## Tuesday, September 23, 2008

### Rewriting history and science and history of science

Joe Biden tells us how it was in the good ol' days (via Megan McArdle via Jesse Walker and Stuart Buck):

"Part of what being a leader does is to instill confidence is to demonstrate what he or she knows what they are talking about and to communicating to people ... this is how we can fix this," Biden said. "When the stock market crashed, Franklin Roosevelt got on the television and didn't just talk about the princes of greed. He said, 'look, here's what happened.'"

Hey, don't laugh! In 80 years, VP candidates will claim that right after 9/11, Barack Obama heroically uplinked to NeuralNet and metacommunicated the full extent of the situation.

### Well, I guess the crisis is over now

Warren Buffett is buying into Goldman Sachs, on very favorable terms -- 10% "perpetual preferred shares" plus the right to buy the stock cheaper than it currently is. This will signal that Goldman Sachs is sound, which will then provide a basis for trusting one party, which can then establish a basis for trusting their counterparties, until everyone can trust each other and the crisis can be averted -- for now -- long enough for me to dump the rest of my US shares on idiots -- without a massive government bailout. Hooray!

Alright, maybe a bit too optimistic.

Yeah, I know some of you are waiting for me to joke about how "Buffett has gold man-sacks" ... not gonna happen. This is a family blog. Hi Mom! :-)

## Friday, September 19, 2008

### Time to review the Put-Call Parity Theorem

With the SEC's recent move to ban short-selling of politically-important securities, it's time to review the beautiful Put-Call Parity Theorem to understand the futility of doing so. Here's my phrasing and elegant explanation of it:

B(t,\$X) = S + P(t,\$X) - C(t,\$X)

B is the value of a bond maturing at time t for \$X.
S is the value of some asset, it doesn't matter which.
P is the value of right to sell the above asset at time t for \$X. (In financial terminology, a put option dated at t with a strike price of \$X.)
C is the value of the right to buy the above asset at time for \$X. (In financial terminology, a call option dated at t with a strike price of \$X.)

In this sign convention, negative means the counterparty to the security, so for example, if the bond term were negative, it would refer to the value to the borrower on that loan, while the negative call option refers to the person having the obligation to sell at \$X to the call owner.

So, the equation means that, for some time t and some money amount \$X, a bond maturing at t for \$X is equal in value to some asset, plus the right to sell the asset at time t for \$X, plus the obligation to sell it at time t for \$X.

Proof: the left-hand side of the equation is worth \$X at time t. The right-hand side is also worth \$X at time t because if S were worth less than \$X, the holder of the put could sell it for \$X, while if it were worth more, the holder of the call could buy it for less. Q.E.D.

Note that if you find a case where the two sides are not equal, you profit through arbitrage buy buying the cheaper side and selling the more expensive side. In a discussion a few years ago, Gene Callahan claimed this was how he made money. You also might be interested to know that this theorem -- though of course it wasn't referred to in such terms -- was historically used to circumvent financial regulations such as bans on usury, since through clever rearrangement of the equation you can recreate any financial security. Here is a neat paper on that history.

Anyway, the point to remember is, let's say I want to take a short position in a stock. That would be represented by "-S" in the above equation. But let's say you found out that was banned! No problem. Just rearrange the equation! With the function arguments suppressed:

-S = -B + P - C

So, borrow money, buy a put, and write (sell) a call. Problem solved! (Except for the cost of fending off the SEC guy giving you an intimidating stare, of course.)

### Verb regularization sighted

You may have heard of the paper published about a year ago modeling when and why verbs regularize, that is, stop having irregular past tenses. (take->took is irregular, while jump->jumped is not) The basic idea is that the less frequently a verb is used, especially its past tense forms, the quicker speakers are to stop using the irregular form. Which makes sense, because those verbs are much easier for people to forget, and much easier for editors not to notice.

Well, in all the turmoil of this week's financial markets, what catches my attention the most? This:

Lending has grinded to a virtual standstill in the wake of the bankruptcy of Lehman Brothers... [emphasis mine]

Now, maybe I've been living in a cave, but that's the first time I'd seen "grinded" instead of "ground" for the past tense in writing. Looks like that one's on the way out!

Oh, and I hope you got out of U.S. stocks and own some gold.

UPDATE: What a crock! They fundamentally revised the article at the link, removing even the sentence that I quoted. I didn't know I was linking to the Department of History Alteration or whatever Orwellian agency it is...

### Arnold Kling asks for crisis joke, Silas delivers

In a great post on the current financial market issues, Arnold Kling says:
The guys who got it right on low-down-payment mortgage are the Freddie Mac folks that [ousted Freddie Mac CEO Richard] Syron ignored. (There has got to be a siren-Syron pun in their somewhere, but I'm missing it.)

Oh, that's easy: "In America, it's dangerous for you to ignore a siren. In Soviet Amerika, it's dangerous for Syron to ignore YOU."

I can't post it in his comments section for obvious reasons. If one of you would point him here, that would be rockin'.

## Tuesday, September 16, 2008

### How come I never caught this before?

"Power corrupts" -- LORD Acton.

Uh huh. Thanks for the tip. Perhaps His Lordship was trying to pull an Epimenides paradox on us?

Full quote: "Power tends to corrupt, and absolute power corrupts absolutely. Great men are almost always bad men."

