Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Thu, 29 Mar 2007

Abel Prize for Varadhan and Large Deviations in Finance

The award of the Abel Prize (often described as the Mathematics Nobel Prize) to Indian born mathematician Srinivasa S. R. Varadhan for his work on the theory of large deviations reminded me of the applications of this theory in finance. Basically one starts with a large and well diversified portfolio of securities and considers the probability distribution of large losses. If the underlying distributions have exponentially declining tails, then the theory of large deviations applies. The conditional probabilty distributions (conditioning on a large loss) can be computed in terms of the cumulant generating function and its Legendre transform.

At one time, this looked liked a very promising approach for risk modelling. Unfortunately, around this time, the mainstream risk management literature embraced fat tailed distributions with a vengeance. Once you bring in fat tails (which do not decline exponentially), the large deviations theory loses much of its applicability. However, there is no denying the mathematical elegance of the whole theory and as the Abel prize citation mentions, the theory has a wide range of applications in other fields.

Posted at 18:12 on Thu, 29 Mar 2007     View/Post Comments (1)     permanent link


Wed, 21 Mar 2007

The joys of Edgar full text search

In November of last year, I blogged about the benefits of being able to do a full text search of all filings with the US SEC. Paul Kedrosky’s infectious greed blog describes some innovative ways of using this feature that I had not thought of at all. Kedrosky says: “I have an ‘interesting word’ search that scans SEC filings and feeds ’em back to me. Out this one popped, much to my childish glee.”

In the filing that Kedrosky refers to, the “interesting word” is followed by the following sentence: “Mr. Chapman then forcefully informed Mr. Shahbazian that it was inappropriate and inadvisable for the Chief Financial Officer of a public company to utter such blasphemy to the advisor of a 9.3% ownership stakeholder in the Issuer.”. This leads Kedrovsky to propose “the 11th Commandment: Thou shalt not blaspheme >9% shareholders.” It also leads to an interesting comment on Kedrosky’s blog: “And nothing so clearly reveals the inner mind of the [venture capitalist]... Blasphemy is restricted to saying bad things about God ... We all know that most VCs view themselves as quasi-divine beings ... But it is invaluable to actually hear a VC claim godlike status publicly. One can only assume the word hubris will mean something to Chapman one day. ”

Posted at 08:28 on Wed, 21 Mar 2007     View/Post Comments (2)     permanent link


Tue, 13 Mar 2007

Hacking online trading accounts

The SEC complaint against three Indians who hacked into online stock trading accounts in the United States illustrates an interesting strategy for using apparently legitimate stock exchange trades to take money out of hacked online trading accounts. Many people seem to have a belief that when shares are held in dematerialized form, the clear audit trail of securities transfers makes theft difficult. Some people connected with depositories in India appear to think that fraud can be reduced by applying stricter checks and controls to non market transfers as opposed to those made pursuant to settlement obligations on an exchange.

The procedure used by Jaisankar Marimuthu, Chockalingam Ramanathan and Thirugnanam Ramanathan illustrates the fallacy of this reasoning. Their method is described in the SEC complaint:

The Defendants first purchased thinly traded securities, at market prices, using their own online brokerage accounts. Shortly thereafter, the Defendants, using stolen usernames and passwords, intruded into the online brokerage accounts of unsuspecting individuals. The Defendants then used these intruded accounts to place a series of unauthorized buy orders, typically at prices well above the then-current market prices for those thinly traded securities. Immediately or shortly thereafter, the Defendants capitalized on the artificially inflated share price of the targeted securities by selling shares in their own accounts. In one instance, Defendant Marimuthu realized a 92% return on his investment in less than one hour.

It is easy to see how this process can be used in reverse to sell shares from the stolen online account and buy them in the fraudster’s account at artificially low prices only to sell them into the market at normal prices. This would be useful if the stolen account had a lot of shares but not much cash. The nice thing about this procedure is that it converts stolen shares into cash using what appears to be a very legitimate exchange transaction. This illustrates the fallacy of designing control systems based on subjective notions of what is suspicious and what is not. The fraudster gets to choose the method of defrauding the victim and the chosen method is likely to be one that is least likely to arouse suspicion.

Marimuthu and Ramanathan were arrested in Hong Kong but by then they had inflicted losses of $875,000 on their victims over a five month period.

Posted at 09:52 on Tue, 13 Mar 2007     View/Post Comments (3)     permanent link


Fri, 09 Mar 2007

SEC wants to hurt stock spammers

The SEC in the United States resorted to an interesting subterfuge while suspending trading in 35 stocks touted in email campaigns. Most of the SEC’s press release appears to suggest that this is merely intended to protect gullible investors who might fall for the spam. But the fag end of the press release coupled with the very different tone of its actual order tell us that the true intent of the SEC is something different – it wants to inflict heavy losses on the spammers.

If successful, this strategy of hurting the spammer rather than just protecting investors could very effectively deter future spam campaigns. The question is the legal and ethical justification for what the SEC is trying to do.

