Risk Markets And Politics

Monday, May 29, 2006

Effective spreads

Chris Masse and JC Kommer agree that traders' demand for liquidity destines futures markets towards monopoly, and that once a market is entrenched, it's almost impossible for another exchange to successfully launch a competing contract. JC Kommer, however, offers a possible counter-example in which Eurex managed to steal away the bund future from LIFFE, and points-out that it was only able to do so because of "technology". Eurex is an electronic platform whereas LIFFE was committed to open outcry floor trading. Degree of transparency has an effect on liquidity, and is an important issue in the competition between futures markets. Physical open outcry markets may be very deep, but lack of transparency can cause effective bid-ask spreads to widen. Floor traders who work side-by-side on a daily basis have quite a "bandwidth" advantage versus traders submitting orders remotely. (Official trading fees could make a difference too, but exchanges that have captured a market should have pricing power anyway.)

These kinds of concerns strongly apply to NYMEX, whose website has for some time begrudgingly proclaimed that "evolution is inevitable". Among US futures exchanges, NYMEX has been the most die-hard in support of floor trading. This stance was the main reason cited when merger talks collapsed with the CME in January. Days later, the largest NYMEX clearing firm initiated legal action against ICE, claiming they had engaged in anticompetitive behavior. Meanwhile, CME seemed poised to launch its own energy contracts, and rumors swirled that the Chicago exchange had takeover interest in ICE. Then, suddenly, in early April, NYMEX and the CME agreed that NYMEX energy and metal contracts would be listed on Globex, the CME's electronic platform. The Globex agreement marked a capitulation of sorts by the New York exchange, but a good one, as the pact staved off competition from both rivals. NYMEX seems to have benefited from the example of the LIFFE/Eurex bund contract. Now some are saying that ICE is increasingly "out in the cold". Others are speculating that ICE might have interest in acquiring or competing with the LME, which is the last European futures exchange to retain a trading floor.

While we're on the subject of liquidity and network effects, one hesitates to say anything at this very early stage, but the lack of trading in the first week of CME's housing futures was surprisingly low. Granted, it was hardly the best week for liquidity and the kind of risk-seeking that would encourage bids, but it seems like more interest on both sides should have been lined-up ahead of the markets' opening day. Here is a good Futuresource link to track the daily activity of all the contracts.

Friday, May 26, 2006

"Our friend dere in Burbank - You want I should pay him a visit?"

Mark Cuban's new venture Content Partners will buy equity in films and tv shows. The company will offer up to $25 million to established actors and other talent in exchange for 50 to 100% of their "back-end" participation rights, which are shares of profit in specific projects. The film industry seems to be moving away from paying talent based on sales alone, and towards such arrangements. Steven Soderberg, who worked with Cuban on "Bubble" had recently stated, "There should be a true partnership between those who make the films and the people who finance it. That means, initially, a lot of people who are being overcompensated up-front [via revenue-sharing, or "first-dollar gross"] would have to be willing to take it on the back [via profit-sharing]." Such a trend would clearly bode well for Content Partners, but to the extent that profits aren't paid-out with interest by studios, rising rates will work against them.

Barring an industry-wide move towards profit-based compensation, one wonders though why actors would agree to the higher risk/reward profile of back-end deals only to sell away their upside (a call-like cash flow) to Content Partners. The initial story by Jane Wells of CNBC stressed the difficulty and time involved with collecting the back-end profits from studios. Since the "enforcement" will largely fall to people already employed by the talent, which will just represent some incremental cost, this angle is only marginally convincing - to this Hollywood outsider at least.

Content Partners apparently has no plans to regularly sell the profit rights they buy. While a full-fledged secondary market would be interesting, it might create conflicts of interest. Likewise, the majority of deals will probably be hammered-out before money starts flowing in. As always, contract language is important.

Following Cuban's abandoned plans to start a sports-gambling hedge fund, some had speculated that he would become involved in prediction markets. While by no means a prediction market venture, Content Partners is certainly an innovative business, is obliquely reminiscent of HSX, and expands the set of tradable interests.

Sunday, May 21, 2006

Crytpophilia

When of the first things most people realize when they get into systematic trading or "technical analysis" (if they are rigorous and honest with themselves, at least) is the danger of trading rules that are excessively tailored to the vagaries of past data. Whether this methodological pit-fall of data-mining is called "data-snooping" or "back-fitting", the idea is the same: the specific prices and desired result of testing had too much influence on model selection, and out-of-sample predictiveness may be lacking. Over-complicated trading signals that produced excellent returns in the past will tend to fare worse going forward, and in markets that weren't included in their development. Even apparently significant and elegant signals are more likely to fall to this sort of mean-reversion if they were developed through an intensive search. Likewise, John Holland in Hidden Order, while outlining his model of complex adaptive systems, favors simplicity in order to avoid what he calls the "unwrapping" problem. The mark of a good scientific model/theory is its capacity to make additional predictions outside of the immediate questions it was designed to address.

