Let’s Take It Backwards – Ruminations for a Foresight

Sometimes one has to take a step back to move forward.

As we end this year today and enter into a New Year one could be excused of being curious how this New Year would shape. I am certainly of the opinion that the world is witnessing some serious structural changes that would hopefully make it a better place in a decade or so but in between that period we would witness unforeseen chaos. Ofcourse no one has an authority over predicting the future however I guess most of believe one simple law that the “nature ultimately corrects the anomalies and take us to the point of sustainability”, to see where this point might lie “let’s take it backwards”.

The main anomaly/fragility I find in the world today is:

-         -  The unnatural government monopolized fiat currency system

From this very anomaly flow two other anomalies/fragilities:

-          - Universities across the world conditioning young minds with wrong economic concepts

-         -  Reward of labour taken away from the productive sector of economy and given to the unproductive sector

The Unnatural government monopolized fiat currency system:

Back in 1776 when Adam Smith wrote “The Wealth of Nations” he talked about the selfish motive of individuals that ironically leads to a functioning of a well functioning economy. This thought in my opinion is absolutely correct and also formed the bedrock of the modern economic machine. However in this context where do the governments fit in?

Surely they are also a part of the society and thus following the analysis of Adam Smith the people in government are also driven by their self interest. So what really is the self interest of people in government?

Well in my opinion again it is “power”; the power to control the destiny of others and the sovereign currencies is one of the most important tools by which they exercise this power. To give an instance, under the presidency of Abraham Lincoln a civil war broke out between the North and Southern states of America, to fund the war Lincoln needed money; ofcourse taxation would have been a way but it would have been grossly unpopular so his advisor asked him to fund the war by simply printing fiat dollar (which has become a norm across the world now). However Lincoln had his doubts, he asked his advisor how do I make people accept this fiat money, the solution was very simple… ask the people to pay their taxes in this fiat currency.

This fiat currency is the instrument by which the government controls not just the economic activity but also as we are seeing now our social lives. Unfortunately we have been brought up to think this cocktail socialism that has carried on since the abolition of gold standard in 1971 and went berserk ever since Alan Greenspan became the Central Banker as free markets. The only way to bring an end to this is by denationalising currency, i.e. bringing it out from the control of government and the few big banks.

Because of this power to siphon off your hard earn wealth without most people even noticing we find the governments becoming too powerful and entering other aspects of our lives and this where the other two points of fragilities come into play.

Universities across the world conditioning young minds with wrong economic concepts:

Teaching a wrong idea is more dangerous than teaching how to pull a trigger, as a misfired can affect lives of a few people but a wrong idea can stray an entire generation onto the wrong path.

A few days back Larry Summers , who happens to be the dean of Harvard, an ex-treasury secretary and was until very recently was heading Obama’s economic team said that “It’s ironic that the solution to the problem of too much debt and consumption is again too much debt and consumption”, listening to this I should have probably thanked my stars that I didn’t go to Harvard but that doesn’t matter as even in Indian colleges the course content is simply copied from such universities which happens to contain lot of macroeconomic gibberish of Keynesian and Monetarist variety (and ofcourse not to mention the financial statistics and option pricing). Ever since leaving college I have found these tools specially Keynesian, as a total waste in understanding the economic machine. I can go on to say that the two years spent in the study of these concepts was a waste of time and I had to spend extra effort unlearning them than I would have spent otherwise. The only purpose that these tools serve is to construct an analytical relationship between a set of variable at a “given point of time” (notice the quotes). However this is of no significant value in a dynamic world.

So the question is why these thought processes become so widespread, simple because under the garb of these economic views the government can have the authority with fiscal and monetary interventions. So the government essentially employs economists with these thought process and since the primary objective of the universities is to provide employment, a person equipped with these ideas find greater chances of employability.

Reward of labour taken away from the productive sector of economy and given to the unproductive sector:

Perhaps the biggest problem the world is facing today is misdirection of resources. The true reason why free markets flourished while socialism collapsed was one “incentives”; free markets gave rewards in lieu of your contribution to society. Aren’t our scientists, engineers, doctors the real people who improve the productive capacity of this world and make it a better place and then shouldn’t they receive the greatest rewards for their labour. However again because of this monopolized fiat monetary system we see that a few banks are hoarding on the wealth and adding very little value to the society and this is giving rise to serious imbalance in this world. Because of this a lot of talented people are going into this sector, the work where demands people of far less talent instead. To give a simple example:

If I want to buy a house and no one in the economy has more than 1 million dollars, the price of the house can never exceed that number. However now come our great banks that are actually nothing but agents spreading the government control of money; through the magic of fractional reserve banking they simply print 9 million dollars out of thin air and give it to an individual at 10% interest. This causes the value of the house to jack up to 9 million dollars and for this useless activity of printing money the banks garb a cool million dollars.

