Finally figured out the title of this great piece. Even before I know it is about river flow i do have some river images in my head when I heard it. I read somewhere online that this music is about contrast and mergers. It's about warm and cold, happy and sad, calm and mad, female and male, day and night... anything that's the opposite of each other. These opposite quality things always go hand in hand, female can't do without male, day won't exist if there is no evening, and cold is the complement of warm. Human being's emotion, sad and happy, are also of the same kind.
in the composer Smetana's own words: The composition describes the course of the Vltava, starting from the two small springs, the Cold and Warm Vltava, to the unification of both streams into a single current, the course of the Vltava through woods and meadows, through landscapes where a farmer's wedding is celebrated, the round dance of the mermaids in the night's moonshine: on the nearby rocks loom proud castles, palaces and ruins aloft. The Vltava swirls into the St. John's Rapids; then it widens and flows toward Prague, past the Vyšehrad, and then majestically vanishes into the distance, ending at the Labe
http://www.youtube.com/watch?v=rMV_rrRBgD8
Monday, February 15, 2010
Videos on WGBH - Justice
This is the link to the lectures given by Harvard professor Michael Sandel on a serious of economic philosophical topics. I like his lectures because, as he puts it, philosophy asked difficult questions to help people think about why we do what we do. This discussion makes more sense to me now that I have been graduated from grad school, have some work experience interacting with people and that I have spent some time exploring larger issues on my own.
First of all I noticed that my thinking and reasoning improved significantly compared to when I was still in college and grad school. Some of the questions the professor asked, I kind of know where he is leading the students to, and that I have my own answer which turned out to be pretty close to his. I am getting older biologically, and I am just glad that my mental age also grow a bit.
Secondly, the discussion has pointed out couple methodologies to analyze and think about the society. Each method has its unique contribution in terms of providing a framework to analyze and put reason to our social bahavior. A lot of the times there are no standard answer or best answer to some issues but if you have a consistent approach to reason and analyze the issue, one should not feel bad sticking to it. Reasoning is a major work required in thinking justic and other major issues potentially affecting all human being at some point in life. If one can be consistent, clear, and supply with good reasoning that his argument or actions pass the judgement of the majority in a group setting, that action will be perceived as morally adjusted.
I watched 5 video clips so far, and I need to watch more and think about these issues more before putting more thoughts on the blog. These definitely are very interesting topics and I am eager to listen to the young bright students utter their confusion or insight. I am a human being, they are also human being, the fact that they are Harvard students doesn't mean they have all the right answers.
If they asked my opinion, I will rate prefessor Sandel's lecture 5 star, excellent. His speech is clear and the tempo is just perfect for me. He asked questions, interacted with students but also make sure he has the control of the lecture so that audience grasp the whole picture from beginning to end. There are some professors not very good at timing where an excited start was ruined by disaapointed ending.
http://www.wgbh.org/programs/programDetail.cfm?programid=429
First of all I noticed that my thinking and reasoning improved significantly compared to when I was still in college and grad school. Some of the questions the professor asked, I kind of know where he is leading the students to, and that I have my own answer which turned out to be pretty close to his. I am getting older biologically, and I am just glad that my mental age also grow a bit.
Secondly, the discussion has pointed out couple methodologies to analyze and think about the society. Each method has its unique contribution in terms of providing a framework to analyze and put reason to our social bahavior. A lot of the times there are no standard answer or best answer to some issues but if you have a consistent approach to reason and analyze the issue, one should not feel bad sticking to it. Reasoning is a major work required in thinking justic and other major issues potentially affecting all human being at some point in life. If one can be consistent, clear, and supply with good reasoning that his argument or actions pass the judgement of the majority in a group setting, that action will be perceived as morally adjusted.
I watched 5 video clips so far, and I need to watch more and think about these issues more before putting more thoughts on the blog. These definitely are very interesting topics and I am eager to listen to the young bright students utter their confusion or insight. I am a human being, they are also human being, the fact that they are Harvard students doesn't mean they have all the right answers.
