James Altucher narrates a fascinating story about how a guy claiming to be related to Middle Eastern royalty almost succeeded in borrowing $10 million from a fund manager against forged shares representing $25 million of restricted stock of a private internet company (h/t Bruce
Schneier
).

To me the red flag in the story was that the borrower agreed without a murmur to the outrageous terms that the fund manager asked for:

  • 15% interest, paid quarterly
  • the full loan is due back in two years
  • $600,000 fee paid up front.
  • 25% of all the upside on the full $25 million in shares for the next ten years

Assuming that the loan is for all practical purposes without recourse to any other assets of the borrower because of the uncertainties of local law, all this can be valued using call and put options on the stock. The upside clause is just 25% of an at-the-money call option on the stock. The default loss is just the value of a put with a strike of $10 million. To discount the interest payments, we need the risk neutral probability of default which I conservatively estimate as the probability of exercise of the two year put option (In fact, the interest is paid quarterly and some interest payments will be received even if the loan ultimately defaults).

For simplicity, I assume the risk free rate to be zero which is realistic for the first two years, but probably undervalues the ten year call. To add to the conservatism, I assume that the volatility of the stock is 100% for the first two years (life of the loan) and drops sharply to 30% for the remaining life of the ten year period of the call option. Taking the square root of the weighted average variance gives the volatility of the call option to be 52%. Since it is an internet stock, one can safely assume that the dividends are zero.

Under these assumptions, the fund manager expects to lose $3 million (put option value) out of the $10 million loan, but expects to make $3.7 million on the call, $1.4 million in interest and $0.6 million upfront fee. That is a net gain of $2.7 million or 27%. If the short term volatility is reduced to 50%, the default loss drops to less than $0.5 million and the net gain rises to 52%. Even if the short term volatility is raised to 160% (without raising the long term volatility), the deal still breaks even.

If a deal looks too good to be true, it usually is. The fund manager should have got suspicious right there.

As an aside, forged shares were a big menace in India in the 1990s, but we have solved that problem by dematerialization. (It is standard while lending against shares in India to ask for the shares to be dematerialized before being pledged.) The Altucher story suggests that the US still has the forged share problem.

Andrew Odlyzko has an interesting paper entitled “Economically irrational pricing of 19th century British government bonds ” (available on SSRN) which demonstrates that more liquid perpetual bonds (consols) issued by the UK government often traded at prices about 1% higher than less liquid bonds with almost identical cash flows. Given that interest rates in that era were around 3%, these perpetual bonds would have a duration of well over 30 years. So the 1% pricing disparity would correspond to a yield differential of about 3 basis points. That is much less than the yield differential between long maturity on-the-run and off-the-run treasuries in the US in recent decades, let alone the differentials in the Indian gilt market.

In other words, contrary to what Odlyzko seems to imply, the 19th century UK gilt market would appear to have been more efficient than modern government bond markets! Odlyzko provides a solution to this puzzle. Most of UK consols in the 19th century were held by retail investors and very little was held by financial institutions. As Odlyzko rightly points out, this would substantially depress the premium for liquidity. Odlyzko argues that the liquidity premium should be zero because the stock of the liquid consols was more than adequate to meet any reasonable liquidity demands. I do not agree with this claim. The experience with quantitative easing since the global financial crisis tells us that the demand for safe and liquid assets can be almost insatiable. That might well have been true two centuries ago.

Today was another reminder that India still does not have a national stock market. The Indian stock markets are closed because Mumbai goes to the poll today. The country as a whole goes to the polls on ten different days spread over more than a month. Either the stock market should be closed on ten days or on none.

It is high time that the regulators required that the exchanges should operate out of their disaster recovery location when Mumbai has a holiday and most of the country is working. That would also be a wonderful way of testing whether all those business continuity plans work as nicely on the ground as they do on paper. But something tells me that this is unlikely to happen anytime soon

Two decades ago, we abolished the physical trading floor in Mumbai. But the trading floor in Mumbai lives on in the minds of key decision makers, and it will take long to liberate ourselves from the oppression of this imaginary trading floor.

The European Court of Human Rights (ECHR) has an interesting judgement (h/t June Rhee) upholding the human rights of those guilty of insider trading (The judgement itself is available only in French but the Press Release is available in English).

Though the fines and penalties imposed by the Italian Companies and Stock Exchange Commission (Consob) were formally defined as administrative in nature under Italian law, the ECHR ruled that “the severity of the fines imposed on the applicants meant that they were criminal in nature.”. As such, the ECHR found fault with the procedures followed by Consob. For example, the accused had not had an opportunity to question any individuals who could have been interviewed by Consob. Moreover, the functions of investigation and judgement were within the same institution reporting to the same president. The only thing that helped Consob was that the accused could and did challenge the Consob ruling in the Italian courts.

The ECHR ruling that the Consob fines were a criminal penalty brought into play the important principle that a person cannot be tried for the same offence twice. Under Italian law (based on the EC Market Abuse Directive), a criminal prosecution had taken place in addition to the Consob fines. ECHR ruled that this violated the human rights of the accused.

It is important to recognize that the ECHR is not objecting to the substance of the insider trading statutes and the need to penalize the alleged offences. The Court clearly states that the regulations are “intended to guarantee the integrity of the financial markets and to maintain public confidence in the security of transactions, which undeniably amounted to an aim that was in the public interest. … Accordingly, the fines imposed on the applicants, while severe, did not appear disproportionate in view of the conduct with which they had been charged.” Rather, the Court’s concerns are about due process of law and the protection of the rights to fair trial.

