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2015-01-01T04:40:00.000-08:00

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Eugene FAMA finally receives the Nobel prize he deserves

2013-10-19T02:52:00.001-07:00

Eugene F. Fama
Photo: B. Rooney, © University of Chicago
Booth School of Business.

This Monday October 14th, more than 50 years after the race to the Moon he contributed to launch in financial economics, in the same vein than Franco Modigliani and Merton Miller, Eugene FAMA was awarded the Nobel Prize in Economics (well, the Swedish National Bank prize for the meticulous ones).

You can read the press release here (Nobel Prize press release) or the excellent full report produced at this occasion.

Fama is known for his numerous articles on testing the Efficient Markets Hypothesis he proposed, many of them written with his fidele co-author Kenneth French.

But what people must realise is that he gave an impulse to a whole generation at University of Chicago, to which Modern Finance owes a lot. A generation that counted among them: Schaefer, Schleifer, Scholes,...and André Farber (ULB). Fama and Farber wrote in 1979: Money, Bonds and Foreign Exchange.

The Europeans of that generation came back from US and gave rise to a substantial update in the way Finance was taught in business schools over this side of the Atlantic.

We suggest you to read his story narrated by himself.

Dear Prof. Fama, congratulations for your work and thank you for the momentum (not in the markets but in research this time) you created.

Hugues Pirotte

HFT, flash crashes, true liquidity and time redefinition

2012-07-03T07:58:00.000-07:00

One of my thesis students, motivated by the quantitative analysis of market data, fell on the subject of the so-called "flash market crash" of May 6 2010 and the related subject of high-frequency trading (HFT). The Dow Jones losing USD 1 trillion in a matter of minutes to then recover quite quickly most of the value lost? That's exciting! Well, at least it is intriguing...
So I was intrigued myself. In fact it was good news for some microstructure authors. An event like that to be analyzed? Well, the fashionable subject of microstructure in the mid-90s, losing then its hype some years later, had found a true exciting event to question again the microstructure of financial markets. At the end of the 90s, it was thought that this was the end of the story because of the liberalisation of exchanges and the possibility to run an market order-book exchange on a server in your garage (like a certain Apple's story).
But, no no no... That wasn't it all. Today, we talk about "market exchange colocations", referring to traders wishing to be again physically very close to the exchange servers because they say they trade up to the...nano second.

Let's go back to our 2010 flash crash. For a visual practitioner's research study on the flash crash with some nice graphs (not for colorblind people), you can take a look at Nanex. They produce graphs with 500ms intervals. Nanex, an intraday market data provider, is part of the firms mentioned in the SEC report as to have ".. hypothesized that these delays are due to a manipulative practice called “quotestuffing” in which high volumes of quotes are purposely sent to exchanges in order to create data delays that would afford the firm sending these quotes a trading advantage". SEC denies this as being the fundamental reason given their own analysis. But concludes:

Nevertheless, as discussed in the Executive Summary, the events of May 6 clearly demonstrate the importance of data in today’s world of fully-automated trading strategies and systems. The SEC staff will therefore be working closely with the market centers to help ensure the integrity and reliability of their data processes, especially those that involve the publication of trades and quotes to the consolidated tape. In addition, the SEC staff will be working with the market centers in exploring their members’ trading practices to identify any unintentional or potentially abusive or manipulative conduct that may cause such system delays that inhibit the ability of market participants to engage in a fair and orderly process of price discovery.

Many debates involve either: (1) who to blame, (2) what safeguards to put on, (3) what limits to define (with microstructure indicators to be used as thresholds), (4) or how to come up with a rule based on a formula trying to encompass the drivers used by the HFT algorithms. First of all, rules to handcuff algorithms would be an endless story. Second, there is still little emphasis on the need or not of HFT itself. The SEC acknowledges still on the data issue and its importance, and whatever the analysis is about, it shows that it is quite the analogy of a car that runs at 200mph but in the dark, without lights, nor brakes. And instead of asking ourselves "is there any value to drive at 200mph", we seem to be saying "well, maybe we should use Xenon lights and prevent all cars to drive by new moon nights". Where are all the studies of the 90s debating on the ins & outs of call vs. continuous markets?

Another comment in the SEC report states that:

At that time, the number of volatility pauses, also known as Liquidity Replenishment Points (“LRPs”), triggered on the New York Stock Exchange (“NYSE”) in individual equities listed and traded on that exchange began to substantially increase above average levels.

