Efficient Markets and Innovation

Our little Internet debate about reverse convertibles (my contribution here) prompted this post by Mike at Rortybomb. To simplify a little, some commentators defended reverse convertibles by saying, “it’s basically the same as writing a put option” – or, looking at it from the other side of the trade, “there are valid reasons to want insurance against a stock price falling.” To which Mike says, “just sell (or buy) the put option.”

But this is just a specific case of an important point that Mike has made before, but that is more clear when seen in the context of a specific security. Mike’s basic point is that efficient markets imply that financial innovation does not create value. The efficient markets hypothesis says that the prices of financial assets already reflect all available information; in other words, there is no such thing as a free lunch.

Here’s Mike’s example for those who may be unfamiliar with the idea:

Let’s look at regular markets: Let’s say that everyone knows that the energy market is a big deal over the next 10 years. You could buy land where oil is buried very deep and innovate digging techniques, you could start an innovative research firm to get better solar energy going, you could try and make an innovative super-carburetor. All of these, if you pull them off, are going to be very profitable and welfare enhancing. Markets work, so you’ll probably find capital and labor more willing to work with you.

Now what about financial markets. Let’s say that everyone knows that the energy market is going to be a big deal over the next 10 year. If you invest in energy stocks, are you going to make a killing? No. The prices of energy stocks have already been bid up to account for the fact that everyone knows this. The price of financial instruments moves to handle all possible information that is available. This is what it means for financial markets to be efficient.

If markets are efficient, the only way you can get higher expected returns is by taking on more risk. If some broker comes to you with a new product that offers higher returns with the same or lower risk – like a super-senior, “safer than AAA” tranche of a collateralized debt obligation – then there are two possibilities: (a) the product exploits some market inefficiency; or (b) the product doesn’t do what the broker says it does. Mike says that if you believe that markets are efficient, you also have to believe that (b) is more likely to be the case than (a). (The corollary is that financial innovation does create value when it exploits some market inefficiency.)

But wait, you may be thinking, didn’t the crisis just prove that markets are not efficient? Well, yes and no. I’ve been reading Justin Fox‘s new book, The Myth of the Rational Market, which is basically an intellectual history of financial economics in the twentieth century, centered on the rise and fall of the efficient markets hypothesis. The strong form of the efficient markets hypothesis is that market prices, such as stock prices, accurately reflect fundamental values; in Eugene Fama’s words, “the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value” (Fox’s book, p. 97). This proposition has not held up well recently – and has been on the defensive since at least the 1980s – unless you are willing to let prices wander very, very far from intrinsic values.

But there’s another version of the efficient markets hypothesis that I happen to believe holds for many markets: in the short term, you cannot beat the market. For example, stock prices can be irrationally, crazily high – when I was at Ariba, our market valuation went up to $40 billion, even though our annual revenues were less than $300 million and we had never turned a profit – but you still have no way of knowing if they will go up or down in the short term. That’s exactly what happens in a bubble; everyone knows that prices are no longer related to fundamentals, but enough people think they will be able to sell before the bubble bursts that prices keep on going up.

And if this is true for stocks, then it is even more true for derivatives linked to stocks, since the value of an equity-linked derivative is just a function of expectations about the price of the underlying stock. So coming back to reverse convertibles, if the basic purpose is to sell a naked put option on a stock, then you should go to the market and sell a naked put option instead of buying a reverse convertible, which has all sorts of complicated features. Here’s how Mike puts it:

I believe the best price of a put option on a stock is going to the market and getting the price of a put option. I believe that the implied price of a put option, married with odd extra risks and transaction costs, in this reverse convertible bond instrument is a worse price for the put option than the market one, because I believe the more markets vet prices the better they are. Nemo’s point is absolutely correct – if they were much different, the market would be arbitraging them away.

So . . . if you think the stock price of Coca-Cola will be higher in 2019 than the market thinks, then it may make sense for you to buy it, since it’s possible that the price is irrationally low at the moment. (Of course, it could be irrationally even lower in 2019.) But if you think you found a way to get a higher price for a one-year put option on Coca-Cola stock than just going to the market for one-year put options, you are probably wrong.