So in short without adding any productive value in this society the banks have accumulate a million dollars; what a waste of resources!!! And they can do it because they have the access to the government money first over any other individual and then on the top of that they have the license to exercise fractional reserve lending; which is nothing but a complete fraud and if done by any common individual can land him into jail.

The first Great War was fought when almost the entire world was captured by few powers and the conflict was the only option to gather more resources. Today as the world population has grown and evolved the need for resources has never been greater; however with the government interventions through monetary and fiscal stimulus, the brazen monopoly of credit by banks and the policy of too big to fail has led to stark misallocation of resources. These are the changes that would be brought about ultimately and probably in this very decade, however if history is any guide then no one likes to relinquish authority by will. While I would resist making any predictions and leave it at the judgment of the readers, all I would like to say is that as we enter into this New Year we are really entering interesting times and if during the course of the year any one wants to understand where the world is headed my suggestion would be to “Take It Backwards”…….

When All Roads Lead To Rome

This article of mine was published in Hindu Business Line print edition on December 8 (link). Has been some time wherein I wrote an article just for this blog so planning to write an article next for this blog in which I would continue my option pricing series.
Here is the article...........

Italy is among the richest countries in the world, a member of G7; among the top 10 largest economies; the population in northern parts of Italy is among the wealthiest by per capita; home to some of the top manufacturing brands and a gold reserve which is second only to Germany in the Euro region (valued at around 400 billion dollars). However now with each passing day the Italian economy is pushed deeper into to the abyss, a nation stripped off its democratic virtues; people burdened with taxes; a government saddled with debt and a nation with uncertain fate.

It’s indeed a real travesty that a nation with so many resources at its disposal is looking at a bleak future with no daylight in sight and one wonders why it is so?

Well a look at this chart can answer a lot of these questions. This graph maps the industrial production of Germany and Italy since 1993. Notice how much abreast the industrial production of these two countries used to move before the introduction of Euro in 1999. However since that time this gap has been widening and today with industrial production of Italy sagging while that of Germany rising, this gap has widened to historical levels!!!

The ills of this Italian economic catastrophe lie in none other than this common currency “The Euro” which is destined to create disparity instead of parity among nations

A currency may be a store of value for an individual but for a society at large it is nothing but a way to transfer wealth and so an increase or decrease in the currency supply doesn't actually change the overall wealth of the society; it simply moves it from one person to the other. Remember a currency is nothing but a short term government liability and so a currency note printed by the Central Bank and given to banks increases the assets of the banks but at the same time increases the liabilities of the government by an equal amount, so net impact on global wealth is “zero”. However this increase in government liability now has to be serviced by ordinary citizens; they end up doing this by either putting in more hours than usual at work for the same pay or giving away more from their existing share of their income to the government in form of taxes.

Central banks already have monopoly over money creation and thus can easily transfer wealth these days by creating more money (to the benefit of capital owners and debtors over labours and savers) or by reducing its supply (to the benefit of labours and savers)

By giving away the power to print money this transfer of wealth is now happening not just between individuals but also between countries in Europe. Euro on a consolidated basis is a weaker currency for Germany and a much stronger currency for Italy in other words there are too few euros for Italy and too many for Germany.

So with such a strong currency there is little incentive for the capitalists in Italy to setup industries thus reducing the country’s productivity and industrial growth (as seen in the graph). Consequently the government ends up picking up the slack (over 50% is government contribution to Italian GDP) by running exorbitant debt that now it cannot repay. Such a condition is advantageous for a country like Germany; this is not to say that Germany and German workers are not good at their work but this provides an even extra edge as with reduced competition from Italian industries it ends up selling lots of its products. A look at the graph below would tell you the story.

Had Italy been able to use its Lira it would certainly have devalued its currency by printing more money and thereby transferring some of the wealth from its labour to its capital holders, thus unleashing the country’s entrepreneurial spirit and giving an incentive for more people to start industries.