We must be very careful here because if someone is manipulating the price behaviour and integrates the triggers of volatility pauses in his/her (statistical) algorithm, there is probably something to do. It is always very dangerous to be extremely liberal on what markets can do but then to put ad-hoc limits/sanctions based on some indicators that may be part of the strategy of these traders thereafter.

Also, it is quite 101 in financial microstructure to know that liquidity is a three-dimensional problem: price, volume and time. To be perfectly liquid is to be able to sell immediately any quantity without any price impact. This of course is not what we find in the real world and that's why there is a trade-off between these three dimensions. It is also why coming up with a single measure of liquidity is not easy. There is a lot of research by Amihud & Mendelson on this subject since the second half of the 80s. I like to cite their paper of 1987 because, apart from being based on bigger time intervals than milliseconds, the conclusion is straightforward: "We conclude that the trading mechanism has a significant effect on stock price behaviour". And that probably started the hype of microstructure in the 90s. Strikingly, more than 20 years later, the SEC report mentions that:

This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.

Another interesting element is that, before, time being defined as clock-time, we were inclined in looking at price- and volume-related measures only. Easley, López and O'Hara (2011) bring the interesting idea that in HFT, "...trade time rather than clock time is the relevant metric to use in sampling the information set. Trade time can be measured by volume increments,...". This is very interesting. First, on a theoretical microstructure ground, it is bringing a modern view on what the time dimension represents. Even more, it would provide a more direct interconnectedness with the volume dimension. Second, it reminds me of the application of "wavelets" from physics to finance for time-frequency analysis. There is certainly something to capture about the various frequency components. Third, philosophically, we might have a concern just related to the "information set". Microstructure is the study of the mechanisms allowing investors to exchange securities or assets based on (1) their willingness to trade for operational reasons, and (2) their information set, whatever that could be. Of course, the idea behind is that if we better understand market formation, then we could probably identify which properties lead to better "information release" through the trading mechanism. Therefore, there is a certain number of motivations behind microstructure, namely mostly "liquidity" and "price discovery". Now, if we focus on price discovery, we might ask ourselves what is the philosophical meaning of having a trading timeline that is thousand (if not million) times faster than that of the flow of fundamental information available to the market (and cynically, of the capacity of the systems and regulators to follow). Of course, the perfect continuum allows to trade just behind having received a new information. But in the meantime, it might generate a lot of "noise" or "liquidity traps".

And finally, most of the litterature is scarce on the definition of HFT and the description of its properties. A lot of press takes back and "re-tweets" the conclusion of the Tabb group report of January 2011 on HFT accounting for 77% of the transactions in UK. But as far as I was told, a transaction involves at least two counterparts, and the real purpose of the transaction is defined by a third party who "gave the mission". So, without this additional information, we can only conclude on the HFT, through algorithmic trading, being the technical mean to trade. That's why "blaming HFT" is not an issue depending on what you want. Yes, if I have an information, I want to trade as soon as possible, which would be good for price discovery and market efficiency purposes. So, if HFT allows me to trade as quickly as possible and dilute the market impact, I would be happy with it. But on the other side of the transaction, I might have a market maker who is using HFT to be "in-&-out" in some seconds, and this is a totally different story, even though me may talk about the same transaction. And a long-only fund doesn't need to stay less than 1 minute in a trade. Golub (2011), referred here below, devotes some reflexions on the definition and characterization of HFT.

In conclusion, the provocative tone of this article aims at trying to ask the right questions before chasing answers. Also, we tend to use terms and "re-tweet" stories. But they deserve more precision in the wording if we want to really evolve in the subject.

References

Amihud, Y. & H. Mendelson (1987), "Trading Mechanisms and Stock Returns: an Empirical Investigation", Journal of Finance, July 1987, Vol XLII, n°3, pp. 533.
CFTC and SEC report (2010), "Findings regarding the market events of may 6, 2010", Report of the staffs of the CFTC and SEC to the joint advisory committee on emerging regulatory issues, September 30, 2010, 104 pages.
Easley, D., M. López de Prado & M. O'Hara (2012), "Flow Toxicity and Volatility in a High-Frequency World", Review of Financial Studies, Vol. 25, No. 5, pp. 1457-1493, 2012.
Easley, D., M. López de Prado & M. O'Hara (2011), "The Microstructure of the ‘Flash Crash’: Flow Toxicity, Liquidity Crashes and the Probability of Informed Trading", The Journal of Portfolio Management, Vol. 37, No. 2, pp. 118-128, Winter 2011.
Golub, A. (2011), "Overview of High Frequency Trading", Working Paper, part of a FP7 EU project, 50 pages.
Sornette, Didier and Von der Becke, Susanne, Crashes and High Frequency Trading (August 2011). Swiss Finance Institute Research Paper No. 11-63.