This brings us back to the main question: why do these things exist?

Some defenders of financial innovation say that because reverse convertibles exist, they must have value. This is the old “Chicago-school” assumption that even though individuals are irrational, markets behave as if people are perfectly rational. This assumption is at least plausible (though almost certainly wrong) when it comes to prices for heavily-traded stocks; there the argument is that a few well-capitalized, rational hedge fund managers are enough to counteract the irrational hordes. But the assumption completely breaks down when you are dealing with complex products that are sold by individual brokers to individual retail investors; it would be crazy for the retail investor in that situation to assume that the price must be fair, because otherwise the broker wouldn’t be offering it. (Do you make the same assumption about a used car salesman?) Or, as Larry Summers wrote in a now-famous though unpublished paper, “THERE ARE IDIOTS. Look around” (Fox, p. 199).

Here’s one answer, suggested by a friend of mine (who has been working in the financial sector for the last two decades):

I think given the existing array of financial instruments available, it is generally possible to construct a return profile of most things you can imagine, so it is hard to create something that has value over existing alternatives. [He gives a positive example, but it isn’t reverse convertibles.] . . .

I think that people may buy these instruments because they are new.  Outside the financial sector, “new” generally implies “better” or “improved”.  Computers, cars, phones, detergent, etc. all get a marketing lift on new models, since in order to stay competitive in most of these industries, your products have to get better and better.  In finance, almost everything is zero sum, so generally there is no better, just different packaging.  So unless the packaging has some value (which in some cases it does), consumers are not getting a better product.  But since it’s “new”, people might assume that they are getting something better.

That sounds about right to me.

(Note: In following Mike’s links I found that Ezra Klein raised this question about financial innovation a couple months ago on his old blog; he now blogs here.)

By James Kwak

43 responses to “Efficient Markets and Innovation

  1. Most of the stuff people buy during peaks and booms just boils down to finding the greater fool and nothing else.
    They really don’t think the product is new and better or anything remotely like that, just that someone else will be willing to buy it at a higher price.

  2. I wonder if regulations sometimes create inefficiencies that can be exploited. For instance, most IRAs are not able to short uncovered options. So if IRA trading is a large portion of market participants in a particular security but these IRA’s are restricted to only taking one side of the trade, then it may be that a flexible account could come in and take the other side at a better rate due to the availability of the trade.

    There was some speculation that allowing mutual funds to short (the advent of the 130/30 funds) would create more efficiency in the market because these large participants could actually vote “no” instead of just “yes” or “abstain.” Unfortunately, many of these fund managers had very little experience shorting and instead of using the tool to offset risk in long positions, they took on short positions which were negatively correlated to their long positions.

    But over time I do believe that less restrictions on investing will create a more efficient market because participants have the ability to trade all available securities. However with less regulation comes risk – so corresponding transparency is probably an important area to look at. Investors in institutional funds or programs need to have the ability to understand what their managers are invested in so that they can adequately determine the risk.

    Good article – definitely a lot to chew on here.
    Zach

  3. This article is pure puffery, and an attempt to deflect from the argument. Stop grandstanding- these investments are quite viable, and if we take your argument to it’s logical conclusion, the only thing an investor should be able to buy are GinnieMaes. There are dozens of investments that do not “create value” as the author intends it. If he is advocating banning them all, let him say so. Let us forbid anyone from buying an option.

  4. Will more regulations fix the financial systems? In my view, there has to be a major revision of the current inefficiencies. I really don’t think that the economies are able to withstand such volatile behaviours. Sure, some will profit from intense volatility, but that is not the point. Our economies are highly dependant of the financial sector, and going forward, I hope finance will revised into a more stable and sustained source of growth.

    For those interested, I have asked Ezra Klein and Mark Thoma what they thought of the recent speculations about recovery while no significant change has occurred so far; you can view their answers here:

    Ezra Klein:
    http://theeconomicword.wordpress.com/wp-admin/post.php?action=edit&post=4

    Mark Thoma:
    http://theeconomicword.wordpress.com/2009/06/22/more-on-economic-recovery/

  5. Putting all ‘instruments’ in the public domain, as in ‘open source’, would certainly eliminate the magic and allow serious scrutiny by both investors and regulators.