Considering this background, it is perennially amusing to hear about decoded bible messages and the like, in which there is little doubt that the cipher was the message, and many ciphers had been tried on a large body of text in order to produce a handful of messages. Sure enough, it's another version of the "uncertainty principle". Paranoia, both the everyday variety and the clinical condition, follows similar a pattern. Namely, projecting meaning into possibly random circumstances (and, additionally, overestimating small probabilities). Ron Howard's portrayal of John Nash comes to mind.

In light of how misleading code interpretation can be, what is its source of fascination? It is a decidedly literal version of proverbial "search for meaning", and also carries a subversive attraction. On one hand it can be an appeal to authority, and on the other, an act of resistance. Intentional codes, including metaphor and other tropes, can disguise the transmission of knowledge to kindred spirits in a possibly hostile environment. The word "code" can likewise refer to the ordering principles of a group, as in a secret society. In the end, everyone wants to be an "insider".

In today's political climate, is it surprising that during the "war on terror" and related controversies regarding privacy, the right to encrypt has not faced a greater challenge? Probably not. It would be difficult to enforce, and intelligence agencies might feel, as is often (amusingly) the case in the corporate world, that an email's sender and recipients can be just as telling as its content. Insofar as an encrypted message would then in itself constitute a "red flag", steganography would become more important anyway.

In the 1980s, David Chaum of MIT produced some crytpographic research with a potentially more intimate bearing on politics. Namely, a cryptographic protocol for online elections. The special problem that online elections represent (from a cryptographic standpoint, at least) is as follows. The election results must be verifiable and correct. Only registered voters should be permitted to vote and only once. However, voting must remain anonymous. It should not be possible to determine who voted for whom. Chaum overcame this tension through an ingenious use of public key cryptography and blind signatures.

While the specific cryptographic problem was nicely solved, many obstacles still remain for the implementation of such a protocol. It is more work to forge physical identification, and so online voting might encourage the buying and selling of votes, or the identity theft of non-voters. Some actually argue that allowing votes to trade freely might be a good idea, but in any case, the more serious obstacle to online voting likely involves more gross and obvious methods of falsifying results outside of the encrypted transmissions, as one hears with regard to the Diebold systems in the 2004 presidential election. These systems were laughable in their security features, and fell far short of Chaum's work, regardless of the partisan circumstances. Clearly, traditional physical voting systems are also subject to fraud. Online elections might actually be more secure as data could be stored in multiple locations and later cross-verified to detect tampering by local agents. When I implemented such a protocol in 1997 as part of an undergraduate project, I also noted that online elections might have interesting effects insofar as they reduce the "cost" of physical voting, and that such technology could be used for "less serious" opinion collection where participants might also wish anonymity, as with television ratings and viewing habits. In a way, this is reverse data-mining: aggregating information while obscuring certain relations, with the aim of maintaining privacy.

Thursday, May 18, 2006

Housing futures margins

The performance bond requirements are out. Based on a very quick glance, these appear to imply a bit more volatility than currencies, but significantly less than equities. Also, it seems that Hedgestreet has suspended the listing of its housing futures.

Saturday, May 13, 2006

Beauty contests and when crowds go wrong

By way of Marginal Revolution comes a study of surprising relevance to prediction markets. A 1990 paper by Judith Langlois and Lori Roggman found that "average" faces are judged to be more attractive than distinct faces. Specifically, digital composite portraits were described as more beautiful in proportion to the number of faces used in their construction, and the composite faces were more highly rated than nearly all of the individuals. Here are some rather convincing examples.

As the authors acknowledged, the idea behind composite photos was hardly new.
In the 1870s, Sir Francis Galton, creator of statistical regression and correlation, came across a set of what we would today call police "mug shots". Galton, who also later pioneered the use of fingerprints in criminal investigations, hoped to identify physical traits that might predict unlawful behavior. He had been toying with the idea of creating composite portraits by superimposing photographic exposures, and the mug shots were perfectly suited for this project. After examining some early results, Galton noted, "All composites are better looking than their components, because the averaged portrait of many persons is free from the irregularities that variously blemish the looks of each of them." Galton went on to publish a number of articles on "composite portraiture", which included a reconstruction of Alexander the Great's likeness based on six different ancient coins, a report on pedigree horses, and even an attempt at "analytical photography" in which a special process would be used to exaggerate the distinct features of a face. Clearly, there is some eugenic motivation behind much of this enquiry, and indeed the political correctness of the late 20th century has (understandably) robbed Galton of some notoriety.

Prediction market enthusiasts will probably be familiar with Galton's ox-weight guessing contest as described by James Surowiecki. The logic behind the wisdom of the crowd as exemplified there is eerily similar to the averaging of portraits. Pertaining to group judgment, individual errors and biases tend to cancel each other out as sought-after information is distilled in some aggregate measure of belief. Pertaining to beauty, asymmetries in facial structure and complexion likewise cancel-out, yielding pleasing symmetrical and robust features.