I think the principles of human rights are broadly similar across the free world – US, Europe and India. The judgement therefore raises important issues that go far beyond Italy.

Heartbleed is perhaps the most catastrophic computer security disaster ever (For those not technically inclined, this xkcd comic is perhaps the most readable explanation of the bug). Bruce Schneier says that “On the scale of 1 to 10, this is an 11.” Since the bug has been around for a few years and the exploit leaves no trace on the server, the assumption has to be that passwords and private keys have been stolen from every server that was ever vulnerable. If you have the private key, you can read everything that is being sent to or received from the server until the private key (SSL Certificate) is changed even if the vulnerability itself has been fixed.

Many popular email, social media and other popular sites are affected and we need to change our passwords everywhere. Over the next few weeks, I intend to change every single password that I am using on the web – more than a hundred of them.

Thankfully, only a few banking sites globally seem to be affected. When I check now, none of the Indian banking sites that I use regularly are being reported as vulnerable. However, the banks have not said anything officially and I am not sure whether they were never vulnerable or whether they fixed the vulnerability over the last few days after the bug was revealed. Even the RBI has been silent on this; if all Indian banks were safe, they should publicly say so, and if some were affected and have been fixed, they should say so too. Incidentally, many Indian banking sites do not seem to implement Perfect Forward Security and that is not good at all.

More importantly, I think it is only a matter of time before large financial institutions around the world suffer a catastrophic security breach. Even if the mathematics of cryptography is robust (P ≠ NP), all the mathematics is implemented in code that often goes through only flimsy code reviews. I think it is necessary to have offline repositories of critical financial data so that one disastrous hack does not destroy the entire financial system. For example, I think every large depository, bank, mutual fund and insurance company should create a monthly backup of the entire database in a secure air-gapped location. Just connect a huge storage rack to the server (or perhaps the disaster recovery backup server), dump everything (encrypted) on the rack, disconnect and remove the rack, and store the air-gapped rack in a secure facility. A few thousands of dollars or even a few tens of thousands of dollars a month is a price that each of these institutions should be willing to pay for partial protection against the tail risk of an irrecoverable security breach.

While much has been written about the 2013 Economics Nobel Prizes, almost everybody has focused on the disagreements between Fama and Shiller, with Hansen mentioned (if at all) as an afterthought (Asness and Lieuw is a good example). By contrast, John Campbell has a paper (h/t Justin Fox) on the 2013 Nobels for the Scandinavian Journal of Economics, in which Hansen appears as the chief protagonist, while Fama and Shiller play supporting roles. The very title of the paper (“Empirical Asset Pricing”) indicates the difference in emphasis – market efficiency and irrational exuberance play second fiddle to Hansen’s GMM methodology.

To finance people like me, this comes as a shock; Fama and Shiller are people in “our field” while Hansen is an “outsider” (a mere economist, not even a financial economist). Yet on deeper reflection, it is hard to disagree with Campbell’s unstated but barely concealed assessment: while Fama and Shiller are story tellers par excellence, Hansen stands on a different pedestal when it comes to rigour and mathematical elegance.

And even if you have no interest in personalities, I would still strongly recommend Campbell’s paper – it is by far, the best 30 page introduction to Empirical Asset Pricing that I have seen.

When I first read about the fascinating ‘Star Wars’ deal between Steven Spielberg and George Lucas, my reaction was that this was a simple diversification story. But then I realized that it is more complex than that; the obstacles in the form of skewness preference, adverse selection and moral hazard are strong enough to make deals like this probably quite rare.

The story itself is very simple and Business Insider tells it well. Back in 1977, George Lucas was making his ‘Star Wars’ film, and Steven Spielberg was making ‘Close Encounters of the Third Kind’. Lucas was worried that his ‘Star Wars’ film might bomb and thought that ‘Close Encounters’ would be great hit. So he made an offer to his friend Spielberg:

All right, I’ll tell you what. I’ll trade some points with you. You want to trade some points? I’ll give you 2.5% of ‘Star Wars’ if you give me 2.5% of ‘Close Encounters’.

Spielberg’s response was:

Sure, I’ll gamble with that. Great.

Both films ended up as great classics, but ‘Star Wars’ was by far the greater commercial success and Lucas ended up paying millions of dollars to Spielberg.

At the time when neither knew whether either of the films would succeed, the exchange was a simple diversification trade that made both better off. So why are such trades not routine? One reason could be that many films are made by large companies that are already well diversified.

A more important factor is information asymmetry: normally, each director would know very little of the other’s film and then trades become impossible. The Lucas-Spielberg trade was possible because they were friends. It is telling that the trade was made after Lucas had spent a few days watching Spielberg make his film. It takes a lot of due diligence to overcome the information asymmetry.

The other problem is skewness preference. Nobody buys a large number of lottery tickets to “diversify the risk”, because that diversification would also remove the skewness that makes lottery tickets worthwhile. Probably both Lucas and Spielberg thought their films had risk adjusted returns that made them attractive even without the skewness characteristic.

It is also possible that Lucas simply did an irrational trade. Lucas is described as “a nervous wreck … [who] felt he had just made this little kids’ movie”. Perhaps, Spielberg was simply at the right time at the right place to do a one-sided trade with an emotional disturbed counterparty. Maybe, we should all be looking out for friends who are sufficiently depressed to offer us a Lucas type trade.

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