Alpha Beta Sigma: Understanding the Greeks

No, I’m not referring to some new fraternity here, dedicated to the promotion of enlightenment, upliftment and/or collective drunkenness. Besides, I wouldn’t know. I got my college education on the other side of the Atlantic, at a place where the frat-boy equivalents preferred to vomit in their tailcoats and where, rather than Greek letters, social clubs often bore the names of the homosexual lovers of medieval kings.

It’s the other Greeks I’ll talk about. The ones used in finance, which are as much misunderstood as the idea that hummus is a Greek dish (it’s not!). The list is pretty long, thanks to the creative use of an alphabet of twenty-four letters. But here I’ll refrain from getting deep into the exotic maze of greek squiggles and contain myself to three of them—the sigma, the beta and the alpha. What are they?

The sigma, σ: Say you think of yourself as a pretty mellow and jovial guy on average, yet, with frequent bouts of Dalai-Lama bliss to “American Psycho” lunacy, or anything in between. Abstracting from the fact that you might want to see a shrink, an economist’s diagnosis of your condition would probably sound something like “a jolly fellow more or less, whose mood exhibits a high standard deviation.” That so-called “standard deviation” is the sigma. It is a measure of how erratic, how dispersed your moods can be, “above” and “below” your average jovial self.

Now say that in the course of your college life you came across a few other “high-sigma” soulmates and you decided to form a fraternity—call it Phi Tau Delta (ΦΤΔ), the Greek initials of the expression “Beware of the Greeks!”. Now, not only are your “brothers” as temperamental as yourself, but your moods tend to vary together; similar things excite you at similar times. We’ll call that a high covariance. No Greek letter here, although a variant concept—correlation—has been assigned by the pros the letter ρ (rho).

Both the standard deviation and the covariance are important for understanding risk, especially when it comes to investing in a portfolio of different securities. To understand this better, let’s go back to our frat-boy example.

Avoiding idiosyncrasies: Suppose I am a bar owner and one of my “regulars” is a ΦΤΔ member. A loyal client, an ardent g&t consumer, yet potentially a nasty business given his sporadic destructive splurges, especially manifested when his baseball team loses. However, I could still do just fine, if my clientele is fairly large and diverse and perhaps less passionate about sports or less keen on participating in havoc. In that case, at worst, I might get a couple of broken chairs, some spilled-over g&t’s and a few spells of foul language before our ΦΤΔ friend is kicked out of the door by those who want to keep on with their happy-hour cocktails in peace.

In other words, by having a large and diversified clientele with variable tastes for anarchy and/or baseball, I managed to minimize the “idiosyncratic risk” to my business from our friend’s eccentricity. In a similar way, if I own a stock that is volatile because of certain idiosyncratic features of the corresponding company—say it’s a mining company in Chile whose workers invariably go on strike—I can diversify away that risk by buying the stocks of many other companies which have neither labor issues nor an exposure to Chilean politics. This idiosyncratic risk is effectively what is encapsulated by the standard deviation.

Risky business: Imagine on the other hand a scenario where the entire ΦΤΔ membership are regulars at my bar, while the rest of my clientele are also pretty passionate sports fans, as well as supporting the same team as ΦΤΔ. Now that’s a risky business. Sure those ΦΤΔ guys drink a lot, which can’t be bad for revenue; and sure, there is something to be said about the entertainment value of a bunch of loud drunkards trying to quote Hamlet while throwing chairs at each other. But hey, these are my chairs that they are throwing, these are my glasses that are broken on the floor... and that is my autographed Yankees shirt they’re about to take down from the wall to wipe off their mess!! Worse, while they’re at it, everyone else is drawn in, though perhaps less “passionately” than the frat-boys, and the entire place gets smashed.

Put it plainly, the fact that my entire clientele tends to drink, get loud and destroy together in response to the same stimuli, makes my business very risky because I have no way to diversify away that risk. I can’t find different clients. That non-diversifiable risk is called the “systematic risk.”

The beta, β: This is where the beta comes in. Beta is a measure of the systematic risk of, say, a single stock or a portfolio of stocks. It measures the risk that stems from the portfolio’s covariance with the stock market as a whole—the risk that you cannot diversify away by adding more and more securities. The higher the covariance, the higher the beta, the higher the systematic risk. And the higher the risk you’re taking, the more you want to get paid.

