Category Archives: dynamic risks

Regret in the here and now, joy in a parallel universe

Morgans

Steven Davidoff, the New York Times’ Deal Professor, thinks that management and shareholders at the Morgans Hotel Group got suckered back in October 2009 when they sold their souls a PIPE for cash. Davidoff implies that the investor, Ronald Burkle’s Yucaipa Companies, is doing fine, while management and the other shareholders are squirming to escape as various control triggers are closing in on them.

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Backwardation in Gold Prices?

Izabella Kaminska at FT Alphaville clarifies what’s going on.

Smooth Talk About Gold

Bruce Bartlett used his New York Times Economix blog post today to argue that “Gold’s Declining Price Is a Reversion to the Mean”. He buttresses his argument by pointing out that,

In a recent paper, the economists Claude B. Erb and Campbell R. Harvey present strong evidence that the gold market was severely overbought. The increase in gold prices did not represent a change in the trend of inflation. As the chart indicates, even with the sell-off, the price of gold is still high and has a long ways to fall to get back to the “golden constant” that gold-standard advocates cite as proof that the dollar should be pegged to gold.

Bartlett Harvey

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Gold’s Random Walk

A number of journalists are helping to broadcast Goldman Sachs’ latest prediction for gold prices. Goldman’s press agents planted the story in the Wall Street Journal, the Financial Times and the New York Times, among other places.

This is silly. There’s plenty of scientific evidence that the gold price is a random walk. Here’s an old reference: Eduardo Schwartz’s Presidential Address to the American Finance Association back in 1996. There are older and more recent papers finding the same.

Last week I wrote a post in which I mentioned that the time series of commodity spot prices are often mean reverting. They contain an element of predictability. Gold, however, is the exception. Gold is very, very, very cheap to store. And it is widely held purely as a store of value without any use value. Consequently, the spot price of gold quickly incorporates changing market views about future supply availability and any other fundamentals like those itemized in the Goldman report. For all intents and purposes, a physical investment in gold is a financial security, which means that the spot price is a martingale. The distinction I made in my last post between the spot price series for a commodity and the time series for a specific futures price is a meaningless distinction for gold.

Dynamic Hedging or Futile Speculation?

chesapeake

Chesapeake still thinks it can time the market.

On Tuesday management held its Conference Call to update to investors and stock analysts. Steve Dixon, the acting CEO, said “We’ve also taken advantage of the recent surge in natural gas prices to lock in additional price protection in 2013, and we have begun to hedge natural gas production in 2014 at prices well above $4, a level the market has not seen for some time.”

The company has had problems in the past from its foolish attempts to time natural gas prices. Last time prices were falling and the company took off its hedges. This time prices are rising and its putting on hedges. But the mindset is the same.

Behind this dynamic hedging strategy is a common misunderstanding about mean reversion in natural gas prices. The same misunderstanding applies to other commodities as well.

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Hiding Risk by Netting Exposures

whistling past the graveyard

Which representation of a bank’s derivative portfolio provides a fairer picture of the risk it presents, the net or gross balances? US banks, operating under US Generally Accepted Accounting Principles (GAAP), report the balance after netting out offsetting exposures with the same counterparty together with collateral. European banks, operating under International Financial Reporting Standards (IFRS), report the balance gross.[1] Consequently, a naïve comparison of banks using total assets as reported under the two different standards gives an erroneous impression that US banks are much smaller relative to their European counterparts. Were the assets reported on a comparable basis, US banks would climb in the rankings. But which comparable basis is the right one? Should the US bank assets be adjusted upward with the netted derivative assets added back, or should the European bank assets be adjusted downward by netting out more of their derivative assets. A number of US banking regulators and experts have recently started calling for putting the gross exposure onto the balance sheet. Not surprisingly, the big US banks and derivative trade associations like the International Swaps and Derivatives Association (ISDA) argue that the net exposure is the right one.

What is at the root of the disagreement?

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Griffin’s Risk Management Superpower

 

The third installment of the feature film series Men in Black features the alien Griffin. Griffin possesses the critical ArcNet shield that can protect the earth against the impending Boglodite invasion. Griffin also possesses an amazing superpower: he can see the many possible futures in store for us. The movie’s writers, director and the actor playing Griffin, Michael Stuhlbarg, exploit this superpower to great comedic effect, first in a scene that takes place in 1969 at Andy Warhol’s Factory, and then later at Shea Stadium where Griffin visualize’s the Miracle Mets’ entirely improbable victory in the World Series later that year. Griffin’s superpower goes an important step further, and this is a key to how the comedy is written. Not only does he see the wide array of possible futures, but he understands, too, which futures are consistent with events as they play out, and which futures are suddenly ruled out by current events. He sees what mathematician’s call the filtration.

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Reading the Term Structure of Futures Prices

Over the last few years, natural gas prices in the U.S. have been pounded by a variety of factors. Front and center are the continuing breakthroughs in horizontal drilling and hydraulic fracturing. On top of this, the winter of 2011-2012 was the fourth warmest on record, according to the National Oceanic Atmospheric Administration (NOAA), and those temperatures slashed demand. From a peak of over $13/mmBtu in July 2008, the price fell to almost $2/mmBtu in March 2012.

How much of the price drop has been due to which factors?

Of course, the answer to that question is anybody’s guess, and no one’s guess can be hazarded with too much certainty. But the term structure of futures prices is a good distillation of the opinions of many market participants. Anyone trying to comment on market movements would be well advised to be informed on how the whole term structure has shifted, and not just on how the spot price has moved.

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Duality and Uncertainty: Lessons from the carbon market

The Great Recession has hit the European carbon market hard. With output down, the demand for allowances is down, and so is the price. As recently as the start of this year, emissions allowances were trading at €14/t CO2. But last week the price was below €7. This is gloomy news for those who want the carbon price to incentivize innovation in low carbon technology. For example, David Hone, Climate Change Advisor for Shell, is one of many who have been advocating that the Union set aside a number of allowances in order to support the price. Earlier this week that proposal moved a step closer to becoming a reality with a favorable vote by the European Parliament’s Environment Committee. The price of carbon subsequently jumped up by 30% on Tuesday on the news.

I bring up this news because I think it highlights a weakness in the economic debate about the best means to the end of pricing emissions. The argument revolves around whether or not the government should set the price of emissions, and let companies choose the quantity of emissions, or whether the government should set the quantity of emissions it will allow, and let the market set the price. The former is a carbon tax, the latter is a cap-and-trade system. In a world of certainty, where the cost of abatement by companies is well known, the two are equivalent. When the government sets the price (tax level), it knows the quantity of emissions that companies will choose. Alternatively, when the government sets the cap, it knows the price that will emerge in the market. That’s duality.

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Song of the Martingale

John Kay at the Financial Times has a nice column reminding us of the delusions of following a martingale betting strategy. It’s a persistent delusion that shows up in many different contexts.

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