the alpha and omega

OTC Derivatives Clearing Technology

Mahalanobis — 2011-10-05T09:38:00Z

OTC Derivatives Clearing Technology: Bringing the Back Office to the Forefront (pdf), TABB Group (Summary)

related items:
Tech upgrade needed for derivatives clearing, Financial Times

Oops :: Basel Risk Weights

Mahalanobis — 2011-09-26T08:20:00Z

Businessweek writes:

The risk-weighting system is far too complex and too easily manipulated to provide a reliable picture of how much capital a bank really has. For a large bank such as JPMorgan, coming up with a risk-weighted ratio requires sorting assets into more than 200,000 different buckets. Even unintentional errors can skew reported capital ratios by several percentage points [sic, emphasis mine]. Thats a problem when the starting point is only 10 percent.

Update:
Financial Alchemy Foils Capital Rules in Europe, Bloomberg

Banks in Europe are undercutting regulators demands that they boost capital by declaring assets they hold less risky today than they were yesterday.

Banco Santander SA (SAN), Spains largest lender, and Banco Bilbao Vizcaya Argentaria SA (BBVA), the second-biggest, say they can go halfway to adding 13.6 billion euros ($18.8 billion) of capital by changing how they calculate risk-weightings, the probability of default lenders assign to loans, mortgages and derivatives. The practice, known as risk-weighted asset optimization, allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders.

Inflation Expectations

Mahalanobis — 2011-06-29T09:30:00Z

Bloomberg: Morgan Stanley was burned by a wager on U.S. inflation expectations in the second quarter, three people informed of the dealings said.

Traders at the bank bet that inflation expectations for the next five years would rise in Treasury markets, while forecasts for the next 30 years would fall, according to two of the people. Such wagers on so-called breakeven rates involve paired purchases and short sales of Treasuries and Treasury Inflation Protected Securities, or TIPS, in both maturities.

The TIPS market was roiled last week by the combination of a slump in the price of crude oil and a stronger-than-expected auction of new 30-year TIPS. Source

Unemployment Statistics

Mahalanobis — 2011-06-10T14:07:00Z

FT: [The size of the Spanish black economy] helps to explain one of the more embarrassing economic mysteries of modern Spanish society: an extraordinarily high rate of official unemployment without much of the civil unrest and popular anger that such a problem would normally generate. If it were true that 4.9m people, or more than 21 per cent of the workforce, were jobless, Spain would not be as peaceful as, barring a few demonstrations, it has so far been, say economists and business leaders.

It is an open secret that the Spanish jobless rate double the European average is a fiction. Hundreds of thousands of people claim unemployment benefit when they actually have some kind of work; millions are not registered as working, which means that neither they nor their employers are paying social security contributions. One proof, say employers, is that when unemployment fell to 8.5 per cent at the height of the boom in 2006-07, they could find no workers to hire. Yet that figure, the recent Spanish minimum, is high enough that it would be associated with a deep economic recession in almost any other industrialised country. [Story]

A different way to look at probability distributions

Mahalanobis — 2011-05-26T15:19:00Z

A different way to view probability distributions, Probability and Statistics Blog

Imported Inflation : Energy Prices

Mahalanobis — 2011-04-22T10:40:00Z

For central banks it poses a big problem when inflation is not "home made" but imported through higher energy prices. In this case inflation is not the result of a booming domestic economy but of external factors (political turmoil, peak oil, ...). Interest rate hiking be the central bank would be pretty ineffective except when it leads to a strengthening of the home currency.

Thanks to the ECB statistical Data Warehouse one can now easily download data on the contribution to the inflation rate (in percentage points) of various components of the harmonized consumer price index. Currently, 50% of the yearly inflation rate in the Euro area is due to higher energy prices even though energy only makes up 10% of the index.