So let’s go back to the frat-boy example. In our second scenario earlier, our ΦΤΔ boys are “high beta.” Their mood tends to swing in the same direction as the mood of my other patrons, but more: Under the “right” prodding, they will drink more, shout more and destroy more. This makes them a rather risky addition to my clientele—I mean, I’d much rather have a fraternity that promotes spiritual development by discussing yoga breathing exercises (over alcohol of course) while everyone else roars as the Yankees are getting smacked by the Indians.

But choice I have not. And given the risk I’m taking here, I expect to get paid for it. That is, I will tend to require higher compensation from the frat boys than the rest of my patrons in the form of, say, regularly higher tips for the potential physical and reputational damage that they may cause on my establishment. Similarly for stocks. If a stock has a high beta (that is a beta larger than 1, which is the beta of the market as a whole), I will expect proportionately higher returns from that stock than the returns of the market index (say the S&P 500).

The alpha, α: So what about that alpha? Alpha is a measure of how well a portfolio of stocks has performed after adjusting for the risks involved. Effectively, what you want to know is how well your portfolio did compared to other portfolios with similar risk characteristics. One way to adjust for these risks is to look at portfolios with similar beta as yours. While simplistic, this approach can be a first step in understanding whether your investment manager has given you great returns because of his/her superior acumen rather than because of riskier choices (which would lead to a higher beta).

Going back to that bar of mine, if I tell you that my profit for the year was 30 percent higher than the other bars in my neighborhood, you might want to congratulate me at first. But on second thought, just when you’re about to give me a check for that loan I asked you for, you may want to ask me a few questions. Am I really a genius or could I be relying for my revenues on those rowdy ΦΤΔ characters who, at any time, could ransack the place? What matters for judging an investment manager’s ability is not the higher returns stemming from higher systematic risk (higher beta) but those due to superior stock picking (that will yield a higher alpha).

So there you go. Your first step in understanding the Greeks (although, as I hinted earlier, what is referred to as “the Greeks” in finance are greek letters used in the context of pricing options—such as the γ (gamma), the δ (delta), the θ (theta) and the ν (called “vega” by the traders, even though the actual Greek letter is called “ni”). Still.. even with this limited knowledge, you will at least know how big a tip to give me when you come to watch the playoffs at my bar!

Glossary: standard deviation, idiosyncratic risk, systematic risk, covariance beta, alpha, tailcoats, hummus, Beware of the Greeks

Economists vs. Accountants: The Duel!

So I’m at this party, a cocktail one I suppose, since cocktails are being made by a couple of sultry Japanese hired help who giggle awkwardly upon mention of anything other than beer before rushing to the cocktail recipe book. I promptly decide to suppress my urge for a cucumber martini and opt for sparkling water instead.. no ice.

“Careful with that, I won’t take you home even if you begged,” says a voice behind me… male. I turn around. Not my type but hey! So we begin the usual party chitchat and within five minutes I know about his favorite martini, his 400 New York friends and his flashy BMW—“courtesy of my employer.” He? The sales rep for a major European cosmetics company. Me?

An economist, I say, expecting the typical bland look followed by a question on the stock market. Au contraire. What I get instead is a smartass laugh and… “a quote I just read, that an economist is someone who is good with numbers, yet lacks the personality to be an accountant!”

Ha ha.. NOT funny! I mean, don’t get me wrong, I would have laughed my head off had the “thesis” come from an economist. But anyone else??… It calls for a duel! Yet, stunned by the need to defend the… obvious (?), I stood there speechless. No… worse! “That’s right,” I said, “I spend my evenings playing with currency models while you’re trying night creams.”

Yes, that didn’t take me far. So that very night I decided to put aside my models for once and collect ammunition instead. Here it is:

1. The celebs: Let’s talk personality first. Think of Adam Smith, renowned political economist of “invisible hand” fame. David Ricardo, the precocious speculator, forerunner of “classical economics” and author of the theory of “comparative advantage.” John Stuart Mill, the influential liberal (and feminist!), free-marketeer and “utilitarianist,” advocating the maximization of (higher, intellectual forms of) happiness. Karl Marx, the father of communism; John Maynard Keynes, the prominent interventionist calling for an active government role as the solution to economic downturns. Joseph Schumpeter, the “creative destructionist.” Milton Friedman, the “freedom fighter.”

