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I’m the author. Thank you for saying it is an excellent read — that was no small amount of work. You ask “Where is the productive output of all these arbitrage
by jdaw1 3y ago
I’m the author. Thank you for saying it is an excellent read — that was no small amount of work.
You ask “Where is the productive output of all these arbitrage shell games?”, which is a very fair question. The purpose of financial markets, sometimes but not always wholly achieved, is to transfer risks to those best able to hold them. E.g., you are not the optimal person to hold the risk that, through no fault of your own, your house burns down. That risk exists, and you are not the optimal holder of it. Hence insurance. A Lincolnshire farmer — and yes, I like the non-abstract solidly of the example — is not the optimal holder of the ‘risk’ that the Australian and Kansas wheat harvests are super-bountiful. Markets allow that risk to be transferred to a non-farmer better able to hold the risk.
Of course, with markets come some ‘unproductive’ stuff. Likewise, democracy is good, but that is not necessarily praising the optimality of all parts of campaign finance legislation.
Let me also mention that I am the author of the definitive reference book on old Vintage Port: Port Vintages (and seemingly the board disallows a link).
- nostrademons 3y agoNote also that in some cases you might be the optimal person to hold the risk that your house burns down, if, for example, your liquid net worth is 100x the replacement cost of your home. And that's illustrative of the value of markets: you can choose to transact in them, depending on your personal circumstances. The insurance market exists because for the vast majority of people, rebuilding their home is not feasible with their current net worth. But for a small number of people it might be, and for a small number of firms it's probably worth it to insure many thousands of people, and then you can even slice up the shares of those insurance firms and sell them on the stock market so that the risk of your house burning down gets socialized across all the other shareholders but at the same time you have a stake in the profits.
- nullindividual 3y agoIt’s not a choice to be part of the insurance market for the vast majority of American homeowners. What you describe is choice in name only.
- rfrey 3y agoYour parent literally said if, for example, your liquid net worth is 100x the replacement cost of your home. and for the vast majority of people, rebuilding their home is not feasible with their current net worth.
- nullindividual 3y agoInsurance is required by the lender (yes, I understand people purchase with cash outright, but that's a vanishingly small portion of the population).
- ezconnect 3y agoHe's saying you are required by law to buy insurance for your house because of government regulation. There's no way of saying no.
- borski 3y agoPlease point me to this law. Unless you are in a mortgage, no law requires you to hold homeowner’s insurance, and you can absolutely self-insure, to my knowledge. The same is not true for auto insurance in most states, though most also have an option to self-insure by putting up collateral.
- h2odragon 3y agoThere may not be a law explicitly stating you have to have homeowner's insurance. But. Without such insurance, specifically the "injury liability type" with its limits; then if someone gets injured on your property there may be no limit to your liability. So even people who could afford the loss buy insurance because it is the best method of limiting intangible risks.
- borski 3y agoPeople who can afford the loss buy insurance because it is simpler peace of mind to do so, not because it is the law.
- im3w1l 3y agoRebuilding a shitty house is quite possible for a person. Like people can literally build simple shelters in a time frame of hours. It's only because of so many regulations and rules that you have to go into multi-decade debt. For instance, apparently the EU is currently considering a regulation that houses must be energy efficient. Getting a current house into compliance would cost on average $50k. That kinda stuff adds up.
- User23 3y agoIt is an interesting reframe to think of insurance as a, roughly, ATM put. Having some experience with both trading derivatives and gambling though, I’m fairly confident saying that it’s a distinction without a difference. In both cases a little guy with an understanding of risk and bankroll management and some aptitude for the game, which for trading is a Keynesian beauty pageant, can scrape up a few bucks. But most people are going to be fish for the house. The derivative markets are providing exactly the same service as casinos, albeit with considerably higher limits and opportunities for crafting complex bets.