Volatility art and rhythm

2012-04-30T13:59:00.000-07:00

Some days ago a very rythmed video was published by Artmeis CM on You Tube on two decades of volatilities and S&P values.

Volatility has been an issue since the studies of Markowitz in the late 50s who, from an operational research perspective, brought the idea of optimizing the risk-return pair, i.e. maximize the return for a given level of risk or minimize the risk for a desired level of return. And "risk" was mapped to the notion of standard deviation or volatility. Now, volatility represents a measure of dispersion around the trend that you are following, and is synonym of "uncertainty" first - today, we know that risk can be much more than just volatility. And therefore, a low volatility does not mean necessarily "good news": a rapidly declining market can show a low volatility if there are strong beliefs about the declining trend.

Since the 70s, volatility then became a key input parameter to the valuation of options, i.e. insurance contracts on the prices of stocks, commodities, currencies, indices,.... Those options need additional inputs/parameters such as the maturity of the contract and the price level where the contract can be exercised. But overall, insurance has a value only because there is uncertainty. And the more you feel risky and you are risk averse about that uncertainty, the higher will be the price you are ready to pay for your insurance contract. On the other hand, the award-winning Black-Scholes-Merton model that was used for option pricing since 1973, was assuming a constant volatility over the life of the contract. And all option traders, statisticians, econometricians knew that, depending on the time window, the measure was changing.

In the 80s, one of them, Robert Engle, appeared working on Autoregressive Conditional Heteroskedasticity models of the volatility, at some point also with Clive Granger in 1987 (Econometrica), and both won the Nobel Prize in Economics in 2003 (Engle and Granger lectures). This would give rise to the ARCH, GARCH, EGARCH, HGARCH, NGARCH, QGARCH, TGARCH....of this World in the years after. More recently, Robert Engle has been the instigator of V-Lab, an online platform producing regularly and automatically estimates for a wide range of time-series. Some nice resources are also available online with the FT.

Finally, a key differentiation must be made between "statistical, historical or realized volatility", whatever the methodology to assess, estimate and predict volatility could be, and "implied volatility". The CBOE has since then created the VIX, an index of implied volatilities from S&P options and others, assumed to represent the expected volatility over the next 30 days. Now, historical volatility and implied volatilities are very different in their approach and meaning. Since the implied volatility is a parameter that has been calibrated based on options of varying maturity and moneyness (the distance between the current price and the strike), it is a measure that depends not only on what the market perceives from the uncertainty on underlying's returns but also of how much the market wants insurance. Therefore the implied volatility is before everything else a measure of how expensive is the insurance today. In times of crisis, you might have a big discrepancy between the realized and the implied volatilities if the general market fear impacts a lot option prices but much less the current offer and demand of the underlying itself (see for example a blog on the matter).

But the true evidence that volatility remains a complex notions that should not be seen as static or independent of risk perceptions (in the case of the implied one), is that the implied volatility measure changes with the maturity and the moneyness of the option. This means that, when crossing both, we obtain a surface of implied volatilities (see example picture from Bloomberg):

Now, philosophically, it seems a little bit peculiar to show up a volatility surface by "inverting" an option-pricing formula that...assumes a constant volatility. Thus the impetu of econometricians to come up with a model for the evolution of volatility...

A newly managed floating Kyat

2012-04-14T02:08:00.000-07:00

Since April 2nd, the Kyat (Myanmar's currency) moved from 6.4335 MMK/USD to 818, in a decision to adapt the unrealistic former rate to a more market-based one. The intention forward is to let the Kyat float completely, with a current quasi-managed regime aiming to it. That will require Myanmar to start accumulating more foreign reserves and the country's Central Bank will be accepting foreigners to freely bring in international currencies in amounts up to 10K USD without any declaration and free international transfers will be soon on the way.

Myanmar's Kyat (MMK) evolution over the last month.The evolution between March 31st and April 2nd should show as a discontinuity in the rate of the currency.