    History supports the proposition that those who claim some sort of intellectual propriety probably can’t be trusted…

  6. Zach Scheidt: “I wonder if regulations sometimes create inefficiencies that can be exploited. For instance, most IRAs are not able to short uncovered options.”

    There are reasons that most IRAs are not able to short uncovered options. If reverse convertibles allow getting around that regulation, then they should be regulated.

    (BTW, if you think that the regulation against writing puts is wrong, that is irrelevant here, because the argument is that both derivatives should be regulated in the same way.)

  7. i’m still wondering (and nobody is able to give me a hint here) — how many of these reverse convertibles were actually sold? are these a real problem?

  8. I think an examination of gambling would be useful when dealing with rational expectations. Look at horse race betting. The odds are adjusted so that the house always gets it cut, and thus the net distributed is that much less than taken in. This is an area where special information could be of use and there is a side industry in selling it to bettors.

    On the other hand slot machines and craps are purely random, but many people believe otherwise.

    Such human behavior would seem to indicate that gambling is motivated by emotion, not logic and that the “theories” that are put forward are an ex post facto attempt to find some organizing principles that really aren’t there.

    Once you accept the random walk theory of stock prices and then assume that you can’t beat the market and put your money in an index fund then there is nothing left to do. The press, the financial sector, the touts and brokers all have a vested interest in obscuring such information and keeping people playing the game.

    It would be interesting to figure out how many people who did well in using some investment strategy or other were actually just lucky.

  9. If a reverse convertible is in many respects similar to buying a put option, it’s worth asking: would we allow institutions (like banks) to buy long-dated put options on their own stock? On the one hand, this would be the easiest way to get banks to have additional capital that would be available at times of crisis. On the other, would seem to have negative implications for corporate governance, like buying insurance on your house and then setting it on fire. Perhaps these balance out, however.

    Or we could think of a market-based solution: force banks to buy put options on the market and give them to the regulator. The regulator would have a contract/right enshrined in law to buy stakes at dilutive rates if needed using the income from the puts.

    There you go: banks are paying depositors’ insurance at market rates, but they would still have every incentive to keep their stock price and volatility high (to keep the cost of buying the puts down).

    If you use this idea, contact me!

  10. Whoops, that should have said stock price high and volatitility low. ;)

  11. I disagree with the premise. Even if markets are efficient, financial innovation can add value through allowing market participants to better insure specific risks. Not saying it is true in the case of reverse convertibles, but I don’t think you can just say that financial innovation has no value in efficient markets.

  12. Yes, I am not persuaded by the basic premise too.

    We are taught that one of the main functions of secondary capital markets is to create liquidity in primary capital markets, thereby reducing risk for providers of primary capital, and reducing the cost of capital for users of primary capital. Increasing the spread between cost of capital and return on capital creates value by definition.

    It seems to me that some financial innovations can be thought of along these lines- creating liquidity in another market that ultimately lowers the cost of capital for capital users. E.g. CDOs make the market for Mortgage-Backed Securities more liquid, which in turn reduces the cost of debt finance for home purchase (mortgages).

    I think your example of insuring against specific types of risk is also valid.

  13. What does any of this have to do with producing food, clothing, shelter, transportation, energy & health care? Can an economy function without food, clothing, shelter, transportation, energy & health care? Can it function without reverse convertibles? I think our priorities are screwed up.

  14. can someone explain, within the efficient markets framework, how loose credit could cause housing prices to go up?

    logically it makes sense. if i have the option to borrow against the value of my house, then it is worth more to me than if i do not have that option.

    hmm, so i have just proven that financial innovation creates value.

    is there something wrong with my argument?

