and regulation-lite Could have raised margin requirements during tech bubble Could have combatted predatory lending during credit crisis Innovation without oversight Claims that no one knew incorrect the front lines knew
Great Hangover
Tearing Down the Walls
November 1999 Congress repeals the Glass Steagall Act, following a $300 million lobbying effort from the banking and financial service industries Reason for Glass Steagall - enacted after the Great Depression had been to curb excesses; separate commercial banks from investment banks This repeal drives a return to higher risk, more leverage April 2004, SEC allows investment banks to increase debtto-capital ratio from 12:1 to 30:1 or higher, so they could buy more Mortgage Backed Securities Self regulation; in 1998, Brooksley Born, head of CFTC, calls for derivatives legislation, Summers and Rubin against it.
Great Hangover
Applying the Leeches
Bush Tax cuts, Economic Growth and Tax Relief Reconciliation Act of 2001, June 7, 2001 and Jobs and Growth Tax Relief Reconciliation Act of 2003, May 28, 2003 Fed floods with liquidity Also implicit cultural attitude with capital gains tax cuts, those who gamble and win are taxed more lightly than wage earners So everybody, lets borrow and roll the dice Flip this house, HELOCs, max out credit cards
Great Hangover
Faking the Numbers
After World Com and Enron collapse, Congress passes Sarbanes-Oxley Act in June 2002 Stock options top management incentivized to pump prices through distorted information Incentives at rating agencies also perverse paid by clients that they graded
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Great Hangover
Letting it Bleed
Bailout package produced October 3, 2008, debates, Paulson, counterproposals Some bailed out, some not Some shareholders get something back, some dont Bonuses return! Moral outrage, but legislators powerless to reverse course Stiglitz very much opposed to the idea that the role of governments should be minimal, but look at their level of competence. Grandstanding, but substance?
Home Value Index
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A Few Words on Glass-Steagall

The Banking Act of 1933 was a law that established the Federal Deposit Insurance Corporation (FDIC) in the United States and introduced banking reforms, some of which were designed to control speculation. The first Glass Steagall Act of 1932 was enacted in an effort to stop deflation, and expanded the Federal Reserves ability to offer rediscounts on more types of assets, such as government bonds as well as commercial paper. The second Glass Steagall Act (the Banking Act of 1933) was a reaction to the collapse of a large portion of the American commercial banking system in early 1933. It introduced the separation of bank types according to their business (commercial and investment banking), and it founded the Federal Deposit Insurance Corporation for insuring bank deposits.
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Glass- Steagall Reversed

Some provisions of the Act, such as Regulation Q, which allowed the Federal Reserve to regulate interest rates in savings accounts, were repealed by the Depository Institutions Deregulation and Monetary Control Act of 1980. Provisions that prohibit a bank holding company from owning other financial companies were repealed by the Gramm-Leach-Bliley Act on November 12, 1999. The repeal of Glass- Steagall effectively removed the separation that existed between Wall Street investment banks and depository banks and has been blamed, in part, for the collapse of the subprime mortgage market that led to the financial crisis of 2007-2010.
The Subprime Solutions

The Subprime Solution Shiller
http://www.standardandpoors.com/indices/sp-caseshiller-home-price-indices/en/us/?indexId=spusacashpidff--p-us----
Regulation: Dodd-Frank
On June 25, 2010, conferees finished reconciling the House and Senate versions of the bills and filed a conference report. The new bill will be called the Dodd-Frank Wall Street Reform and Consumer Protection Act. On June 30, 2010, the House passed the "Dodd-Frank" conference report of H.R. 4173 by a vote of 237-192. The Senate passed the bill on July 15 by a vote of 60-39, sending the legislation to President Obama's desk.
The Performativity of Economics

What is less straightforward conceptually, and more complicated empirically, is to determine what effect, if any, the use of economics has on the economic process in question. The presence of such an effect is what is required for a stronger meaning of performativityFor the use of a theory, a model, a concept, a procedure, a data setto count as effective performativity, the use must make a difference.Except in the simplest cases, one cannot expect observation alone to reveal the effect of the use of an aspect of economics It might be that the use of economics is epiphenomenal a empty gloss on a process that would have had essentially the same outcomes without it.
Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets
Computational Fluid Dynamics

Finance: Theory and Practice Behavior: Human Psychology
Individual and Collective; Wisdom of Masses?
Economics: Local, National, Global

Ability to telescope
Technology: Better, Faster, Stronger Regulatory: Unintended Consequences Quant

Tries to sit above this mess, but is that possible?
Start with Complexity of Global Finance

Part III: Complexity I - Globalization

Traders, Guns, and Money story Crisis and Contagion When Markets Collide Capital Rules Money on the Move Case Study: Sterling 1992 Case Studies: A Tale of Two Atolls Bail Ins and Bail Outs Fixing Global Finance
No Risk
OCM is a noodle maker, operates in Indonesia, and all its income is in rupiah? I asked and Budi confirmed it. In 1995, you decided to convert your borrowings into dollars? Yes. Why? Cheaper, much cheaper, Budi said. What about currency risk? You have borrowings in dollars but no dollar income. If the dollar rose against the rupiah, the you would show losses. Did you consider the currency risk? No risk, no risk, Budi countered. Why? Rupiah fixed against dollar, no risk. Bank advise us. They tell us no risk, Adewiko interjected. They advise that we have low cost, no currency risk. Morrison, Albie and the junior accountant were making copious notes - Satyajit Das, Traders, Guns, and Money
Crisis: Going Global

Mexico - 1994-5 Argentina - 1995 Asia 1997 Russia 1998, particularly August 17, 1998 US Bear Market: October 11, 2007 2009
The Dow Jones Industrial Average, Nasdaq Composite and S&P 500 all experienced declines of greater than 20% from their peaks in late 2007
Dubai 2009, November 27 debt deferment request Iceland - 2009 Greece 2010 - April 27, 2010 Standard & Poors downgrades Greeces sovereign credit rating to junk, four days after the countrys government requests the activation of a 45-billion euro EU-IMF bailout. European debt panic ensues Euro Contagion The PI(I)GS?
Contagions: Not So New After All

London Paris 1700s
First international crisis, 1720, speculation in Great Britain and France affected the Netherlands, Italy, and Hamburg 1763 Holland, Hamburg, Russia, Scandinavia
Panics in 1800s
1825 Great Britain and South America Paris 1847-8 Failures chart 1850 London and Paris as world financial centers
Panic of 1907 New York, London, Paris Post-WWI Crisis in 1920-1 no international lender; highlights need for Bretton Woods post WWII
When Markets Collide