As for all countries opening their economies to international markets under the pressure of others,
the expected forthcoming evolutions are clear: (1) allow foreign banks to operate in Myanmar, (2) allow free human flows (importing workers, etc...), (3) allow foreigners to own or lease land and operate resources in their own name, etc... Of course, there is a debate on how sanctions should be lifted and aid provided, aiming at sustainable development in the country instead of just enrichment of the still-current apparatchik. As BusinessWeek has put it, look at Cambodia's counterexample.
Now, the kind of openness we see and are expecting for Myanmar is typical of countries that have been granted access to the WTO (World Trade Organization) under that sort of pressure by other nations. For example, look at Vietnam's accession on November 7th, 2006 (2001 for China, and 2004 for Cambodia and Nepal)....but with seminal works dating...January 1995! Now, interestingly, Myanmar is a member of the WTO since January 1st 1995 (as many other states, i.e. the inception's date of the WTO, after the GATT's round negotiations), part of the subgroups G-90 and LDCs (Least-developed countries). For reference, three countries in Asia are still out of the WTO: Laos and Bhutan, that are both in the process of accession (latest draft in 2012 and 2007 respectively), and North Korea.
Today in Burma, the situation shares some ressemblance with that of May 1990, when the NLD party of Aung San Suu Kyi won a landslide victory. At that time, Aung San Suu Kyi was detained and finally released in... 1995. As The Economist mentions it: "The victory [of April 1st 2012], when the NLD party won 43 of the 44 available seats in the parliament] is more symbolic than practical. The NLD won 6% of the 650-odd seats in parliament". And a quarter of these seats are reserved by Constitution to army-appointed MPS. Let's see how the president Thein Sein, a liberalising reformer from being a general before, will combine with Miss Suu Kyi charism and oratory strength, to overcome the challenge of promoting a real vent of change but country stability at the same time.
In the meantime, hoping to see one day a developed and open stock exchange in Myanmar (the MSEC actually exists but trades 2 stocks and government bond issuances through a 50-50 Japanese-Burmese joint venture acting for the Central Bank), we can watch Kyat's evolution. This is still a country where everything is possible; look at the change of capital from Yangon to Naypyidaw, the later being one of the 10 World's fastest growing cities!

Research in Finance: Evolution and Perspectives

2012-04-11T05:48:00.000-07:00

[in French]
Les Amis de la Bibliothèque de l'ULB ont le plaisir de vous inviter a leur prochaine rencontre. Les Midis des Amis de la Bibliothèque de l'ULB offrent l'occasion aux chercheurs et enseignants de faire connaître plus largement leurs publications. Ces rencontres ont lieu le mercredi de 12h15 à 14h et prennent place dans un espace approprié aux thèmes abordés. La prochaine séance aura lieu le 25 AVRIL 2012 dans l'auditoire R42.2.110 situé dans le bâtiment qui abrite la Solvay Brussels School of Economics & Management (SBS-EM), Avenue Roosevelt 42 - 1050 Bruxelles.
« La recherche en Finance : Evolution et Perspectives », par André Farber et Kim Oosterlinck

Bien que les marchés financiers existent depuis plusieurs siècles, il faudra attendre la seconde moitié du 20ème siècle pour que la théorie financière soit appréhendée de manière scientifique. La théorie financière est donc une science relativement récente. Malgré son jeune âge, les connaissances ont connu une diffusion extrêmement large qui s'explique par des changements de société (les marchés financiers étaient autrefois uniquement considérés par les élites) mais aussi par l'apparition de programmes de certification privés et d'ouvrages de références de qualité.

La présentation mettra en avant les traits marquants de l'évolution des connaissances en finance. Elle montrera que l'évolution des techniques (et notamment la démocratisation de l'informatique) a permis de faire émerger des théories basées sur des faits empiriques vérifiés sur de larges bases de données. Enfin la présentation offrira un aperçu des recherches menées en finance, notamment de l'apport de la finance à l'histoire et à la compréhension des crises financières.

Les présentations sont animées par le Président des Amis de la Bibliothèque de l'ULB, le Professeur Lambros Couloubaritsis.

Gekko is back

2012-03-01T02:08:00.002-08:00

Michael Douglas received an Oscar for his role as Gordon Gekko in the 1987 film Wall Street. He remains famous for his line “greed is good”. Aficionados should rejoice: Gekko is back but in a new role as spokesman of the Federal Bureau of Investigation in its war against insider trading. His new line: “If a deal look too good to be true, it probably is”.

Insider trading refers to trades of securities by individuals based on non-public information. Such transactions are considered as unfair since one side of the trade has private information that has not yet affected the price of the security. Therefore, lawmakers consider that insider trading is bad for financial markets. Regulations to ban trading on inside information have been introduced in the US as early as 1934. Other countries implemented similar rules, although more recently (see Bhattacharya and Daouk 1992). This theme keeps lawmakers busy on both side of the Atlantic. In Europe, for instance, the European Commission is currently working on MAD II, the second incarnation of its Market Abuse Directive.