The fiat monopolised currency system existing today in any case is flawed and on the top of that a common currency area is structurally and economically wrong and as we are seeing today has disastrous consequences. By giving away the right to the printing presses not only have the Italians and other European countries given away their economic fates to foreign masters but have also as we are seeing today, possibly given away their democratic ethos. Not only is it unfair for the common Italian citizens to pay for the folly of the bankers but living under this flawed economic structure, they are also paying for the misjudgments and hubris of their politicians and economic elites. It’s time for Italy to exit this common currency experiment and in the process pave the path for others to follow.

Time for Redemption: Don't Blame The Oriental Land

This article of mine was published in Hindu Business Line on November 19 ( link ) , posting it here on the blog with some additions.

The world is steadily but surely moving towards an era of trade wars and protectionism. With the controversial bill to punish China over its currency having been approved by the Senate, the Sino-US tensions have moved up by a few notches.

When there is dis-illusionment among the masses and the protestors are on the streets it’s rather easy to put the blame for one’s precarious state of affairs on a distant foregin land and it’s government.

The reality is that it’s not the Chinese policies but the policies of the US itself that has been responsible the nations huge indebtedness, joblessness and high Current Account Deficits.

Ever since 1980s the US financial sector has been in trouble for some reason or the other, be it the tequilla crisis, LTCM, Asian crisis, the subprime crisis and now ofcourse the sovereign debt crisis and everytime the response of the US government (infact most Western governments for that matter) has been pretty predictable; transferring of the bank’s bad debts onto its own balance sheet thereby increasing the soveregin debt load and the Central Bank happily monetizing a part of it.

The problem with money printing and issuing sovereign guarantees is that it never increases the wealth of the society; money is a store of value for an individual but for the society as a whole it is just a medium to transfer wealth from one person to the other or more broadly from one sector of the economy to another. As a result of the government’s and Central Bank’s fire fighting exercises over the  last three decades, everytime the financial sector was saved capital was transferred from the manufacturing and other prodcutive sectors of the US economy and given to the financial sector.

Chart a

Chart b

 As one can see from the graphs above; that thanks to the government bailouts and Fed money printing the bloated financial sector sucked resources from every other sector of the economy specially the manufacturing sector. Even here a large part of what is actually accounted for as the contribution of financial sector to the US GDP is the non productive activity of flipping around assets and derivatives and generating a fee income. One can only fathom of the numbers considering the 700 trillion dollars market with a daily turnover of as much as 40 trillion (globally). As also seen from the graph, for all the GDP contribution that the financial sector makes to the US economy its contribution to job creation has been paltry to say the least.

Had all these dollars that were generated to save the defunct financial sector botteled up inside the US, the CPI levels would have exploded; instead it was because the Oriental land came to its rescue by happily servicing the US citizens with cheaper goods due to its lower labour cost and cheaper currency that the US was able to maintain its mojo.

The symbiotic relationship wherein the Chinese sold their goods and services for US dollar and then recycycled them back to US by buying up the treasury bonds is what gave the US government the ability to run its various social welfare programs and ofcourse save the banks every now and then.

Chart c

As can be seen from the graph, post 2007 with the bailouts having become bigger, the fiscal deficits have outgrown the Current Account Deficits forcing the Fed to intervene with it’s massive QE programs.

It’s not the weaker Chinese yuan that is the reason for US woes, the trouble lies with the government and the Fed “Put” on the US financial sector that has led to serious mis-allocation of capital. Infact the only reason why the bloated financial sector which has taken away the productive jobs but has still not managed to completely take away the purchasing power from the US citizens thereby draining the vitality of the average US household is because of the cheaper Chinese goods for which the cheaper yuan has a big role to play.

A bill in the US senate is required to be passed, but not against the Chinese currency manipulation rather against the Fed and government’s policy towards what they term as “Too Big To Fail”.

Inefficacy of Central Bank Interventions

Part of my article below actually appeared in the Hindu Business Line Link a few days back, made some additions to the original post and re-posting it.