Signals and Noise - Structural Factors
Fundamental realignment of global economic power Pronounced accumulation of financial wealth by countries that had been debtors historically
Sovereign Wealth Funds Reinforced desire for diversification Politicians in industrialized countries paying attention
Proliferation of new financial instruments
Aberrations, Conundrums and Puzzles

Economic Data Interest Rates Conundrum Global Payment Imbalances developing economies Most liquid market puzzle http://www.pimco.com/LeftNav/Viewpoints/2008/When+Markets+Co llide+El+Erian+June+2008.htm

investors face more than just the difficult challenge of understanding the new destination (or steady state), including what it implies for institutional and organizational set-ups. They also have to understand and navigate a journey that is inevitably turbulent and nonlinear. And with that comes the probability of market accidents and policy mistakes. Due to the difficulties in being able to rapidly identify and adapt to multiple structural changes, it is inevitable that some investors (including previously successful investors) will trip, some firms will fail, some admired policy makers will be slow in reacting, and some international institutions will lose relevance. As long as the numbers remain contained, they will constitute only flesh wounds for a generally robust secular transformation. But if few become many, the world faces the prospect of a disorderly adjustment characterized by disappointing economic growth, higher unemployment, greater poverty, trade wars, capital controls, and financial market instability.
Mohammed El-Erian, When Markets Collide
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Contagion - emerging markets prone through three distinct transmission channels:
Economics need to access industrialized countries through exports to generate cash to service their own debt obligations Funding reliance on sources to roll over maturing debt obligations Technical assessing tactical investors, beyond small pool of strategics
Enormous correlation within these channels And yet, EM no longer the most vulnerable to global shocks IMF Reform Agenda
Universal membership: 185 countries end of 2007 Unmatched access to member countries; articles of agreement annual check-up Complements surveillance of national policies with multilateral responsibilities
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Capital Rules: The Construction of Global Finance

End of the first wave - globalization, 1914-44
Gold standard Exchange rates
Embedding liberalism, 1944-61

IMF, Articles of Agreement, 1945 European Community, Treaty of Rome, 1957 OECD, Code of Liberalization of Capital Movements, 1961
Ad Hoc Globalization, 1961-86 Rewriting the Rules, 1986 - present

Capital Rules
Causes of Globalization
American Hegemony and the French Period of Mondialisation Maitrisees Neoliberalism and the European Left Scientific Progress and Social Learning End of Fixed Exchange Rates
Fixed Rates and Controlled Capital, 1945-71 Floating and Financial Flows, 1971-90 Age of Capital, 1990-97 Rise and Fall of Capital Account Amendment
Capital Rules
Paradoxes of Globalization
Managed Globalization Idiosyncrasies of Organization Building Liberalism and the Left Constitutive Norms and Market Expectations
Nationally Recognized Statistical Rating Organization Status,

SEC creation of NRSROS in 1975 S&P Moodys
BIS Basel Accord, 1988 and Basel II, June 2004

Money on the Move

Revolution in Global Finance since 1980 Debt crisis of developing countries Political leadership:
Margaret Thatcher, 1979 Ronald Reagan, 1980, President in 1981 Helmut Kohl, 1982 Japan LDP strong throughout 1970s and 80s
In US Federal Reserve the reign of Paul Volcker

Practical Monetarism
Money on the Move

Second Oil shock
Precipitated by Iranian Revolution, 1979
Consumer Price Index for G7 countries

8% per year, 1976 1978 Rises to 12.7% in 1980
Balance of payments: Germany and Japan have surpluses

US grew faster than EC from 1983-88 And faster than Japan in 1983, 84 and 86
Gold
Approximately $225/ounce in 1979 Hits $850/ounce in January 1980 Down to ~ $400/ounce mid 1981 Fluctuates from $300-400/oz for rest of the decade Falls below $300/oz in late 1997
Money on the Move

Wide ranging dollar 1980 to 1990
Rising from 1981-85 Declining from 1985-87
Plaza Accord, 1985

G5 intervention ~ $2.7 Billion G10 sold $7.5 Billion to buy Euro currencies and Yen US Share of activity - $2.8 Billion Dollar declined gradually
Money on the Move

The Plaza Accord or Plaza Agreement was an agreement between the governments of France, West Germany, Japan, the United States and the United Kingdom, to depreciate the US Dollar in relation to the Japanese yen and the German Deutsche Mark by intervening in currency markets. The exchange rate value of the dollar versus the yen declined by 51% from 1985 to 1987. Most of this devaluation was due to the $10 billion spent by the participating central banks. Currency speculation caused the dollar to continue its fall after the end of coordinated interventions. However, in general, this devaluation was planned, done in an orderly, pre-announced manner and did not lead to financial panic in the world markets. The reason for the dollar's devaluation was twofold: to reduce the U.S. current account deficit, which had reached 3.5% of the GDP, and to help the US economy to emerge from a serious recession that began in the early 1980s. The Plaza Accord was successful in reducing the U.S. trade deficit with Western European nations but largely failed to fulfill its primary objective of alleviating the trade deficit with Japan because this deficit was due to structural rather than monetary conditions. However, the signing of the Plaza Accord reflected Japan's emergence as a real player in managing the international monetary system.
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Money on the Move

Louvre Accord, 1986-7
The Louvre Accord was signed by the then G6 (France, West Germany, Japan, Canada, the United States and the United Kingdom) on February 22, 1987 in Paris. Italy had been an invited member, but declined to finalize the agreement. The goal of the Louvre Accord was to stabilize the international currency markets and halt the continued decline of the US Dollar caused by the Plaza Accord (of which a primary aim was depreciation of the US dollar in relation to the Japanese yen and German Deutsche Mark by the mutual agreement of the G7 Minister of Finance meeting that had been held in Louvre in Paris in 1987. Since the Plaza accord, the dollar rate had continued to slide, reaching an exchange rate of 150 per US$1 in 1987. The ministers of the G7 nations gathered at the Louvre in Paris to "put the brakes" on this decline.
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Money on the Move

Foreign Exchange developments, 1988-90 US Balance of Payments, 1987-90 Exchange Rate Mechanism in Europe
Delors Report Prelude to EMS Zone of Monetary Stability
Single European Act, 1986 Europe 1992