  15. Hey “q” !!!!!
    $8.5 billion reverse convertibles sold 2007
    $7.0 billion reverse convertibles sold 2008
    $1.0 billion reverse convertibles sold THUS FAR 2009

    The 2009 sales are down 2/3 from 2008, I assume because of the economic crisis. All of those numbers above are from the original June 16 Wall Street Journal article written by Larry Light that started this discussion. DO NOT DEPEND ON ANY OF THE NUMBERS IN THIS POST AS I MAY HAVE MADE A TYPO. Look in the original article yourself. Here is the link.
    http://online.wsj.com/article/SB124511060085417057.html

    Hope that helps you “q”

  16. thanks Ted K

    here’s a rule: ‘never buy any financial product with the word ‘reverse’ in it.’

  17. Pingback: Monday links: performance divergence Abnormal Returns

  18. That’s an interesting argument. Financial economists do accept that the conventional account of value, as told by present value, doesn’t account for option value- that’s why option valuation models exist at all, and have been extended to real option theory. So I guess the argument would be that options do exist, and have value, but they are not liquid or well-captured by the traditional account. So then it becomes plausible that creating an apparatus for valuing and trading options would create (or at least uncover) value.

    I need to think about this more. This is complex.

  19. What’s up with the Ezra Klein boosterism? Perhaps a million people have made Ezra’s points long before he did, and you know this perfectly well. To boldly propose in *APRIL 2009* that financial innovation is not all it’s cracked up to be? Way to go out on a limb, Ezra. ZZzzzzzzzz…

    I always respected Baseline for being focused on genuine experts rather than partisan hacks, so I’m curious why you’re somewhat insincerely IMO promoting a Liberal opinion blogger who occasionally makes tired, derivative points about policy. Please stick to experts and leave the echo-chamber-partisan-political-operative garbage out of it!

  20. Your question is self-contradictory. In the EMH, there is no such thing as “loose” credit. The credit market is perfectly efficient. :)

    However, let’s say for some exogenous reason housing supply is limited (thus decoupling equillibrium housing prices from construction costs). And, further, let us assume that prices in the future will be higher than in the present (exogenously increasing demand, exogenously decreasing supply, exogenously increasing costs to construction), THEN lower rates (perhaps due to some exogenous reason like limited opportunity costs for non-housing investments) yield higher prices.

    Think of future housing prices as a bond that delivers X at maturity. If interest rates go down, the price of the house (bond) increases. This pricing mechanism is entirely separate from what probably happens in the real world (aka, interest rates go down so people can afford a higher mortgage so prices go up).

  21. If you accept EMH, the risk-arbitrage explanation is perhaps the _only_ argument for innovation. The presumption is that different people have different “tastes” for risk, and that instruments can be fashioned that more perfectly match taste, thereby increasing demand for credit instruments overall and lowering rates for “average american homebuyers”.

    Presumably, “taste” is driven by things like a decreasing maginal utility curve for money, so that poorer people are more risk averse (in raw dollar terms). Or perhaps the risk averse folks are risk averse because they have specific obligations (like pension funds or insurance companies). Thus, these instruments allow such risk averse folks to participate in a high-risk market. The instruments pay these people a higher rate than things like savings accounts, but not as high a rate as high-risk investments are getting. The “innovator” and the entity that is absorbing the risk keep the difference as a premium.

    So that’s the story, and it’s pretty much a total lie.

    First, much of the “taste” for these instruments was driven by financial institutions that were seeking ways to increase their leverage (that is, borrow more money with less of a capital cushion to absorb it). The instruments got rated better than their component parts, and cap/asset ratios are set by risk tier. (You can loan a higher multiple of your capital base if those loans are more secure.) In an easy-credit world, everyone wants to lever up; regulation limits this, but “innovation” helped end-run these regulatory limits.

    For all of this to succeed, you have to imagine that either:

    A) The people peddling these instruments believed their own lies, which I find impossible to believe (especially given the press reports describing the suppression of internal folks who questioned the models). That’s a lot of zero-covariance terms flying around. Any trained statistician would have to be a total idjut to ignore that.

    B) There was a vast amount of fraud (among banks, ratings agencies, investment banks, and govt. regulators)

    One of the main questions is what WOULD have stopped this behavior? Was Too-Big-To-Fail the main culprit (implying that big banks would not have loaded up on these instruments without the implicit guarantee of government backup)? Or mass psychology? Or complicit government agencies? Or the impoverishing of the middle class?