- bombcar 3y agoThe derivatives market is like if they let you buy insurance on anyone without ah insurable risk. So I could decide that I think your house is likely to burn down, so I buy insurance on it. That's what enables the gambling. If the only people who could buy puts or calls were people who had insurable risks in the underlying; it would be a lot smaller market and less gambling.
- dnadler 3y agoGood point. The flip side is that allowing anyone to transact in options makes the pricing far more efficient.
- perpocet 3y agoRegulating participants to only those who have a purpose and meaningful reasons, would mean higher bid-ask spreads, less liquidity and less turnover, which then means those markets would probably cease to exist. Gamblers in these special markets are a net-positive, non-gamblers are happy to give some gamblers a payday or some drink money, since it allows non-gamblers to focus on their main activity, instead of doing their activity and gamble that everything turns out fine.
- bombcar 3y agoOf course they're happy to have the gamblers! Almost by definition the gamblers are subsidizing their risk management strategies!
- Folcon 3y agoDo you mean this[0] when you wanted to link to `the definitive reference book on old Vintage Port: Port Vintages`? Also, welcome! - [0]: https://www.portvintages.com/ https://www.portvintages.com/
- asdff 3y agoWhy have them privately controlled at all? The fed prints the money. The fed could be the bank and insurer as well, and obviate the middle men skimming the pot.
- anon291 3y agoI think the question should be 'why not'? The default should be the government doesn't do things and only does things that it is uniquely able to do.
- asdff 3y agoI think that just invites parasitic loss into the system through profit seeking, but maybe this is in fact by design, and us laborers are merely a means to another's greatly yielding end.
- Matl 3y ago> The default should be the government doesn't do things Right, but taking this in the opposite direction then, why for public interest things should the default of 'people who just want to buy the next yacht' run them good?
- totallywrong 3y ago
- jeron 3y agoI like how this guy has written two books on completely different subjects - Money and Wine
- RyEgswuCsn 3y agoExcept that is not exactly "productive", isn't it? After all, risk was not eliminated, only redistributed. Productive output, e.g., would be something that reduces the chance of your house catching fire.
- ummonk 3y agoPeople can be more productive by engaging in ventures they would otherwise not have due to prohibitive risk. (Likewise with credit allowing people to finance ventures that they would otherwise be unable to)
- nimithryn 3y agoThe redistribution is productive, because by redistributing risk (not just among people, but also across time), some ventures that were otherwise not feasible become feasible. For example, you want to build a house - but you don’t have the cash. A bank gives you a loan. They take the risk that you won’t pay them back, you get a house, and return they get a premium. This benefits many stakeholders (you, the bank, the builders, etc). If the bank has too much risk, they can off board it to someone with deeper pockets and a more diversified portfolio.
- fsckboy 3y ago> If the bank has too much risk, they can off board it to someone with deeper pockets and a more diversified portfolio ... or especially to somebody who happens to bear the reverse risk. For example, a wheat farmer doesn't want the risk that wheat prices might collapse by harvest time due to windfall harvests somewhere else in the world; and the spaghetti maker doesn't want the risk that wheat prices might be soaring due to crop failures somewhere else-else. They make a deal now so they don't need to worry about the future, but they don't need to make the deal directly, they can each buy or sell wheat futures.
- RyEgswuCsn 3y agoI am not saying that the redistribution of risk is not useful —— it certainly is, and I agree with what you said. But let us suppose we would like to reverse climate change at a global scale in a short time without further damaging the environment, right now; I don’t see how it would be possible with our current technologies, even if every possible risk redistribution options are exhausted.
- tech_ken 3y ago>that was no small amount of work. It definitely shows, thank you for publishing it freely >The purpose of financial markets, sometimes but not always wholly achieved, is to transfer risks to those best able to hold them. This makes a sense to me, thanks for explaining. I can definitely understand how insurance collectivizes and smooths individual risks, and from this and other examples I can see why a lending institution might seek something similar to enable them to keep cash moving. It does seem a little epicyclic to me that a farmer faces a glut as a result of organizing food production through a market economy, and then we resort to like a second-order market trick to resolve that problem. Presumably it would be simpler to just dump all the food in the middle of the table and then hand it out evenly, but I've heard this runs into its own set of difficulties. >Let me also mention that I am the author of the definitive reference book on old Vintage Port: Port Vintages Very welcomed, I may not buy the book but I will definitely go buy some port. TGIF!