Even after two decades when it was decisively established that the forces of invisible hand are far superior to the command and control structure in bringing about the economic growth and prosperity, the Central Bankers across the world have not stopped trying. Perhaps the human urge for power and to feel that he is in control of his surroundings may also be playing a part; the belief that they have the might and the power to control the business cycles and to do away with recessions is evident in the dramatic increase in their interventions in the asset markets this past decade and now with the global economy in a flux ever since the financial crisis of 2008 it has increased further. Like the financial derivatives, the asset classes (equity, commodity, fx, bonds and real estate) are derivatives on the real economy and hence their price action is just a forward looking reflection of the economic condition. Thus a high volatility in any one of these asset classes can be a harbinger of the perilous state of the economy and so ever since bouncing off the abyss in 2008-09 the Central Bankers and Planners try to control the behaviour of the asset class that starts to exhibit high volatility. 

With years of intervention we have reached at a crossroad where the Central Banks have completely lost their control over the only component of the asset market where they actually had one; “the yield curve”. This became apparent in the late 90s in Japan and then finally here in US, when the Fed after propping up the property market in lieu of the busted Nasdaq bubble tried to control the elephant from turning into a dinasour by increasing the Fed Funds Rate in June 2004, however it soon found that it has completely lost control over the yield curve as the graph below demonstrates:

Chart a

So from June 2004 to August 2005 the Fed funds rate increased from 1% to 3.75% however the 10 year yield was at best flat; result - the property boom couldn’t be slowed down and the elephant actually grew bigger leading to the ofcourse eventual dramtic collapse. So as is apparent from the graph above, the Fed lost control of the yield curve almost 6-7 years ago however even now the Central Banks are living in a cinderlla world as is apparent by the announcement of “Operation Twist”.

The recent announcement of the Swiss Central bank to peg the Swiss Franc against the euro shows how this contagian to control the asset markets is spreading like a wildfire and in turn leading to a mispricing of assets and thus aggravating the economic situation. Let me elaborate further by picking on this example, so to maintain this peg the Swiss Central Bank would have to print as many CHF as it would take. Now because of the peg the volatility in the CHF-EUR currency market would diminish however the question that one should ask is what would one do of the new swiss francs that have been created, well using that the market participants would buy more of bonds/stocks/commodities etc. and thus what happens is that volatility would spill over and add to the existing volatilities in other markets, in essence volatility is not destroyed, just transferred.

 To establish how the volatility from this currency pair has moved into the other asset classes, below are the charts of standard deviation (volatility in simple words) of the daily changes in the CHF-EUR currency pair pre and post the announcement of the peg and a similar chart for the equity pair of the Swiss Stock Index to the French Stock Index i.e the (SMI/CAC ratio) for the same two periods. Please note that in order to have a similar comparison with a "currency pair" it's important to pair the Swiss market with a major Euro market as this would remove the effects of the volatility due to the broad common macro moves thus bringing about clearly the volatility impact due to the currency peg, also I am excluding the market data on the announcement day as we are interested in what happens "pre" and "post" peg announcements.

Chart b

Chart c

 A brief glance at these charts would tell you that even though the Swiss Central Bank was succesful in reducing the volatility of the CHF-EUR currency pair, however the unforseen impact of their action has been that part of the currency market volatility has moved into the Swiss stock market as exhibited by the volaitlity of the SMI/CAC ratio which has almost doubled post currency peg announcement

All this shows the ineffectiveness of the actions of the Central Banks as not only the volatility from one asset class moves to the other asset class thereby keeping the overall volatility in the system as same but excess of control would mean the volatility entering into the broad economy which is precisely what they intended to control to start with and so instead of taking the signal from the asset class exhibiting high volatility their actions leads to a mispricing of assets and thus aggravating the economic situation. 

The cries of Plutus – Why Greece should exit the Euro

With each passing day the Greek economy is pushed deeper into to the abyss, a country halted by strikes; people burdened with taxes; a government saddled with debt and a nation with uncertain fate.

Not only is it unfair for the common Greek citizens to pay for the folly of the bankers but living under a flawed economic structure – “The Euro” that is destined to create disparity instead of parity, they are also paying for the misjudgments and hubris of their politicians and economic elites.

A single currency area is equivalent to a monopolised business where the consumer is at the mercy of the industrialist only that this type of system can be termed as a "foreign social monopoly”. As one can see that the name itself encapsulates all the possible social and economic evils. By giving away the right to the printing presses not only the Greeks and other European countries have given away their economic fates to foreign masters but have also possibly given away their democratic ethos.

