84, Charing Cross Road

I had no idea there was still food rationing in the 1950's London. In any case, a warm book for a cold day.

My Favorite Essays (in progress)

In no particular order, the below are my all time favorite non-fiction readings (Borges is not fiction!):

1.  College Admissions and the Stability of Marriage. A superb article (a bucket list one by all means).
2. Econometric Policy Evaluation: A critique. Very econo-nerdy, but I really liked it.
3. The Role of Monetary Policy. If you read this one and you do not feel like you should have been an economist ... I just don't understand you.
4. Why we have never used the Black-Scholes-Merton Option Pricing Formula?. From the unbearable Nassim Nicholas Taleb (the black swan guy). Great paper.
5. Pierre Menard, Author of the Quixote. Only a genius could have written something like this. It is also a bucket list reading. I suggest to read it together with four. By the way, if you are a native Spanish speaker and you feel terrified by the idea of reading Borges in English; no worries, you can read it here instead.
6. Some Simple Economics of Mandated Benefits. Great ideas come in simple packages. Larry Summers might have been the worst president of Harvard University ever, but this one is a great essay.
7. There's something about macro. Before becoming a famous blogger Paul Krugman was already "blogging" at his MIT website.
8. What is seen and what is not seen. Yes, Bastiat. Really good.
9. Oracular philosophy and the revolt against reason. Chapter 24 of vol II of "The Open Society and its Enemies" by Karl Popper. Go buy the book, there is no link for it.
10. Why I am not a conservative? By Hayek, go read it.
11. Politics as Vocation and Science as Vocation. If you do not want to read both, then pick the first one.
12. What is philosophy? If you want to loose your religious faith, loose it with style. This one did it for me. If you are also terrified of reading Ortega y Gasset (who loved German) in English, the Spanish version is here.
13. The Labyrinth of Solitude. Want to show off in a party? This one is for you. It is more a self-portrait of the author than a description of Mexicans, but it is beautifully written (at least in Spanish, I have never read the English translation).
14. Expectations and Exchange Rate Dynamics. This is probably the only model on foreign exchange rates that I have actually understood. Pretty useful if you work in finance even if you probably cannot make money out of it.
15. Enforcing Property Rights Through Reputation: Mexico’s Early Industrialization, 1878–1913. Doing science in history is actually possible: math, stats and background narrative. All in one paper!

Libor down to earth

I wrote a long boring article on the libor based upon the scandals that had happened around those dates when it would have been more useful to explain what is the libor?, why is it so popular?, what is the main difference between it and other rates like the fed fund rate?

I am not going to do this here either because they recently gave me at work this great article, that I'm sure you'll enjoy too if you are interested in the soporific fascinating world of the interest rates. It's from Credit Suisse and it is definitely worth reading, or at least pages seven to nine.

What is going on with the LIBOR?

After a series of scandals (see here a good summary) related to the rigging of the so called LIBOR rate (London interbank offered rate which is published over serveral tenors (1m 2m, 3m, etc.)  and which works as a benchmark to the cost of unsecured borrowing in 10 different currencies over different time periods that banks face) there is reform approaching. There are two papers worth reading on the subject: The first one is a discussion paper made public on August 10th, 2012. It is called "The Wheately Review on Libor: Consultative Document". The second one is called "The Wheately Review Of Libor: Final Report.". A short summary of both document follows (mainly on the first, the second one is just the conclusions of the fist one)  for all those not interested in going over the details but curious about what they are about.

The Consultative Document

The first document is, as the name implies, a document aimed at getting feedback from the market paricipants, it is orgainized in the following four sections: 1. Issues and failures withing the current LIBOR process. 2. Options to strengthening the LIBOR. 3. Could the LIBOR be replaced? 4. What lessons can be extraplated to other benchmarks used in the financial markets.

In regards to point one, the document highlights four mayor reasons why the LIBOR is in crisis: a. The unsecured lending market has become smaller after the crisis since alternative forms of funding have increased in importance: secured borrowing, retail depositis and liquitidity provided by central banks have increased in importance. b. Quote submitters are not independent market data providers, but market participants and hence have a conflict of interest. c. Given a., market quotes are many times not transaction based, but based upon judgement, which together with b., make the self-policing method unreliable. d. Given the previous three points, stronger independence and transparency is recomended.

The document then goes to tackle its core task: how to strenghthen the LIBOR? Here the document gives several ideas as to what can be done without choosing anything in particular. The main points of this section are the following ones: 1. Move away from a system based upond judgement and inference from one based upon actual money transactions like it is already the case in other benchmarks like the SONIA (Sterling Overnight index rates) which is a weighted average of interest rates from actual overnight unsecured sterling transactions. 2. Institute a procedure so that individual submissions are corroborated, i.e. challenged. 3. Widen the definition of the LIBOR rate so as to include all wholesale deposits rates. 4.Narrrow the scope of the LIBOR with less currencies and maturities covered.  5. Reduce the vulnerability to manipulation. For this, they propose the following: a. Restrict the publication of individual submissions to an oversight body and delay or agregate the daily publication of individual submissions. Note that this course of action would in fact reduce transparency as, and the comitte acknowledges this .b. Use the median instead of the median as is the current practice. c. Similar to b, change the method of calculation of libor towards one that is less prone to rigging. 6. Finally, the documents starts talking about institutional reform, it is hard to follow if you are not familiar with British regulatory framework as it is my case, so I'll leave this with their intented objective: strenghten the independence, transparency, oversight and criminal sanctions regime.

