Status report – Passion and economics / Poetry and programming

Did a lot of reading this weekend  on papers detail with incomplete markets and utility based pricing.

I didn’t realize how the concept of “incomplete markets” was so tightly mixed in with neo-classical economics.  The basic problem with neo-classical economics when applied to derivatives pricing is that neo-classical economics assumes equilibrium states and in an equilibrium state there is no need for a market.  I think I can “go Austrian” and assume that you have a lot of actors with different utility functions.  One immediate consequence of this is that the trading volume of Shanghai warrants should be a function of the price volatility.  If the price is constant then everything moves to equilibrium, but if the price starts changing, then people will start trading derivatives back and forth.

All this connects with my earlier posts about passion and emotion.  Neoclassical economics assumes rationality on the part of people participating in a market, whereas Austrian economics by focusing on the individual allows for passion and emotion.  Passion can be almost defined as an irrational willingness to decrease individual utility, which breaks the assumptions of neoclassical economics.

This creates a duality which I think is apt

neo-classical economics <-> Austrian economics

Plato <-> Aristole

Song Learning Neo-Confucianism <-> Han Learning / Evidential school

Chu Xi <-> Dai Zhen

Part of the reason I distrust neoclassical economics is that I’ve worked in a corporation.  You just are not going to be able to convince me that corporations are rational profit maximizers.

I need to read more about Veblen.  I think I can describe my economic views about the Chinese economy as Austrian institutionalism.  You begin with the Austrian view of individual choice as the basis for an economy.  You then look at how these choices influence and are influenced by economic institutions.  Then and only then, you see how these economic institutions behave give certain economic inputs.  The problem with applying neo-classical economics to China is that they assume that a certain institutional structure already exists, and it doesn’t.

Anyway, I now have a testable prediction which is that the volume of warrant trades on Shanghai is a function of the daily shift in prices.  This will be one of the things that I want to graph once my system comes back up.  Right now things are broken because python 2.5 is out and not all of the packages have been upgraded.  I looks like to integrate vtk, quantlib, and python will take a lot of thinking.

The other thing I want to do is to review some of the papers on the Malliavin calculus.  The problem with the Malliavin calculus is that it should be a calculus.  There should be a canned set of rules that will let you apply it to a derivatives pricing situation.  Something like Feymann rules.

OK now that I seem rational, do I have permission to go a little nuts?

Maybe not now….  But…..  There is a “craziness quotient” that I have to keep aware of.  If I start looking to crazy people tend to get scared and turn off.  So before I go crazy, I have to wear the nice suit, and look “normal.”  See I can talk about economics and program C++, so I must not be too insane, and then once I “fake normal” *then* I can take off the mask and let people know how cracked I really am.

The problem is that I’m getting a little tired of the mask.  Businesses just want the C++ programmer and the nice quantitative models.  What they don’t realize is that programming and model building is a creative, artistic process, and you just have to put up with a bit of insanity to get the good stuff.

Writing good code is a lot like writing poetry.  In fact it *is* writing poetry.  When you code something, you are trying to strip the process to its creative essence, you are using odd rules of meter and rhyming (each open brace in C++ must be followed by a close brace), and making interesting allusions in the form of library calls.

The problem with the code at work that I’ve written in the last two or three weeks is that my heart just isn’t in it.  Yes the code works, but it is not particularly elegant or graceful or beautiful.  I’m just too upset about my work environment to write poetry about it.

TCFA 2006

Posting this from Hayden Library at MIT.  I just finished TCFA 2006 a few hours ago, and I have got huge amounts of notes that I need to transcribe to the blog.  Tomorrow is FEA 2006, but I think that I’m going to skip day one and just attend day two and the banquet.  Conferences are amazingly exhausting, and I need to do some sightseeing while I’m at MIT.

I learned a whole bunch, but the main thing that I learned was that I’m not doomed….

There was always the nagging feeling that if I didn’t do the right things that I would be doomed in finance.  This fear was reinforced by the fact that my first contact with finance was through headhunters, and they strictly control the information that they give you about what it is like in finance, and also suggest that if you don’t take the job you are doomed.  The fear that this is your one and only chance is a powerful emotion, but fortunately the main thing that I learned is that everything is probably going to work out alright for me.  The main thing is that I’ve talked to enough people that I now see myself as on the “inside” of the finance community rather than on the “outside.”

Looking forward to TCFA

Looking forward to the Chinese Financial Association meeting in Boston, and then the trip to NYC.  Right now I’m trying to put together an iternary.  My paper didn’t make the final cut, but I sent them a suggestion that next year that they ought to have a poster session.

It looks like it will be another few months before I can get a paper out.  I’ve taken a look at the Carr-Wu paper, and the basic problem is that they require an OTM option and at ATM option to do their analysis, and I only have two OTM options.  I’m going to see if I can salvage anything, but it looks like I’m going to have to do some pretty deep quant work to get out anything useful at all from the Shanghai warrants.  Not that this is a bad thing or anything.
At some point next week, I’m going to put in an FFT into QuantLib since I’ll need that to do anything with Levy processes.

Bought plane tickets….

I’ll be at MIT for the Chinese Financial Association conference on 10/6-10/7 and then I’ll stay a few days for the ISEAD Financial Engineering Applications.  This will get me until Wednesday when I’ll travel down to NYC.

