Thursday 29 April 2010

Liquidity – at what cost?

Last week I read an interesting definition of arbitrage: "making money by buying and selling something without adding value." Those last three words began a train of thought that led to a conversation that led me to conclude that the world probably has too many arbitrageurs, and too many financial traders in general. Probably.

The primary purpose of financial instruments used to be for large companies to raise finance (through debt or through equity) and to hedge risk (through derivatives). Now it seems like their main purpose is to allow hedge fund managers and bank’s proprietary traders to make large profits.

In most industries, making a profit is achieved by adding value to some product or service and selling it at more than the cost of delivering it. The value added usually corresponds to a direct benefit for society – think of a baker turning flour into bread or a bike mechanic making a broken bicycle usable. One person’s effort allows them to earn a living while benefitting another person.

With the trading industry it is much harder to see who are the net beneficiaries - but they do exist. Speculators and arbitrageurs create liquid markets for financial instruments, which are important for companies to be able to raise finance with which to grow. Growth allows economies of scale, and public listings create a certain level of discipline amongst corporate management.

Having said this, I would argue that there are probably more people working in speculation and arbitrage than are required to make the financial markets liquid. The cost to society of the additional liquidity is that the people working as traders could have otherwise been adding value to society through industry or entrepreneurship. In this trade-off of the allocation of talent, there must be an optimal level of trading activity – enough to make financial markets work, without damaging other industries by sucking up too much brainpower – and I don’t think we are there.

Tuesday 20 April 2010

Planes go down; Cars go up?

Following up on the Enron post, the ash cloud currently over Europe reminds of a great moment in that play when they explain the financial concept of hedging.

The character explains that if you invest only in airlines, then you put yourself at serious risk that planes might start falling out of the sky. So you would ‘hedge’ your investment by buying shares in car hire firms. “Planes go down; car hire goes up.” At least so the theory goes.

The irony is quite acute. Of course no one expects planes to start falling out of the sky, but the nearest equivalent (that all planes are grounded) has taken place, for a completely unexpected reason. So does “The Enron Theory of Hedging” stand up to empirical testing? Here’s how the share prices look:

British Airways – down 4% Friday pm to Monday am
EasyJet – down 7% Friday pm to Monday am
Ryanair – down 4% Friday pm to Monday am

Avis Europe (car rental) – up 9% Friday pm to Monday pm
Hertz (car rental) – down 1% Friday pm to Monday pm
Go-Ahead (public transport and airport parking) – up 3% Friday pm to Monday pm

So the car rental hedge would have partly but not entirely worked. I should add that in calculating the airline percentages I have taken the Monday am price because they rallied later in the day, presumably on the back of expectations of either the flight ban lifting or even the possibility of a government bail-out.

In the longer term, the effect of a flight ban on Europe’s economies will be scrutinised in some detail. For now I would just like to congratulate the script writer of Enron (the play) for their prescience...

Sunday 18 April 2010

Augmented conversations: the future is here

It seems like recently iPhones and iPads have become a staple of any conversation. First comes ‘How are you?’ then comes ‘How’s the weather?’ then comes ‘How’s your iPhone?’

Almost as a matter of protest, I do not own an iPhone myself. However, this weekend I had an experience that left me deeply impressed. For the first time, with the aid of an iPhone, I had what I would call an ‘Augmented Conversation.’

My friend, whom I had not seen for some time, had his iPhone out on the table. Fair enough, I thought, as long as you don’t start checking your texts instead of talking to me (my past experiences of phones interacting with face-to-face conversation have generally been negative). It wasn’t long, though, before the topic of conversation moved onto areas that were greatly enhanced by the use of the iPhone. While talking about his new job he could bring up the company website and show me some photos of his workplace. Chatting about running routes, I could bring up googlemaps to help describe the routes I recommended. Upon passing on the news about Demetri Martin’s 224-word palindrome poem, instead of just passing on a vague description of it, I could read it and feel truly awed.

And at the end, when it was time to go home, we could check what time the last tube was.

This ‘augmented conversation’ is a use of a smartphone I had not even considered, and it makes me a little less sceptical about iPhones and their merits. It also lead myself and my friend to an even more profound conclusion: we are living in the future. The advances in telecoms and computing that have made the iPhone have been gradual but their impact is unquestionable, and things that seemed like science fiction a few years ago are now, at this moment, reality.