Amazing market micro-structure

In the post, Zero Hedge says that the maximum possible level implied correlation can reach is 100%.  That is wrong.

Although a 100% maximum is true when talking about realized correlation, it is NOT TRUE when talking about implied correlation.  Implied correlation is basically a measure comparing the implied volatility of index options to the implied volatility of the options of the constituent securities.  If the implied volatility of the index options spikes to a sky-high reading while individual stock option volatilities don’t rise as fast, you could get a situation where the implied correlation rises above 100%.

In fact, it’s already happened once.  The 2009 index spiked above 100 a few times in November 2008.

Implied Correlation … How High is High?

This is fascinating, but I don’t see how they assign a number to this. Correlation is Cov(X,Y)/ SQRT(var(X)*Var(Y)). It can be shown mathematically that this is always between -1 and 1. I assume that there is some underlying pricing model, probably built on a Gaussian copula. But given that mathematically that this relationship cannot be greater than one, are they saying simply that the pricing model implies that the only way to reconcile the observed price is to see a correlation of greater than 1 which is impossible. But clearly the market is inefficient and / or the model is wrong. In either case, why would we care specific number is generated, because we know it is garbage in any case. I’d view any implied correlation higher than 1 as simple model and market breakdown and not a useful quantity beyond that.

Link roundup

Things I thought were interesting or provocative but with little comment

Conrad Black’s Decline, but Not Inevitable Decline

What is needed is a colossal reorientation of the country away from consumption and toward investment, the cleaning out of the morass of the plea-bargain justice system and attendant vacuum cleaners of the legal and prison industries (and the gigantic fraud of the War on Drugs), drastic education reform, genuine health-care reform, a redefinition of U.S. national interests in the world to what is essential and defensible, and then restructured alliances to reflect shared interests. Until those issues are addressed, all talk of the American superpower is rubbish. Obama’s is the fourth consecutive failed administration, and each succeeding one will make the festering problems more dangerous and difficult. As the problem is misdirection, not internal degeneracy or imperial overreach, it is a decline that will end in recovery, not a fall.

Why complex numbers are fundamental in physics

The shocking revelation came in 1572 when Rafael Bambelli was able to find real solutions using the complex numbers as tools in the intermediate calculations. This is an event that shows that the new tool was bringing you something useful: it wasn’t just a piece of unnecessary garbage for which the costs are equal the expenses and that should be cut away by Occam’s razor: it actually helps you to solve your old problems.

10 Rules for Radicals on how to win against government bureaucracies. Amazing and must see.

Why is the government trying to force me to divorce my wife? On the marriage penalty

How to tell when your boss is lying It’s not just that his lips are moving

David Larcker and Anastasia Zakolyukina of Stanford’s Graduate School of Business analysed the transcripts of nearly 30,000 conference calls by American chief executives and chief financial officers between 2003 and 2007. They noted each boss’s choice of words, and how he delivered them. They drew on psychological studies that show how people speak differently when they are fibbing, testing whether these “tells” were more common during calls to discuss profits that were later “materially restated”, as the euphemism goes. They published their findings in a paper called “Detecting Deceptive Discussions in Conference Calls”.

Deceptive bosses, it transpires, tend to make more references to general knowledge (“as you know…”), and refer less to shareholder value (perhaps to minimise the risk of a lawsuit, the authors hypothesise). They also use fewer “non-extreme positive emotion words”. That is, instead of describing something as “good”, they call it “fantastic”. The aim is to “sound more persuasive” while talking horsefeathers.

When they are lying, bosses avoid the word “I”, opting instead for the third person. They use fewer “hesitation words”, such as “um” and “er”, suggesting that they may have been coached in their deception. As with Mr Skilling’s “asshole”, more frequent use of swear words indicates deception. These results were significant, and arguably would have been even stronger had the authors been able to distinguish between executives who knowingly misled and those who did so unwittingly. They had to assume that every restatement was the result of deliberate deception; but the psychological traits they tested for would only appear in a person who knew he was lying.