You’ve heard of these guys, right? Some of them? Scratching your head? Fine, just wait until you hear the accounting “superstars.” “Father of accounting” Luca Pacioli, a wandering Franciscan monk and author of the first written description of double entry bookkeeping (in 1494). Josiah Wedgwood, an 18th century potter(!), leading figure in the Industrial Revolution and “inventor” of modern cost accounting . The “legendary” Abe Briloff, “philosopher-king” of accounting today and ardent advocate of ethics, rectitude and high standards in the profession. Kenny G! (apparently an accountant before gaining global renown as the composer of ultimate cheese!). OK, I’m struggling here.. someone help?

2. The parties: Perhaps not the right benchmark for a good party, but economists’ gatherings are much (much) more exciting than those of accountants! Think Jackson Hole, the annual economic symposium and a prime occasion for spotters of policy wonks, academic nerds and Wall Street VIPs (paparazzi please attest!). The WTO Ministerials, where trade negotiations (purportedly) in the name of free trade have invariably raised the passions of thousands of hot-blooded protesters. Or Davos, the glitzy ski resort and seat of the World Economic Forum—an event so glamorous that even Angelina Jolie turned to an economics cause (the plight of refugees) to get an invitation. Now, just try to invite Brangelina to a conference of the American Institute of Certified Public Accountants! (A bit sneaky on my side perhaps, but this is a photo collection from what seems to be a typical accountants’ party!)

3. The scandals: One must admit, there have indeed been occasions when accountants have managed to steal the limelight: Accounting scandals! From Enron to Tyco to WorldCom to the many more instances of auditing negligence and/or abuses, accountants managed to grab their few “seconds” of front-page fame, together with the collective abhorrence of the victims, who saw their pension savings evaporate as the firms’ stock plummeted (and so did their 401k’s).

That said… economic “scandals” (we prefer to call them “crises”) have arguably been far more sensational! A fresh example is the subprime-mortgage crisis that has been unfolding in front of our eyes since last summer: The stock market losses that have accompanied it have been staggering: The market capitalization of the S&P500 Index has dropped by 1.7 trillion dollars—a rather hefty destruction of wealth, equivalent to 12 percent of America’s annual product (or GDP). Not to mention the wealth losses from the calamitous decline in home prices and the millions of those affected. Not really something to boast about, but, remember, the criterion here is headline-grabbing! Besides, as economists will tell you, “it’s not our fault!” Better yet.. What they’ll say is “I told you so!”.

4. Our “issues”: What would you rather daydream about… how to fill out your 1040 or how to spend that $600 tax rebate that the government might be mailing you, come May? Exactly! Unlike accountants, who will bore you with tax talk, economists prefer to banter about tax stimuli! A far more exciting topic, and it's not just semantics. Debates about the nature and magnitude of a tax stimulus package tend to be “electrifying,” as economic efficiency is traded off with political expediency: Temporary refundable tax credits or permanent tax cuts? Target everyone or just the lower-income groups? Aim at boosting consumption or investment? And, crucially, how big a package? Questions that, I’d say, dominate the details (however important!) of how to file short vs. long capital gains for tax purposes.

5. Our philosophy: The differences go beyond tax banter, however, to a more fundamental level. Think of the concept of “cost,” as simple as it sounds: Let’s say you go and buy an I-phone for 400 dollars. When I see you showing off your new gadget, I ask you “how much did it cost you?” and you say “400 bucks.” You know what I’ll say? I’ll say, “I’m sorry to tell you, but you were born to be an accountant!” You see, economists don’t think in terms of the “accounting cost” (those 400 bucks) but in terms of “opportunity cost,” i.e. the cost of missing out on (better) alternatives by spending your $400 on an I-phone—be it a fine dinner with a beautiful woman or a well-informed investment in the stock market. And when it comes to efficient allocation of our (scarce) resources, economists’ perspective wins this one big time!

6. Our profits: An extension of our differences over cost is our concept of “profit.” Accountants will measure profit as revenue minus cost, which, as I’ll show, is somewhat misplaced. Say I quit my job for a year and move down to Tulum to write a book about how thrilling the economics profession is. I live in a cheap beach hut, fish for my food and contain my entertainment to daily strolls through dilapidated Mayan temples, so that for $5,000 a year I can live like a (beach) queen. As “production” completes, an unlikely publisher emerges and the book gets published. You guys go out and buy three copies each (a fine investment!) and I end up making $50,000 out of the whole thing. Great job, you say, you made $45,000 of profit. No, my friend, I’ve just made an economic loss—for good or for worse, I could be earning a bit more spending my days (and nights) playing with currency models in New York.