Let me elaborate, a currency may be a store of value for an individual but for a society at large it is nothing but a way to transfer wealth. Remember a currency is nothing but a short term government liability and so a currency note printed by the Central Bank and given to banks increases the assets of the banks but at the same time increases the liabilities of the government by an equal amount, so net impact on global wealth; “zero”. However this increase in government liability now has to be serviced by ordinary citizens; and how do we expect the citizens to service it…. Well by either putting in more hours than usual at work at same pay or giving away more from their existing share of their income to the government in form of taxes. The net effect of this whole guerilla circus is that the citizens end up giving more of their personal income to the banks in form of taxes or in form of harder workload.

So an increase or decrease in the currency supply doesn't actually change the overall wealth of the society; it simply moves it from one person to the other. This phenomenon of wealth transfer is quite apparent and common these days when the Central Banks prints a lot of money so let me explain what happens when this supply reduces.

So let’s assume that 2 people A&B have one euro each and vie for a product, they both can acquire it for a euro each. Now as fate would have it, A loses his euro; it simply vanishes from the world, has the world become poorer... NO, as now B can buy two of the same product with his euro, in other words wealth has not been destroyed, just transferred from person A to person B. Governments and Central banks already have monopoly over money creation and thus can easily transfer wealth these days by creating money (here capital owners and debtors benefit over labours and savers) or by destroying it.

By giving away the power to print money this transfer of wealth is now happening not just between individuals but also between countries in Europe. Euro on a consolidated basis is a weaker currency for Germany and a much stronger currency for Greece in other words there are too few euros for Greece and too many for Germany, remember a loose currency transfers wealth from labour to holders of capital and strong currency transfers it back to the labour.

So with such a strong currency there is little incentive for the capitalists in Greece to setup industries and employ people as a result the government ends up employing too many people (over 40% is government contribution to Greek GDP) and government true to its nature ends up making lofty promises, running exorbitant debt that now it cannot repay. Such a condition is advantageous for a country like Germany; this is not to say that Germany and German workers are not good at their work but this provides an even extra edge as with little competition from Greek internal industries it ends up selling lots of its products.

Had Greece been able to use its drachma it would certainly have devalued its currency by printing more money and thereby transferring some of the wealth from its labour to its capital holders, thus unleashing the country’s entrepreneurial spirit and giving an incentive for more people to start industries.

A monopolised currency system in any case is flawed but a common currency area is structurally and economically wrong and as we are seeing today has disastrous consequences. This would never lead to convergence but always a divergence away from the normal equilibrium. The leaders must accept their past mistakes and bring an end to this euro experiment else it will not just bankrupt many nations and benefit just a few but it could seriously jeopardise not just our economic but even our democratic setup. It was this land of acropolis which was the cradle of our modern day democratic system; today Greece should again pick the baton to preserve the same very values that it stood for. It’s time for Greece to exit this common currency experiment and in the process pave the path for others to follow.

My Article Published in Hindu Business Line on Oct 1, 2011

Options - The Pricing Ways Continued.......

Today let’s take a break from economic issues and get back to option pricing. In continuation with my last piece on option pricing (Link) , wherein we explored a much easier way to price options and what was even better was that it allowed for the flexibility to have non-normal probability distribution in pricing. Today I would like to write about how we can develop the concept further to include in the money and out of money options. Well if one understands the basic premise of my last article on this topic it’s fairly simple.

As I wrote before, basically if I buy an “At the money” call and put, the price that I should pay is the expected movement of the stock in that period. So in essence

C+P = E[S] – Eq 1

Now for any option that is “In the money” for the buyer to make any money and for the seller to loose money would be when the Stock crosses the Strike price of the option, so in essence what we really care about are the probabilities wherein the Stock Price crosses the Strike Price of the option.

So the price of the option would be:

C = (S-K) +E[ ∑_x=kⁿ p_x*S]

The above formula gives the flexibility to the reader to assume different probability distributions and use them in the option pricing.

Please Note that If I try to simplify the Black Scholes model i.e. take the assumption of Normal probability distribution I would be only be approximating the pricing, but nevertheless let me put it down anyways.

The call price (assuming interest rates as negligible) c = SN(d1) – KN(d2), the put formula is also accordingly KN(-d2) – SN(-d1),

c= SN(ln(S/K) + σ/2*√t) – KN(ln(S/K) - σ/2*√t), Since We are taking volatility for the entire duration of the option so I am going to replace σ*√t with σ .