So where do crowds go wrong? When biases lack diversity, and here we can reference Keynes' "beauty contest", in which judges suppress their own opinions and vote according to their predictions of how other judges will vote, or by even higher-order predictions. This loss of independence can cause initial biases to wildly exaggerate themselves instead of neutralizing one another. Keynes suggested the beauty contest dynamic as a metaphor for the stock market, and this is sometimes apt. At least, there is pervasive feedback and momentum trading in established markets, and these markets deal in objects much less tangible than oxen and jelly-bean jars. Insofar as returns on a given scale don't seem to fit a normal distribution, these dynamics might well play a role. Though, like many fiercely independent critics, they might overstate their case, Taleb and Mandelbrot warn, "One can safely disregard the odds of running into someone several miles tall, or someone who weighs several million kilogrammes, but similar excessive observations can never be ruled out in other areas of life."

Tuesday, May 09, 2006

Ghosts of Futures Past

Mortgage futures have had a rather tortured existence on US exchanges: CBOT GNMA-CDR 1975-87, GNMA-CD 1978-81, GNMA-II 1984, Cash-settled GNMA 1986, MBFs 1989-92; COMEX 1979-8?; ACE/NYFE 1978-81; Hedgestreet 30yr 2004-present. Still others made it to late planning stages but never materialized.

GNMAs, the world's first interest rate futures, enjoyed some initial success but were supplanted by treasury bond futures within a few years. CBOT had hoped that the large underlying market would ensure liquidity, but design issues with the contract undermined its effectiveness in hedging mortgage-specific (prepayment) risk. Several refinements of the contract were tried, but it was too late. Lower basis risk couldn't entice traders away from the already impressive liquidity of the treasury markets.

One hears similar concerns about the upcoming housing futures. That is, if housing prices are largely determined by interest rates, why not hedge in the more established and liquid markets, despite the greater basis risk? Is this just the latest manifestation of the restless mortgage futures spirit? Well, for one thing, the relationship between the Case-Shiller Index and interest rates is unclear. Quarterly returns from December 1995 through 2005 give a correlation of only 35% between the composite CSI and the cash 10-year treasury bond. (Using various lags or mortgage rates didn't seem to improve the significance of this result.) This suggests that the basis risk involved in trying to hedge real estate with fixed income is too large, but note that the CSI only had 3 down quarters in this period, and one might expect the correlation to be more pronounced in a nasty downturn — precisely when the hedge is most valuable.

Second, there is an aspect of the current investment environment that should work in favor of housing futures liquidity. The failed contracts of the '80s and early '90s did not have the advantage of institutional speculation in the form of hedge funds, at least at nothing like the current scale. Recent years have also seen volatilities and credit spreads grind almost relentlessly lower. The global "savings glut" and concomitant yield-seeking seem to have something to do with these trends. There is even anecdotal evidence of funds getting involved in especially unusual investments like baseball teams and film productions. Taken together, these conditions point to an auspicious time to launch new markets — speculators are looking for investment capacity, and this desire will help to mitigate the previously described imbalance.

Some time before the current "prediction market" wave which roughly includes Hedgestreet and INREEX, property futures were given a direct try on the London Futures and Options Exchange. This market, which included a commercial real-estate contract, was open from May to October of 1991. (Robert Shiller recently noted that its launch corresponded with a significant top in real-estate.) The "London Fox" chapter was a bit of a fiasco, as the exchange was found to have created artificial volume via wash trades. The discovery of this mischief hastened the contracts' demise. Perhaps we can write this up to an "execution" failure on the part of the exchange.

In any case, when Shiller, Case & Weiss wrote "Index-Based Futures and Options Markets in Real Estate" in 1992, they seemed more concerned about the failure of the Consumer Price Index futures, which traded on the Coffee, Sugar and Cocoa Exchange from 1985 to 1989. CME and Hedgestreet currently offer CPI contracts, and these also see very light volume. The reasons for the CPI contract's unpopularity are numerous and include the stand-bys of the literature: no cash market, a questionable basis, and similar, more liquid, markets. On the last point, the newer incarnations have to face competition from TIPS spreads, economic derivatives auctions, and even Fed Funds futures. Infrequent updates and manipulation fears were also cited as reasons for lack of trade in the original contracts, and so it would be nice to see greater transparency in the CSI methodology, as was promised. Market imbalance was a problem as well. The government would be the most significant natural seller of inflation, but there is little motivation for such a hedge.

Overall, the housing futures have been in the works for a long time and score reasonably well on the above concerns. We've belabored the market imbalance issue enough for now. Basis risk may be a problem, especially for individuals, but institutional trading and hedgers with large exposure will drive the market. Note how CME is only going to launch with contracts extending one year into the future. Surely, individual homeowner interest would gravitate towards longer maturities. The time doesn't seem ripe for retail hedging just yet. Hopefully, the general public won't catch-on at the worst possible time.