    In any case, financial innovation _theoretically_ offers some benefits under EMH, but creates vast problems. Yet the titans among us (Larry Summers) seem to think that financial innovation was not the problem; we simply didn’t understand it well enough.

    Rather than outlawing these things, the assertion is that they really are critically important in a modern economy and that _next time_ we’ll get it right!

  22. OH, and I forgot to add…

    Isn’t the function of spreading risk supposed to be born by banks? And if banks were competing (and were efficient), then wouldn’t the spread on those rates reflect the cost of covering the risk?

    We have YET to hear an argument explaining why the traditional bank model (assuming competition is present) is SOOO inefficient that society requires decoupling the servicing and funding functions of a loan, and selling mortgage-backed-bonds directly to investors?

    And, for that matter, why do we need credit default swaps on currencies rather than traditional options? How does EMH allow for these to offer unique value?

  23. StatsGuy:”B) There was a vast amount of fraud”

    I don’t think we could have gotten in this deep a mess without fraud. Bubbles attract fraud.

  24. It seems that the more heavily traded a security is, the more accurately it will be priced.

    If this is the case, then limiting the number of types of securities, while possibly giving up some small measure of efficiency, will tend to make the prices of all securities more accurately reflect their value, as this will result in fewer and more heavily-traded securities.

    Considering that mispriced assets were at the core of the recent crisis, one would think that this would be a good thing.

  25. i’m not sure where you get the idea that these instruments were modeled with zero covariance. that was completely not the case. (possibly at ratings agencies, but not at investment banks / dealers / hedge funds.) i think that the the risk modeling for these instruments was poor but these days that is a fairly non-controversial statement.

    in my experience people did not have strong beliefs regarding the models, but they did have strong beliefs regarding the general concept of pooling/tranching and then distributing and levering the tranches. people felt that the market was liquid and basically ‘correct’.

    the big banks (in the US) did not load up on these instruments. in fact they strove to sell them to others. (that is the ‘distribute’ part of the model.) toward the end of the cycle they were left with a huge amount of the worst unsold inventory. but if you look at the numbers — for example IMF is expecting $3.1T of losses on US credit instruments but only $1.2 (i think) within the banking system — most of these instruments were not kept within the banking system. so the majority of the losses were born by institutions and individuals with no government guarantee whatsoever, at least from the US govt.

    i don’t know much about efficient market theory but at the risk of being wrong i’ll say a few things. most EMH believers don’t think much of securitization because EMH declares the details of the financial system — how capital gets from point A to point B — irrelevant. it just ‘happens’.

    many derivatives don’t have use in an EMH world. many of them have to do with moving risk from one holder to another, and all of this happens under the covers of the efficient market. a leveraged entity (say a hedge fund) might want to choose its risks carefully — say buying a convertible bond and hedging the credit exposure — as each risk component it accepts counts against its allowable leverage.

  26. there are no credit default swaps on currencies. that doesn’t make sense. are you talking about sovereign CDSs, or is it a typo?

  27. we eat way too much food by any measure (average intake is 3,600 calories per person in the US — remarkable) and spend plenty on health care – the difficulties are primarily with health care finance. i haven’t seen people who lack basic clothing — we export our old clothes to places like africa. transportation? we have the most advanced highways in the world and a very large number of automobiles. energy? we use plenty. so i think your bases are covered, and we can go and do reverse convertibles now.

  28. Does this include the 5-6 million unemployed Americans? What are reverse convertibles doing to help them?

  29. Efficient Market Hypothesis is a useful tool and mental exercise to understand and see things more clearly. No one in their right mind really believes it. Let me repeat that. NO ONE IN THEIR RIGHT MIND REALLY BELIEVES IN EMH. I don’t even think Milton Friedman or Burton Malkiel believe it deep in their heart (or recesses of their mind). Alan Greenspan, one of the biggest proponents of EMH spent a large segment of his life in government and quasi-government jobs. And Greenspan spent many hours looking at inventory build-ups and the cardboard box business (tracking liner board prices) and zillions of other numbers/indicators pumped out by the Federal Reserve to see if he could outguess the next moves of the market. Which shows you what a GIGANTIC ego Alan Greenspan had/has that he thought he could adjust something he proclaimed as in essence perfectly efficient.
    Economics and finance are human activities. They have the same imperfect (sometimes inefficient) character as ALL human
    activities. TRY TO GET OVER IT.

