Thursday, June 23, 2016

Explaining Market Crashes

The body of academic theories for market crashes explores a number of possible explanations. Why do markets crash? There may be some event that sets everything in motion, but why and when does a decline turn from an ordinary slide to a crash? Didier Sornette wrote a book and did a TED talk on the subject. Scholars as illustrious as Fischer Black and Myron Scholes weighed in on the subject. There are four main theories addressing this phenomenon:

  1. Leverage effects: Drop in prices increases leverage both operating and financial thus exacerbating volatility when businesses and investors have to raise capital to cover leverage or by reducing leverage
  2. Volatility feedback: When bad news arrives, the risk premia magnifies the direct effect of the news
  3. Stochastic bubbles: Crash occurs when a buble pops thus resulting in a low-probability event that produces large negative returns
  4. Investor heterogeneity: Different investors have varying constraints when it comes to short-sales. The more bearish group of investors subject to short-sales constraints may just sell all their sales, a suboptimal solution, and thus their information is not fully included in the market
The oldest theory is focused on leverage effects. The idea is that a drop in prices raises operating and financial leverage thus exacerbating volatility. This theory is articulated by Fischer Black and Myron Scholes in 1973 "The Pricing of Options and Corporate Liabilities" in the Journal of Political Economy. Andrew A. Christie further explores the idea in "The Stochastic Behavior of Common Stock Variances--Value, Leverage and Interest Rate Effects" in the Journal of Financial Economics 1982.

Wednesday, April 6, 2016

Cloud Providers in China

The cloud business is slowly but surely picking up in China as it has in the West. Out of the major multinational providers, only Microsoft Azure offers comprehensive service in China. Amazon in 2014 has introduced a closed limited program for region in Beijing, but this service excludes common services such as Elastic Beanstalk. China, however, has its own homegrown cloud services, principally SinaCloud and AliYun from Sina and Alibaba respectively. Baidu offers a PaaS service but not a full fledged IaaS. Unlike US cloud services, most Chinese cloud services are pay by the month instead of pay by the hour. This arrangement is quite limiting since one would be unable to scale down costs below the monthly unit. This truly adds up when one is talking about thousands of instances.

Tuesday, February 2, 2016

Investigating dislocations in the oil complex

The oil and basic material complex has suffered quite a downturn in 2015 and also in the beginning of 2016. Equity prices have declined dramatically. Oil and basic material company bonds have also been under quite a lot of pressure from downgrades from the credit rating agencies. Even large-cap companies have seen the yields they have to pay skyrocket. As the truism goes, when market volatility goes up, correlations all head to 1, since everyone sells everything. Having noticed HAL, BHP, and COP bonds going for 4.5% to 6%+, which is a huge spread to Treasuries, one wonders how severe of a downturn the market is pricing in.

The following is the correlation of the changes in bond yield (ought to be inversely related to bond price) and USO returns over the period January 4 to February 1.
Bond YieldEquity Price

Unsurprisingly, each of these companies equity prices are highly correlated to oil prices at this juncture. Even BHP, which is mildly removed from the oil complex, since it works in many basic materials and mining beyond oil, is highly correlated. It turns out that the bond yields of these otherwise investment grade bonds are also moving with the oil prices except for the case of HAL.