Also I would express S in terms of K and σ as that’s what we are concerned about, i.e.

S = K+ K*σ*Ɵ

Putting these values into the Black Scholes formula and expanding the log portion using taylor equation the log portion would be reduced to Ɵ – Ɵ^2* σ/2

Finally adding both these terms and using the Normal expansion and exponential expansion by taylor series

N(x) =[∫_-∞⁰exp^^{- (x)^2}  + ∫₀ ^σ/2exp^^{- (x)^2}]/sqrt(2 π)

The first part is equal to 0.5, to integrate the second part of the expression let me expand it using the Taylor series. The Taylor series expansion of the exponential term is

e^x = 1 + x + x^2/2! + x^3/3! ……

Replacing x by Ɵ – Ɵ^2* σ/2+σ/2 and then integrating we get

N(Ɵ – Ɵ^2* σ/2+σ/2) = 0.5+ [₀ ^σ/2 ∑₀ⁿ (-1) ⁿ (Ɵ – Ɵ^2* σ/2+σ/2 )²ⁿ⁺¹/2ⁿn!(2n+1)] /sqrt(2 π)

As SD is small number (in decimals) we can ignore the higher power of σ,

Please note that if σ is high the whole notion of Normality falls apart and as does the Black Scholes model.

So expanding this expression and putting it in Eq 1 we get

C = (2* Ɵ - Ɵ^2* σ/2 + σ) * √(1/2π)  

Or more simply C = (2* Ɵ + σ) * √(1/2π)

Again this is simplying Black Scholes using mathematical tools what’s more important to understand is that the genesis of any option pricing i.e. using any probability distribution is this formula below:

C = (S-K) +E[ ∑_x=kⁿ p_x*S]

Till Next Time………….

Failure is the option

Writing after a long time indeed, got stuck in some daily chores and also reduced travel in the last couple of months gave me less time to think. Anyways here it goes now; also I did put up this article at Business Insider yesterday.

The high unemployment rate that has engulfed the major economies of the world is not just serious but also bewildering and these moments of pain and awe among the population is when governments try to intefere and curb the freedom of the society, the case in point being the new excess stimulus plan of Obama. After all wasn't capitalism supposed to allocate the resources efficiently then why is that we have 16% unemployment in US (U6), over 30% youth unemployment in Spain, Greece, Italy. I mean the problem of this world is fall output and so isn't it ironic that with so much unemployment around we are taking about this problem. A garbage reason that I always listen on television by many analysts and CEO's is that of lot of policy uncertainty which is leading to this bemusing irony. Well this may be playing a very small part in e scheme of things as I find it hard to believe that policy makers of a few decades back were far idealistic, efficient and superior than what the are now. The real reason for this catharsis is that the world we are living in is no longer free markets or the economic order is no longer capitalist but "crony capitalist"

Recessions, fall in stock prices and asset prices in general and failure of big and mighty are features of capitalism wherein it reorganises resources and efficiently allocates it to new sectors, people and industries which then take it forward thus creating jobs and continuing the boom. Unfortunately now even a 10-15% stock market fall is followed up by printing of money by the Central Bank of US, companies like GE and GM are saved under the garb of avoid huge job losses and of course the banks and the financial institutions (the less said of those the better) these institutions that add very little value in this society but for continuing the ponzi currency scheme. What's worse is that with every time they being saved under the farce too big to fail these banks have raked in too much of the economic resources.

What's required is not another failed government induced spending plan but instead the government getting out of the way of this economic reset, let the markets crash if ey have to and the companies and banks go bankrupt... There will be brief period of chaos followed by a new reinvigorated order as new capable people take over those deflated resources and as the capital froth from those assets move to new places thus creating opportunities from our young entrepreneurs and providing jobs to millions. Socialism and today's crony capitalism suffer from the same problem "misallocation of resources" the only difference is that while socialism gives less to the competent, crony capitalism gives almost everything to the incompetent but not letting them fail.


In the next article (sometime this month only) probably we shall talk about how this increase in government debt ends up doing no good but preserving the existing world order of ponzi banks and its monetary system.