If they asked my opinion, I will rate prefessor Sandel's lecture 5 star, excellent. His speech is clear and the tempo is just perfect for me. He asked questions, interacted with students but also make sure he has the control of the lecture so that audience grasp the whole picture from beginning to end. There are some professors not very good at timing where an excited start was ruined by disaapointed ending.
http://www.wgbh.org/programs/programDetail.cfm?programid=429
Pension Plan Assets and Liabilities and WACC
Today I am reading SS 5 Reading 22, an edited transcript of a speech delivered in London in 2004 by Robert C. Merton, titled Allocation Shareholder Capital to Pension Plans. Below is an excerpt from the text:
“ That brings me to the concept of a “risk budget” I mentioned earlier. I find it useful to think of companies as having risk budgets that are very much analogous to their capital budgets. Reducing risk in one place releases capacity to increase risk elsewhere without having to add more equity capital to the firm. And this means that the total opportunity created by reducing risks in the pension fund is to enable the firm to take more risk in its operating business, which is presumably where it is most likely to find positive net present value opportunities. The expected net effect of such changes is an increase in firm value. Although you reduce the expected return on your pension assets, you gain more from the new operating assets that you are now able to hold without additional equity capital – all of which is made possible by the reduction of risk in the pension fund.”
Merton pointed out that most firms do not include their pension plan risk when they explore capital structure decision. A firm sponsoring a DB plan should realize that it has two sets of assets and liabilities components, one is obvious as can be found on accounting statement, the operating assets and liabilities; while the other is less obvious and is probably showing nowhere on accounting statement (except in the filing footnotes), the pension assets and pension liabilities. Merton argued that the traditional WACC where only operating asset and liabilities are included overstated the WACC, that to truly reflect how investors perceive the firm’s total risk one need to include pension assets and liabilities in the calculation.
Here is an example he gave to illustrate the point:
Table 1 Errors in Estimates of Weighted Average Cost of Capital
Pension Assets ($bn) Pension Liabilities ($bn) Pension Surplus/ Deficit ($bn) Market Cap ($bn) Book Value of Debt ($bn) Standard WACC WACC Adjusted for Pension Risks
Boeing 33.8 32.7 1.1 30.9 12.3 8.8% 6.09%
DuPoint 17.9 18.8 (0.9) 42.6 6.8 9.44% 8.15%
EK 7.9 7.4 0.5 8.6 3.2 9.75% 7.47%
Textron 4.5 3.9 0.6 5.9 7.1 7.98% 6.81%
*EK-- Eastman Kodak
All four firms are doing just fine with their pension plans, but notice how the WACC adjusted is much lower than the traditional WACC in the last two columns. That is an example of how to calculate the adjusted WACC. We saw the adjusted WACC smaller than standard WACC probably because their equities holding in the pension plan is no more than 50%.
DB sponsors that invest heavily in equities expose themselves to greater market risk and their price tend to be less attractive. According to Merton analysts and market participants at large already pricing company’s pension management.
“But if the pension assets were largely in equities and the liability is largely fixed-rate debt, the risk exposure would be huge. And the question we were attempting to answer in our study was: Does the market capture that risk? Given the arcane accounting and institutional separation between the pension plan and the rest of the business, I did not think the market would take it into account.
But our results suggest that, during the period of our study – 1993 to 1998 – the U.S. stock market did a pretty good job of picking up the differences in risk. More specifically, a company with a larger fraction of equity in its pension portfolio tended, all other things equal, to have a larger “beta” – a widely used measure or risk that reflects, among other things, the “systematic-risk” volatility of the stock price itself. In other words – and this is simplifying things a bit – the greater risk associated with equity-heavy pension plans seemed to show up in more volatile stock prices.”