  30. On financial innovation: a thought that has been running around in my head is that the financial industry has so much money now that they don’t have enough places to put it, so they keep inventing new places to stash it–sort of circularly flowing piggy banks. If we imagine that all the fancy stuff went away (reverse convertibles, CDS, CDO, MBS, options, futures, etc) where would all that money go? The only thing I can think of that could absorb that much money would be privatizing space exploration, as an investment. Since that isn’t seen as a likely bet, they must come up with innovations just to have a place to store their cash.

    I’m not saying they’re consciously doing this, but perhaps there’s a bit of deep panic over what to do with all that money (you can be close to bankruptcy and still have lots and lots of money, right?).

  31. James Kwak:

    “This is the old “Chicago-school” assumption that even though individuals are irrational, markets behave as if people are perfectly rational. This assumption is at least plausible (though almost certainly wrong) when it comes to prices for heavily-traded stocks; there the argument is that a few well-capitalized, rational hedge fund managers are enough to counteract the irrational hordes.”

    Chicago is rather notorious for resurrecting discredited arguments and trying to pass them off as something novel. The reason the above argument is likely to be wrong was clearly spelled out by Keynes all those years ago:

    Keynes (GT Chapter 12):

    ‘It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.’

    ‘This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

    Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.’

  32. James,

    Although you make a convincing argument about some products being less innovative than meets the eye, I think your argument gets a little twisted when it assumes that efficient markets and complete markets means the same thing. These two concepts are not the same.

    The arguments (whether credible or not) given for innovations like reverse convertibles was that they were ‘completing the market’. This is not the same as saying that they were making markets more efficient. Market efficiency is more related to the idea of no-arbitrage.

    In both theory and practice, we can have markets that are complete, but not arbitrage free (i.e. markets that are complete, but not efficient), as well as markets that are efficient, but not complete.

    I think your arguments would be even more persuasive if you focused on the validity (or lack thereof) of whether products like reverse convertibles really were completing the market, or were just “chicken dressed up like ham”.

    Alan.

  33. Quoting a homosexual anti-Semite educated at King’s College, Cambridge…….. but he was a genius…….
    Jolly good show!!! Jolly good show!!!

  34. Rereading Ch 12 I am tempted to put the whole chapter here. By a great effort of will, however, I’ll limit myself to just one more paragraph. Personally, I find it amazing that the clearest, most cogent, and the most convincing demolition of the Efficient Market Hypothesis actually predates the EMH itself!
    Back to Keynes…

    Keynes (General Theoty Chapter 12 cont.):

    ‘If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.[4] For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.’

  35. Pingback: Mother, I Thought We Went Over This Already «  Modeled Behavior

  36. James,

    Is this how you really think bubbles form:

    “That’s exactly what happens in a bubble; everyone knows that prices are no longer related to fundamentals, but enough people think they will be able to sell before the bubble bursts that prices keep on going up.”

    Bubbles are just one big conspiracy where everyone thinks they will find a bigger fool? I think plenty of behavioral finance research (Thaler, Schiller, et al.) has shown that herd behavior and other psychological reasons exist for why bubbles form.

  37. An interesting academic paper which hasn’t been discussed in this thread:

    See Szymanowska, Ter Horst, Veld (2009) Journal of Futures Markets: “Reverse Convertibles Analyzed”. The authors show that the securities are, on average, overpriced by almost 6%. But they find some rational factors to explain some (but not all) of the overpricing. A must read for the quant wonks!

    Click on this link, and then the SSRN button to download the paper:
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=730543

  38. The efficient-market hypothesis has been debunked again and again. The fact that you’ve heard of a man named “Warren Buffett” is a testament to that.

  39. Yes, sorry. Sovereign CDSs are effectively being used as a hedge against currency devaluation. But we already have currency options. So, why are they really needed?

