Archive for the ‘Economics’ Category

Understanding the credit crisis

June 17, 2012

In an earlier post (see here) I put a link to an online book that explains all the main concepts of economics in terms of the classic ‘Island Economy’.

If you think about it in theoretical terms, this book is a ‘proof’ that the Island Economy is a sufficiently rich model into which many important elements of economic life can be incorporated.

And like all good models, it is light and understandable.

Very importantly, this means that everyone can get involved in a healthy debate about its assumptions & simplifications, and any policy implications coming from it.

This is something that undermines the quality of our mathematical models of financial or economic processes: they require a very large amount of technical ability before you can even start to understand the terms of the model (for derivatives pricing this means stochastic calculus & arbitrage-free pricing theory; for systematic trading this means advanced statistical analysis; for economics this means advanced calculus and plenty of background reading of fragmented economic theories).

Experience tells me that the more technically ‘perfect’ we make our models, the less able the users become of giving an informed critique of the theory’s assumptions and main features.

The lesson I draw from this is that it is the responsibility of the model builders to work even harder to make our theories and models accessible to an averagely intelligent user.

What does this hard work look like?

Well here are four examples:

  1. Irwin Schiff’s book on economics (see my post here).
  2. Ray Dalio’s paper on why economies rise and fall (see my post here).
  3. A series of articles by Isabella Kaminski from FTAlphaville that present the credit crisis in terms of a felt cartoon story about water gathering and storing (see here).
  4. My work on understanding the Black-Scholes formula for out-of-the-money options (see my post here).

Economics book with cartoons, online for free!

May 23, 2012

I’m on a roll with Economics, getting through books and articles at a tremendous rate.

But this one is a gem.

Written by Irwin Schiff (read about him on Wikipedia do), it’s available here as a free-to-download pdf.

His sons Peter & Andrew have published their own version of the story which reflects historical events more carefully. You have to buy that one; I did, it’s good too.

Navigating NewWorldEconomics.com

May 23, 2012

I mentioned in a previous post that I had come across Nathan Lewis’s archive of his articles in NewWorldEconomics.com.

Fascinating stuff, but with so much to read, you need a system of attack.

Mine is here below.

It’s a bit rough, lacks a unifying form, but I think it is worth getting out there already.

I’ll update and shape as I make progress myself.

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Irving Fisher’s debt-deflation theory

May 15, 2012

In an effort to make sense of the current chaos, I am ploughing through a collection of readings on economics, and came across a brilliant article by Irving Fisher.

Written in 1933, it lays out his (educated) intuition on the causes and dynamics of debt-deflation cycles.

Frankly it is so fresh it could have been written as recently as yesterday.

You can find it here.

What does ‘reduce the balance sheet’ mean?

April 26, 2012

This post is a LeanPost: it will be developed further depending on feedback from my readers.

See my note here on what a LeanPost is.

Many companies are these days talking about reducing the balance sheet.

Another term used is de-leveraging.

In the simplest terms, this just means that a company is reducing the number of loans it has taken out. As a consequence, it will be probably be selling off assets to pay back those loans.

In this post we have a give some details on the borrowing/assets relationship for companies and mention some of the main concepts in corporate accounting that are useful to know if you are on the trading floor.

I always like to think in terms of concrete examples, so for this post I develop a story of setting up a business and show how we naturally come across the concepts of balance-sheet optimization, cost of capital, and other topics which are part of the standard courses in corporate finance.

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The history of a shop

April 6, 2012

I am in the process of writing a post on corporate finance, and have been doing some research into debt levels and leverage.

It’s part of an effort to understand more about companies, and specifically to answer the question of why quite a few companies have been struggling to get through the crisis.

There are two important aspects: (1) high leverage has meant that even a relatively small drop in customer spending gets magnified to the point where it poses serious risks to the financial viability of the company, (2) consequently it has been difficult for many companies to refinance their debts and many have failed.

Interesting stuff, I’ll complete the post soon.

Here I just want to post a link to an online history of Woolworths that I have found.

Woolworths is a great example of a business which pretty-much everyone in the UK is familiar with: a big, unglamorous shop in most towns which sold inexpensive toys, sweets, household goods, children’s clothes and suchlike.

Basically Woolworths was a ‘sell everything’ kind of store, easy to describe, nothing complicated. Woolworths had existed in the lives of everyone’s grandparents, in the lives of everyone’s parents. Your local Woolworths provoked no questions.

But browse the history, and you get a good sense of how your local Woolworths was actually just one small part of a long history of corporate actions. Perhaps it was sometimes even a very minor part of that history.

Click here to visit the Museum of Woolworths.

Compliments to the persons that produced the site, it gives an important historical insight into the forces at work in the modern economy.

The current crisis in historical perspective

March 28, 2012

This short post is primarily to give links to three excellent articles on macro economics by Ray Dalio, founder of Bridgewater.

The first, a ‘template for understanding’ how economies work, is better than anything I have ever seen in introductory books on economics.

The other two articles take a closer look at the dynamics of debt and deleveraging, and give a good sense of the processes that we are currently seeing in action at the moment.

Click here to go to the articles.

Fixed-income investment strategies in the age of the New Normal

March 27, 2012

I came across an interesting presentation given by one of the senior members of PIMCO UK, a chap called Mike Amey.

Click here to see it (a PDF).

What I especially like about this presentation is that it covers a lot of the main topics that I hear investors discussing at the moment, ranging from the bigger themes like EMs vs developed markets or the general Health of Economies, global inflation, tail risk, through to the more technical strategies like carry.

In this post I give background and thoughts on some of the topics and terms that Mr Amey uses in his presentation.

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Why does the yield curve slope upwards?

January 26, 2012

In this post I give a short, but I think rather usefully direct reason for why the yield curve should slope upwards. All it requires is for you to put yourself in the shoes of an investor that has to lock up their money in a bond for a fixed amount of time (and a very simple piece of algebra).

Yes, you can find plenty of papers which give complicated economic reasons for why this should be the case, but I tend to think that it is the simple insights that explain most of what you see happening in financial markets.

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