Convergence Britain and EMS German Unification
Maastricht turmoil in EMS

Spain and Portugal join in 189 92 with wide margin of +/-6%
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European Monetary System

European Monetary System (EMS) was an arrangement established in 1979 under the Jenkins European Commission where most nations of the EEC linked their currencies to prevent large fluctuations relative to one another. Bretton Woods system in 1971, most of the EEC countries agreed in 1972 to maintain stable exchange rates by preventing exchange fluctuations of more than 2.25% (the European "currency snake"). In March 1979, this system was replaced by the European Monetary System, and the ECU was defined. The basic elements of the arrangement were: The ECU: A basket of currencies, preventing movements above 2.25% (6% for Italy) around parity in bilateral exchange rates with other member countries. An Exchange Rate Mechanism An extension of European credit facilities. The European Monetary Cooperation Fund was created in October 1972 and allocated ECUs to members' central banks in exchange for gold and US dollar deposits. Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank were unquestionably the center of the EMS.
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EMS - Stage I
Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but after 1986 changes in national interest rates were used to keep the currencies within a narrow range. In the early 1990s the European Monetary System was strained by the differing economic policies and conditions of its members, especially the newly reunified Germany, and Britain. 1992 Crisis:
On 13 September 1992 Italy decided to devalue Italian Lira by 3.5%. On 16 September 1992 UK withdrew from ERM. On 17 September 1992 Italy withdrew from ERM.
Speculative attacks on the French Franc during the following year led to the so-called Brussels Compromise in August 1993 which established a new fluctuation band of +15%.
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EMS Stage II and Stage III (EMU)

Stage II The European Monetary System was no longer a functional arrangement in May 1998 as the member countries fixed their mutual exchange rates when participating in the euro. Its successor however, the ERM-II, was launched on 1 January 1999. In ERM-II the ECU basket was discarded and the new single currency euro has become an anchor for the other currencies participating in the ERM 2. Participation in the ERM 2 is voluntary and the fluctuation bands remain the same as in the original ERM, i.e. +15 percent, once again with the possibility of individually setting a narrower band with respect to the euro. Denmark and Greece became new members. Stage III The EMS-2 is sometimes described as "waiting room" for joining the Economic and Monetary Union of the EU. In the EMU (Stage III) the actual currencies in the participating member states are replaced by euro banknotes and coins, thus entering the Euro Zone.
Money on the Move

From USSR to Commonwealth of Independent States Further increases Capital Mobility Currency Crisis: Mexico, Brazil, Argentina, 1982 British pound, Italian lira, other European currencies, 1992 Mexico peso, 1994 5
Tequila Effect
Asia: Thai bhat, Malaysian ringgit, other Asian, 1997 Russia, ruble, 1998 Brazil, real, 1999 Argentina, peso, 2001
Money on the Move

The Second World centrally planned economies under communist governments is transitioning to market economies and democracy The Third World is changing rapidly and less dependent on First World countries OPEC has become a less powerful force in the world economy World trade in goods and services had grown much faster than output New financial instruments have transformed the markets and influenced enormous capital mobility Capital flows to developing countries have increased Monetary policy and central banks more visible and important Determinants of exchanges rates have changed; moderate current account imbalances less likely to move rates Unemployment at high levels in continental Europe; a political problem European economies have become much more integrated with each other, creation of the Euro, and further enlargement
Princes and Paupers: Speculation and Predation in 1990s

High finance trembles in its boots whenever there is some political complication.
An aide to Bismarck, 19th century
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Case Study: The Pound Sterling, 1992

In 1979, the Hunt family of Texas used silver futures contracts in a scheme to corner the silver market. This scandal made it unlikely that regulators would approve new ways of speculating in silver and gold. That left currencies.
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The Vandal Has a Crown

History of currency exchange
Up to 1971, Foreign Exchange was done by banks only In 1971, the International Monetary Market of CMEX was founded and began to trade currency futures
Black Scholes 1973 A Very Useful Tool 1992 Attack on EMS Soros Quantum Fund
The Sting UK Style

On Black Wednesday (September 16, 1992), Soros's fund sold short more than $10 billion worth of the pound sterling, profiting from the Bank of Englands reluctance to either raise its interest rates to levels comparable to those of other European Exchange Rate Mechanism countries or to float its currency. Finally, the Bank of England withdrew the currency from the European Exchange Rate Mechanism, devaluing the pound sterling, and Soros earned an estimated US$ 1.1 billion in the process. He was dubbed "the man who broke the Bank of England." In 1997, the UK Treasury estimated the cost of Black Wednesday at 3.4 billion. The Times of Monday, October 26, 1992, quoted Soros as saying: "Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell." Stanley Druckenmiller , who traded under Soros, originally saw the weakness in the pound. "Soros' contribution was pushing him to take a gigantic position."
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But The Emperor Has No Clothes
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Better to be Lucky and Smart! (clothing optional)
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A Tale of Two Atolls: East and West

Japan 1990s
Balance Sheet Analysis
Iceland 2000s
Wild Beasts of Finance
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Lessons from Japans Great Recession

Structural problems and banking sector cannot explain Japans long recession Points to supply side issues, Japans economy suffered from lack of demand The bubbles collapse destroyed 1,500 Trillion Yen in wealth and triggered a balance sheet recession
Plunging asset prices triggered corporate balance sheet problems Japanese companies moved collectively to repair balance sheets by paying down debt Demand from Japans corporate sector fell by more than 20% of GDP and yet GDP did not fall after the bubbles collapse

Fiscal expenditures bolstered Japans economy
Delays on a cap for government deposit insurance also helped to avert a crisis
Debt minimization and monetary policy

Monetary policy is ineffective during a balance sheet recession, when there is no demand for funds Government borrowing propped up the money supply Fiscal policy determines the effectiveness of monetary policy
Conventional economic theory does not allow for corporate debt minimization

Exploring Balance Sheet Recessions
Germany has faced the same problem The US took 30 years to recover from the Great Depression, to the level of the 1920s Was that a Balance Sheet Recession?
May agree or disagree with the analysis, but it is worthwhile to explore alternative viewpoints Ask ten economists, obtain ten (different) opinions
Iceland 2008-10
The 20082010 Icelandic financial crisis is a major ongoing economic crisis that involves the collapse of all three of the country's major banks following their difficulties in refinancing their short-term debt and a run on deposits in the United Kingdom. Relative to the size of its economy, Icelands banking collapse is the largest suffered by any country in economic history. In late September 2008, it was announced that the Glitnir bank would be nationalized. The following week, control of Landsbanki and Glitnir was handed over to receivers appointed by the Financial Supervisory Authority (FME). Soon after that, the same organization placed Iceland's largest bank, Kaupthing, into receivership as well.
Iceland 2008-2010 Banking Development