- FabHK 3y ago> The purpose of financial markets, sometimes but not always wholly achieved, is to transfer risks to those best able to hold them. That is just one of the purposes; others are: - time-shifting of consumption: borrow when you study or build a house, then invest and save during work years, then live of retirement portfolio - maturity transformation enabling investment: extra cash goes in the bank (and can be redeemed on demand), is bundled and lent (long-term) to fund construction or businesses [1] - allocative function: send capital to its most productive use. For that, you need accurate prices, supported by equity research and markets. So, in real financial markets, all the arbitrage games etc. [2] at least support actual productive purposes. In crypto, it's just a pure cargo cult copy of financial markets without any underlying productive purpose. [1] that whole banking business is somewhat precarious, but reasonably well understood (since Bagehot) and regulated/insured, though in recent times obviously hasn't worked great. Alternative models (narrow banks + private credit) are conceivable. [2] and to be clear: the amount finance skims of the economy is way too large. Similarly, building a somewhat straighter fibre (and then microwave towers) from Chicago to NY has no societal benefit I can discern. (But the solution to that is fintech and regulation, not crypto.)
- agentgumshoe 3y ago> So, in real financial markets, all the arbitrage games etc. [2] at least support actual productive purposes. So without all those games, what would be substantially different?
- lxgr 3y agoYou‘d probably see much larger spreads and lower liquidity when buying and selling stocks or commodities/currencies; you’d often overpay on insurance etc. (All assuming a properly working market without collusion, illegal usage of non-public information etc. – which is unfortunately not always the case.)
- MrMan 3y ago[dead]
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- kqr 3y ago> A Lincolnshire farmer — and yes, I like the non-abstract solidly of the example — is not the optimal holder of the ‘risk’ that the Australian and Kansas wheat harvests are super-bountiful. Markets allow that risk to be transferred to a non-farmer better able to hold the risk. Are you familiar with the arguments of (more popularly) Aaron Brown and (transitively) Jeffrey Williams? Essentially, the idea that a farmer would be an active participant in a futures market is quaint, but the vast majority of activity is speculation. This is not a contradiction of your point, but an elaboration of a counter-intuitive part of it. One might look at a futures market and see that well over 98 % of the activity is buying and selling by people who never have any reason to care about wheat other than for the possibility of its price going up or down. But this large-scale speculation is precisely the thing that makes it possible for a farmer to hedge (by providing liquidity and a motive for the counterpart of the hedge) or, as Williams' points out, perhaps more commonly "take out loans in commodities" for their convenience yield. Essentially, the Lincolnshire farmer can lock in a price with a plain forward contract. However, that does take a double coincidence of demands (or whatever the phrase is) and the standardised nature of futures contracts help avoid that problem. But! The most common use of futures contracts (aside from speculation) is not (or at least was not, when Williams wrote his book) hedging, but effectively borrowing and lending in commodities.
- lxgr 3y ago> the vast majority of activity is speculation Where do you draw the line between (useful) arbitrage and "pure speculation"? Much of what is commonly known as speculation is actually an important mechanism for price quality or liquidity. Obviously there are limits, and there are ample opportunities for making a one-sided profit without regulations, but people often seem to miss the value that arbitrageurs tangibly provide to them: Being able to exchange foreign currency at very tight spreads almost 24/7; being able to buy and sell even not commonly traded stocks etc. are often a function of that.
- kqr 3y agoI think you and I are saying the same thing! What's counter-intuitive about many well-functioning markets is that the vast majority of what happens is superfluous in one sense, but its side effects are desirable by most!
