Archive for July 23rd, 2007

Adaptive Market Hypothesis

July 23, 2007

On surfing, I came across this term ‘Adaptive Market Hypothesis’. I got interested and decided to do some research. Andrew Lo, an MIT Prof. has coined the term. I know him as he has written the famous book- Econometrics of Financial Markets.  

So what is this AMH? He has written couple of papers on the subject. This is the paper I read. The abstract says it all:

One of the most influential ideas in the past 30 years of the Journal of Portfolio Management is the Efficient Markets Hypothesis, the idea that market prices incorporate all information rationally and instantaneously. However, the emerging discipline of behavioral economics and finance has challenged this hypothesis, arguing that markets are not rational, but are driven by fear and greed instead. Recent research in the cognitive neurosciences suggests that these two perspectives are opposite sides of the same coin. In this article I propose a new framework that reconciles market efficiency with behavioral alternatives by applying the principles of evolution—competition, adaptation, and natural selection—to financial interactions. By extending Herbert Simon’s notion of “satisficing” with evolutionary dynamics, I argue that much of what behavioralists cite as counterexamples to economic rationality—loss aversion, overconfidence, overreaction, mental accounting, and other behavioral biases—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment via simple heuristics. Despite the qualitative nature of this new paradigm, the Adaptive Markets Hypothesis offers a number of surprisingly concrete implications for the practice of portfolio management.

This is one of the few papers in finance, which is without all that maths and statistics jazz. It is a paper that gives an idea on the way new developments in finance should be understood and further research would be needed.

So how does one reconcile the 2 divergent streams of finance (i.e. EMH and BF):

Specifically, the Adaptive Markets Hypothesis can be viewed as a new version of the EMH, derived from evolutionary principles. Prices react as much information as dictatedby the combination of environmental conditions and the number and nature of species” in the economy or, to use the appropriate biological term, the ecology.

By species, I mean distinct groups of market participants, each behaving in a common manner. For example, pension funds may be considered one species; retail investors, another; marketmakers, a third; and hedge-fund managers, a fourth. If multiple species (or the members of a single highly populous species) are competing for rather scarce resources within a single market, that market is likely to be highly efficient, e.g., the market for 10-Year US treasury Notes, which reacts most relevant information very quickly indeed.

If, on the other hand, a small number of species are competing for rather abundant resources in a given market, that market will be less efficient, e.g., the market for oil paintings from the Italian Renaissance. Market efficiency cannot be evaluated in a vacuum, but is highly context-dependent and dynamic, just as insect populations advance and decline as a function of the seasons, the number of predators and prey they face, and their abilities to adapt to an ever-changing environment.

Wow! that makes finance so exciting. Read the whole thing as it is a great paper which builds on views of leading economists and their philosophies. Now, what about the practical implications, as that is what matters:

1. The first implication is that to the extent that a relation between risk and reward exists, it is unlikely to be stable over time. Such a relation is determined by the relative sizes and preferences of various populations in the market ecology, as well as institutional aspects such as the regulatory environment and tax laws. As these factors shift over time, any risk/reward relation is likely to be affected. A corollary of this implication is that the equity risk premium is also time-varying and path-dependent…..

2. Contrary to the classical EMH, arbitrage opportunities do exist from time to time in the AMH.

3. Investment strategies will also wax and wane, performing well in certain environments and performing poorly in other environments. Contrary to the classical EMH in which arbitrage opportunities are competed away, eventually eliminating the profitability of the strategy designed to exploit the arbitrage, the AMH implies that such strategies may decline for a time, and then return to profitability when environmental conditions become more conducive to such trades.

 4. Innovation is the key to survival. The classical EMH suggests that certain levels of expected returns can be achieved simply by bearing a sufficient degree of risk. The AMH implies that the risk/reward relation varies through time, and that a better way of achieving a consistent level of expected returns is to adapt to changing market conditions. By evolving a multiplicity of capabilities that are suited to a variety of environmental conditions, investment managers are less likely to become extinct as a result of rapid changes in business conditions.

