Macro Effects Of A Hypothetical Crypto Crash?

This article is a short outline of what I see as the macroeconomic effects of a possible continuation of weakness in crypto financial markets. The direct effects would be small, although weakness in crypto is interleaved with the fortunes of the tech sector. It is certainly possible that all risk assets will be under pressure if the economic situation deteriorates, so crypto might be akin to the canary in the coal mine — a signal of other dangers.

I end with a discussion of so-called “stable coins.”

Academic Finance Destroys Yet More Capital

The recent equity market shenanigans has confirmed one of my biases: modern academic finance has been very good at destroying capital. If one were of a conspiratorial bent, one might guess that finance faculties were being secretly backed by the enemies of capitalism. (I have been currently watching a documentary series on secret societies, and such misdirection is not unprecedented.) The simultaneous advocacy of efficient markets as well as the ability of hedge funds to continuously outperform created the backdrop for short squeezes that even gamers can participate in.

The Currency Market Is A Market. Act Accordingly.

One recurrent line of discussion I have seen over the years are assertions or questions about currency values that follow this format: if some particular economic event happens, then the currency will rise (or fall). This seems to be the result of "all else equal" logic, but it is highly misleading. Foreign exchange markets are markets, and prices (exchange rates) should not be expected to follow simple rules. Otherwise, all foreign exchange traders would end up with above average profits, and we would have discovered a private sector magic money tree.

Liability Matching Versus Return Maximisation And Bonds

Before we discuss investment strategies, we first need to decide what our ultimate objectives are. When we are investing, the two usual objectives is that we are either attempting to achieve maximum returns, or we are matching against liabilities, using a broad sense of liabilities. A boring non-levered bond portfolio is a reasonable choice for liability matching, but it is much harder to see how it fits within a pure returns maximisation view.

I Blame The Finance Profs

The equity market got smashed around today again, and commentators were busy trying to find the culprit: inflation, deficits, the Illuminati? As the article title indicates, I put finance academics as being the underlying cause of this problem. Once again, capital is being destroyed in size as a result of the side effects of their theories.

Bitcoin Valuation Part II(a): What Might Work

We need to distinguish between a fair value and what price an instrument trades at. Economic and financial theory is almost invariably about the first part, and the second is not viewed as respectable. However, Bitcoin as an instrument is an excellent example how observed prices are actually determined by the actions of human beings, and not mathematical models. If we wanted to have a more formal approach, we need to look at the valuation of Bitcoin on a macro basis, and not arguments about the valuation of one Bitcoin on the margin.

Bitcoin Valuation Part I: The Wrong Answers

The rise of Bitcoin (and other crypto-currencies) appears that it will have a negative net effect for most law-abiding citizens, but it has provided us with a rather wonderful teaching opportunity. It underlines the weaknesses of existing analytical techniques. (I discussed Bitcoin in a previous article, but I used it to take a sideswipe at DSGE models, and I didn't bother giving the correct answer.)

Due to article length, this article will discuss incorrect valuation techniques. Part II will give the correct methodology.... 

Increasing The Range Of Irrelevance Of r*

Eric Lonergan wrote an interesting article recently: "r* and the range of irrelevance." I largely agree with his points, but in my view, he is far too sympathetic to economist's theories about the "natural real rate" (r*; although economists have switched to referring it to as r* to avoid the hangups around the word "natural rate.") I just wanted to expand on one topic he touches in the first sentence; it seems unclear to me that the risk free rate is extremely influential in all financial asset markets.

(Also: Happy New Year!)

Defining Market Efficiency Properly

The concept of market efficiency has attracted a considerable amount of debate over the decades. The issue is that the definition is problematic; efficiency is more an attribute of the investors in the market, rather than the market itself. If we turn the focus to the role of investors, most of the mysteries associated with the concept evaporate.

Primer: Fixed Income Arbitrage

The concept of arbitrage is important in financial theory, particularly in the bond market. For example, term premium estimates are derived from arbitrage-free term structure models. The simplest definition of arbitrage is the ability to lock-in risk-free profits (above the cost of capital); the usual efficient markets story is that arbitrageurs will trade in such a way to squash out such profits. This article explains how the term arbitrage is used in fixed income markets, and how this relates to ideas like arbitrage-free yield curve models. The discussion here avoids the use of mathematics, on the theory that anyone who understands financial market mathematics has already been introduced to the technical definition of arbitrage.

Primer: Understanding Portfolio Allocations And Returns

Portfolio allocation is an important concept in economics and finance. We normally want to think about investments as a percentage of a portfolio, rather than dollar amounts.

This article is a draft that will be incorporated into my book describing my Python Stock-Flow Consistent (SFC) modelling framework, but this may also be of interest to people who are new to the concept and wish to understand how to model portfolio returns.

Book Review: Pragmatic Capitalism

Pragmatic Capitalism: What Every Investor Needs to Know about Money and Finance was first published in 2014 by Cullen Roche (publisher of pragcap.com). It is an interesting blend of discussions of personal finance and financial market behaviour, integrated with top down macro views. On the macro side, he introduces what he calls "Monetary Realism."

Book Review: How To Make Money With Global Macro

Javier Gonzalez has published How to Make Money with Global Macro. The book offers an overview of a global macro framework. It is commodity and currency focused -- which is a popular viewpoint amongst many market participants -- but one might question the applicability of some of the ideas to modern developed economies.

Book Review: Shock Exchange

The book Shock Exchange: How Inner-City Kids From Brooklyn Predicted the Great Recession and the Pain Ahead, by Ralph W. Baker Jr., is an interesting blend of a personal memoir and an analysis of the defects of modern capitalism as was uncovered by the Financial Crisis. Ralph Baker worked as an investment banker, and formed the "Shock Exchange," a travelling youth basketball team/mentorship programme based in Brooklyn (web site: www.newyorkshockexchange.com)  . In addition to teaching the kids basketball skills, the programme also taught them the fundamentals of investing. Interestingly enough, the players in the programme had a better idea of how the American economy was unravelling than the various "experts" on television. "If a bunch of 12-year-olds from the inner city could see it then why couldn't they?"

Primer: Understanding Covered Interest Rate Parity

Covered interest rate parity is the relationship that determines the fair value of forward currency levels. It is easily understood from the perspective of an international bond investor or issuer, and these entities ensure that it holds in practice.

Musings On Top-Down Macro

I wrote a review of the book Investing from the Top Down: A Macro Approach to Capital Markets, by Anthoni Crescenzi (now at Pimco), on the Personal Finance section of my web site. The book is relatively old (published in 2009), but it is one of the few books (that I know of) that cover top-down macro investing. (That is, making asset allocations based on a view on the macroeconomy and aggregate market pricing, as opposed to bottom-up security picking, where you scour corporations' financial statements to find good buys.) The book's main audience is retail investors, but it may be of use for people working in finance that are unfamiliar with top-down macro.

What I find interesting is how under-served this approach to finance is when compared to other methodologies.