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

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Fri, 27 Nov 2009

Dubai World brings Islamic finance down to earth

Back in 2007 and 2008, people were fond of arguing that the crisis was due to highly complex financial instruments and that if finance became boring, it would be a good thing. People even argued that Islamic finance would be a good idea.

This week Dubai put an end to this talk by making it clear that Dubai World would default on debt issued by its subsidiary Nakheel Development Limited. The debt falls due in the middle of December, but Dubai wants creditors to agree on a standstill till May while a restructuring is worked out.

The interesting thing is that the instrument in question is an Islamic bond – a Sukuk. The prospectus (available in the FT Alphaville Long Room) proudly refers to the “pronouncement dated 11 December 2006 issued on behalf of the Sharia Supervision Board of Dubai Islamic Bank PJSC confirming that, in their view, the proposed issue of the Certificates and the related structure and mechanism described in the Transaction Documents are in compliance with Sharia principles.” (page 34)

Of course, one can argue that there is really nothing Islamic about modern Islamic bonds other than an opportunity for some religious scholars to earn a living by issuing pronouncements on Sharia compliance. But that itself is a warning that trying to legislate simplicity in finance is often futile.

Modern corporate finance teaches us that money is made and lost on the asset side of the balance sheet. To adapt a favourite statement of the Austrian economists, losses occur when wrong investment decisions are made. The defaults on the liabilities side of the balance sheet only serve to announce and crystallize this loss. Last month, I blogged about how bank losses from loans in the current crisis exceed losses on securities. The default on the Sukuk reinforces this idea that mis-allocation of capital produces losses regardless of the composition of the liability structure.

Posted at 11:19 on Fri, 27 Nov 2009     View/Post Comments (3)     permanent link

Tue, 17 Nov 2009

Bayesians in Finance

At the EconLog blog, Bryan Caplan asks why academic economists are not Bayesians. Caplan was talking about a Bayesian approach to the validity of economic theories. Stephen Gordon responded with a post about why economists do not use enough of Bayesian econometrics. Both questions are valid and should cause some introspection.

The issue is probably even more important in finance where key parameters are estimated with such large confidence intervals that the prior does not get washed out by the sample. In fact, I think that one of the defining characteristics of finance as a discipline is that first moments (for example, mean returns) are estimated very poorly even with extremely large samples while second moments (variances) are somewhat better estimated.

For example, Aswath Damodaran has an interesting paper last month discussing the difficulties of estimating the Equity Risk Premium reliably. Damodaran states bluntly that:

At the risk of sounding harsh, the risk premiums in academic surveys indicate how far removed most academics are from the real world of valuation and corporate finance and how much of their own thinking is framed by the historical risk premiums they were exposed to back when they were graduate students.

What Damodaran is really saying is that despite being exposed to recent academic research using centuries of global stock market data, the posterior distributions of most academics are still strongly influenced by the prior distributions formed during their student days. In such a situation, there is merit in making the prior distribution quite explicit rather than leaving it implicit.

Classical statistics also involves priors; the tragedy is that in that framework, there are only two kinds of priors:

  1. Dogmatic priors which totally ignore what the data says, and arbitrarily set some parameters to zero or some other special value.
  2. Diffuse (or improper) priors which impose no priors beliefs at all and leave everything to the data.

Bayesians can however use the more interesting priors which reflect non trivial prior beliefs that can be overruled by the data.

At a different level, I think it is also essential to incorporate Bayesian learning into theoretical models. Rational expectations models are richer when they recognize that even with large samples, posterior distributions could have large error variances.

Posted at 08:32 on Tue, 17 Nov 2009     View/Post Comments (0)     permanent link

Tue, 10 Nov 2009

Lehman, Reserve Primary or TARP?

In the popular imagination, the crisis in the global financial markets in the last quarter of 2008 is identified with the collapse of Lehman on September 15, 2008. However, many perceptive analysts believe that it was not the collapse of Lehman itself, but the resulting collapse on September 17 of the Reserve Primary Fund (a large money market mutual fund) that was the real culprit. Finally, some revisionists like John Taylor have argued that the panic started not with the Lehman collapse but with the mishandling of the TARP legislation later in September.

William Sterling has a nice paper analyzing this issue relying on a broad index of financial conditions covering money markets, bond markets and equity markets. Taylor’s use of measures related to Libor was controversial because at the time, people joked that Libor was the rate at which banks did not lend to each other. I like the more comprehensive measure chosen by Sterling.

Based on this index, all three views receive some support, but on balance Sterling rightly concludes that the revisionist case is quite weak. The financial conditions index fell 9.85 points when Lehman collapsed, and fell a further 10.37 points when the Reserve Primary Fund failed. If we regard these two as a single event, the fall in the index over the three days was 20.76 points. But the biggest single day fall was 11.77 points on the day that Congress rejected the first TARP bill. (The index is constructed as a Z-score so that each point change in the index can be regarded as one standard deviation move. Clearly, all three days are extreme tail events).

The most intriguing thing in the paper is the 12.68 point rise in the index on the day before a bailout plan for the money market mutual funds was announced. This is the largest one day change in the index in its entire history. It appears to me that this is indicative of insider trading on a truly massive scale. If this interpretation is correct, this insider trading would make Galleon look like small change.

Posted at 13:48 on Tue, 10 Nov 2009     View/Post Comments (0)     permanent link

Mon, 09 Nov 2009

SEC Division of Risk, Strategy, and Financial Innovation

Back in September, the SEC created a new division of Risk, Strategy, and Financial Innovation and appointed a well respected law professor, Henry T C Hu, to head it. Hu has been very active in writing about regulation and financial innovation. For example, twenty years ago he wrote a hundred page paper about the regulatory challenges of regulating the swap market arguing that the Basel framework would be ineffective in dealing with anything beyond the most plain vanilla swaps. He concluded that “the BIS Accord’s reliance on legalistic solutions – rigid, classification-based rules administered and maintained by government regulators – is reflective of a simpler, more static financial era. The process of financial innovation is now far too institutionalized and complex to be so confined. ”

Hu’s appointment was widely welcomed at the time, but it was clear that the success of the new division would depend on the people that Hu is able to hire. On this score, the news last week was good. The division announced three new hires with diverse backgrounds all relevant to the tasks that the division has to perform. The best known was Richard Bookstaber, the author of the excellent book “A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation” in which he describes his experience running firm-wide risk management at Salomon Brothers and at other firms.

Clearly, the division will soon have the talent and experience to perform its mandate: “identifying new developments and trends in financial markets and systemic risk; ... [and] making recommendations as to how these new developments and trends affect the Commission’s regulatory activities.” The open question is whether the rest of the SEC can be reformed adequately to take advantage of this.

Posted at 20:32 on Mon, 09 Nov 2009     View/Post Comments (0)     permanent link