Twofish's Blog

October 4, 2007

Should Chinese Banks Acquire Banks Abroad?

Filed under: china, finance, quantitative finance — twofish @ 8:29 am

This is really interesting because this calls into question one of the basic assumptions of corporate finance which is that the well being of the company is measured by its share price. If an insolvent risky Chinese bank were to buy a solvent one, it would seem obvious to me that this would be “good” for the company, not withstanding the drop in share price.

Along these lines, it would seem therefore that incentive structures that encourage management to increase share prices may simply cause them to accquire more risk at the expense of long term corporate stability, which nicely explains dot-coms…..

By TwofishOpen in a new window – Wed, 03 Oct 2007 15:18:33 GMT

Thinking out loud….

1) How does this apply to minority shareholders?

2) How does this apply to *solvent* banks? Most banks are highly leveraged structures that are always skating on the thin ice of insolvency.

3) How does this apply to a situation in which a person has a given utility function? The regulator has a different loss profile than the shareholder, but the regulator also has a different utility function.

4) How does this apply to different shareholders with different utility functions?

I have to think through this, but I wouldn’t be surprised if the result is that unregulated banks are inherently unstable and that banks need to be highly regulated to function.

By TwofishOpen in a new window – Wed, 03 Oct 2007 15:26:07 GMT

Something that really bothers me about the option framework. In a Black-Scholes world, volatility only affects the price of an option, it shouldn’t affect the price of the stock. It will affect the *return* of a stock, but that shouldn’t change the price of the stock.

Now since we have empirical evidence that it does, then the conclusion is that we are not living in a Black-Scholes world. This opens up the question of what world we are living in. I have a feeling that there are two effects here

1) people are investing not based on the current value of the stock but rather on the expected future value of the stock

2) people have non-linear utility functions, and if you have a non-linear utility function (i.e. you don’t care if the stock falls but you really care if it rises or vice versa) then volatility does under the picture. One bit of thinking that I have is that when people buy an option, they are actually hedging against their own personal utility function, which explains why people buy and sell options.

There is some cool work by Robert Jarrow on how options behave in the middle of an asset price bubble. This line of thought also explains why and how assets are misallocated in a bubble. In Black-Scholes world, everything can be reduced to risk-neutral prices and so there isn’t any incentive to buy risky stocks over treasuries. In a bubble, we are no longer living in a world in which Black-Scholes or Miller-Modigliani apply.

The question is:

1) How do you make cash money from these insights?

2) How do you structure the rules so that you maximize social welfare? We’ve been talking about the national balance sheet. There is probably an equivalent concept of the national utility function.

Those two questions are linked. You would be structure the rules so that in making cash money people engage in behaviors that maximize social welfare.


1 Comment »

  1. Models with stochastic volatility take into account the relation between spot and market volatility future returns through a correlation parameter. Models with spot “jumps” will often lead to situations where you cannot hedge all risks in an option.

    Also market participant know that model do not “apply” in the physics meaning: they’re just good enough in most case not to eat your commercial and safety margins.

    Comment by Laurent GUERBY — October 4, 2007 @ 6:30 pm

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