Stage 1. Pure financial intermediation
Banks lend our from surplus savings to those in need of financing, no money multiplier
Stage 2. Fractional reserve banking deposits used as money

Longer term, larger and riskier loans Liquidity is distributed across the financial markets Lender with power of money printing offers insurance against systemic Liquidity shocks Lending and matching funds deposit seeking, interbank lending or wholesale funding Banks turn existing loans into marketable securities; turn away form lending and favor derivatives products and off-balance-sheet profit opportunities
Stage 3. Interbank lending
Stage 4. Lender of last resort facility

Stage 5. Liability management Stage 6. Securitization
Iceland 2008-10
Commenting on the need for emergency measures, Prime Minister Geir Haarde said on 6 October, "There [was] a very real danger ... that the Icelandic economy, in the worst case, could be sucked with the banks into the whirlpool and the result could have been national bankruptcy. The financial crisis has had serious consequences for the Icelandic economy. The national currency fell sharply in value, foreign currency transactions were suspended for weeks, and the market capitalizations of the Icelandic stock exchange dropped by more than 90%. As a result of the crisis, Iceland entered into a severe economic recession; the nation's gross domestic product decreased by 5.5% in real terms in the first six months of 2009.
Bail Ins and Bail Outs

Sources of vulnerability within Balance Sheet framework
Maturity mismatch Currency mismatch Capital structure mismatch
Debt problems and their resolution

Inability or unwillingness to pay Crisis of creditor coordination IMF as source of emergency liquidity
Stand stills versus emergency loans IMF lending may not lead to moral hazard
Partial bailouts IMF and bilateral first and second financings
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Bail Ins and Bail Outs

Proposals for a more defined system of sovereign priorities
Bolton- Skeel First-in First-out lender Soros International Deposit Insurance Agency Gelpern Pick your own priority scheme
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Fixing Global Finance

Risks in financial globalization Fiscal cost of financial crises Current account balances Private net capital flows Spreads of Emerging Market Loans
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International Financial System

What can individual countries do?
1) Devise a sensible strategy for liberalizing domestic financial markets and international capital flows 2) Strengthen Institutions, Information, and the Financial and Corporate sectors 3) Adopt sustainable Exchange Rate Agreements 4) Maintain Debt Discipline, sound macro economic policies, and market confidence 5) Open the economy to trade and FDI in a manner that results in growth-enhancing activities
International Financial System

How can the International Financial System be reformed?
1) Strengthen the quality and impact of IMF surveillance 2) Induce changes in the composition of the international capital flows 3) Introduce contingent debt contracts or other mechanisms for hedging against macro economic risks 4) Address informational imperfections and distorted incentives on the supply side of int. capital flows 5) Revamp debt resolution procedures : SDRM Proposed 6) Strengthen frameworks for development aid and official non-concessional lending
The Two Horns of a Dilemma
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Part IV: Complexity II Financial and Technological Innovation

Here Come the Quants Story: Emanuel Derman: My Life as a Quant Six Basic Functions of Finance Basic Steps in Financial Risk Management The People: Capital Ideas Evolving Case Study: When Genius Fails The Technology: Black Boxes and Big Pipes Pandoras Box Rise of the Machines The Future of the Exchanges
Engaging with Models

The right way to engage with a model is, like a fiction reader or a really great pretender, to temporarily suspend disbelief, and then push it as far as possible. The success of the theory of options valuation, the best model economics can offer, is the story of a Platonically simple theory, taken more seriously than it deserves and then used extravagantly, with hubris, as a crutch to human thinking. If a fool would persist in his folly, he would become wise, wrote Blake in The Marriage of Heaven and Hell. This is what quants have done with options theory.
Emanuel Derman, My Life as a Quant: Reflections on Physics and Finance
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Six Basic Functions of Finance

1) Making payments to facilitate the exchange of assets, goods, and services 2) Providing resources to fund large projects or enterprises 3) Transferring resources from savers to borrowers 4) Managing risk 5) Providing price information required for the coordination of decentralized decision making 6) Creating incentives to perform well the stakeholders interests
Basic Steps in Financial Risk Management

First step:
Diversification and collateralization
Second step:
Limited liability, bankruptcy laws, seniority rules, balance sheet structure
Third step:
Creating tradable instruments and liquidity in organized markets Convertibles existed by the 1600s
Basic Steps in Financial Risk Management

Fourth and final step:
Derivatives and financial engineering
Diagnosis of problem Analysis of solutions Production of instrument Pricing and customization
On versus off-balance sheet activities
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Capital Ideas Evolving: The People

Neoclassical theory is a theory of sharks. Behavioral: Kahneman and Tversky, Thaler Shliefer and Vishny: The Limits of Arbitrage, p. 26 The Theoreticians
Samuelson
The Institutionalists
Merton, Lo, Shiller
The Engineers:
Sharpe, Markowitz, Scholes
The Practitioners:
Barclays Global Investors, Yale Endowment Fund (Swensen), Leibowitz, TIAA-CREF, Goldman Sachs Asset Management
GSAM is a Black Box.
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Myth of the Rational Market

Irving Fisher Fred Macauley Holbrook Working Harry Markowitz Paul Samuelson Modigliani and Miller Gene Fama Jack Bogle Fisher Black Michael Jensen Richard Thaler, Andrei Shleifer Robert Shiller Warren Buffett Ed Thorp Alan Greenspan
Case Study: When Genius Fails, LTCM

The total losses were found to be $4.6 billion. Major losses: $1.6 bn in swaps $1.3 bn in equity volatility $430 mn in Russia and other emerging markets $371 mn in directional trades in developed countries $286 mn in equity pairs (such as VW, Shell) $215 mn in yield curve arbitrage $203 mn in S&P 500 stocks $100 mn in junk bond arbitrage No substantial losses in merger arbitrage
Thats Not Supposed to Happen

