Anomaly – The real architects of the economic crisis?

Those of you, while Asian Nouriel Roubini of the currency crisis for over a decade pursuing * should already have realized that the similarity between this crisis. Roubini was recently interviewed and gave his opinion: "The United States lives in a situation of excess for too long. Consumers Were spending than had their income and expenditure of the country most of its income, running up large deficits currents. Now we must tighten our belts and save more. TheThe problem is that major savings in the medium term are positive, but in the short term reduction in consumption of consumer makes the economic crisis worsened. "

This is the paradox of thrift. But we need to spare more than one country and we need more resources to those parts of the economy that are more productive channels. And if you have too many financial engineers, not as many software engineers, you have a problem …… I think this country needs more people who areEntrepreneurs, more people in production, more people are in areas that are driving long-term economic growth. If the best minds in the country, all go to Wall Street, so the distortion is in the distribution of human capital for some of the activity becomes excessive and inefficient, finally. "However, the Nobel laureate Robert Merton of Harvard Business School, a different perspective:

We need more financial engineering, not less risk and innovation, includingDerivatives have not disappeared, and we need leaders, boards, and understand the regulatory authority of financial institutions to them.? "Who are the financial engineers and what the hell are you talking about?" I have my Master of Science degree in financial engineering in 2002 and until now nobody knows what the hell. OK, financial engineers often means "Rocket Scientists" (literally) that employed by major banks and multinational companies to build sophisticatedmathematical models with the intention to predict the probability of risk events in the delivery, valuations for instruments that are traditionally difficult to create synthetic securities pricing and risk insurance (and sometimes even to speculate).

"As LBO specialist once said Ted Stolberg, Inc. Magazine" Financial engineering is a bit 'like building a bridge. You can build however you want, until they collapse when heavy trucks go over it and you can add extra lanes ifWant more traffic to pass through them. And when all is done, should be a thing of beauty, like the Golden Gate (Warsh, 1993, p. 296). This "quants" as they are affectionately called, are often paid by the poor academic jobs on Wall Street drew well-paid jobs in London, New York, Chicago or California. The company executives that this quantum remember how often rent to investors that everything is OK, because now they have the best minds are on the payroll.Unfortunately, there are two main problems of financial engineering that caused the event. First, the funding ultimately one another about people and their relationships.

Real Finance little resemblance to the logical order of mathematics and physics. Most models in the financial sector with the basic assumption of the "Homo Economus Start the assumption that man is a rational being. This is amply demonstrated that he is incorrect assumption by recent research in cognitiveNeuroscience. Secondly, the output from the models of financial decision-makers in managing high is interpreted. As Alfred Korzybski said: "The map is the territory." is too much decision-making based on these models, which makes them far too much weight. The leaders seem all too eager to recognize their successes and deny their faults, it is human nature after all. Financial modeling: Stock market rationality or irrationality? "There is more of a metaphordescribe the price system as a kind of machine, or a telecommunications system, to see the individual producers, only the movement of a guide just like an engineer could see the hands of a few dials, adjust their activities to changes that may may never know, as indicated in the price of the shares. "- FA Hayek The efficient market hypothesis is quite attractive conceptually and empirically, accounting for its enduring popularity.

In aIn short, the stock market efficient in the Rule of thinking as a market equilibrium in which security prices fully reflect that all available information "the fundamental value of assets (tangential, Benjamin Graham, known for his speech fundamentalist co Security Analysis-authoring, with David L. Dodd, was quoted as saying shortly before his death: "I am not a supporter of the processing techniques of security analysis to find higher valueOpportunities … I doubt that these choices wide enough effort to justify their higher costs … I am on the "efficient market" school of thought … [Malkiel, 1996, p. 191]). Despite its popularity, more efficient capital markets theory has withstood some criticism very appropriate. Since a theory is a model of reality and "reality" itself, the anomalies are occur when the theory does not reflect reality and the theory of efficient capital markets is notException.