“ That brings me to the concept of a “risk budget” I mentioned earlier. I find it useful to think of companies as having risk budgets that are very much analogous to their capital budgets. Reducing risk in one place releases capacity to increase risk elsewhere without having to add more equity capital to the firm. And this means that the total opportunity created by reducing risks in the pension fund is to enable the firm to take more risk in its operating business, which is presumably where it is most likely to find positive net present value opportunities. The expected net effect of such changes is an increase in firm value. Although you reduce the expected return on your pension assets, you gain more from the new operating assets that you are now able to hold without additional equity capital – all of which is made possible by the reduction of risk in the pension fund.”
Merton pointed out that most firms do not include their pension plan risk when they explore capital structure decision. A firm sponsoring a DB plan should realize that it has two sets of assets and liabilities components, one is obvious as can be found on accounting statement, the operating assets and liabilities; while the other is less obvious and is probably showing nowhere on accounting statement (except in the filing footnotes), the pension assets and pension liabilities. Merton argued that the traditional WACC where only operating asset and liabilities are included overstated the WACC, that to truly reflect how investors perceive the firm’s total risk one need to include pension assets and liabilities in the calculation.
Here is an example he gave to illustrate the point:
Table 1 Errors in Estimates of Weighted Average Cost of Capital
Pension Assets ($bn) Pension Liabilities ($bn) Pension Surplus/ Deficit ($bn) Market Cap ($bn) Book Value of Debt ($bn) Standard WACC WACC Adjusted for Pension Risks
Boeing 33.8 32.7 1.1 30.9 12.3 8.8% 6.09%
DuPoint 17.9 18.8 (0.9) 42.6 6.8 9.44% 8.15%
EK 7.9 7.4 0.5 8.6 3.2 9.75% 7.47%
Textron 4.5 3.9 0.6 5.9 7.1 7.98% 6.81%
*EK-- Eastman Kodak
All four firms are doing just fine with their pension plans, but notice how the WACC adjusted is much lower than the traditional WACC in the last two columns. That is an example of how to calculate the adjusted WACC. We saw the adjusted WACC smaller than standard WACC probably because their equities holding in the pension plan is no more than 50%.
DB sponsors that invest heavily in equities expose themselves to greater market risk and their price tend to be less attractive. According to Merton analysts and market participants at large already pricing company’s pension management.
“But if the pension assets were largely in equities and the liability is largely fixed-rate debt, the risk exposure would be huge. And the question we were attempting to answer in our study was: Does the market capture that risk? Given the arcane accounting and institutional separation between the pension plan and the rest of the business, I did not think the market would take it into account.
But our results suggest that, during the period of our study – 1993 to 1998 – the U.S. stock market did a pretty good job of picking up the differences in risk. More specifically, a company with a larger fraction of equity in its pension portfolio tended, all other things equal, to have a larger “beta” – a widely used measure or risk that reflects, among other things, the “systematic-risk” volatility of the stock price itself. In other words – and this is simplifying things a bit – the greater risk associated with equity-heavy pension plans seemed to show up in more volatile stock prices.”
Sunday, February 7, 2010
Traditional vs, Behavioral Finance Assumptions
I am reading the personality typing section from the 2010 CFA level 3 book2, reading 14 – Managing Individual Investor Portfolios, by Bronson, Scanlan, and Squires (BSS). Below I will quote some of their works with quotation marks or if none I will make obvious note. So far it’s been a very interesting reading – it briefly compares traditional finance assumption to the behavioral ones. My understanding is that traditional finance assumes rational investors (or more appropriately, the institutional investors) operate in a perfect market condition utilizing financial science to make investment decision, while the behavioral finance focus on individual investor’s investment making process which involves many psychological factors and which almost totally throw away the rational assumptions used in the traditional finance model. The two theories maybe are the complement to each other, covering the major investment decision making process happened to the human society. Financial advisors (institutional and individual) need to know both in order to be able to quickly gear the discussion with clients to the potential concern areas.