7. The pick-up lines: Not convinced? Think dating! Once again, differences between accountants and economists are stark, with one fuzzy exception perhaps: Their respective pick-up lines, where I confess I’m having a hard time deciding the winner. I mean, would you rather go for “baby, let me withhold you!” or “I’ll be capital, you’ll be labor, you know the rest”? So I’ve decided to cheat.. only a little bit. Heard of John Nash? Famous mathematician and inventor of the Nash equilibrium, widely used in game theory? (You got it, the “Beautiful Mind!”). At the risk of receiving threat mail from mathematicians the world over for downgrading him to an economist (though he did share a Nobel prize in Economics!), I’ll borrow the line that he was made to say in the movie by screenwriter Akiva Goldsman to Alicia, his date and, eventually, wife (one of the funniest I’ve heard, but don’t get ideas, it only works for geniuses!):

“I find you very attractive. Your aggressive moves toward me indicate that you feel the same way. But still, ritual requires that we go through a number of platonic activities before we ….have sex. I'm simply proceeding with those activities. But in point of actual fact, all I really want to do is have intercourse with you as soon as possible.”

8. The dating: Despite their purported expertise in “dual dating,” accountants can be a pain to date. First of all, it’s darn hard to even find an accountant to date: Nobody admits to knowing an accountant, let alone being one (“no no, I’m a tax consultant”)! And in the rare cases when you do get hold of one, just try to set a date with him/her before April 16th. Taxes come first, it seems.

Economists, though.. oh no.. they won’t miss a single opportunity for a bit of making out (or, more accurately, the expectation thereof)! Whether in between meetings, in the taxi to the airport or pressed for time to deliver a critical presentation by 12 midnight, they will still make a move—“on demand” or not—even whilst you’re in the middle of discussing the impact of the Sarbanes-Oxley act on American competitiveness!

9. Après dating: So let’s say it all went well.. pick-up line worked, conversation rocked, move was accepted. What next? Given my limited experience in the field, I’ve decided to report the “gossip” as told by those at the frontier of the "professionals-in-grey-suits" dating scene. Accordingly, accountants do it “by the book,” though they often also do it “with double entry” and “without losing their balance!” Economists, on the other hand, do it “with interest,” will never miss “the bliss point” and, importantly, know how those “yield curves” respond! Your pick!

10. So… Economics or Accounting? You can tell, I’m running out of arguments! So in my quest for a proof as to which profession dominates, I decided to seek advice from Autoadmit.com, an online discussion group about college admissions and career choices and (according to itself) “the most prestigious college admission discussion board in the world.” Apparently, someone else had asked the question before me:

“Hi I'm trying to decide whether I want to continue pursuing my economics major or change my major into accounting. […] My main concern is the difficulty of getting a job as an economics degree after graduation , whereas with an accounting degree, it wouldn't seem too difficult. […] Can anybody help me with this decision? […] I’m very lost!”

I won’t “ruin” it by giving out the verdict. All I can say is keep on scrolling down, it gets better and better!

Glossary: accounting vs. opportunity cost, accounting vs. economic profit, invisible hand, comparative advantage, dual dating, beautiful minds.

Systemic Risk Squad

If Hollywood ever makes a movie on the “rescue” of Bear Stearns, I bet you the title will feature two words: “Systemic risk.” Not your typical box office mega-hit title, you might think, but I can assure you that “Systemic Risk Squad” can be at least as “sexy” as “Live Free or Die Hard.”

Perhaps a first step in this direction would be to define what systemic risk is—admittedly a bit of a challenge. There is more than one definitions floating around policy-making and academic circles which, despite sharing common elements, are far from identical. So before getting there, I’ll first give you the “you’ll know it when you see it” version.