Article Ray Ball, The Theory of Stock Market Efficiency: Results and limits (Ball, 1994, p. 40) provides a general perspective, balanced and highlights some interesting anomalies: 1) A study of French and Roll suggests that prices on new information overreact then followed by a correction, contrarian investors to take profit. 2) excess volatility of prices due to "extraordinary delusion and the madness of the masses." 3) Prices on unterreagierenQuarterly reports that in itself seems an anomaly in the trend of prices over-react to new information. 4) A recent study by Fama and French show that there is a relationship between beta and returns historic lead many historians to be the adoption of balance-based CAPM developed paralyzed by the enormous amount of empirical data on effectiveness has failed . (Not included in the ball to the article, but told in Malkiel's A Random Walk Down Wall Street is theHistory, as Fama and French also noted that buying a stock that runs badly for the past two years, often above the average for the next two years (Malkiel, p. 198), that maverick to a profit again. ) 5) Are there seasonal patterns in the data on stocks or small businesses, such as the effect of January, where stock prices are abnormally high in the first days of January or the effect of "weekend", which found an average stockNegatively correlated returns before closing on Friday to close on Monday.

Article anomalies included absent Ball: a test shows that companies with low price / earnings ratios than those with higher P / E. According to the evidence that stocks that sell low-book-value ratio, tend to offer higher returns. The third test that stocks tend to offer high initial investment with higher returns pp dividends (Malkiel. 204 -207). Where different ball in his article from the otherSummary of trials and tribulations of the theory of efficient capital markets is a section called "deficiencies" efficiency "as a model of equity markets" (Ball, p. 41-46), where negligence is General Manager and discussed in the theoretical empirical research on the stock exchange, the efficiency of development and acquisition of information. This neglect may be the reason for the anomalies, such as the 'small firm effect "to supply the tendency of small-cap stocks offer higher returns. Hecriticized the theory of efficient markets, the investor "homogeneity" and suggests the need for a new research program. Ball also considers the role of both transaction cost theory of efficient markets literature "largely resolved" and the actual effect of the market mechanism to negotiate prices for market effects like 'microstructure "known.

He defends the theory of efficient markets argument by Robert Shiller (ie, the variance of historical stock priceswere much more volatile than historical variations of real dividends justified) in nominal terms Shiller challenging use of a market in constant expected return. Since CAPM is a constant risk-free return and a constant market risk premium, it is impossible to define a "right amount of variance in the market index. Ball also defended market efficiency Shiller and other behaviorists argue that the return to average stock returns do notnecessarily market irrationality. CAPM makes no claim trend for a period of relatively high yields of dismissal, to follow periods of relatively low yields. In reality, these cyclical patterns, the result of rational reactions of investors to political or economic conditions and changes in demand in the business of investors in shares.

Ball then Shiller gives more space and the behavioral ending his piece with the rhetorical question "Is 'behavior' of fundingAnswer? "He replied quickly:" I do not believe it "(Ball, p. 47). I would rephrase the question so that it reads" means "change the behavior of finance" produce useful answers? "And my answer would be:" Yes "If investors behave rationally, that is, if not only to maximize the expected benefits to investors, an important prerequisite for the efficient market hypothesis, and if not true, may explain why there are anomalies. Allias job in Prospect Theory, Kahneman and Tversky offeredimportant evidence that the recruitment standards of expected utility maximization by most economists expected cash can not provide accurate representations of human behavior (prospect theory argues that people are better than the maximization of a weighted sum of "utilities", through function represent the true probability determined, which is equal to zero probability of low weight and a weight of a very high likelihood). While condemning such evidence is not, it is worryingto say the least (Shiller, 1997).

Interestingly, Ball in his article omitted the current practice of financial economists on the theory of market efficiency are classified into three types from Least to Most Orthodox, as follows: 1 The weak form says that the history of price movements does not contain useful information, enabling investors to beat buy-and-hold portfolio management theory. The second semi-strong form states that no available publishedinformation security experts to help select "undervalued" securities. The third form of strong claims that everything is known or even seen on a company is in the price of the shares against. Statistical data lends credibility to the weak form and semi-strong and strong form of discounts, reveals that corporate insiders have excess profits trading on inside information is worth. In support of weak forms and semi-strong, the results of Ball and Brown study half of 1960 (Ball, p. 35)like the stock market reacts to announcements of annual earnings suggest that the market expects a stop approximately 80% of new information in annual earnings before the earnings were actually announced.