The obscure spices quiz

Enhancing linux terminals with byobu, a better version of screen

Momentum in Employment: Why it Matters

The story I would tell is that there are clusters of firms that interact with one another. In an expanding cluster, growth of one firm leads to growth in others. In the 1920′s, as more people were employed in building automobiles, there were bound to be more people employed at gas stations. In a contracting cluster, declines in some firms lead to declines in others. As you get fewer horse-and-buggy drivers, you get fewer horse trainers, fewer horseshoe makers, and fewer manure sweepers.

A Time to Appease  by  Paul Kennedy

Bond holders and impartiality.

Felix Salmon discusses the chatter around the impartiality of Pimco’s El-Erian Op-Ed Why another fiscal stimulus won’t do.

A better answer is that there simply isn’t a clash between what’s good for the global economy and what’s good for Pimco, which is overwhelmingly a long-only investment house. Pimco’s long-term health is a function of there being a strong global economy which generates lots of savings for Pimco to manage.

The best answer, however, is that it doesn’t really matter who wrote the op-ed: it should stand or fall on its own merits.

This first point cannot be right. Bond holders only own the downside of the capital structure. Any upside goes to the equity holders. If bondholders solely ran the economy for their own benefit then risk taking would diminish substantially. Sure, there might currently be too much risk taking and this would reduce it. But that’s a separate case to be made.  Untimately, bond holders have a distinct set of interests that do not perfectly align with labor and equity holder interests.

The second point is absolutely right. Ideas should live and die on their own merits. That said, the Op-Ed page of a major American newspaper is a serious bully pulpit that leaves little room for the extensive footnoting and exposition of scholarly discourse. They are often filled with factual claims without basis to check them. As such, we have to trust the writer or at least the editing process to have properly checked the facts in the face of their inevitable biases. That’s why we care about conflicts of interest in scholarly work. Not because bias prevents us from generating excellent scholarship, but because it is hard to check everything. Therefore, we can avoid checking those without vested interest with less danger of being lead astray.

From the everything you believe is a lie department: Katrina edition








Debunking the Myths of Hurricane Katrina: Special Report

A good read.

This was pretty awesome

I liked the way that it combined 70′s-80′s style animation with a neat rock song.

Infuriating and misguided.

“A Letter to My Students” was sent to me by a thoughtful economist friend on the other end of the political spectrum.  This excerpt shows you what the letter is about:

The bad news is that you have been the victims of a terrible swindle, denied an inheritance you deserve by contract and by your merits. And you aren’t the only ones; victims of this ripoff include the students who were on your left and on your right in high school but didn’t get into Cal, a whole generation stiffed by mine. This letter is an apology, and more usefully, perhaps a signal to start demanding what’s been taken from you so you can pass it on with interest.

He sent it without comment, but I think he meant it to be an indictment of the sorry state of selfish politics in California. I apologize if what follows sounds like me bellowing from a high horse. It got me very worked up. I hope it is still interesting.

I intensely disliked this piece. State subsidized higher education has long been a method at which the middle class enriches itself at the expense of the rest. The idea that it was some statewide bargain to produce all these positive externalities is to take the rhetoric at face value and ignore the genuine underlying political economy. We know that overwhelming benefits of higher education accrue to graduating students, and yet we insist on using precious general revenue funds to subsidize it. Much like the mortgage interest tax deduction this is special interests politics not thoughtful welfare or investment policy.

I also think it is offensive to suggest that budget cuts are the real problem with California’s public purse. Over practically every period you can mention, including notably both the Schwarzenegger and Davis governorships the rate of government spending in California has exceeded the combined effects of inflation and population growth. Yes, you could close the budget with more taxes. But you could easily close the budget by returning to the levels of expenditure of 5, 10, or 15 years ago when California was not dangerously under-governed. Since his thesis is that “This deal held until about thirty years ago, when for a variety of reasons, California voters realized that while they had done very well from the existing contract, they could do even better by walking away from their obligations and spending what they had inherited on themselves. ” Surely it matters that real spending on government services is much higher today than it was then. That is, he begs the question by assuming that in fact spending is lower which is completely wrong as a factual matter. The problem with California, as with so much of our generally excellent nation, is that there are special interests collecting too much money and returning to little in exchange. To a lesser extent there is some Baumol cost disease in some government services, but the general problem is that we have a vast, expensive, and inefficient state government.