The good news: Many people look at the price of oil as a crude proxy for energy prices. Though it is true that the variation in the crude oil price explains the variation in consumer energy prices very well, the "beta" is pretty low. Crude oil prices (in EUR) have increased 700% since 1999 whereas consumer energy prices have "only" increased 90%. Given that many market participants think that at current oil prices the price elasticity of demand is no longer negligible the pressure might abate.

The New Fear Barometer (?)

Mahalanobis — 2011-04-06T08:57:00Z

There has been some talk about the high level of the Credit Suisse Fear Barometer lately (e.g. SurlyTrader).

Bloomberg: The CS Fear Barometer measures investor sentiment for 3-month investment horizons by pricing a zero-cost collar. The collar is implemented by the selling of a 10% OTM SPX call option and using the proceeds to buy an OTM put. The CSFB level represents how far out-of-the-money that SPX put is. The higher the level, the greater the fear.

With the proceeds of selling a 10% OTM call you can currently only buy a 28% OTM put:

{Click to enlarge}

But what does that mean? When comparing the CS Fear Barometer with the level of the S&P 500 over the last 15 years you will notice that

Fear had a very low reading at the time of the dot-com crash and it stayed pretty low during the whole 2000-2003 equity market downturn
Fear trended upwards during the equity market recovery
Fear fell off a cliff quite some time before the global financial market meltdown (false sense of security?)
Fear was close to its all-time low at a time where many bankers where talking about buying farmland
Fear has been rising since the markets turned in March 2009

So it seems like the indicator could measure anything but fear. In 2009, when Credit Suisse introduced the index Reuters wrote: "The index would rise when there is excess investor demand for portfolio insurance or lack of demand for call options."

Obviously, it could also be a glut in the market. For example in case fund mangers think that there is not much upside in the current market they would start writing covered calls and reduce implied call volatility in the process. That shouldn't count as "fear".

Anyway, since for the last couple of years the CS Fear Barometer was just a blurred version of the inverse VIX I wonder whether anybody can distill some additional information:

Speculative Grade

Mahalanobis — 2011-03-09T19:26:00Z

FT: Junk bonds, the darling of the debt markets for two years, are proving remarkably resilient.

Globally, triple C-rated companies, which include names such as J Crew, the clothing chain, and Level 3, the communications group, have sold $9.8bn of debt this year, well above the previous year-to-date record of $5.2bn in 2007.

This reflects demand from the continued inflows into mutual funds investing in high-yield corporate bonds, as well as appetite for risk from hedge fund investors. In general, there used to be pretty strong resistance to accept new issuance from companies that were rated triple C, said Martin Fridson, global credit strategist at BNP Paribas Asset Management.
A handful of bond sales recently included two features considered particularly risky, according to Standard & Poors LCD, which tracks the leveraged finance markets. One of those features was so-called PIK toggle, a popular structure before the financial crisis that gives an issuer the option to pay interest with more bonds rather than in cash. Debt was borrowed, too, to pay special dividends to companies owners, in a dividend deal. Typically, investors will accept these features from companies with ratings on the higher rungs of the junk category, but all four of these deals were rated triple C.

Bonnie Baha, head of global developed credit at DoubleLine, says there are now more riskier companies than in the past. If you are just looking at spreads, you can say we still have room to run, but what people fail to recognise is that the credit quality of the relevant credit indices is lower now than it was at the previous low points in credit spreads and that alters the logic, she says. The days of the junk bull run may be numbered.

Story: Junk bonds resilient as US recovery trumps oil, FT

Vasicek asymptotic single factor model ("Gaussian Copula")

Mahalanobis — 2011-03-03T14:00:00Z

This post explains the Vasicek/Merton single factor model which is part of the Basel framework (IRB approach) and has been used to evaluate CDOs.

Imagine you loan money to a friend who will default with a probability of 1%. When it comes to paying back the loan you will either receive 100% (plus any interest) or 0%. That's pretty risky. So you figure you can improve your situation by making same size loans to n friends. (NB: You will need a license for doing so). In case they all default individually with a probability of p = 1%, the law of large numbers tells you that the more loans you make (increase n), the closer the average default rate (= portfolio default rate) will be to 1%. "The" central limit theorem states that the portfolio default rate will be normally distributed with a mean of 1% and a variance that goes to zero as n increases.