Let’s say you are a homeowner in suburban Detroit and, with the economy going downhill, you’ve just lost your job at the nearby Chrysler plant. Suddenly, the cost of keeping up with your mortgage payments, on top of feeding your two kids, wife and poodle, becomes unaffordable. So you stop paying, your bank gets upset, your home goes into foreclosure and you get kicked out. But… who cares? Your wife and kids, surely, your local barber perhaps, possibly the poodle. But that’s about it. Put it simply, you’re not of “systemic” importance.

Bear Stearns though… that’s another story. First of all Bear is big—multibillion-dollar-big. And in the context of a closely intertwined financial system, “big” means interconnected with a large number of market players, both as a matter of fact and as a matter of association. By matter-of-fact connections I mean those guys who would get directly smacked by a Bear bankruptcy… Like Bear’s trading counterparties (e.g. fixed income traders or other investment banks); hedge funds who use Bear as an intermediary to borrow money or clear trades (and who therefore keep cash with Bear); or money market funds who have invested in Bear Stearns debt.

By matter-of-association I mean those hit indirectly, because of owning similar types of securities as those held by Bear—say mortgage backed securities (MBS), a Bear favorite. The danger being that, if Bear went bust and were forced to liquidate its (huge) MBS holdings, MBS prices would go into a tailspin, and this can’t be good for anyone owning them.

Worse, a Bear bankruptcy could start breeding suspicions in investors’ minds that what went wrong at Bear could also go wrong at other banks with similar investment portfolios. And with markets crashing, investors nervous and information about who-holds-what blurry at best, “speculation” becomes the word du jour and people start pulling out of banks that (poor guys!) might have been solvent otherwise (think “Lehman Brothers”!). Speculations thus become self-fulfilling, more banks go bankrupt, fire sales ensue, markets crash.

Now that’s systemic!

And by the way, in case you were thinking: “Rich bankers getting hammered…. who cares?” Well, you, actually. You may not hold mortgage-backed securities, but you likely have a mortgage (or aspire to one). And, unfortunately, if those bankers stopped buying MBS, your mortgage rates would go up. In fact it’s bigger than that. With banks going down, and stocks markets copying them, the cost of borrowing will shoot up for absolutely everyone—a rather lousy outcome whether you’re called Alan Scwartz, Ben Bernanke or Joe Schmoe.

But let’s go back to our movie. We have a trigger event (the subprime meltdown); collateral damage (crisis spreading to “prime” securities); panic and fear (market stampede); a looming fatality (Bear Stearns); the threat of a catastrophic chain of explosions (stock markets spiraling down, other banks going bust); the clock ticking (solution must be found before the Asian market open, else...); inspector squads dispatched; accountants on the scene (checking how “fatal” Bear’s portfolio really is) ; sleepless nights at the New York Fed; 5am phone calls; coldblooded negotiations; clandestine deals; relief!!... a brave rescuer emerges (JP Morgan Chase)…. Just in time of course!

There you go. The broad outline of “Systemic Risk Squad.” True, not enough romance perhaps. Though you can always fit in some sultry brunette trickling herself into her near-demise while running on her bank in her Jimmy Choo’s. At which point the unassuming-yet-intrepid Tim Geithner throws himself to her rescue. Len Wiseman prepare!

Still.. you might wonder. Bear Stearns is “systemic” alright, so let’s save it. But in a world where capital markets and non-banks such as hedge funds, conduits, SIVs and the like are increasingly important (see “systemic”) in the capital allocation game, why should we just save banks? Applying the “Bear logic”, the Fed might as well proceed with the “model bail-out:” Step in and buy the ailing MBS securities directly from the markets. Why not? In fact, the parallel has been drawn many a time, and the present crisis has raised the urgency of adapting the existing regulations to better reflect the shift of financial intermediation away from banks.

Better yet.. You can extend the Bear case beyond Wall Street, to Main Street. Think of this scenario: More foreclosures; a higher inventory of unsold homes; pressure on house prices builds up; the downward spiral continues; more homeowners enter the negative-equity territory; more foreclosures ensue, etc etc. Hmmm.. rings a bell. A “trigger event”.. a “chain of bad consequences”… house prices into tailspin.. many fatalities… Smells “systemic” enough for willing (and/or politically-expedient) politicians to use it as the rationale for direct government intervention to save homeowners from losing(/leaving) their (unaffordable) homes.

And yes, in that case, even Joe Schmoe can be an action movie hero!


Glossary: systemic risk, self-fulfilling expectations, fire sales, Jimmy Choo, Die Hard.