5. The AMH has a clear implication for all financial market participants: survival is the only objective that matters. While profit maximization, utility maximization, and general equilibrium are certainly relevant aspects of market ecology, the organizing principle in determining the evolution of markets and financial technology is simply survival.

This is a must read for all finance professional. It helps build and develop new perspectives. This is what research is all about.

The Economics of Sovereign Defaults

July 23, 2007

Why does a country default? What happens when a country defaults on its loans? This paper from Richmond Fed answers a few of these questions in simple English. It is in a way a like a literature survey.

First what is a sovereign default? The authors say:

There are different definitions of a sovereign default. First, from a legal point of view, a default event is an episode in which a scheduled debt service is not paid beyond a grace period specified in the debt contract.

Second, credit-rating agencies consider a “technical” default an episode in which the sovereign makes a restructuring offer that contains terms less favorable than the original debt.

Why does a government need to borrow? Simple, when its expenses are more than the revenues, in order to finance the public goods and pay its salaries, the government borrows from the creditors in forms of loans or by issuing bonds. Here, they are similar to private agents:  

Like private agents (households and corporations), governments can borrow to finance long-lived investments. Furthermore, in the same way households borrow to preserve living standards through periods of temporary hardship, governments borrow if they do not want to decrease expenditures when tax revenues are low.

However, there is difference between government defaulting and any private agent defaulting:

It is easier for households and firms to post appropriable collateral in order to improve borrowing conditions. If a private agent defaults, the government forces him to hand over the assets posted as collateral. On the other hand, a sovereign cannot commit to hand over its assets if it defaults, and in general there is no authority that can force it to do so……..Thus, sovereign debt is typically unsecured.

While for households and firms an important part of the costs of debt repudiation is determined by bankruptcy law, there is no international legal framework that imposes costs on a defaulting sovereign. 

Politico-economic factors affect the issuance of government debt. For example, a politician who cares mostly about the period during which he will be in office may not fully internalize the costs of issuing debt. Moreover, governments can borrow strategically to bind the hands of future governments with different preferences. Such strategic behavior would be more important in economies where policymakers’ interests are more polarized.

Why govts default?

1. When current resources to pay are very low.
2. When borrowing costs i.e. interest rates become high.

The importance of external factors for the borrowing cost of developing countries is suggested by empirical studies that  find that the interest rates paid by these countries have tended to move in the same direction as U.S. interest rates.

 3. Political angle

Apart from this, the paper has tabulated all sovereign defaults from 1824 onwards. They basically pick it from one of the numerous papers they have reviewed.

In one of the tables it tells how much the creditors recovered on neogotiations after the default. Like for the much known Russian default in 1998 (which lead to famous LTCM collapse) the creditors recovered 38-45% on average (basically a government takes many kinds of loans each with different of profie) of the total credit given. In Argentina crisis, sovereign paid 58% of domestic and just 27% of International borrowing.

A nice simple paper worth reading.

Assorted Links

July 23, 2007

1. MR points to a new paper on income inequality. It is pretty detailed one. What caught my eye is this:

…the top 25 hedge fund managers combined appear to have earned more than all 500 S&P 500 CEOs combined (both realized and estimated).

2. Dani Rodrik points out to an interesting graph- why Asia and Africa grew? Basically Asia gre on account of undervalued currency. He says (look at the graphs first) :

In Asia, growth accelerations are preceded by a period of sustained increase in undervaluation, which is maintained during the period of high-growth. In Africa, by contrast, growth accelerations are preceded by growing overvaluation; the currency always remains in the overvalued zone (= negative undervaluation).

Here is the simplest explanation. In Asia, growth is typically engineered by increasing the profitability in manufacturing and other tradables. But in Africa the typical growth spurt is preceded by aid inflows and other transfers, which appreciate the exchange rate, and render future growth less sustainable. This is the so-called Dutch disease.

He has also written a new paper which he explains how an undervalued real exchange rate can promote economic growth.

3. WSJ Blog points out the problems with FOMC forecasts.

4. Jungle Economics….pretty interesting

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