The myth of Wage Increments

Today let’s take a break from the statistical and option pricing articles and discuss something very close to probably every reader of this blog “Salary Increments”, I had almost finished an article on the farce of the PEG ratios however I would post it at some later date.

I would like to believe that I am one the most ardent votary of free markets and contrary to what many people have wrongly built an impression I think that Karl Marx is one of the most original thinkers in the field of economics and whose views are actually not anti-capitalist rather he just exposes the fallacies of capitalism, mind you there is a huge difference between free markets and capitalism. Certainly what has been happening since 1971 after the collapse of the Bretton woods system is hardly free markets, on the contrary it’s the worst form of Communism. The reason I say that is because atleast the communists are open about their ideologies and hence atleast are true to what they say. Our so called proponents of free markets i.e. the respective governments have been imposing centrally planned economies since the last 40 years. However this type of system is even worse because unlike in communism where government controls price of capital and labour, here the government certainly controls the price of labour and transfers that wealth to the capitalists. Let me explain this in a bit more detail by taking the example of “Salary Increments”.

So how was your Salary increment this year, Oh!!! Sorry did it hurt… didn’t get any?? Or were you that unfortunate one who got the middle of the band 10-14%, or were you that star performer who managed that 20% raise!!! Sorry to all but let me break it to you……….. you all have lost out!!!

The labour like in most other countries is paid in currency (government’s proxy banks controlled). So in essence like any competition the labour force is competing for the x amount of cash that exists in this economy. Now let’s say that these banks true to their nature induce an extra 20% cash in the economy, so just to be at par with what you were the last year you should get atleast x*1.2 cash for your labour, this is the minimum amount that you should get and even if you get this you are still not being rewarded for you improvement in productivity that would have happened because of the experience that you gained at work and the knowledge and skills you added in the last one year.

Compared to last year and extra 24-25% of fresh money was created this year, thanks to the base money of RBI and add to that the printing presses of the banks that create money because of the fractional reserve system. Assuming that an extra 4% people joined the Indian workforce and adding that to the workforce even the star performer getting a 20% raise has lost out and who actually ends up at the winning side… that’s right “the capitalists”. Remember price rise is not inflation it is just a symptom of inflation. Inflation is always more money chasing fewer goods so the myth that if the raise is atleast equal to the rate of inflation and hence you are not worse of is nothing more than a false propaganda.

The raise should atleast be equal to the increase in the money supply in the economy net off the increase in labour supply and if we add to that the increase in your productivity because of improvement in skills and knowledge only then we would truly say that you have been justly compensated.

However this is rarely the case that the extra cash ends up with the capitalists who get compensated more than warranted and thus widening the gap between the capitalists and labour. Please don’t misunderstand that I am against them, I am just stating the case as is. The real culprit are the global governments that have monopolized the issuance of base money. If this whole system has to become just then like any other product the issuance of money should be liberalized i.e. anyone should be in a position to issue money and let the invisible hand decide whose money is sound. Remember “money is nothing but a promise” and I certainly never trust the governments.

Alright so this looks like a solution that would not come about before another decade when the whole system would collapse, till that time what to do. Ofcourse the first solution is to start your own business (not everyone’s cup of tea) so the next is going to be based upon the old saying “If you can’t beat them then join them” i.e. invest your money with the capitalists i.e. by buying stocks, third and even better print your own money.. is that possible? Sure it is; taking debt is equivalent to printing your own money, hence take debt and invest, and if you can ride the rabid this fiat money system would ensure that you are much better off, or fourth (the best in my opinion) is to invest in commodities and precious metals… since the entire system is doomed to collapse ultimately the biggest loosers then are going to be the holders of financial capital and the biggest gainers are going to be holder of real/tangible capital (commodity owners) and lastly if one can face the stomach crunches go for the “Random Chalice option” buy those wealth cups (please refer to the very first article of this blog). Surely we all are mature people and capable of taking our own decisions but when you are being cheated in your face it’s important to be cognizant about it and do something about it.

Till next time…………

Statistical Follies

In the previous article I showed how the price of an At the money option is nothing but .8* σ or in other words more generally the expected price movement of the stock. Now I would like to show how we can compute price of any option with much more flexibility i.e “Out of money” or “In the money” and then finally introduce interest rates. The idea behind this whole song and dance is not to attack any existing model etc. because anyways in my opinion they are nothing more than epitome of Platonicity but to provide with sufficient flexibility to price these derivatives under the real practical market conditions which are highly volatile more often than not.