In other words, investors were largely deprived of opportunities for the future benefit of new information, because the share price already processed the information published in the annual reports of income. It seems that investors and "what" would have done equally wellnot to take on a concept as a whole, good and bad, but consider carefully the evidence for all the different approaches. In scientific experiments, where Quants feel at home, there are successes and failures, only the results or outcomes. All data points that emerge are that when you say is correct or not. Unfortunately, in capital markets if an "experiment" is exploited enough, you can bankrupt entire countries, and now, perhaps the world. In capital markets, the currentRisk of such experimentation can lead people not to eat. What is the risk and financial engineering Where to be? Well, we can say that intuitively seems to be a positive relationship between risk and uncertainty. The more certain we can move from a particular outcome, which is less risky. However, in a world as dynamic as ours, where we can barely (and often accurate) to predict the weather five days from now, how can a finance director, farmer, or any party interestedexpect, anticipate, for example, the price of tea in China, weeks, months or even years?

This is where the green of the financial instrument asymmetric part, an "option" which is "A call option is the right to a certain quantity of an underlying Some buying at an exercise price determined, or before the due date. A put option is the right quantity at a certain number of underlying assets for a specified exercise price, for sale or before the due date "(Figlewski and Silver, 1990, p. 4). An investor, the potential loss is limited to the premium, while the profit potential is unlimited. So even though it may be impossible to predict the future price of tea in China, it is possible, a plan for the level of damage can occur without a roof to be harvested for profit. Options belong to a class of securities called derivatives, aptly named because they derive their value from something else. Options, for example, derive theirValue of the underlying. Other derivatives include interest rate and exchange rate futures and swaps, whose values depend on interest and exchange rate policy levels (some exchange shares for cash commitments, because maybe someone prefers other payment service flow) , commodity futures, whose value depends on forward commodity prices and contracts for similar future agreements, unless the goods are actually delivered on a specified future date under the contract. But how can weUse these tools to our commitment to minimize the risk?

"Financial Engineering, the use of financial instruments to an existing profile financial restructuring in a property more desirable" (Galitz, is 1995, p. 5). In other words, is the province of the financial engineering design to create synthetic "securities risk and return desired results. Take the combinations of options, futures, swaps, create, etc., and new titles in order to mitigate unexpected risks. Assuming that the cashTrade flows between the right and security portfolio are synthetic equivalents, and no difference in the current market value of the two is the arbitrage opportunities. Arbitrage trading, buying something sold at a price, while essentially the same thing at a higher price for a profit without risk (In an efficient market should make such opportunities rarely, and when smart investors took advantage of the process should drive the price of whatbuy and sell below that price).

A simple example of financial engineering actually works in his article, the arithmetic of Financial Engineering (Smith, 1999, p. 534) Donald J. Smith uses simple arithmetic and algebra, the relations of a variety of different combinations of security (show titles synthetic), creating the financial engineers, this unique risk-return trade-offs. His basic formula of the explanation is as follows: A + B = C, where AC + B include synthetic portfolio plus security line represents a long position or credit posture – sign indicates a short position or posture connection with the above arithmetic, Smith can explain the relational structure of these securities synthesis rate interest swaps Interest rate swaps + + = no fixed rate notes – floating rate, the coupon is for the most titles before the deadline, hence the name are fixed income, but many questionsCoupons that are reset at regular intervals and therefore are floating, the latter as a variable rate.