According to BSS, in traditional investment decision making, investors are assumed to “exhibit risk aversion, hold rational expectations, and practice asset integration.” However, behavioral finance assumes investors “exhibit loss aversion, hold biased expectations, and practice asset segregation.”
Risk aversion exhibited by rational investors means that they will look at standard deviation and talk about probability of loss at the end of investment horizon. They possess statistic like standard deviation and covariance because they use market information to predict future investment outcome and that they can accurate predict various economic variable like inflation rate, interest rate and real growth rate of GDP. Investors are like scientists in this model, gathering, analyzing and making investment decision objectively without emotional attachment.
Loss aversion exhibited by individual investors means that individual investor “opportunities in terms of gain or loss rather than in terms of uncertainty with respect to terminal wealth.” Human brain understands and calculates whole number quickly and effectively then fraction in conjunction with multiplication and division. I once heard a co-worker complained that his parents don’t understand standard deviation even after he tried explaining to them multiple times. The brain is not wired to think in terms of complex math and one need be trained to think in terms of financial math is my take away. OK we are jumping to psychology already, but it seems like psychology industry is still developing slowly in terms of their understanding of the human brain. Maybe due to legal and humanitarian consideration neuron study are progressing much slower than other fields like the finance and IT industry. Behavioral finance also points out that individual investor is no expert in terms of predicting economy future, that average individual investor won’t have the knowledge and tools to accurately estimate inflation, interest rate and GDP growth ex ante.
As a consequence of the different assumptions about investor’s behavior, the portfolio construction process is different under the two theories:
"• Traditional finance: (1) Asset pricing is driven by economic considerations such as production costs and prices of substitutes. (2) Portfolios are constructed holistically, reflecting covariances between assets and overall objectives and constraints.
• Behavioral finance: (1) Asset pricing reflects both economic considerations, such as production costs and prices of substitutes, and subjective individual considerations, such as tastes and fears. (2) Portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer reflects certain goals and constraints."
According to BSS, in traditional investment decision making, investors are assumed to “exhibit risk aversion, hold rational expectations, and practice asset integration.” However, behavioral finance assumes investors “exhibit loss aversion, hold biased expectations, and practice asset segregation.”
Risk aversion exhibited by rational investors means that they will look at standard deviation and talk about probability of loss at the end of investment horizon. They possess statistic like standard deviation and covariance because they use market information to predict future investment outcome and that they can accurate predict various economic variable like inflation rate, interest rate and real growth rate of GDP. Investors are like scientists in this model, gathering, analyzing and making investment decision objectively without emotional attachment.
Loss aversion exhibited by individual investors means that individual investor “opportunities in terms of gain or loss rather than in terms of uncertainty with respect to terminal wealth.” Human brain understands and calculates whole number quickly and effectively then fraction in conjunction with multiplication and division. I once heard a co-worker complained that his parents don’t understand standard deviation even after he tried explaining to them multiple times. The brain is not wired to think in terms of complex math and one need be trained to think in terms of financial math is my take away. OK we are jumping to psychology already, but it seems like psychology industry is still developing slowly in terms of their understanding of the human brain. Maybe due to legal and humanitarian consideration neuron study are progressing much slower than other fields like the finance and IT industry. Behavioral finance also points out that individual investor is no expert in terms of predicting economy future, that average individual investor won’t have the knowledge and tools to accurately estimate inflation, interest rate and GDP growth ex ante.
As a consequence of the different assumptions about investor’s behavior, the portfolio construction process is different under the two theories:
"• Traditional finance: (1) Asset pricing is driven by economic considerations such as production costs and prices of substitutes. (2) Portfolios are constructed holistically, reflecting covariances between assets and overall objectives and constraints.
• Behavioral finance: (1) Asset pricing reflects both economic considerations, such as production costs and prices of substitutes, and subjective individual considerations, such as tastes and fears. (2) Portfolios are constructed as “pyramids” of assets, layer by layer, in which each layer reflects certain goals and constraints."