But before that let’s first have a look at what is fundamentally wrong with the financial modeling. As always if the design of the whole building is flawed but the problem lies in the basics or the groundwork and that is what we are going to explore in this article. Again the following content would be a little technical but not a whole lot, since this article series are going to continue for sometime, I have decided to alternatively put out more pleasant read articles after each one these.

With the progression of time it seems and more and more aspects of our society are becoming centrally planned rather than aligned to efficiencies of the free markets.  With everything denoted and measured in government controlled currencies it’s a big sham to call global economies as free markets. Closing the heels is education and knowledge. What awards like Noble Prize etc. ensures is that rather than the forces of free market discovering what type of knowledge/research paper/theory is good for the world, this whole notion ends up in the hands of a few people. Can you believe it a “few good men” I am sure deciding what the coming generations are going to study and based upon that would eventually the future of this planet would get shaped.

Let me pick up the most cardinal concept in statistics – “standard deviation (SD)”. In my last article I showed how the value of an At the Money option is nothing but equal to its Mean Absolute Deviation (MD), we eventually replaced it by 0.8*SD to get it inline with the Black Scholes. Infact as I would show in this article using Mean Absolute Deviation is a far superior method of use in social sciences than SD. So the question:

Why on earth is SD in widespread fashion?

Answer: Happens when few people decide the fate of learning.

In the field of statistics a “statistic” is used for measurement if it has the smallest probable error as an estimate of the population parameter. If the population is perfectly normal then the standard deviation of their individual mean deviations is 14% higher than the standard deviations of their individual standard deviations. Please note the bold italicized word, that’s it… so basically SD is a perfect lab rat however in the field of real social sciences it’s an abject failure. The icing on the cake is that this useless musings are imparted to millions of naïve souls in schools and colleges since almost a century.

Himanshu Jain: “SD as a useless measure in the field of economic science”

Wrong Knowledge is tantamount to a Fukushima whereby even the coming generations pay a heavy price. With these noble thoughts let’s have a look at it’s disastrous consequences. Since I started with the option valuations and the Black Scholes hoax let’s take this topic for example.

Thinking intuitively the price of an option should have been equal to the expected value of the stock or in other words mean deviation. In perfectly normal world of lab rats we replaced it with .8*SD, however stock market returns are anything but normal. Ofcourse with Central Planning of Stock Market these days there can be an illusion of normality. My point if I carry on with MD as the measure of option (instead of replacing it with .8*SD) we find that:

C+P = E[S]  - Eq 1

Expanding E[S] we get:

S*∑_k=0ⁿ p_k*abs(S-x_k), Now if I assume that the distribution is leptokurtic (fat tailed – high kurtosis)

p_kl lim_s->0(probability of leptokurtic distribution close to mean) ≤  p_km lim_s->0(probability of mesokurtic distribution (no excess kurtosis) close to mean).

-          In other words the option prices of At the Money options should be slightly less than what is being computed by using standard volatility measure i.e. SD (σ)

Now-

p_kl lim_s->∞(probability of leptokurtic distribution far away from mean) >>  p_km lim_s->∞(probability of mesokurtic distribution (no excess kurtosis) far away from mean).

-          This implies that the prices of out of money options is far lower as estimated by using σ

For someone keeping a Platonic mindset let me put the proof below:

Since σ is calculated by squaring the movements of the deviations from mean, as the deviations increase σ basically explodes when compared to MD. To prove:

σ₁  = √[∑_k=0ⁿ a_k^2+S^2]/n, S>> a_k

MD₁ (d₁) = [∑_k=0ⁿ a_k + S]/n, S>> a_k

σ₂  = √[∑_k=0ⁿ⁺¹ a_k^2]/n

MD₂ (d₂) = [∑_k=0ⁿ⁺¹ a_k]/n

Since S>> a_k d₁ -d₂ ≈ S/n

And σ₁ - σ₂ ≈ S/√n , Since n is large in other words it shows that σ explodes parabolically when the deviations  are more meaningful and if SD explodes parabollicaly then think what would happen to kurtosis!!!

The implications of the use of the most fundamental concept of standard deviation in option pricing are enormous. It leads to a clear under pricing of Out of money options while making At the money options slightly expensive and it is this very pricing that we are going to explore soon………..