I’m putting together an itinerary of conferences and a list of people to meet.

I’m psychologically preparing myself to leave Austin.  Rationally, I know that I don’t have a future here, but emotionally, it will be hard to leave.  I’m going to spend the next two weeks seeing if there is any chance that I can stay.

The thing that worried me was that the stress of NYC or Houston would be bad for my mental health, and that I’d end up miserable.  But it was the Nightline interview that convinced me that nothing that could happen to me out of Austin could be as bad as if I stayed.  If I go to NYC, I might completely burn out, but at least I’ll learn something new.  If I stay here, then over time, the difference between what I’m doing and what I think I should be doing is just going to get worse and worse.

Staying in Austin seems “safe” but rationally, that apparent safety is an illusion.  I need to really ask myself, looking forward ten to twenty years, is there really a future in the work I’m doing?  Rationally, I don’t see that there is.  Twenty years from now, C++ programmer is going to be like unionized auto worker.

Connecting some dots

The talk about IMF having more voting power for developing nations is part of a deal that the US Treasury Department is trying to orchestrate in which China gets more say in international organizations in exchange for revaluing the RMB.  The prospect of a RMB revaluations means that China is going to buy fewer Treasury bonds and mortgage backed securities which is putting some upward pressure on interest rates which is starting to deflate the housing bubble.

It will be *really* interesting to see what happens next.

Wackier and wackier – Shanghai warrants

http://www.cs.com.cn/sylm/02/200608/t20060831_986231.htm

And it ends with a large number of people exercising their underwater warrants.  What the heck????

This is going to be a *FUN* paper to write

http://www.cs.com.cn/sylm/04/t20060824_983387.htm

Baosteel warrants drop 80.0% in one day. This is one week before they expire. Cool.

I probably will have something in time for the Darden Conference on Emerging Markets

I’ll have to keep an eye on this page
http://finance.sina.com.cn/focus/bgqzdc/index.shtml

Two recommendations for Shanghai warrants

Still thinking about this, but I already have two recommendations for Shanghai warrants.

1. Encourage companies to issue warrants at more than two strike prices. If you have warrants at four strike prices, then you can trace out the volatility smile, and this gives you much better information about the dynamics of prices.
2. Do not use Black-Scholes to determine the issue price. Black-Scholes wildly underestimates the value of Shanghai warrants. This has two effects, one obvious and one not so obvious. The obvious one is that the company issuing the warrants loses money. The not so-obvious one is that if the issue price of the warrant is highly underpriced then market mechanisms will fail to allocate the warrants, and so who actually gets these underpriced warrants will be determined by non-market mechanisms which are unlikely to be conducive to market transparency (i.e. the brokers friends are going to get them and flip them on the first day).

As far as what to use other than Black-Scholes, that’s what I’m thinking about. The two general ways are to use a different formula which takes into account jumps, or else use some social mechanism to derive the fair price for the warrants.

Also, I’m highly concerned of the use of stock options for employee incentives in Chinese corporations, given how they have been wildly misused in American corporations.  The problem is that in American corporations, stock options have been used essential as a means of creating “free money” and one rule of a market economy is that there is no such thing as “free money.”

Revised publications schedule

Now that I mentioned something silly about the corporate world, let me mention something nice I’ve found and that is the wonderful world of project management.  Project management and schedule is one of the core skills that you need to run a good software shop, and seeing good project managers at work, has been very useful for me in doing academic stuff.  Because Austin, Texas has things like Dell and a lot of semiconductor businesses, there is a pretty high standard of project management just like there is a high standard of barbeque.

One important principle of project management is what I call the knapsack principle, if you put something in, you have to take something out.  I had been expecting a week off each month, and now to looks like I won’t have that, and will have to spend some time with testing the waters for a job search.  This means that I had been planning on two papers for the rest of the year, but realistically, I’ll need to schedule for one, by the end of the year.  This will probably be a retrospective on BaoAn steel, tracing changes in the implied volatility with regulatory changes, as well as trying to do a Carr-Wu analysis to see what the dynamics of the underlying process are.

I’m still trying to get a rejection letter from the Chinese Finance Association for I wrote about R-SWIG.  It’s kind of fun to try to be getting someone to reject you, but without a rejection letter, I’m not able to submit the paper to anyone else.  At worst, I’ll hear nothing until the conference in October passes.  Ideally, I’d like to get the paper in some peer reviewed journal, but the trouble is that it is too “computer science-y” for a finance journal and too “finance-y” for a computer science journal.

If all else fails, I’ll post it into arxiv.org or the Willmott research paper forums.  That will get me a publications section in my CV.  People who don’t know any better will be impressed by that, people who *do* know better won’t be impressed by the line in the CV, but hopefully will be impressed by the paper itself.

The paper on Baosteel, will be intended for a finance journal, and one of the things I’m going to have to do is to look through the finance literature to find some similar papers, and use those as a template for the analysis I’m trying to do for that warrant.  My motivations for trying to get something into the finance literature is interesting, in that the main reason that I want to do it is to prove to myself that I can do it.

Physics of Finance: Gauge Modelling in Non-equilibrium Pricing

Wow!!!!

Really cool book.  If you are trying to understand fiber bundles (even if you don’t have anything to do with finance), get this book.  The first three chapters have the most readable explanation of fiber bundles I’ve seen anywhere.