Peter Levin’s Rethinking Markets

November 29, 2007

Southwest’s Profitable Hedge

Filed under: Markets — Peter @ 3:16 pm

Soutwest Airlines apparently has less to worry about in the recent spike in oil prices than its competitors. Why? Because they used futures markets to hedge the risk of rises in future oil prices. So, when the price of oil goes up, the cost of running airplanes gets more expensive, but their futures contracts become much more valuable. One exec quipped that he wasn’t sure whether he was hoping for oil prices to go up or down…down would be cheaper for refueling, but up screwed their competitors with no added costs to SW.

This is what futures markets are really good at, when those who have risk actually use markets to hedge them, and those who speculate take those risks on. This makes it difficult if not impossible to extract out those people (whom I earlier argued should be ousted from oil futures trading) using oil futures as investment vehicles. I would normally say that perhaps what’s missing are more stories about the real-world benefits of speculation and hedging, but actually if you look more closely at the graphic, you can see that part of the problem is that no other airline was doing this at all. In the article, they note that many airlines were ‘too busy’ with other stuff (merge! dominate!) during better days to worry about oil prices and whatnot.

As an aside, my uncle Steve (who teaches courses on markets in the Business Institutions Program at Northwestern) pointed me to an intrepid student of his once, who did a senior thesis on the potential use of weather futures by Wrigleyville merchants to hedge against rainouts during summers when Cubs games dramatically affect their businesses. To my knowledge no one uses them in this way, and they didn’t really even seem receptive to this kind of analysis.

November 28, 2007

Daily is no longer the daily

Filed under: Daily — Peter @ 7:42 am

For some reason, the main daily page seems to get quite a few hits - a legacy of the old site, I think. In any event, the daily is no longer the daily, it’s just the whole thing.

November 27, 2007

The Blow-Up

Filed under: Prices, Technology — Peter @ 6:01 pm

There’s a lot to say about Bryant Urstadt’s article about quant traders in this past fall’s Technology Review (free reg required), called “The Blow-up.” Combined with Amir Khandani and Andrew Lo’s “What Happened to the Quants in August 2007″ (.pdf link), it gives a fuller picture of how quantitative finance is altering markets.

Clumping quantitative derivatives traders together is getting to be a little too gross a distinction, but there are, it seems, a small number of strategies being pursued by these kinds of traders. Two of the most important are: 1) pairs trading and 2) long-short equity trading. Pairs trading is where an historical relationship between two securities are found, tested, and analyzed; and then when the pairs get out of this relationship for no good reason, trades are executed expecting that this relationship reasserts itself. This differs in spirit, but not entirely in practice, from arbitrage trading, which is trading on the differences between two kinds of products which are ’supposed’ to be identical (a company’s stock and its bonds, for example, or a company’s stock in two trading environments).

Long/short equity trading is when a market-neutral position is taken, whereby long positions are made up of ‘losers’ (under-performing stocks), while short positions are made up of ‘winners’ (over-performing stocks). This strategy is based on the idea that outliers will eventually revert to the mean - effectively betting on consistent market overreaction. Given the behavioral finance work on how people tend to, you know, overreact to news, this makes sense. And because your position is effectively market-neutral - long positions offset short positions - it is possible (for broker/dealers) to highly leverage these positions.

These are two main strategies, and for the most part, they work. So, what happened in August? Here’s my reading of the two articles: First CDOs - the bundled up derivatives from housing loans that are spoken about when we talk about the ’sub-prime lending crisis’, went into the sink. Second, an outlying series of days in the week of August 6 caused a dramatic drop in the long-short strategy.

The effects of these two events (possibly, though it’s not clear if they were linked) was the following: a bunch of funds began selling equities to liquidate positions in order to meet margin calls for their CDO investments, which pushed pairs trading into abnormal positions. This caused more hardship, and all sorts of things happened - funds sold blue-chips to raise margin cash; and bought back short positions causing price relationships to swing further out of historical norms. Khandani and Lo speculate that one or more of the long-short funds liquidated its position, and that it turned out that many other funds were also engaged in these kinds of trades, so that when one or two got out, everyone else got hammered.

What makes this interesting? A couple of things. First, as markets are brought into tension with one another via pairs trading, they effectively create a new product, with new features and sometimes not-well-understood properties. A Collateralized Debt Obligation (CDO) can package together such disparate cash flows as sub-prime loans and airplane leases; by virtue of the CDO itself, these otherwise distinct streams are linked together. Second, as traders and funds are brought into tension with one another via sharing similar trading strategies, it creates collective action events that simply do not resemble atomized traders. It’s not surprising that the expression of these problems is always liquidity - IMHO that’s a fancy finance way of saying that people act in concert, when they are ’supposed’ to act according to their own preferences.