That Friday, Long-Term lost money wherever it looked. Credit spreads simply exploded. Mortgage spreads surged to 121 points, up from 107 only weeks before. High-yield bonds climbed from 269 to 276. Off-the-run Treasuries vaulted from 8 basis points to 13. Though these moves may seem small in absolute terms, the effect on Long-Term was magnified by the funds potent level of leverage and position size. Even in seemingly unrelated markets, Long-Term suffered a drubbingIn fact, nothing in any market went right that day. - Roger Lowenstein, When Genius Failed: The Rise and Fall of LTCM
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LTCM: The Higher They Fly
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The Last Word

Now is the time to encourage the Bank of International Settlements and other regulatory bodies to support studies on stress test and concentration methodologies. Planning for crises is more important than VaR analysis.
- Myron Scholes, reflecting on LTCM aftermath, American Economic Review, May 2000
Black Boxes and Big Pipes: The Technology

For Crying Out Loud
Globex Timeline Equity Owners Association Rocket Fuel E-Mini: The spring board for the Mercs Success
Regulatory and Infrastructural activity

Securities Exchange Act of 1934 Broker-Dealer Licensing NASDAQ Small Order Execution System, 1988 1990s Market reforms lead to rise of ECNs Financial Information Exchange Protocol, 1993 Island first ECN, 1996 SEC Regulation of Alternative Trading Systems, 1997 This is a turning point in the uptake of ECNs by institutionals At same era, Interactive Brokers new offering Computer to Computer Interface using an API (Application Programming Interface) - direct connection Next stop: Black Pools
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Pandoras Box
Chasing the Same Signals
Black Box trend following
Momentum Statistical arbitrage Market neutral Automated market making Algorithmic trading Balance Sheet metrics Market data indicators Macroeconomic data: u/e, interest rates, inflation Volatility spreads Volume Disturbances
What kinds of signals?
Pandoras Box
Science and Economic signals
Econometrics Microstructure Research - variables
Mid point Bid and Offer Volumes Bid to offer ratio Effective spread Weighted bid price
Operations Research: Optimization and Execution

Pandoras Box
Risk Factor Models
P/E ratio Book to Market Cash Flow to Price Earnings Momentum Dividend Yield Senior Debt Ratio
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Black Box Brethren

Measure, manage, model engineering
Renaissance Technologies/Simons D. E. Shaw Cliff Asness Monroe Trout Peter Muller
High Frequency Trading

Pinging the box - submit and cancel Predatory algorithms Rebate structure
Smoke Signals
Decay effect contrarian Weather data Location data Search data consumers, Googlenomics Adaptive Machine Theory
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The Elixir: Liquidity?

Look back again to August 2007 There were signals of imbalance high vol, but the S&P unchanged excessive dispersion
Are quants creating volatility or stabilizing the markets? Are large price swings and reversals more prevalent than ever? What happened to buy and hold? What about small retail investors?
Competition for liquidity when it is most needed, do these new liquidity providers stand back and watch?
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Speed Freaks
Top Ten Markets by Velocity (by volume of turnover)
NASDAQ 811% China Shenzhen 285% AMEX 279% Germany 236% NYSE 205% Italy 198% Korea - 189% Spain 179% Taiwan 155% London 155%
But also composition LSE $25B/day volume, with 70% of that taking place with London, Germany, Spain and Italy
Rise of the Machines

Minicrash: May 6, 2010 The DJIA suffers its worst intraday loss, dropping nearly 1,000 points before partially recovering, all within less than half an hour.
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Case Study: Flash Crash

The May 6, 2010 Flash Crash was a stock market crash on May 6, 2010 involving U.S. corporate stocks, followed by an almost immediate rebound. It was the second largest point swing, 1,010.14 points, and the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average history. Initial reports indicated that the event may have been triggered by a "fat-finger trade", an inadvertent large "sell order" for Proctor and Gamble stock, inciting massive algorithmic trading orders to dump the stock; however, this theory was quickly disproved after it was determined that Procter and Gamble's decline occurred after a significant decline in the Emini S&P Futures contracts. The "fat-finger trade" hypothesis was also disproved when it was determined that existing CME Group and ICE safeguards would have prevented such an error. Some analysts were skeptical of this hypothesis, suggesting that deliberate market manipulation could be to blame. Others have said it may have been tied to short positions, in the form of put options, taken on the S&P 500 just before the crash or a movement in the US Dollar to Japanese Yen exchange rate. Both the regulatory agencies and the US Congress announced investigations into the causes of the crash.
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Case Study: Flash Crash

The cause of the drop remained unknown, but investigators focused on a number of possible causes, including a confluence of computer-automated trades, or possibly an error by human traders. By the weekend, regulators had discounted the possibility of trader error and focused on automated trades conducted on exchanges other than the NYSE. Others speculate that an intermarket sweep order may have played a role in triggering the crash. On May 11, The Wall Street Journal suggested that a large purchase of put options by the hedge fund Universa Investments shortly before the crash may have been among the primary causes. On May 14, reports appeared suggesting that the event may have been triggered by a single sale of 75,000 e-mini contracts valued at around $4 billion by the Overland Park, Kansas firm Waddell and Reed on the Chicago Mercantile Exchange.
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The Future of the Financial Exchanges

1309 commodity traders form Bruges Beurse
Spreads to Ghent, Amsterdam, Italy (government securities); Holland allows the formation of joint stock companies
1602 First stocks and bonds issued on the Amsterdam Stock Exchange
Dutch East Indian Company Continuous trading Speculative investments
1698 Trading in coffee houses of London

Jonathans issues a list of stock and commodity prices for traders after they were expelled from the Royal Exchange for rowdy behavior
1761 150 Brokers form a club, build the Stock Exchange in 1769 1801 A modernized London Stock Exchange opens
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The Future of the Financial Exchanges

Governance
Demutualization, separation of ownership and membership, Stockholm in the early 1990s Innovation in products and services
Technical
Small Order Management System Stock Exchange Electronic Trading System
Structural - Mergers
NYSE-Euro Next Eurex (Deutsche Bourse and SWX acquires ICE December 07 TSE-NYSE Euro Next January 07 agreement, w/ LSE, Feb 07
Speed on the Outside

Black Pools Liquidnet vs. NYSE - 42,000 vs 400 sh. on average trade Turquoise, Chi-X- Instinet; who will go faster than the speed of light?
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Part V: The Garden of Forking Paths