Academics are not sure that insider trading is all bad. Leland (2002) summarized the arguments as follow:

“Pro.-(a) Insider trading will bring new and useful information into asset prices. Decision makers-both portfolio managers and firms making real investment decisions-can reduce risk and improve performance when prices reflect better information. (b) Because of reduced risk, asset prices will be higher and more real investment will occur.

Con.-(a) Outside investor will invest less because the market is “unfair”. Asset prices will be lower and less real investment will occur. (b) Market liquidity will be reduced, thereby disadvantaging traders who must trade for life cycle or other reasons not related to information. (c) Insiders trading will make current stock prices more volatiles, further hurting traders with liquidity needs.”

Sorting through these arguments will take time and the outcome is uncertain. It should be based on empirical evidence. Measuring the benefits of insider trading requires calculating the difference between the “wrong price” and the “right price”. In a beautiful paper, Liza Meulbroeck (1992) analyses stock price effect of insider trading in the US. She finds that “the stock market detects the possibility of informed trading and impounds this information into the stock price.” Markets might be better than regulators to detect insider trading. More recent evidence is badly needed. Stephen Bainbridge, a law professor at UCLA, provides a legal viewpoint on his website ProfessorBainbridge.com.

Gordon Gekko might have been right in the first place.

References

Scannell, K. (2012), FBI casts Wall Street’s Gekko to remind traders greed is no good, Financial Times, February 28 2012

Bhattacharya, U. and H. Daouk (2002), The World Price of Insider Trading, Journal of Finance 62, 1 (February) 75-108

Leland, H. (2002) Insider Trading: Should It be Prohibited?, Journal of Political Economy 100, 4, 859-887

Meulbroek, L. (1992) An Empirical Analysis of Illegal Insider Trading, Journal of Finance 47, 7 (December) 1661-1699

A short story

2012-02-23T02:57:00.001-08:00

Some days ago, France and Spain lifted the restrictions they had imposed on short selling (Financial Times, February 13 and February 16, 2012). Many countries had implemented similar bans in 2008 in reaction to the financial crisis. (see Beber and Pagano, Journal of Finance, forthcoming for more details).

Selling short consists in selling something that you don’t own. If you borrow the asset before selling it, the transaction is a covered short sale. If the sale takes place before stock borrowing, the transaction is a naked short. Short position can also be realized using derivatives such as forward contracts, futures or options.

Regulators and politicians tend to have a negative view on short selling. They fear that short sellers might spread false rumors and create price declines unrelated to true value.

But academics tend to have a positive view. Shorts sellers facilitate price adjustment to new information and therefore contribute to market efficiency. Short sellers also have a positive impact on liquidity. Herinckx and Szafarz (2012) confirm these findings in a recent paper. They conclude:

Overall, all short-sale regulations are detrimental to market efficiency. However, naked short-selling prohibition is the only regulation that leaves volumes unchanged while addressing the failure to deliver. Therefore, we argue that this is the least damaging to market efficiency.

Moreover, the possibility of selling short is an essential condition to rule out arbitrage. This condition underlies pricing in the derivatives industry.

Last but not least, Karpoff and Lou (2010) show that short sellers are faster at identifying financial misrepresentations than the US regulator.

To conclude, regulators should think hard before imposing new limits. The costs might be higher than the benefits. Short selling is not all bad, after all.

References

Beber, A. and M. Pagano, Short-Selling Bans around the World: Evidence from the 2007-09 Crisis, Forthcoming Journal of Finance

Del Marmol, Thomas, (2011), Short selling: need or fear? Impact on financial markets and implications for regulators, Mémoire, SBS-EM, Université Libre de Bruxelles, Année académique 2010-2011

Herinckx A. and A. Szafarz, (2012), Which Short-Selling Regulation is the Least Damaging to Market Efficiency? Evidence from Europe WP-CEB: N°12-002

Karpoff, J.M. and X. Lou (2010), Short Sellers and Financial Misconduct, Journal of Finance 65, 5 (October 2010) pp. 1879- 1913

Sovereign Debt Diplomacy

2012-02-23T00:34:00.001-08:00

The recent second Greek bailout has been accepted after intense negotiations. As for any negotiations, countries came with their own political agenda. Press reports shed some light on these motivations. For example, European diplomats informed the Financial Times that “the German and Dutch finance ministers pushed for further “haircuts” in Greek bonds” suggesting that these countries were willing to limit the involvement of their taxpayers.