Wasn't Lord Acton so great?

I know, I know, British peerage system, he doesn't actually gain much power by being 22nd Earl of Halfingwaysshireford, blah blah blah ...

## Wednesday, September 10, 2008

### So I was right again. Now, let's fix inflation measures.

There's a story on CNN Money today about shrinking and degrading products in response to inflation. Unfortunately, it doesn't give more than passing mention to the real stickler in inflation, the "degrading" part, which is harder for measurers to notice.

Consumers are discovering more air in their bag of chips, fewer sheets of paper towels on the roll, thinner garbage bags and even smaller squares of toilet paper. (emphasis mine)

You don't say! I've been noticing this for a while, and haven't been convinced the BEA and BLS capture the impact. When you pay the same for a debased product, that is price inflation, and precisely what you need to measure. But like the fool who won't search for his keys outside of the light, the BEA and BLS don't do the lab testing necessary to incorporate critical quality-related aspects of products.

In my personal experience, I have noticed cereal boxes and paper cups as being flimsier and thus harder to hold -- about as big an inconvenience as you can tag onto such a simple, trivial product. Soda bottles also had confoundingly irritating changes: in addition to the 25% vending machine price increase, they shrunk the cap height beyond all reason so that it's nearly impossible to get a good enough grip to twist open with your hands. The fact that Coca-Cola even made this decision is a testimony to either a) the low quality of their engineering teams, or b) how desperately they needed to debase the product. Neither is encouraging. (To their credit, the caps have returned to "good enough", meaning they've hidden the price increase somewhere else.)

I should feel fortunate to live in a country where "difficulty in opening products" ranks highly enough to complain about. But that's also worrying: in a country with such enormous, overflowing wealth (which the US has, right?) shouldn't producers have kept such noticeable inconveniences out as a matter of course? Something's not right about that picture...

So, if you really want to measure inflation, you're going to have to track these very tricky quality changes. But there's an alternative: focus on measures were this quality debasement just isn't possible. As I'm sure I've argued here and on several boards by now, the ideal candidate is an insulin index which does the work of policing quality improvements for you. If you debase insulin, someone dies. The other benefits are:

-Global market with many buyers
-Many inputs, so it's immune to any one specific input's volatility
-No transient intellectual property effects

Which probably accounts for why such information is so durn hard to find!

Second, in addition to capturing quality degradations, they need to fundamentally rework how luxury-type items are accounted for. Those typically "scale" with what other people have. Faster computers mean enabling nicer software, but they can also mean having to pay for hardware I don't need, as the older stuff isn't available, and my current one can't run the latest software that assumes I have a faster machine. And the value I can squeeze out of it doesn't increase one-to-one with the MegaHertz rating!

I absolutely accept that modern technologies have vastly expanded the entertainment and learning options available to me, but an inflation measure must at the same time account for when food and energy prices put the squeeze on me.

I'd be interested in transforming these ideas into an academic paper, except there are a few things ahead on that list...

## Monday, September 8, 2008

### Play-money arbitrage opportunity

Now this is weird: there's a play money contract on Intrade on whether Fannie Mae common stock will be under \$1 per share on Jan 20, 2009. The market there is placing about a 14% chance of it happening.

But then when we look over at financial markets, we see puts on Fannie (the right to sell Fannie shares) trading at \$1.60 for a stike price of \$2.50 dated right near that. Do the math. To make a profit on the right to sell Fannie at \$2.50 when you pay \$1.60 for it, the shares must be under \$1 at that time, so the financial markets are placing -- at least if my understanding of options is in order -- over a 100% chance on that same event.

If there were a real-money contract on this, it would be a nice arbitrage opportunity. I'll let you figure out what the trades would have to be.

As for me, I snagged 325 contracts, average price \$1.21 (payoff is \$10/contract if the event happens). All in play money, keep in mind.

UPDATE: Okay, my understanding of options isn't in order. But the point stands: the market places a "very high" chance of Fannie shares being under a dollar by innauguration day, while the play money prediction markets place a "pretty low" chance.

## Thursday, September 4, 2008

### The Bob Murphy and Gene Callahan problem

If you've read their post about banning me, you may have by now a one-sided view of the dispute. I will explain here why I make so many posts on their blog that they find annoying. (some links missing and I apologize)

1) I have called out Bob on his deception of readers. As Bob admits here, his shameful op-ed was written to convince the public that carbon caps are necessarily stupid, a position he rejects. Now, when you are so misleading -- basically trivializing the suffering of hundreds of millions of people to justify why your gas should be cheaper -- yes, it will make you livid when someone points this out in front of others, and Bob's desire to ban me is a predictable manifestation this effect.

2) I regularly call out Gene on his selective invocation of rules of civility. Hey: having a civilzed discussion is great. But here's how Gene defines "civility":

Acceptable behavior:
-Lying about what someone believes (geo-engineering thread)
-Lying about the economics and morality of tradeable pollution caps (the op-ed above)
-Assuming the worst possible interpretation of any argument someone makes. (The discussion on the iMac and the "He must own the place" thread)
-Personal attacks, when Gene or Bob is making them. (apple thread and recent posts resulting in the ban consideration)

Non-acceptable behavior:
-Personal attacks, when Silas makes them.