Dog Collars + = + Cap – Floor "caps" and "plans" are option contracts that the greatest] ch [, and at least [Archive rate], which can guarantee to achieve. Rate caps and floors are essentially insurance contracts of interest, levels of insurance against losses arising from rising interest rates up or down within the given. Mini-Max Mini-Max + Floater floating rate note + = TypicalFloating Rate Notes – Cap Inverse floaters – Inverse floaters = – Two Notes-rate unlimited + FRN-Cap Inverse Floater appeal to investors who are bullish on bond prices and expect interest rates lower. This is for safety and synthetic Robert Citron used incorrectly, and eventually bankruptcy, Orange County, California, when the Federal Reserve has raised interest rates significantly in 1994. This folly cost including Orange County at $ 1700000000 $ 1994! ParticipationParticipation + agreement agreements + = Cap – Plan This great swing simple arithmetic formula explanatory power for those seeking a simple understanding of the complexity of financial engineering.

However, the financial engineer to be careful with the double-edged sword of derivatives. If hedging, derivatives, can make a valuable protection against the risk, if used to speculate that ask them to unnecessary risks. Moreover, the arrogance, as sometimes devastatingThe payments are too complex to understand. unintended consequences can be a bitch (see credit default swaps) The U.S. government = The Paleo-financial engineers "Blessed are the young, because they are the debt look-Herbert Hoover Let's one of the arrangements more complex financial engineering of all time, the relations between the U.S. Treasury and the Federal Reserve System. The Federal Reserve is a private company. In other words, howThe popular phrase goes, "The Federal Reserve is a" federal ", as Federal Express. The owner of the largest stock of the Federal Reserve Bank are the 17 largest banks in the world. As has been the subject of record for the United States a century of deficit and debt.

In simple terms, a deficit occurs when more is spent. Whenever the government more than it should be a debt or an IOU, usually a government bond of the United States to cover the problem. TheFederal Reserve banking cartel to buy these bonds (with paper money has literally created from nothing), the promise that the Government of the Federal Reserve will pay back both principal and a fixed rate of interest. In exchange for this payment of interest, the Fed literally creates money (mostly electronic and entirely from the air) from the ledger accounts handled. What most people do not realize the primary method of revenue to pay the Treasury to generate non-recurring incomeDebt for the Federal Reserve is in the form of taxes. In short, our taxes will go directly to bankers. A sobering fact is to get an idea of what the U.S. owes to bondholders (ie to get the Federal Reserve banking cartel), a single view of government debt. It rises above $ 11000000000000 (reminiscent of a trillion is a thousand billion, a billion is a thousand million, million and a thousand times a thousand.

With an estimated population of the United States 305 367 770, whichmeans that every citizen of the United States, the percentage of public debt is almost $ 40K in this letter. The hard part is that, if the growth of debt is constant and higher than the rate of growth of average real income, then what should we do if the government tax revenues are no longer sufficient to be paid interest on securities to be expected? Then, once the money (again, that was created from nothing) as it flows into the government there, and finds itsWay back in private banks. Once there, the actual inflation starts through the magic of fractional reserve banking. All this is documented in the Federal Republic reserves its manual entitled "Modern Money Mechanics. In short, as they say only a fraction of the actual reserves on hand (they say falsely During their books, have the entire amount) of money is inflated and the risk of bank runs are always present.

There are only three basic courses of action the Government mayrefuse to take; hyperinflate, or liquidated. I am here for the liquidation of the assets of government (state-owned non-essential, as the FDA, FCC or the IRS) on the non-recognition or hyperinflation, simply because the assets of the government is the surest way to end big government as we know it. Retirement shocks to the economy, interest rates would have exploded, and bond prices would fall, too much risk is associated. Hyperinflation only devalue the currency and impoverishing allconcerned. Ultimately, this brings me back to circle again citing Nouriel Roubini: "The United States of excesses living in a situation too long. Consumers were spending more of their income and the country was spending most of his income running a large current account deficits . Now tighten their belts and save for more. The problem is that major savings in the medium term are positive, but in the short term a reduction in energy consumption makeseconomic crisis worsened.

This is the paradox of thrift. But we need to spare more than one country and we need more resources to those parts of the economy that are more productive channels. And if you have too many financial engineers, not as many software engineers, you have a problem …… I think this country needs more people who are entrepreneurs, people in more production, more people are in areas that are driving long-term economic growth. If thebest minds in the country, all go to Wall Street, is a distortion in the distribution of human capital in some businesses become excessive and ultimately ineffective. "I absolutely agree that the solution lies in entrepreneurship. However, the rate of bookended the concept of" excess "and connects with our economic crisis. This raises the question, however, who are the real architects of this surplus are the financial engineers alone or the Federal Reserve andTreasury and accomplices?