Wednesday, February 3, 2010
DC and DB plans
I believe there are 2 types of retirement plans offered in the U.S. currently, defined contribution plan and defined benefit plan. In the DC plan, employees make investment decisions and bear investment risk; in teh DB plan, employers make investment decisions and provide guarantee retirement outcome. The traditional method is the DB plan, but corporate actions are shying away from DB because of its negative impact on financial statment. The dominant retirement plans offered nowdays is the DC plan. I am not sure about the statistic, but I believe the target retirement accounts are widely offered in most DC plans.
The behavioral finance theory argued that average individual investor is not well suited to make retirement investment decision because most of the traditional finance theory assume average investor is ratioanl and utility maximizer. Bahavioral finance people argue that due to limited time and intelligence, average investor is emotional, use heristic other than statistic to make investment decisions. To be successful managing retirement account in the DC plan, an investor will need to have a good estimate of their retirement need, final salary level, life expectancy, and the various complex relationship between different investment vehicles. DB retirement plans are managed by professional managers and from traditional finance we know that they on average do not beat the passive index funds when management fee is taken into account. Such an complicated task is being handed over from the IM to the average investor and there is great risk that the majority investors do not know how to properly manage their own retirement account.
I once was scanning through a pension book written a Canidian author who serves in the pension industry. He argued that neither DB plan or DC plan is appropriate, that there should be a third, or maybe millions other version to the the simple approaches. So i was thinking that maybe one possible approach is to combine the DB and DC features in a new investment plan -- using the DB features to ensure minimum retirement amount is met and uses the DC features to allow flexible investment options once the minimum is ensured. But that's easier said than done, setting and achieiving the minimum income is already tough enough. Oh wait a minute, isn't that what we were asked to do in level 3 CFA exam, to design an investment policy statement for individual investor. Yes, i can do that, but the problem is how to turn custom tailor workshop into massive standard investment factory, where investors can pick and choose the proper investment group according to their own circumstances, what's more important is, how to design the filter/rules that are intuitive to average investors.
The behavioral finance theory argued that average individual investor is not well suited to make retirement investment decision because most of the traditional finance theory assume average investor is ratioanl and utility maximizer. Bahavioral finance people argue that due to limited time and intelligence, average investor is emotional, use heristic other than statistic to make investment decisions. To be successful managing retirement account in the DC plan, an investor will need to have a good estimate of their retirement need, final salary level, life expectancy, and the various complex relationship between different investment vehicles. DB retirement plans are managed by professional managers and from traditional finance we know that they on average do not beat the passive index funds when management fee is taken into account. Such an complicated task is being handed over from the IM to the average investor and there is great risk that the majority investors do not know how to properly manage their own retirement account.
I once was scanning through a pension book written a Canidian author who serves in the pension industry. He argued that neither DB plan or DC plan is appropriate, that there should be a third, or maybe millions other version to the the simple approaches. So i was thinking that maybe one possible approach is to combine the DB and DC features in a new investment plan -- using the DB features to ensure minimum retirement amount is met and uses the DC features to allow flexible investment options once the minimum is ensured. But that's easier said than done, setting and achieiving the minimum income is already tough enough. Oh wait a minute, isn't that what we were asked to do in level 3 CFA exam, to design an investment policy statement for individual investor. Yes, i can do that, but the problem is how to turn custom tailor workshop into massive standard investment factory, where investors can pick and choose the proper investment group according to their own circumstances, what's more important is, how to design the filter/rules that are intuitive to average investors.
Sunday, January 31, 2010
Reading notes -- Long Term Capital Management
Introduction:
Long Term Capital Management was a hedge fund founded by John Meriwether in 1994. Other famous members include two Noble Price winning economists, Myron Scholes and Robert C. Merton. They intended to exploit market inefficiency by using sophisticated pricing model like Black Scholes Merton’s option pricing model, in combination with high leverage. The hedge fund enjoyed great success in the first year, a 40% annual return, probably due to market inefficiency. However the good return didn’t last too long and the hedge fund lost $4.6 billion in 1997.