Modern Economics in Brief Invoking the Animal Spirits Eight Big Questions Swensens Edges - Advanced Portfolio Theory Tip of the Iceberg Risk - Beyond Modern Portfolio Theory The Behemoth RenTech Of Mice and Men: Are Central Banks Necessary? The Misbehavior of Markets in a World of Chance The Network Effect: X Degrees of Separation Systemic Risk Redux Origins of Wealth: The Production of Goods and Provision of Services Creation and Destruction Little Blue Planet
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Modern Economics in Brief

The Modern Movement Keynesian Revolution, 1935
Macro glitches are dangerous need regulation and active financial policy to smooth the road
Samuelson MIT, 1941 Economics goes high tech Chicago Cowles Commission, 1954 Counter-Keynesians, Milton Friedman
Condemns fine tuning, warns of perverse effects that would likely arise from attempts to interfere extolls the magic of the market
Greatest economist Kenneth Arrow and the new math

Infinite Dimensional Spreadsheet
1970s becomes and era of tool making

Behavioral Economics
Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market prices, returns, and the resource allocation. The fields are primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which describes another source of economic decisions with related biases towards promoting self-interest.
Invoking the Animal Spirits

Confidence The Cornerstone
Feedback mechanisms between it and economy that amplifies disturbances
Fairness Setting wage and price controls

Opinion measurement, norms, expectations
Corruption and Anti-social Behavior - Temptation

Past three recessions each featured a major scandal:
S&L Associations and the Recession of 1991 Enron and the Nuclear Winter of 2001 Subprime market and the Crisis of 2007-9
Animal Spirits
The Money Illusion Public confused by inflation/deflation
Wage contracts, Cost of Living increases, expectations Debt contracts, bonds and repayment Accounting Failure to comprehend the consequences of a drop in consumer prices Human Mind Political and economic explanations Epidemic of stories Back to Taleb The Narrative Fallacy
Stories: Our sense of reality intertwined with others
Eight Big Questions

Why do economies fall into depressions?
1980s example crash of confidence, stories of corruption and failure, sense of unfairness in economic policy
Why do central bankers have power over the economy?

Standard story open market operations, rediscounting or lending at the discount window Interest rate story Managing quantity and price supply and demand Alternative view: The central banks will take action when confidence might be collapsing
Eight Big Questions

Central Banks continued
Shadow banking system experiences intense fear of failure late in the cycle; could lead to financial panic So the central bank is the lender of last resort counters the systemic risk in a liquidity crisis However, in recent years, the magnitude of the crises has become so great that the central banks are more engaged in trying to save their own economies and, more generally, the world economy through coordination with peers
Evidenced domestically by the US failing to relieve the pressure on Lehman resulting in Chapter 11 filing in September 2008
Animal Spirits or Lap Dogs

Even so, the Fed also provided:
Discount window lending through TALF, and Direct injections of capital - $250 billion from TALF to:
Bank of America Bank of New York Mellon Citigroup Goldman Sachs JP Morgan Chase Morgan Stanley Wells Fargo
So for investors, what strategies and tactics to pursue on this quasi-level, interventionist playing field?
Swensens Edges Advanced Portfolio Theory

David Swensen, Chief Investment Officer, Yale Endowment Fund Allocation to Alternative Investments
Helps attain an 17.4% annualized return
Data on VC and Hedge Fund Manager Performance Access is the Golden Word Global Investment people on the ground
Venture Capital Contraction
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Hedge Fund Performance
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The Tip of the Iceberg Risk Beyond MPT

Addresses the abnormality of normality Focus on rebalancing Optimal mix with conditional Brownian Motion Optimal mix with moderate Poisson risks In Wilmott Mag: The Tracks of Tears and others http://www.wilmott.com/ detail.cfm?articleID=310
Iceberg Risk
Most people assume that portfolios are bound to suffer less than individual assets from high standard-deviation outliers. Thats not true. Granted, according to the Central Limit Theorem, portfolios of many independent, identically distributed assets have approximately normal distributions, even when those of individual assets are very fat-tailed. But even a small degree of dependence can render the CLT inapplicable. - Kent Osband, Iceberg Risk: An Adventure in Portfolio Theory
The Behemoth - RenTech

Jim Simons in Lecturing Birds on Flying story
December 2007, Jim Simons gave a lecture at NYU Stern, Pablo Triana relates some of the discussion in Lecturing Birds(reading) And Triana concludes, There can be no Einstein or Newton. Even the math genius raking in $1B a year and consistently generating 30 percent return wouldnt qualify. The terrain, unlike the physical world, is just too untamable and lawless.
Of Mice and Men: Are Central Banks Necessary?

Can Central Banks Protect Us from Depression and Lead the Economy? Argument 1: Yes. Without a central bank, there would be no way to control the dangerous excesses of the banking system and otherwise keep the economy on a steady course. US Panic of 1907 leads to the Federal Reserve Act, 1913
Loose or tight money, accelerators and brakes
Are Central Banks Necessary?

Arguments 2 9 = No 2. The record of the US Fed has been poor; the country did much better before its founding
The severity of each of the major contractions, 1920-1, 1929-33, and 1937-8 is directly attributable to acts of commission and omission by the Reserve authorities and would not have occurred under earlier monetary and banking arrangements.
- Milton Friedman

3. Price fixing is especially toxic for an economy and central banks are price fixers. 4. Central banks are national economic planners and that planning does not work. 5. Central banks rely on flimsy tools and rules. 6. The Greenspan Fed A case study in Unintended Consequences 7. CBs represent moral, not only practical problems

Central banks service the interests of politicians, primarily, rich people secondarily, and the poor not at all. Central banks can and should be replaced
Return to Gold Private banking facilities
Possible to have reserve requirements of 100%
Disclaimer: for discussion only

Other Big Picture Debates

Classical gold standard Gold exchange system Floating rates Managed floating rates Dollarization One World Money The World Bank International Monetary Fund And Market Mechanics the Liquidity Story
The Quant World: Fractals, God (Higgs), and Dice
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A Game of Chance
On the facing page you see four price charts of the kind you would find in a brokerage-house report, but with identifying dates and values removed. Two of the charts are real chronicles of the price of a real financial instrument name also removed. Two are forgeries, entirely fictitious series of numbers, generated using different theoretical models of how markets work. Ignore whether they trend up or down. Focus on how they vary from one moment to the next. Which are real? Which fake? What rules were used to draw the fake? - Benoit Mandelbrot, The (mis)Behavior of Markets
Fractals: Ten Heresies of Finance