Could the Libor be changed? Here the document is very honest in their powers to move the market towards a new benchmark by mentioning an impressive statistic: there are around 300.00 trillion USD in notionals outstanding in the market referenced to LIBOR. Notwithstanding this they give a brief overview of other potential instruments to be used as substitutes. 1. Central Bank Policy Rate (e.g. Fed Fund Rate).  This is the target insterest rates that central banck use for conducting monetary policy and is what they pay to member banks on reserves held at them. Banks usually do not trade among themselves at that rate. 2. Overnight unsercured lending. It is the market representation of the previous one. This form of lending has increased since the begining of the financial crisis, however, since it is overnight, is not possible to draw a maturity curve out of it and has little or not credit and liquidity risk embedded into it. 3. Certicates of Deposit (CD's) or Commercial Paper (CP's). Banks issue them to raise their cash funding needs, however they are low on trading volume and have been negatively affected by the crisis.4. Overnight index swaps (OIS). This one my personal favorite, these ones are interst rate swaps between a fixed and an overnight cash lending rate over a specified period of time. Transactions in the swap market can then be used to generate a maturity curve for overnight rates. Its drawback is again its depth, as it is currently not considered to be liquid enough. 5. Treasury Bills (T-Bills). The yield of this high quality short term debt securities could potentially be used as alternative. 6. Repurchase agreements (Repo rates). These are the rates paid by transactions of collateralized lending, Its biggest drawback is the short maturity of these transactions. '

Implications for other benchmarks. Finally this first document finishes by mentioning that there are plenty of other benchmarks which could benefinit from the Libor experience. The first one they mention is the Spot Oil Market where the Oil Price Reporting Agencies (PRA's) are privately owned and where publishers rely on information voluntarily submitted by market participants. The other benchmarks mentioned by the document are the plethora of interest rate indices in other markets where the submisison of market information is also done voluntarily by privately held companies. Examples are the EURIBOR, TIBOR, etc.

The Final Document

This one contains the main conlcusions reached after the consultation process and the steps to be followed, it has a lot of overlap with the first and is not as interesting to read, but the main conclusion are the following ones: 1. The review favors reforming rather to replacing the LIBOR benchmark. The main argument in reaching this conclusion is the widespread usage of such index. 2. Transaction data should be explicitly used to support LIBOR submissions. The number of tenors and currencies is limited to make this a more transparent process. For day to day practicioners this will mean they will be now interpolating among the available tenors. 3. Market participants should continue to play a significant role in the production and oversight of the LIBOR, but note that from now on individual submissions will only be made public after a three month period. This apparently has the objective to diminish one of the incentives institutions have in submitting "bad" quotes: signalling the market their creditworthiness. How this is a bad idea is not clear to me.

The rest of the document dwells into the new regulations to be instituted as well as the new institutions that will be carrying out such a job. Not interested in copying-pasting the rest of the article, so I'll leave it here.

Fixed Income with Equity

The first day of class in a financial engineering course generally starts with the following:

Let S1 be the price of  a stock today,  F1 the the value of an equity forward contract, K the strike price of such a contract and R the risk free rate. What is the non-arbitrage price of K?

(Side note: There are not that many good ideas in finance. I would actually summarize them in three: 1. Time value of money. 2. Non-arbitrage and 3. Risk neutral pricing (state contingent pricing is probably better) which is what Black, Scholes and Merton did).

Note, the value of F1 today is equal to F1=S1-K, the question is, what is the value of this K then or how much should you pay for it? The class continues in the following way:

Assume you sell (short) a stock, you could invest the proceeds at the rate R and in the next period get the amount of S1*(1+R). Now, imagine that at the same time that you sold S1 you opened with your favorite broker a forward contract where you agreed to buy stock S in the following period (you eventually have to deliver the stock you sold). The market value of your forward in the future will be F2=S2-K. Got it? No? Well, just look at the profit equation at time 2

Profit= S1*(1+R) + (S2-K) -(S2) The first term is what you invested at the bank, the second one the market value of your forward and the third the cost you incur for giving back the stock you shorted. Clearly (regardless of S2), if K is less than S1*(1+R) you can make yourself rich without investing any money, people will start selling S1 until K=S1*(1+R). You can apply a similar logic when K is greater than S1*(1+R).

Why all this? Well, note that the  payoff does not depend upon the final value of the stock, that is, we have managed to transform equity trades into a fixed income transaction. That is financial engineering, although I still prefer the name quantitative finance.

The New Pamphlets (Published in The Economist as "How Luther Went Viral")

http://www.economist.com/node/21541719

Short Selling and Adam Smith

So you sell a security that does not belong to you: Is that a naked short? If yes, how can that be legal if they are not paying a fee to the owner?

Most of the talk about how bad is short selling is just not very informative: There is nothing wrong on this activity in itself. I think it is perfectly rational and ethical to short a stock from a company that you think is going down.The hedge funds that shorted Lehman or Enron not only were right and made money in between, they unintentionally signaled that something was rotten in those companies (yes, the invisible hand). Not the heroes of Ayn Rand, just another butcher providing dinner to itself and the community (yes, again Adam Smith).


Having said the above I do think short selling securities in a naked way (see an older on this subject) is just plain theft. What the custodian or borrower of somebody else securities should do is engage in a borrowing transaction with the owner of these assets and pay a fee if required --could be zero, my point is the transaction should exist. This is not only the ethical way to proceed, but the unintentionally efficient one as "sands in the wheels"  to this activity in markets prone to "overshootings" seems to me to be the best answer, or second best, given that markets are far from perfect (as much as I like Adam Smith).