Now here is the result for n = 5000 loans and 100,000 simulations (portfolios):

Unfortunately, this is only true when default solely happens due to idiosyncratic reason such as illness or a divorce, i.e. when the default of one friend is not related to the default of another friend. But in case you make loans to colleagues from work this assumption won't be correct since bankruptcy of the company would turn most of your loans sour at the same time no matter how large (number of obligors) your loan portfolio actually is. In other words: Certain systemic risk can't be diversified away.

Assuming you really have lots of "similar" friends (p = 1%) and they are all pretty evenly distributed across the sectors the economy has to offer one could argue that defaults are actually only a function of this idiosyncratic risk (as before) and a single systemic risk factor reflecting the overall state of the economy. In case the economy does very well, hardly anybody will default (even an expensive divorce is not an issue) and in case the economy enters into a deep recession, the default rate goes north. The sensitivity of each obligor to this systemic factor and the correlation among the obligors is given by √ρ and ρ, respectively.

Result for n = 5000 loans and 100,000 simulations (portfolios):

The average portfolio default rate is not affected by an increase in correlation, but the higher the correlation the more likely extreme portfolio default rates become (good or bad). In case the correlation is one, we are back to a single obligor. Either nobody (0%) or everybody (100%) defaults.

The model (see comment section for details) is a useful starting point but since both systemic and idiosyncratic risk is assumed to be normally distributed and are connected via an uncertain correlation coefficient you could easily be on the wrong end of the trade. NB: That doesn't mean the Basel guys did a bad job. They had two parameters (correlation and systemic shock size) for calibrating the model.

EUR Greece Sov Curve :: 3D

Mahalanobis — 2011-02-25T17:59:00Z

Aging Population :: Banks vs Insurance Companies

Mahalanobis — 2011-02-24T19:20:00Z

Oliver Wyman:

As the population ages, the demand for financial products will change. Broadly speaking, older consumers are wealthier than younger ones. They have greater balances in savings and investment accounts and are much more likely to live in an un-mortgaged home. As they reach retirement, their demand for accumulation products, such as equity mutual funds and amortizing mortgages (designed to accumulate home equity), declines markedly from their peak accumulation years. At this stage of life, their needs shift to draw-down products, such as annuities and structured income contracts. [...]

Banks that can develop solutions for these consumers will create massive value for them. Life insurers begin with one advantage over banks. Their traditional business involves expertise in precisely the kinds of products and risks (especially longevity risk) that are required to serve an aging customer base. To succeed in the emerging demographic environment, banks will need to acquire the skills characteristic of life insurers.

The Future of Banking : Six trend that will shape the industry, Oliver Wyman

Greece :: Negative Basis Trade

Mahalanobis — 2011-02-24T12:19:00Z

CDS Curve (white line) vs. Z-Spread (+)

Read: Citi sees free lunch in Greek basis (almost), FT Alphaville

High-frequency Trading :: Impact Analysis

Mahalanobis — 2011-02-23T12:17:00Z

Deutsche Bank Research: Existing evidence related to the impact of HFT on certain market quality and efficiency indicators is inconclusive. Some studies (e.g. Hendershott and Riordan, 2009; Jovanovic and Menkveld, 2010) suggest that HFT using market making and arbitrage strategies has added liquidity to the market, reduced spreads and helped align prices across markets. While there is no proof of a negative liquidity impact in the academic literature, certain issues still remain:

HFs are under no affirmative market making obligation, i.e. they are not obliged to provide liquidity by consistently displaying high-quality, two-sided quotes. This may translate into a lack of available liquidity, in particular during volatile market conditions.
HFTs contribute little to market depth due to the marginal size of their quotes. This may result in larger orders having to transact with many small orders and may affect overall transaction costs
HFT quotes are barely accessible due to the short duration for which the liquidity is available when orders are cancelled within milliseconds.