1) 2) 3) Markets are turbulent Markets are risky, much more than standard theories admit Market timing matters greatly; big gains, losses concentrate into small packages of time 4) Prices often leap, not glide, adding to risk 5) Time is flexible 6) Markets in all places and ages work alike 7) Markets are inherently uncertain and bubbles are inevitable 8) Markets are deceptive 9) Forecasting prices is perilous, but you can estimate the odds of future volatility 10) In financial markets, the idea of Value has limited value.
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Fractals
Chance Simple or complex House of Modern Finance:
Bachelier Markowitz What is Risk? MPT; Efficient portfolios Sharpe What is an Asset worth? CAPM Black Scholes What is Risk worth? BS
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Fractals
Shaky assumptions
People are rational and aim only to get rich All investors are alike Price change is practically continuous Price change follows Brownian Motion
Anomalies that do not fit/contradict CAPM:

The P/E effect, p. 101-2 The small firm in January effect The Market to Book effect
Turbulent markets fractals are studies in roughness

Fractals: A Primer
Initiator Generator Rule of recursion Scale up or down Self-similar Self-affine Multi-fractals Pictures Sierpinski gasket, fractal skewed web, Cantor distribution, Koch curve Cluster forms: clouds, cauliflower, human lung
Does God Play Dice?

A World of Chance: Brenner and Brown
Gambling stigma, prohibitions Rise of entertainment and sports industries From poker banks to clearing houses Poker banks and junk bonds Gambling on central banks
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Or it is just people in the kitchen, cooking with Gas: Enron & Amaranth
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The Network Effect: X Degrees of Separation

The Company of Strangers Fragility and strangeness in our everyday lives Our evolved ability of abstract reasoning has allowed institutions like money markets, cities, and the banking system to provide the foundations of social trust. Even basic provisions of food and clothing now rely on a web of interaction that spans the globe Civilization may act as a curb on our more violent instincts, but it is also highly dependent on their suppression
Systemic Risk Redux

Lo, What Happened to the Quants, August 2007 Dr. Mila Getmansky Shermans video Finance Department at UMASS and affiliated with CISDM Papers on SSRN
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All Ships Rise and Fall Together?
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Origins of Wealth
Production of Goods and Provision of Services Technological Innovation Productivity Supported by:
Infrastructure Legal System: Rule of Law Intellectual Property Rights Regime Robust and Liquid Capital Markets Transparency Higher Education System Work by Amsden, Saxenian, Bhide
Creation and Destruction

The Trimurti (Three forms) is a concept in Hinduism in which the three cosmic functions are personified by the forms of Brahma, the Creator, Vishnu, the Maintainer or Preserver, and Shiva, the Destroyer or Transformer. The Hindu scriptures, the Puranas, explain that Absolute Satchinanda, or Absolute-Existence-Bliss once had a wish to be seer and player in the unreal world of Maya. So he created the Trimurtis, symbolizing the Universal Creator, Men, and Demons. They suggest that there are many perspectives conflicting with each other, but no one can say which one is right.
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Part VI: The Fire Next Time

Where will the next crisis come from?
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Old World Crisis
168
New World Crisis
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Those D@rn Swans

Emanuel Derman from Alchemists on Wall Street: the models are not the problem, more the inputs those are judgments. But his fear really centered on the prospect of the race going to the quickest Alchemists came out before May 6
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Financial Modelers Manifesto

I will remember that I didnt make the world, and it doesnt satisfy my equations. Though I will use models boldly to estimate value, I will not be overly impressed by mathematics. I will never sacrifice reality for elegance without explaining why I have done so. Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights. I understand that my work may have enormous impacts on society and the economy, many of them beyond my comprehension. http://www.wilmott.com/detail.cfm?articleID=298
Dungeons and Dragons

Contagion: Macro Meltdown Europe Regulation: Spillover Effects Speculation: Precious Metals, FX, Carbon Techno: Black Box Trading Flash Crash II Techno-Human: Hackers and Terrorists Acts of God (or Higgs): Solar Storms Visible on the Horizon The Power of Words
Contagion: Macro Meltdown Europe
173
Regulation: Spillover Effects

Capital goes where it is appreciated. Domestic Regulation
Actor Cooperation Penalties for Anti-Social Behavior
Global Regulation
Sincerity and Deception Oversight and Enforcement
Again, Vandals Crown and Emperors Clothing Cases of the Marshall Plan (grand scale), Plaza and Louvre Accords (moderate collaboration)
Speculation: Precious Metals, FX, Carbon

Platinum chart
1972-2004
EMU falls apart

Who wins? Who loses? Imagine returning to the DMark, Drachma, Lira
Carbon Trading regime

Government regulation Emerging venues
175
Techno: Black Box Trading Flash Crash II

Role of Black Pools Data:
Average trade on NYSE is 400 shares Average trade on Liquidnet is 42,000 shares
You apply circuit breakers and where is the flow going to go? Race to the quickest latency Horse racing handicap weight for age or for winning; maybe force some latency on GS
Techno-Human: Hackers and Terrorists

Penetration of Networks
Levels of Damage from Theft How much is just exploring, for now?
Growth in Dependence on Electronic Money Haug Options Embedded in Physical Money

http://papers.ssrn.com/sol3/papers.cfm?abstract_id= 1313665
And not only Human Interlopers in our systems

Acts of God or Higgs: Solar Storms

Another recent paper by Haug: When Will God Destroy Our Money? NASA statements, data Preparedness, very low http://papers.ssrn.com/ sol3/papers.cfm?abstra ct_id=1591768
Back to Barter?
(If) a very large coronal mass ejection from the sun that could cause a super solar storm should hit the earth, it might wipe out the global money system within minutes from impact. Stock exchanges would not operate, banking systems would not function, and credit card and ATM machines would stop working. We could find ourselves without the use of our modern electronic forms of money for months and possibly years. And yet, even in a catastrophic scenario, where water pumps, power plants, public transportation, and other infrastructural assets that are essential to contemporary life had failed, some type of functioning money system would be required to keep the basic necessities, such as food and medical supplies, flowing without too much friction. - Espen G. Haug, When Will God Destroy Our Money?
Visible on the Horizon

The Power of the Word
National Governments International Organizations Lobbyists The Silent Majority
Global Political Flows Global Financial Flows Global News Flows