Although the role of diplomacy is important, the exact motivations of the countries providing the bailout are often overlooked. Diplomatic, economic and geopolitical considerations probably play a more important role than pure altruistic motivations. For instance, Der Spiegel published a few months ago an insightful article detailing French sales of military vessels to Greece, which was already at the time struggling to make end meets. The article stressed German reactions to these sales. Surprising as it may seem, it was not the sale itself which was questioned but the fact that ThyssenKrup had lost the deal to the French company DCNS! German taxpayer money was going to end up subsidizing a French company (read: instead of a German one). Critiques regarding arm sales to Greece had however been voiced a year earlier by Turkey. Stephen Castle, in the New York Times had indeed reported in March 2010 that “Egemen Bagis, Turkey’s chief negotiator with the European Union, has criticized Germany, along with France, for seeking to sell military equipment to Greece while pressing the government in Athens to make drastic public spending cuts as a result of its dire financial crisis.”

For economic historians, this arms sales saga hardly comes as a surprise. The exchange of financial favors for economic or even diplomatic support has a long history.

For instance, the French government took in the past advantage of the demand by foreign governments to have their bonds listed on the Paris Bourse. From the 1880s on, foreign listing on the Paris Stock Exchange were subject to the approval of both the French Finance and Foreign Affairs Ministers (Boissière, 1925). Loans to be issued by companies in competition with the French industry, such as the one proposed by US Steel Corporation in 1909, were sometimes excluded from the French market (Feis, 1930). The French government did not hide its intentions. In parliamentary debates, the Foreign Affairs Minister explicitly conditioned financial support to orders for the French industry. Serbia or Bulgaria were explicitly told that they should buy from where they had borrowed… In some instances, financial support was exchanged against diplomatic help. For example, Russia traded its political support at the Algeciras conference in 1906 against a new loan on the Paris stock exchange. The Russian support helped France counter the German ambitions in Morocco.

Arm sales were also crucial at the time. Feis (1930) lists a series of fascinating examples. In 1909, an Argentinean loan was blacklisted because Argentina had committed the major crime of buying armaments from Germany! A year later, Japan omitted to place orders with French shipyards and saw its loan opposed. A message of similar nature was sent to Portugal: if it kept on planning to buy from British shipyards, it should abandon all hope to float a bond in Paris. One century later the situation seems strikingly similar.

To conclude, quoting Lawrence Durrell (who spent a long part of his life in Greece on the island of Corfu) seems appropriate: “History is an endless repetition of the wrong way of living”.

References:
Boissière G., (1925), La compagnie des agents de change et le marché officiel à la bourse de Paris, 2ème édition, Paris, Arthur Rousseau.

Feis H., (1930), Europe the World’s Banker 1870-1914: An Account of European Foreign Investment and the Connection of World Finance with Diplomacy before the War, New Haven, Yale University Press.

Greece, Germany and “Supersanctions”

2012-02-16T00:59:00.002-08:00

“The German government wants Greece to cede sovereignty over tax and spending decisions to a eurozone “budget commissioner” to secure a second €130bn bail-out.”

“German holders of Greek bonds had demanded international financial control of Greek finances.”

Despite their strong similarity, 119 years separate these two quotes. The first one emanates from the January 27th, online version of the Financial Times, the second one is the description made by Wynne (1951) of the Greek situation in 1893!

In 1893, existing financial difficulties combined with a strong crisis in currant trade forced the Greek government to declare a partial default. The country announced a unilateral reduction of interests on its foreign bonds of 70%. This led to immediate protests by English, French and German bondholders association. Most notably, bondholders wanted the government to pledge substantial revenues for the bond service. Negotiations between Greece and bondholders were still going on at the outbreak of the Greco-Turkish War (1897). Defeated Greece was forced to pay a large war indemnity to Turkey. Needless to say, its financial position rendered it unable to meet these obligations without foreign aid. In this situation, it became easy for German representatives to impose the control of Greek public finances by an international financial commission. As a guarantee, the commission could count on the control of state monopolies, stamp duties and custom duties of the ports of Piraeus, Corfu, Volos, Lavrion and Patra (Andrepoulos, 1981).

Were German demands a sign of a deep rooted German Hellenophobia? Was it exceptional or quite common at the time? And if so, did it prove useful? According to Kris Mitchener and Marc Weidenmier (2010), “supersanctions”, defined as military pressure or political control applied following a debt default, were commonly used during the gold standard period (1870-1913). During this period, 64% of defaulting countries experienced a form of sanction. For small Central American countries threat of (or actual) military interventions were common following a default (Costa Rica, 1911; Guatemala, 1913; Nicaragua, 1912, Santo Domingo 1905-1913 and Venezuela 1902-1903).