  40. First, a recommendation: “Animal Spirits” by Akerloff and Shiller. In this book, the authors take the presumption of homo economicus (particularly the naive version) and the macroeconomic theoretical edifice (artifice?) upon which it is built to task. It’s a terrific read, very accessible, sensible, yet, technically first quality (as is the academic work of its authors). The EMH and CAPM can be viewed as special cases of the arguments they build for including a much larger and more scientific assessment of the role of “animal spirits” (Keynes’ phrase) in economic decisions.

    Second, to assert that derivatives exist because they add value by assuming that they couldn’t exist if they didn’t is circular. In the study of rhetoric, there is a name for it: begging the question, which means, simply, assuming the point you are trying to prove.

    Third, all decisions about assets reduce to buy or sell (hold is simply sell the asset at close, buy the same asset in the same quantity at open or, in a continuous market, sell and buy the same asset in the same quantity continuously). All financial innovations are variations on this choice and can be analyzed in terms of how well a particular asset reflects it. If we are rational, we buy them because we believe that we will be able to sell them for more than we paid for them or we sell them because we believe that we won’t and would prefer to buy an asset that we think we will be able to sell for more.

    I realize that “everybody knows this” (sigh), but I also see people forgetting it every day (from which I infer that “everybody” “knows” otherwise). In an efficient market (even a weak-form efficient market) with rational participants, hybrid securities and strategies wouldn’t exist, even at the margins (of creditworthiness, in particular). They add no value and, therefore, have no role to play. If you are rational and have gathered all of the information available and necessary to decide whether you are sufficiently confident that the price of the asset(s) you are considering buying will increase, you should buy the asset or a call option on it (if you’re confident that you can predict the duration of the window of opportunity). If you decide that the price will decrease and you own this asset, you will sell it or buy a put option. To employ any other strategy or combination of strategies increases transaction costs, incurs greater risk without offering commensurately greater potential return or reduces risk by limiting potential returns commensurately or more.

    Selling a covered call (buying a covered put) is a good, simple example of a hybrid strategy that limits return potential and reduces transaction costs, but doesn’t limit risk materially. Another example is the convertible bond. The buyer sacrifices current return (lower coupon payments) and future return (the sum of the below-strike-price segment of the price appreciation of the associated stock and the above-call price appreciation of the stock), thereby achieving the worst of both worlds—lower coupon and lower potential price appreciation. Who would buy such an instrument? The seller, on the other hand, pays a smaller premium on the bond then he would’ve on a simple bond and avoids the far greater cost of selling equity in the firm (especially if the firm’s performance is not strong). The seller does bear some of the risk of his own success. If the seller’s enterprise succeeds beyond his limited expectations, a greater share of the rewards are transferred to the bondholders when they convert. Hence, the seller installs a call provision, which he exercises when he succeeds, thereby, limiting the rewards he must share with those bondholders to the cost of calling the shares and paying for them (an increase in the coupon, really) less the cost of the interest and principal repayments he would’ve made had the bonds been allowed to mature.

    No rational investor would buy such securities or employ such investment strategies. What would the financial condition of a firm have to be to offer such securities? Surely, rational investors in an efficient market would identify such firms as troubled simply because they have to offer this type of compromise (deception?) to raise money.

    q, btw, is correct in his assertion that derivatives function mainly to shift risk to another player from oneself. I must say that Max’s quotes from GT provide wonderful narratives to that process, in which the unsold inventory of highest-risk assets are the Old Maid in that game. There are no hedges against holding the Old Maid when the game stops.

    There is, without question, much more to this story. Nevertheless, the role or existence of hybrid securities or derivatives has not been explained by any economic theory of which I’m aware that does not include a significant role for “animal spirits” (or any other phrase you want to use to describe how people feel about events, acts and motives).

  41. Thanks for the reminder, Max. The GT is still the best book on macroeconomics.

  42. they aren’t in any way necessary. i am also not sure if they are allowed to be traded in the US. most of them are traded out of london i think.

    for a good explanation of them read this: http://www.acredittrader.com/?p=81.

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