Global Coordination and Cooperation

Central Bank activity Construction projects in US and UK 30 years on infrastructure US low rates do not choke the recovery Europe always a deathly fear of inflation Emerging Markets: For Better and for Worse
Emerging Markets
As emerging market economies become increasingly important in the global trading and financial systems, the world economy will depend even more on them to maintain strong domestic growth and economic and financial stability. Thus, the improvements in emerging market policies and policy frameworks I have discussed today have ramifications beyond the emerging market economies themselves. Emerging market nations also have a key role to play in the important efforts to reduce global imbalances in trade and capital flows. Again, the G-20 is in a position to lead.
Chairman Ben. Bernanke at Bank of Koreas International Conference, May 30 ,2010
Power of the News Media

After dot com introspection and some new rules of the game
Fairness Balance Accuracy Disclosure
Then severely tested by Subprime Meltdowns And even more so by Flash Crash
Interdisciplinarity, or CFD Revisited

We joked before about Computational Fluid Dynamics, but the multivariate analysis angle is relevant: Finance: Theory and Practice Technology: Electrical Engineering, Computer Science, Math, Physics Economics: Local, National, Global Regulatory: Too Little, Too Much, Too Late , Unintended Consequences Behavioral Psychology, including Mass Media
Loops and Influences

Financial Markets
Technology
Economics
Behavioral Psychology
Regulation
185
The Blank Swan

In the midst of this cauldron, a new breed of analysis is brewing: In a world that is only made of contingency, it is only natural that we should invent options or derivatives contractsthat we should circulate, today, things that we know will make a difference in the future. Thus we write those derivatives contracts and in their writing (the Ifthen, else ifthen formula) there is nothing even remotely related to possibility. It is the pure, material writing of contingency. It is pure difference. Writing is difference, as Derrida would say. However, writing, as we all know and as Roland Barthes suggests, is only the prelude to an exchange...
Elie Ayache, The Blank Swan: The End of Probability
Contingency
In philosophy and logic, contingency is the status of propositions that are neither true under every possible valuation (i.e. tautologies) nor false under every possible valuation (i.e. contradictions). A contingent proposition is neither necessarily true nor necessarily false. Propositions that are contingent may be so because they contain logical connectives which, along with the truth value of any of its atomic parts, determine the truth value of the proposition. This is to say that the truth value of the proposition is contingent upon the truth values of the sentences which comprise it. Contingent propositions depend on the facts, whereas analytical propositions are true without regard to any facts about which they speak.
187
Propositions
Along with contingent propositions, there are at least three other classes of propositions, some of which overlap: Tautological propositions, which must be true, no matter what the circumstances are or could be (example: "The sky is blue or the sky is not blue."). Contradictions which must necessarily be untrue, no matter what the circumstances are or could be (example: "It's raining and it's not raining."). Possible propositions, which are true or could have been true given certain circumstances (examples: x + y = 4; There are only three planets; There are more than three planets). All necessarily true propositions, and all contingent propositions, are also possible propositions.
Little Blue Planet

Terrain Human Inhabitants Species: Flora and Fauna GDP Quality of Life Index Perspective from successful software entrepreneur to Oyster Fisherman
Finding the Signal

Philosophy Art Music Hot Links
Solar Flares http://soundcloud.com/unive rsity-of-sheffield/sound-ofthe-sun http://www.youtube.com/wa tch?v=ZbIffp40U8w&feature= player_embedded Whale Songs http://www.youtube.com/wa tch?v=WabT1L-nN-E
190
Aporias Return
We sharea secret which cannot be shared, a secret which we know nothing about To share a secret is not to know or to reveal the secret, it is to share we know not what: nothing that can be determined. What is a secret that is a secret about nothing and a sharing that doesnt share anything?
Jacques Derrida, The Gift of Death
191

Financial Crises - Contagion - and Complexity - July 19 FINAL

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Financial Crises - Contagion - and Complexity - July 19 FINAL

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Financial Crises, Contagion, and Complexity

The Challenges of an Interconnected World

Part III: Complexity 1: The Globalization of Finance

Part V: The Garden of Forking Paths: Finance and Economics

A Note on Style and Format

Part 1: An Overview of Financial Crises

Regulatory Responses US - Up to WWII US - Post-War Boom

CQF Lecture, Copyright PHE, 2010

CQF Lecture, Copyright PHE, 2010

Manias and Bubbles: Defined

CQF Lecture, Copyright PHE, 2010

Top Ten Bubbles

Tulip Mania, 1634 early 1637

South Sea Company, 1711-20

Top Bank Panics

CQF Lecture, Copyright PHE, 2010

Bank Panic, 1907

CQF Lecture, Copyright PHE, 2010

CQF Lecture, Copyright PHE, 2010

Crash of 1929: Black Monday

CQF Lecture, Copyright PHE, 2010

Crash of 1929: Black Monday

CQF Lecture, Copyright PHE, 2010

Regulatory Responses to 1929

CQF Lecture, Copyright PHE, 2010

CQF Lecture, Copyright PHE, 2010

CQF Lecture, Copyright PHE, 2010

Post WWII: Boom

CQF Lecture, Copyright PHE, 2010

Part II: Modern Events

The Great Hangover Seeking Solutions: An Engine not a Camera

Top Banking Crises

CQF Lecture, Copyright PHE, 2010

The Tools of the Trade

CQF Lecture, Copyright PHE, 2010

Modern Methods: Fundamental Analysis

CQF Lecture, Copyright PHE, 2010

Modern Methods: Technical Analysis

Beware, the Black Swan

CQF Lecture, Copyright PHE, 2010

Modern Methods: Quantitative Analysis

CQF Lecture, Copyright PHE, 2010

Investment Timeline: 1950s - 1960s

Generous p/e multiples

Investment Trends: 1950s - 1960s

CQF Lecture, Copyright PHE, 2010

Investment Timeline: 1970s

Investment Trends: 1970s

CQF Lecture, Copyright PHE, 2010

Elites Weave Webs with Silver Threads

CQF Lecture, Copyright PHE, 2010

Cornering the Silver Market

CQF Lecture, Copyright PHE, 2010

Among the Gold Bugs

CQF Lecture, Copyright PHE, 2010

Regulation to 1980 and Beyond

CQF Lecture, Copyright PHE, 2010

CQF Lecture, Copyright PHE, 2010

Investment Timeline: 1980s

CQF Lecture, Copyright PHE, 2010

Investment Trends: 1980s

CQF Lecture, Copyright PHE, 2010