The core of a spam campaign is well described by Frieder and Zittrain in their January 2007 SSRN paper Spam Works: Evidence from Stock Touts and Corresponding Market Activity:

The evidence accords with a hypothesis that spammers “buy low and spam high,” purchasing penny stocks with comparatively low liquidity, then touting them – perhaps immediately after an independently occurring upward tick in price, or after having caused the uptick themselves by engaging in preparatory purchasing – in order to increase or maintain trading activity and price enough to unload their positions at a profit. We find that prolific spamming greatly affects the trading volume of a targeted stock, drumming up buyers to prevent the spammer’s initial selling from depressing the stock’s price. Subsequent selling by the spammer (or others) while this buying pressure subsides results in negative returns following touting. Before brokerage fees, the average investor who buys a stock on the day it is most heavily touted and sells it 2 days after the touting ends will lose approximately 5.5%. For the top half of most thoroughly touted stocks, a spammer who buys at the ask price on the day before unleashing touts and sells at the bid price on the day his or her touting is the heaviest will, on average, earn 5.79%.

The SEC’ action has the potential to inflict heavy losses on the touts by making his holding of the touted stock worthless. Not only can he not sell his holding for the 10 days for which the suspension is in force, but the SEC is making it more or less clear that it would not like these stocks to trade any time soon. As the SEC points out:

For stocks that trade in the OTC or the over-the-counter market, trading does not automatically resume when a suspension ends. (The OTC market includes the Bulletin Board and the Pink Sheets.) Before trading can resume for OTC stocks, SEC regulations require a broker-dealer to review information about a company before publishing a quote. If a broker-dealer does not have confidence that a company’s financial statements are current and accurate, especially in light of the questions raised by the SEC, then a broker-dealer may not publish a quote for the company’s stock.

In its press release, the SEC makes its intentions very clear on this point:

Further, broker-dealers should be alert to the fact that, pursuant to Rule 15c2-11 under the Exchange Act, at the termination of the trading suspensions, no quotation may be entered unless and until they have strictly complied with all of the provisions of the rule. If any broker-dealer enters any quotation that is in violation of the rule, the Commission will consider the need for prompt enforcement action.

The interesting point is that unlike the press release which talks at length of spamming, the actual order itself mentions nothing about spamming. For each company, the order states that “Questions have arisen regarding the adequacy and accuracy of press releases concerning the company’s operations and performance” or something similar. This is clearly designed to make it impossible for any broker or dealer to have the “reasonable basis under the circumstances for believing” that the information required under Rule 15c2-11 is “accurate in all material respects”. The statute itself does not require the SEC to raise questions about the accuracy of available information to suspend trading in the stock. Section 12(k) of the Securities Exchange Act allows the SEC to order suspension for 10 days “[i]f in its opinion the public interest and the protection of investors so require”.

Clearly the temporary suspension permitted by law might help protect investors, but an indefinite suspension does not do so – it hurts those genuine investors who were holding the stock. An indefinite suspension is needed to hurt the spammers by making their initial investment worthless. Unfortunately, the statute does not give the SEC the power to do this. Hence the subterfuge is needed. I find this action disturbing because (a) it turns the regulator into a stock price manipulator even if it is for a just cause and (b) it compromises the honesty and integrity of the regulator.

Posted at 09:13 on Fri, 09 Mar 2007     View/Post Comments (0)     permanent link


Thu, 01 Mar 2007

Tax-and-spend budget has good long-term initiatives for the capital market

The Indian government budget for 2007-08 presented yesterday was a tax-and-spend Budget, and neither the taxation nor the spending was capital market-friendly, but the budget contained some policy initiatives for the capital market that would enhance its vibrancy and efficiency in the long term. I wrote a piece on this in the Financial Express today. You can also read this here

  1. I welcome the proposal to allow institutional short selling and create a proper securities lending and borrowing mechanism for this purpose.
  2. I think exchangeable bonds are a good idea, both as an additional financial instrument in the marketplace and as a mechanism for unwinding interlocked corporate holdings.
  3. The elimination of tax arbitrage on mutual funds is probably a good thing in the long run for the industry.
  4. The promise to move forward on making Mumbai a regional financial hub is welcome. This initiative announced in the 2005 Budget has gone through a tortuous process, with delays in committee formation and rumours of dissent within the committee itself. The FM’s announcement hopefully means that we will see some real action backed by a strategic vision.
  5. I read the Budget speech as signalling a willingness to improve access of Indian investors to foreign securities both directly and through mutual funds. Today it is much easier for Indians to use the $50,000 limit to invest in foreign currency bank deposits than to invest in foreign stocks and bonds.

All of this means that we will have a cleaner, stronger and deeper capital market in the years to come. That is little consolation to those nursing stock market losses on budget day, but it is hugely important for the future of India.

Posted at 13:25 on Thu, 01 Mar 2007     View/Post Comments (3)     permanent link