- boppo1 3y agoThe book is from 2001; are there any substantial changes in the landscape a motivated finance student should be aware of?
- beefield 3y agoAs a beginner book, no there are no substantial changes on what a beginner should read. However, while the simple discounting formulas described (likely, haven't read other than the list of contents) in the book were at the time actually used more or less as-is to value instruments in the derivative markets, nowadays they are seldomly used on their own. Two major developments there are multi curve discounting taking collateralization into account and different valuation adjustments, collectively known as XVAs. That is not to say you do not need to understand the beginner basics, vice versa, iys just that nowadays there is much more nuance in actual valuation. Edit: to add, I'm not sure if its useful to study these nuances in detail, unless you are going to actually work on the markets. In the big picture their details are likely not worth it, but of course it is good to try to understand why these developments have been needed/wanted by market participants.
- boppo1 3y agoI had wanted to work in markets, but my GPA (& now post-grad resume) didn't quite work out for it. I don't do well in the lecture-homework format. Nonetheless I'm interested in the minutiae, so thank you for the elucidation!
- jdaw1 3y agoThere’s a free HTML version on my website, which has some green-boxed updates. But even without those, the book is an excellent beginner’s guide to the interest rate markets. (I am the author, so might be thought not to have a NPoV.)
- boppo1 3y agoThanks for your effort!
- hbarka 3y agoI would love to hear your opinion on Silicon Valley Bank and First Republic Bank. Did they deserve their fate on equal terms and also in retrospect who should have been the optimal holder of their risks?
- chii 3y ago> who should have been the optimal holder of their risks? they _produced_ more risk (by holding long maturity bonds that lose value as interest rate grows). This risk was not something that is inherent - they could've chosen not to do that with the large deposits from the pandemic money growth. There's noone who can be the optimal holder of the risk that is produced this way, because there's no value on the other end - SVB is taking the full value already (the interest payments on said long bonds). If someone were to hold that risk, SVB would have to pay out premiums that would surpass the interest income they receive. The alternative is for society (aka, the central bank) to hold that risk. But this just means socializing the losses but privatizing the gains - something i'm very much against. In the end, SVB was the optimal holder of the risk (that they produced for themselves). And they can't actually hold that risk - thus their failure.
- hbarka 3y agoWhat about First Republic Bank?
- chii 3y agoI know less about FRB's failure. It was likely due to a domino effect from SVB's - specifically, FRB has a high uninsured ratio of deposits (they service rich people). The FDIC has announced that they will not do a repeat of what they did for SVB - insure the full deposit amount rather than just the $250k. Therefore, anyone with a large deposit in a small bank is going to want to move their money out into a "too big to fail" bank. Unfortunately for FRB, this is what happened to them. No bank can survive a real run, no matter how carefully balanced they are with risk (after all, they _do_ take on some risks in order to make a profit). In my opinion, the FDIC's announcement of what they will not do (insure the full deposit, even if above the $250k limit) after doing it for SVB, while have good intentions, is what backfired. They should've just lied, and said that they'd do it for another bank, if there's a need to; this would've stopped any fear of a run, and thus stop the run before any more dominos collapse.
- kenniskrag 3y agoIs https://www.portvintages.com/ https://www.portvintages.com/ the book?
- k__ 3y agoThanks for the book. I started with blockchain development, but noticed a huge gap in knowledge when it came to economics. Hopefully, this book can give me some insights on tokens that resemble "money".
- dmurray 3y agoI think you did a great job of explaining why someone might want each of these products, starting from first principles of "a company borrows some money from its bank". To still ask GP's question is either to not have understood the book, or to not understand any scenario where one might want to lend or borrow money.
- yobbo 3y ago> you are not the optimal person to hold the risk that The view presented here assumes that the market prices risk (premium) arbitrarily correctly, and then argues the benefits of that. What is optimal depends on the premium and a subjective assessment of the risk. There is no guarantee that what market offers is optimal.