Another interesting issue is whether HFT contributes to the price formation process on equities markets. In this context, Brogaard (2010) examines a large data set of HFT firms trading on Nasdaq and finds that, firstly, HFTs add substantially to the price formation process as they tend to follow a price reversal strategy (irrespective of whether they are supplying liquidity or demanding it), driven by order imbalances, and so tend to stabilise prices. Secondly, HFTs do not seem to systematically front-run non-HFTs. They provide the best bid and offer quotes for a significant portion of the trading day, but only around a quarter of the book depth (as do non-HFTs) and reduce their supply of liquidity only moderately as volatility increases. Thirdly, HFTs engage in a less diverse variety of strategies than non-HFTs, which may exacerbate market movements if HFTs use similar trading strategies. Fourthly, while in principle high cancellation rates could impact the smoothness of execution in markets where HFTs are present, prevailing narrow spreads seem to suggest that cancelled quotes are quickly replaced by other market participants. Hendershott and Riordan (2009) find that algorithmic traders quotes play a larger role in the price formation process than human quotes. Summing up, on the one hand, price discovery benefits from market participants who quickly detect anomalies in market prices and correct them. On the other hand, HFT may distort price formation if it creates an incentive for natural liquidity to shift into dark pools as a way of avoiding transacting with ever-decreasing order sizes. In terms of market volatility, neither Hendershott and Riordan (2009) nor Brogaard (2010) find any evidence for a detrimental impact of either AT [algorithmic trading] or HFT. Economic perspective and potential regulatory aspects.

High-frequency trading? Better than its reputation?, DB Research, Feb 2011

Economic Theory Bashing : 1942 Style

Mahalanobis — 2011-02-22T11:57:00Z

Theory has, at length, become so "scientific" and abstract as to intrigue the mathematicians who have taken delight in developing the concept of a kaleidoscopic and frictionless play of atomistic units in a complex and eternally unfolding equilibrium. The notion of equilibrium suggested equations; equations are prolific parents of their kind; and the game has gone on until the pages of the more esoteric economic journals have become a mass of hieroglyphics intelligible only to those who know the code. All the inconvenient freight of fact has been discarded by the more recondite practitioners until the "science" has come to move in a realm of pure abstraction useful for purposes of cerebration but of steadily declining practical importance.

Much first-rate analytical skill and much scholarly industry has miscarried because the road to academic recognition lay in the refinement of traditional technique, or in assiduous dust-gathering, with little consideration of ultimate purpose. The means have been exalted over the end, and the neophyte, compelled to show his mastery of technique, has quickly learned to love and practice it for its own sake.
This is not to deny the virtue, even the necessity, of abstract speculation or the desirability of the most catholic comprehension of the facts. It is merely to assert that these should be tools rather than ornaments and that we should never cease to ask ourselves what we want and how we propose to get it.

Frank D. Graham, 1942

Source:
Social Goals and Economic Institutions, Frank D. Graham, Princeton University Press, 1942, pp. xv-xx
What do Economists Contribute?, Cato Institute, NY University Press, 1999, pp. 27

Active vs. Passive Management

Mahalanobis — 2011-02-21T18:16:00Z

Financial News: Investment consultants are pushing for a seismic shift from active asset management to passive in a move that could result in savings of more than $50bn a year for pension schemes and other institutional investors and a switch of trillions of dollars in assets.

The advice is based on consultants growing belief that some markets, including the US and UK equity markets, have become so efficient that active managers will find it hard to add value.

Tim Hodgson, a senior investment consultant at global consultancy Towers Watson, told Financial News: We estimate the overall ratio of passive to active, including all invested assets globally, is 10:90. We think it should be 70:30.

Pension schemes globally controlled more than $26 trillion of assets at the end of last year, according to Towers Watson. A switch of the magnitude proposed would involve almost $16 trillion moving from active to passive mandates. It would also precipitate a fundamental overhaul of the global fund management industry. Full Story