Some other interesting things from the Blow-up:
- it’s estimated that 38% of all equities are traded automatically, and that this percentage may rise to over 50% in the next three years;
- computers for some high-frequency traders execute hundreds of thousands of trades every day.

There is a giant blind spot here, rooted in financial theory, enabled by even cautious policy-makers and economists, and executed by very smart people. Sometimes at home when we watch commercials, my partner and I play a game called ‘good for them, or good for us’ - to see if a product or policy or feature is good for the company or good for consumers. I would guess that the number of people who would argue that derivatives trading today is ‘good for us’ is very small.

November 15, 2007

Value and art, SK style

Filed under: Art, Front Page, Prices — Peter @ 10:44 am

I participated in a panel earlier this week at Columbia called ‘Unraveling the Art Market’. It was me, two incredibly insightful women from the Christie’s Art education program, and an artist named Steve Keene. Keene does these paintings on wood in mass execution fashion, 60-80 a day, and he sells them for $10-$15 online, sometimes less in person. He was brilliantly engaging, and in the middle of discussions about the multi-million dollar secondary art market, it is worth thinking more about what he’s doing…

For him, the art is one continuous, giant piece, and he sells off little pieces of it as it becomes finished. Starting with bands in the punk music scene, his notion of selling the art is like the idea of going to a (bygone era) concert and having the band try to sell the 15-20 tapes they made to people in the audience. He noted that for many, buying his art was their first art purchase, and that when they leave their apartments, his art is maybe something that might get left behind.

Two of the more interesting features to note. First, people sometimes try to resell his work on eBay, which annoys him, since: 1) he doesn’t get the money for it (and he needs it); and 2) because his art is supposed to be what it is - cheap, mass. People who buy his art, as he says, sometimes get annoyed that it doesn’t increase in monetary value, since 1) this indicates that it’s not a good investment; and 2) it indicates that its cultural value is not rising as well. That is, price is assumed to be an indicator of cultural value. If it doesn’t get more expensive, how can we know it’s really good?

Second, once a few of his pictures landed in the hands of JFK Jr. When he died, the pieces were put into a sort of estate sale/garage sale of Kennedy stuff, at Sotheby’s (the sale is here - reg required), and the lot (here - reg required) was estimated at $2000-$3000, and it sold for $12,000. SK was thrilled and hesitant, since he was not identified as the paintings’ author but he didn’t want to tell them and have the buyer feel silly for buying something he sells for $5. Anyhow, it’s the clearest example of identifying the value of Kennedy provenance yet.

A shout out to Jen Lena

Filed under: Daily — Peter @ 8:34 am

Jen does her thing over at What is the What?, and since then we’ve been having completely interesting discussions about innovation, music, art, markets, and the creative use of data.

And in 99.9% of the cases, she knows more about music than you and I do. But I bet she doesn’t know about this.

November 11, 2007

I predict…

Filed under: Daily — Peter @ 9:50 pm

…that Fabio Rojas will hedge on his prediction before the final tally is in.

November 8, 2007

Ban oil speculation?

Filed under: Prices — Peter @ 9:51 am

A proposal that comes around from time to time has re-emerged in light of the skyrocketing prices of oil in the global markets. As oil pushes towards $100/barrel, the petroleum secretary of India has proposed abolishing the trading of oil in commodity markets.

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November 7, 2007

Art market craziness

Filed under: Art, Prices — Peter @ 7:22 pm

As my friend Chuck says, even the crappy Picasso’s are bringing in $30 million. What in the world is going on? The all-art index is up 21% in the first half of 2007, compared to 14% for the S&P500. The November ArtNews reports that Sotheby’s and Christie’s are offering upwards of $1 billion in guarantees this year. Sotheby’s and Christie’s sold $7.5 billion in art in 2006, and more this year. Add Phillips de Pury & Co. (which emphasizes contemporary, where the action is), and it’s surreal.

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November 6, 2007

prices and baselines, part 2

Filed under: Prices, Technology — Peter @ 11:02 am

In an earlier attempt to think through pricing, I was trying to understand the importance of public, baseline prices from which traders, investors, potential buyers and sellers could determine commodity prices. This leads me to discussions of ‘dark pools’ of liquidity..

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