Archive for July 31st, 2009

What impacts emerging foreign currencies more? US news or domestic news?

July 31, 2009

Fed economists Fang Cai, Hyunsoo Joo, and Zhiwei Zhang in their new paper say:

This paper utilizes a unique high-frequency database to measure how exchange rates in nine emerging markets react to macroeconomic news in the U.S. and domestic economies from 2000 to 2006. We find that major U.S. macroeconomic news have a strong impact on the returns and volatilities of emerging market exchange rates, but many domestic news do not. Emerging market currencies have become more sensitive to U.S. news in recent years. We also find that market sentiment could sway the impact of news on these currencies systematically, as good (bad) news seems to matter more when optimism (pessimism) prevails. Market uncertainty also interacts with macroeconomic news in a statistically significant way, but its role varies across currencies and news.

In sum foreign currency of the selected emerging econ reacts more to US eco data/ news compared to domestic eco data/ news. The researched countries are: Czech Republic, Hungary, Indonesia, Koreea, Mexico, Poland, South Africa, Thailand and Turkey. Barring Thailand and Turkey, all currencies react more strongly to US news and the connections is getting stronger. They add it is first such paper to track the impact on these 9 countries

I am not surprised by the results. The oppposite results would have been more surprising. Seeing the way Indian markets react to everything US, the results are expected to be same for other emerging economies.  Similar paper on India would be highly welcome.

High frequency algorithmic trading- the new buzzword or next disaster?

July 31, 2009

I see a lot of posts today morning on the new financial assets trading jazz- High Frequency Trading or High Frequency Algorithmic Trading (HFT).

Wilmott explains what it is:

The idea is straightforward: Computers take information — primarily “real-time” share prices — and try to predict the next twitch in the stock market. Using an algorithmic formula, the computers can buy and sell stocks within fractions of seconds, with the bank or fund making a tiny profit on the blip of price change of each share.

I don’t know what the excitement is about (as Wilmott rightly points ) . This has been happening for a long time. I have read many articles/interviews (before the crisis that is) where people sang praises about their new algorithmic/quantitative model and how they are making so much money. The only difference this time (and each time) is a new name and new buzzword- it is  HFT this time. Supposedly Goldman has made quite a lot of money using HFT. This has led others to be excited and would most likely join in.

I have never been a part of designing any such algorithms and am not even capable of doing it. So cannot pass much comments on what it is and what it is not.

However, one thing I have noted and can say it with much confidence - When financial market players get excited about any new trading strategy/buzzword, it is most likely to fail. Most of it is done to make quick money and the long/mid-term repercussions are never discussed/ understood. As Wilmott says:

It’s a nice idea, and to do it properly requires some knowledge of option theory as developed by the economists Fischer Black of Goldman Sachs, Myron S. Scholes of Stanford and Robert C. Merton of Harvard. You type into some formula the current stock price, and this tells you how many shares to hold. The market falls and you type the new price into the formula, which tells you how many to sell.

By 1987, however, the problem was the sheer number of people following the strategy and the market share that they collectively controlled. If a fall in the market leads to people selling according to some formula, and if there are enough of these people following the same algorithm, then it will lead to a further fall in the market, and a further wave of selling, and so on — until the Standard & Poor’s 500 index loses over 20 percent of its value in single day: Oct. 19, Black Monday. Dynamic portfolio insurance caused the very thing it was designed to protect against.

This is the sort of feedback that occurs between a popular strategy and the underlying market, with a long-lasting effect on the broader economy. A rise in price begets a rise. (Think bubbles.) And a fall begets a fall. (Think crashes.) Volatility rises and the market is destabilized. All that’s needed is for a large number of people to be following the same type of strategy. And if we’ve learned only one lesson from the recent financial crisis it is that people do like to copy each other when they see a profitable idea.

Most strategies are like picking nickels in front of a steamroller. You may fool the steamroller most of the time but even once the steamrollers gets ahead, it is enough to create a much bigger damage  and erode all the nickels made so far.

It is not that people who design these strategies are not aware of the problems. They are just too smart to know the limitations. However, they also know at the back of the mind that the losses would be socialised and some kind of bailout/support would come from Govt/ Central banks. Each crisis leads to a much bigger moral hazard and the machine keeps running. How else do you explain the recurrence of some fancy strategy when its near-twin has just failed?

Top 10 books on international economic history

July 31, 2009

Prof. Daniel Drezner points to top 10 books on international economic history. He was about to give a list of top books in International Political Economics but decided that students need to know a bit of eco history first. He says:

The thing is, most graduate programs in political economy don’t give you that much historical background before throwing the cutting-edge theory and methodology at you.  This year I was lunching with some Ph.D. students at one of the top IPE schools in the country, and the students (and some of the professors) made it pretty clear that they didn’t know all that much about the topic beyond the tricks of the trade – formal modeling, econometric techniques, etc. 

If you’re expecting me to go off on a rant here about the uselessness of these tools, well, you’re going to be sadly disappointed.  There are some pretty good reasons to learn these techniques – among other things, they’ll help you to separate the wheat from the chaff when it comes to what blogs, pundits and public intellectuals are saying about the global economy. 

That said, the opportunity cost can be significant – a failure to learn anything about global economic history beyond the stylized facts contained in the most-cited articles.  This would be a weird collection of scattered knowledge, ranging from the 1860 Cobden-Chevalier Treaty to the 1934 Reciprocal Trade Agreements Act to the birth of the Washington Consensus. 

Soooo….. before you are ready to ready the ten books in IPE that you have to read, you should first read these ten books on global economic history.  

Once you imbibe the (sometimes contradictory) information contained in these books, you can look at what the stylized facts contained in IPE books with a much more astringent perspective.  It’s not a coincidence that the foundational IPE texts are by the twentieth century’s greatest economic historians – Eli Heckscher, Albert Hirschman, Charles Kindleberger, and Jacob Viner.  Trust me – you will feel much the wiser for it. 

:-) The list is as per Prof Drezner so would differ from people to people. But knowing (and above all remembering)  eco history is very very important.

Primer on Central Bank Communications

July 31, 2009

Richard Lambert of BoE has a useful speech (old though) on Central Bank Communications.  It lists the basic issues and hasa  short literature survey of the issues.


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