Fiscal “house arrest” was also common following a default. Taking over public finances could either be done by a single country or by a group of creditor countries. In some cases, such a control led to the imposition of a protectorate (Morocco and Tunisia). A quick look at the countries sanctioned gives the impression that small Latin American countries were likely to face military intervention, whereas Middle Eastern (Egypt, 1881; Ottoman Empire, 1882) or small European countries (Greece, 1893, Serbia, 1895) were likely to see their fiscal powers taken over.

How did these sanctions affect the economy of the different countries? Kris Mitchener and Marc Weidenmier (2010) look at two distinct elements: trade and public finances. They show that following the sanctions trade declined dramatically in Egypt, Greece and the Ottoman Empire. To give an idea, they estimate that Greece trade declined by approximately 20%. More positively, they find that the imposition of an external control helped improve public finances.

Are these results worth the loss of sovereignty experienced by the defaulting countries? In the Greek case, an international financial commission was appointed in 1898 to control public finances. As pointed out by Andreopoulos (1981), “with this humiliating intervention, public finance was surrendered to the Great Powers for a period of 44 years” (in 1932, Greece defaulted once more on its sovereign debt).

Whatever the costs for bondholders, humiliation is never a good long run policy. As Mark Twain remarked: “History Doesn't Repeat Itself, But It Does Rhyme”.

References:
Andreopoulos George, (1981), “State and Irredentism: Some Reflexions on the Case of Greece”, The Historical Journal, 24.4, pp.949-959.
Mitchener Kris, Weidenmier Marc, (2010), "Supersanctions and Sovereign Debt Repayment", Journal of International Money and Finance, 29, pp. 19-36.
Spiegel Peter, Hope Kerin, “Call for EU to control Greek budget”, The Financial Times, January 27th, 2012, available at http://www.ft.com/intl/cms/s/0/33ab91f0-4913-11e1-88f0-00144feabdc0.html#axzz1mSFWOy6c
Wynne William H., (1951), State insolvency and foreign bondholders, New Haven, Yale University Press, vol. 2, p. 284

Greece before Greece… Betting on Victory and Patriotism

2012-02-12T02:43:00.001-08:00

Greek is under the spotlight…and, with my partner and in laws from Cephalonia, I could not resist sharing my thoughts about the earliest Greek default.

Following the fall of Constantinople and the end of the Byzantine Empire, Greece fell under the Ottoman rule. Many attempts to regain independence failed during the following centuries. At the beginning of the 1820s, the war between Persia and the Ottoman Empire opened a window of opportunity to start a revolution. As had been the case with Latin American countries seeking independence at the same time, the Greek insurgents badly needed external finance to wage the war.

The strong legacy from Ancient Greece had lead to the development of a strong positive feeling towards Greece in Western Europe. Philhellenic movements in Europe flourished. In Great-Britain, the London Philhellenic Committee helped float the two first Greek bonds. In 1824 an amount of £800 000 was raised followed by £2 000 000 the year after. Both loans paid a 5% coupon and were issued respectively at 59 and 55% of par. At this price bondholders could expect substantial gains should Greece gain independence. Quite presumptuously, the issuer was pledging “all the revenues” of Greece even though the country was still under foreign rule! Proceeds of the bonds were used to buy war material, most notably warships. The Greeks usually astute traders were in this case not as sharp as expected and bought ships which were delivered with huge delays…

One may wonder why bondholders would be willing to invest in such a bond. From an objective point of view they were buying a bond from a country which did not yet exist as such!!! Were they simply irrational or can one think of another motivation? From a financial point of view, reimbursement was almost without discussion conditional on independence. So, bondholders were in fact taking a bet on a Greek victory but also on Greece’s ability to repay the debt should it become independent. Alternatively one could have expected investors to buy bonds for Philhellenic or Patriotic Motives. Distinguishing each motivation is pretty hard since bondholders don’t make public their inner motivations.

In another context, Kang and Rockoff (2006) have suggested an elegant way to disentangle motivations. They analyze the case of Liberty Loans issued by the US to finance its contribution to the First World War. At the time, no efforts were spared to convince US citizens to buy war bonds. Boy Scouts volunteered to sell these and Hollywood stars such as Douglas Fairbanks, Mary Pickford, and Charlie Chaplin were involved directly to facilitate their placement. But did it work? Were people buying bonds because of their patriotism? To answer this question Kang and Rockoff (2006) look at spreads between the Liberty Bonds and other bonds at the end of the war. If investors were ready to forego part of their returns for patriotic motives at the end of the war this element should have disappeared. In other terms if bond pricing included a negative premium because of patriotism, this premium should disappear at the end of the war. They conclude that patriotism had limited effects.