A different sort of worker

I’ve long wondered why it is that the grocery store Trader Joe’s has such educated, clear speaking, skilled, and well, white employees. I thought maybe that the firm had such a great reputation as a cool and fun place to work that they could afford to be discriminating in who they hired. Now I’m pretty sure it is just the pay:

You can’t buy engagement from employees, but the pay at Trader Joe’s helps. Store managers, “captains” in Trader Joe’s parlance — the nautical titles are a holdover from Coulombe (newly promoted captains are commanders; assistant store managers are first mates) — can make in the low six figures, and full-time crew members can start in the $40,000 to $60,000 range. But on top of the pay, Trader Joe’s annually contributes 15.4% of employees’ gross income to tax-deferred retirement accounts.

Inside the secret world of Trader Joe’s

The whole article is interesting. As usual, it isn’t just the seemingly cool attitude that makes Trader Joe’s successful, but a series of business process innovations like reducing the number of products offered, just in time inventory, catering to customer needs in product placement, and alternative packing for fruits and vegetables to speed checkout that makes shopping there cheap and easy. I love shopping there but I find their fruits and veggies the least impressive and most expensive part of shopping there.

Unintended consequences in action

Eliminate the chocolate in milk and kids drink a lot less milk.

Most recently, chocolate  milk has emerged as both villain and victim in a cafeteria drama that pits the milk industry, administrators and parents against one another.For those who haven’t been in a school cafeteria lately, 71 percent of the milk served nationwide is flavored. In New York City, school food officials say fat-free chocolate milk fills nearly 60 percent of the 100 million cartons served each year. The rest is one-percent plain.But chocolate milk can contain about twice as much sugar as plain low-fat milk. Milk is naturally sweet from lactose; flavored milk also contains cane sugar or high-fructose corn syrup, making it unwelcome in some cafeterias.

“There’s been a lot of pressure on flavored milk recently,” said Diane Pratt-Heavner of the School Nutrition Association.Flavoring milk, some school officials and milk processors say, is the only way to get students to drink it. Milk provides a host of nutrients, including calcium, protein and vitamin D, which recent studies show is deficient in about three-quarters of teenagers and adults.“It’s better for them to have some milk with some flavoring and a little added sugar than to go without milk,” said Ms. Pratt-Heavner, whose organization last month helped release a study that showed that elementary school children drank 35 percent less milk at school on average when flavored milk was removed.

A School Fight Over Chocolate Milk

My littlest brothers refused to drink milk and they got their calcium mostly through calcium fortified OJ. That too has lots of empty calories but tasted much better to them. I wonder if anyone has considered using a combination of lactose free milk and artificiality sweeteners to make chocolate milk with the taste of conventional chocolate milk but the nutrition of plain milk.

I found this fascinating

The Uncircumcised Israel Lobby — What Jews misunderstand about Christian Zionism. By Steven I. Weiss

There has always been something paranoid, ugly, nearly anti-Christian about the way many of my Jewish friends and family members regard American Christian support for Israel. Weiss’s piece is the best explanation I’ve seen about this phenomenon.

Miss-describing the Institute for Justice

I enjoyed Covert Operations — The billionaire brothers who are waging a war against Obama. by Jane Mayer, a fascinating if paranoid look at the Koch brothers, a pair of politically active billionaires who are trying to influence the direction of America by trying practically everything.It is long but if you might like it.

However, I’d like to take strong umbrage with one thing that Ms. Mayer says:

Among the institutions that they have subsidized are the Institute for Justice, which files lawsuits opposing state and federal regulations

This is a horrible and inaccurate  description of the Institute for Justice. While it is true that they oppose regulations, that is only a small part of what they do. Their most prominent case was Kelo v. New London, the most important eminent domain case in recent history and not really having anything to do with regulation. They also played a major role in District of Columbia v. Heller, the major second amendment rights decision in modern times. They also have numerous free speech cases in the pipes. The only way they can reasonably be described as opposing state and federal regulations is to say that by fighting for our rights they must fight illegal (unconstitutional) laws, regulations, and acts. In that sense the ACLU could get the same (inaccurate and misleading)  descriptor.