REFERENCES
Hayek, FA (September 1948). The use of knowledge in society.
The American Economic Review, XXXV, No 4 Malkiel, BG (1996).
A Random Walk Down Wall Street. New York, NY Ball, R. (1994).
The theory of market efficiency: advantages and limitations. In DH Chew, Jr. (Eds.),
The new corporate finance, where theory meets practice (pp. 35-48). Boston, MA. Shiller, RJ (1997). Human behavior andEfficiency of the financial system. [Online]. Available: [~ http://www.econ.yale.edu/ Shiller /] handbook.html.
Warsh, D. (January 17, 1988). After the accident (financial engineering). economic principles.
New York, NY Figlewski, S. and Silver, WL (1990).
financial capacity: from theory into practice. New York, NY Galitz, LC (1995).
Financial engineering: Tools and techniques for managing financial risks. Burr Ridge, Illinois. Smith, DJ (1999). The arithmetic average ofFinancial engineering. In DH Chew, Jr. (ed.), The New Corporate Finance, where theory meets practice (p. 535-543). Boston, MA. (June 20, 1999).

* The lessons of the yen (I wrote this in 1998 for the student newspaper Golden Gate University, if you replace "Japan" to "America" may be true today) as little as ten years ago it was thought that America Unemployment rates and growth never been more attractive than that of Japan. This thinking is wrong, good andthe sting will be felt worldwide. What impact, if applicable, the problems in other parts of the world? Well, the Japanese economy fell, the last of the Asian tigers, which the Asian currency crisis of the iceberg because of concern for some students Golden Gate University in San Francisco. International students who receive funds from Japan are the most affected. Erina Ishikawa (MBA, entrepreneurship) and Dongili Yun (Master, computer information systems)both felt the effects of unfavorable exchange rates, after the fall of the yen.

"When I came (to America) ten years ago, things were much cheaper for us in Japan, now the opposite is true," said Yun. In anticipation of the economic problems of Japan and said interest rates in the United States, Misa Aoki (MA, Public Relations) has changed their yen, dollars in savings over a year. Although not influenced by the threat of declining purchasing power of their vision, yet worry about findinga job after graduation and his return to Japan. These fears are not unfounded. The increase in the unemployment rate of 4.1% is the highest in Japan after the Second World War. Fortunately, none of the respondents knew of who were his studies and return to Japan for the decline of the United Nations. All said they are concerned about the future of the Japanese economy have been, But that ultimately do not believe that the current crisis, which is a big deal. Jiro Ushio, chairman of the powerful JapanAssociation of Corporate Executives echo the same sentiment, "[t] he reality of the Japanese economy are not as bad as the world thinks." The president of the American Chamber of Commerce in Japan, Glenn S. Fukushima, said, "[f ] undamentally is that I do not think the Japanese people in general, that things so badly that they must have changed radically, they are. "In Japan, the U.S. believes that its own bubble economy expected soon and pop is looking for aScapegoat.

Obviously there were problems enough to Treasury Secretary Robert Rubin to intervene to support the yen fall in mid-June. His game multi-billion dollar pay-off short-term reversal of the yen slide by 8% in one day. Critics say that the Japanese Government that the work under the supervision of the Ministry of Finance, Japanese banks from bad loans in firms in difficulty but the market. The loans represent more than 600 billion dollars, an amountlarger than the entire economy of China, the world's most populous country. Surprisingly, however, the Japanese people overwhelmingly re-elected the current government. The recipes are available for recovery are everywhere, MIT, Paul Krugman suggests that the central bank of Japan to stimulate inflate the money supply and interest rates lower than domestic demand, while others say that Japan, in April deregulatory "big bang" program liberalization will pay long term. That the "big bang"Schumpeter or more "evolutionary path was taken last week with the resignation of Prime Minister Hashimoto, the outlook is uncertain.

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