In the case of our Greek bonds such an analysis is unfortunately not feasible. Indeed, Greek insurgents were hoping for a quick victory but failed to repay their bonds before gaining independence. In 1827, bonds ended up in default and Greece would only gain independence in 1832. In dire needs of funds it turned itself to international markets again. With the guarantee of France, Great-Britain and Russia it issued a loan in 1833. However it refused to settle the case of the previous loans leading to many protests from bondholders associations. It was not until the 1860s and following repeated defaults that a settlement was agreed upon.

Holders of these first Greek bonds eventually won the military bet (Greece became independent) but lost the financial one… In Virgil's Aeneid, the Trojan priest Laocoön is quoted saying “Quidquid id est, timeo Danaos et dona ferentis” (Whatever it is, I fear the Greeks even when they bring gifts). In our case, gifts were the last thing holders of the 1824 and 1825 bonds received from Greece. Whatever their motives, recognition was not on the agenda for the first Greek governments.

References:
Kang Sung Won, Rockoff Hugh, (2006), "Capitalizing patriotism: the Liberty Loans of WW1", NBER Working Paper No. W11919, 55p.

Wynne William H., (1951), State insolvency and foreign bondholders, New Haven, Yale University Press, vol. 2, p. 284

The Hull nouveau has arrived

2012-02-11T03:47:00.000-08:00

Some days ago, after my first Derivatives class, a student asked me whether he should buy the latest edition of John Hull’s “Options, Futures and Other Derivatives” (JH8). He had borrowed the 1^st edition (JH1) from his father and was wondering whether the new version was very different. Browsing through the new edition, he quickly realized that this was the case. My advice was: “Keep the 1^st edition as might gain value. Buy the new edition, use it for this class and transmit it to your children. The return on investment should be positive”.

JH has accompanied me for the last 23 years. I started teaching derivatives in 1989, when the John Hull’s first edition (JH1) had just been published. As it fitted exactly my teaching needs, I chose it as the reference for my course. I have been true to it since then. The book strikes a delicate balance between mathematics and intuition. It has been hugely successful. The book is ranked #1 on the Amazon.co.uk website in the category “Books > Business, Finance & Law > Management > Budgeting & Finance”. For a textbook, this is the equivalent of an Oscar award. Interestingly, book#2 in the same category is “Principle of Corporate Finance” by Brealey Myers & Allen, another reference that I used for many years. I am very bad at stock picking but I might be good at book picking.

In 1989, the derivatives industry was still in infancy. The total notional principal was about just 4 trillions US dollar. JH1 had 13 chapters and 330 pages. Derivatives now weight 789 trillions US dollar. JH8 has 36 chapters and 846 pages.

But the number of hours I was assigned to teach the topic remained unchanged. Universities do not adapt quickly to changes.

Colloque sur les Agences de Notation (26 mars 2012, Brussels) Save the date!

2012-01-25T16:11:00.000-08:00

Les agences de notation entre les marchés et les Etats
Créées au début du siècle dernier pour informer les investisseurs sur la santé économique des entreprises de chemin de fer, les agences de notation financière défrayent la chronique. Mises en cause en 2008 pour leurs notations des produits structurés responsables de la « crise des subprimes », elles sont aujourd’hui critiquées en tous sens pour leur rôle dans la crise de la dette souveraine. Hier encore structures mystérieuses du monde de l’expertise, les agences de notation financières sont désormais au cœur des débats d’une opinion publique inquiète. Quelles méthodes de notation financière mettent-elles en œuvre et que faut-il en penser ? Comment ont-elles été propulsées au rang de régulateur mondial du crédit ? Quelles sont les règles juridiques qui encadrent ou devraient encadrer leurs actions ? Ne sont-elles pas en train de faire main basse sur des enjeux politiques à l’égard desquels elles ne jouissent d’aucune légitimité ? Ne sont-elles pas également un symptôme d’une évolution plus fondamentale de la gouvernance globale ? Autant de questions que se posent tant les spécialistes de ces matières que les citoyens.
Afin de contribuer à ces débats, le Centre Emile Bernheim de la Solvay Brussels School of Economics and Management (ULB) et le Centre Perelman de Philosophie du droit de la Faculté de Droit (ULB), au sein du Finance Club of Brussels, organisent conjointement une journée d’étude le lundi 26 mars 2012. Réunissant des spécialistes issus du monde de la finance, du droit et de la philosophie, celle-ci a l’ambition de confronter les points de vue sur les agences de notation et leur rôle dans une perspective interdisciplinaire.