Notes:
Hersh Sherfrin, Heuristic- Driven Bias: The First Theme.
“Remember the Wall Street proverb about greed and hear? I note that the emotional aspect of aversion to ambiguity is fear of the unknown. The case of Long-Term Capital Management provides an apt example of this phenomenon. On September 23, 1998, a $3.6 billion private rescue of LTCM was arranged. The Federal Reserve Bank of New York orchestrated this plan because of a concern that the failure of LTCM might cause a collapse in the global financial system. The November 16, 1998, issue of the Wall Street Journal describe the scene as the participants departed the meeting at which the deal was struck The article attributes an interesting remark to Herbert Allison, then president of Merrill Lunch, a remark that typifies aversion to ambiguity as fear of the unknown. “As they filed out, they were left to ponder whether all this was necessary, and whether a collapse would really have jolted the global financial system. ‘It was a very large unknown,’ Merrill’s Mr. Allison says, ‘It wasn’t worth a jump into the abyss to find out how deep it was.’”
Hersh Shefrin, Inefficient Markets: The Third Theme.
One of the most fiercely debated questions in finance is whether the market is efficient or inefficient. Remember the hedge fund Long-Term Capital Management (LTCM)? How did it advertise itself to investors? LTCM members promoted their firm as an exploiter of pricing anomalies in global markets. In this regard, consider the following heated exchange between Myron Scholes, LTCM partner and Nobel laureate, and Andrew Chow, vice president in charge of derivatives for potential investor Conseco Capital. Chow is quoted as saying to Scholes, “ I don’t think there are that many pure anomalies that can occur”, to which Scholes responded: “As long as there continue to be people like you, we’ll make money.”
That last remark might not be the best way to win friends and influence people. But Scholes is correct about cause and effect – investors’ errors are the cause of mispricing. Is the market efficient?
The fact is that from 1994 through 1997, LTCM claims to have successfully made leveraged bets – bets that exploited mispricing identified by the option pricing theory for which Scholes and Merton jointly received the Nobel price. In this regard Merton Miller, another Nobel laureate, is quoted as having said, “Myron once told me they are sucking up nickels from all over the world. But because they are so leveraged, that amounts to a lot of money.” “Sucking up nickels” is indicative of inefficiency. Of course, then came LTCM’s 1998 fiasco, but more on that later….”
Overconfidence
There are many behavioral lessons in the saga of LTCM. It does appear that their early success can be attributed to the exploitation of mispricing. At the same time, mispricing does get reduced as investors trade to exploit the associated profit opportunities. And investor do learn, albeit slowly; thus profit opportunities that had existed in 1994 through 1996 in the derivatives markets dried up in 1997. In response, LTCM began to take other kinds of positions, such as bets on the movements of foreign currency movements. Myron Scholes is reported to have been critical of these trades, asking his LTCM colleagues questions like “What informational advantage do we have over other traders?”
……
A Wall Street Journal article describing the experience of Long-Term Capital Management quotes Nobel laureate William Sharpe.
“Most of academic finance is teaching that you can’t earn 40 percent a year without some risk of losing a lot of money,” says Mr. Sharpe, the former Stanford colleague of Mr. Scholes. “In some sense, what happened is nicely consistent with what we teach.”
Long Term Capital Management was a hedge fund founded by John Meriwether in 1994. Other famous members include two Noble Price winning economists, Myron Scholes and Robert C. Merton. They intended to exploit market inefficiency by using sophisticated pricing model like Black Scholes Merton’s option pricing model, in combination with high leverage. The hedge fund enjoyed great success in the first year, a 40% annual return, probably due to market inefficiency. However the good return didn’t last too long and the hedge fund lost $4.6 billion in 1997.
Notes:
Hersh Sherfrin, Heuristic- Driven Bias: The First Theme.
“Remember the Wall Street proverb about greed and hear? I note that the emotional aspect of aversion to ambiguity is fear of the unknown. The case of Long-Term Capital Management provides an apt example of this phenomenon. On September 23, 1998, a $3.6 billion private rescue of LTCM was arranged. The Federal Reserve Bank of New York orchestrated this plan because of a concern that the failure of LTCM might cause a collapse in the global financial system. The November 16, 1998, issue of the Wall Street Journal describe the scene as the participants departed the meeting at which the deal was struck The article attributes an interesting remark to Herbert Allison, then president of Merrill Lunch, a remark that typifies aversion to ambiguity as fear of the unknown. “As they filed out, they were left to ponder whether all this was necessary, and whether a collapse would really have jolted the global financial system. ‘It was a very large unknown,’ Merrill’s Mr. Allison says, ‘It wasn’t worth a jump into the abyss to find out how deep it was.’”
Hersh Shefrin, Inefficient Markets: The Third Theme.
One of the most fiercely debated questions in finance is whether the market is efficient or inefficient. Remember the hedge fund Long-Term Capital Management (LTCM)? How did it advertise itself to investors? LTCM members promoted their firm as an exploiter of pricing anomalies in global markets. In this regard, consider the following heated exchange between Myron Scholes, LTCM partner and Nobel laureate, and Andrew Chow, vice president in charge of derivatives for potential investor Conseco Capital. Chow is quoted as saying to Scholes, “ I don’t think there are that many pure anomalies that can occur”, to which Scholes responded: “As long as there continue to be people like you, we’ll make money.”
That last remark might not be the best way to win friends and influence people. But Scholes is correct about cause and effect – investors’ errors are the cause of mispricing. Is the market efficient?
The fact is that from 1994 through 1997, LTCM claims to have successfully made leveraged bets – bets that exploited mispricing identified by the option pricing theory for which Scholes and Merton jointly received the Nobel price. In this regard Merton Miller, another Nobel laureate, is quoted as having said, “Myron once told me they are sucking up nickels from all over the world. But because they are so leveraged, that amounts to a lot of money.” “Sucking up nickels” is indicative of inefficiency. Of course, then came LTCM’s 1998 fiasco, but more on that later….”
Overconfidence
There are many behavioral lessons in the saga of LTCM. It does appear that their early success can be attributed to the exploitation of mispricing. At the same time, mispricing does get reduced as investors trade to exploit the associated profit opportunities. And investor do learn, albeit slowly; thus profit opportunities that had existed in 1994 through 1996 in the derivatives markets dried up in 1997. In response, LTCM began to take other kinds of positions, such as bets on the movements of foreign currency movements. Myron Scholes is reported to have been critical of these trades, asking his LTCM colleagues questions like “What informational advantage do we have over other traders?”
……
A Wall Street Journal article describing the experience of Long-Term Capital Management quotes Nobel laureate William Sharpe.
“Most of academic finance is teaching that you can’t earn 40 percent a year without some risk of losing a lot of money,” says Mr. Sharpe, the former Stanford colleague of Mr. Scholes. “In some sense, what happened is nicely consistent with what we teach.”
Wednesday, January 20, 2010
Hedge Fund Crashes
I am studying the commidity forward section for the CFA exam, checking out a short video lecture about natural gas forward curve. The instructor mentioned the Amaranth Advisors natural gas trading failure in September 2006. I typed in the hedge fund name and a power point presentation case study on the hedge fund poped up, done by Ludwig Chincarini, who is a CFA charterholder and has a Ph.D. degree.
According to the case study, Amaranth Advisors's attempted to profit from the long winter, short non-winter natural gas futures contracts trading strategy. This strategy seems to work for years prior to 2006. The energy desk trader took on a bet that's too risky and when the market go south the entire firm was dragged down -- the natural gas bet causes the firm to lose almost 50% of its NAV which is about $5 billion.
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