WHAT scientific concept would improve everybody’s cognitive toolkit? Here’s economist Richard Thaler:I am proposing that we now change the usage of the word Aether, using the old spelling, since there is no need for a term that refers to something that does not exist. Instead, I suggest we use that term to describe the role of any free parameter used in a similar way: that is, Aether is the thing that makes my theory work…Aether variables are extremely common in my own field of economics. Utility is the thing you must be maximizing in order to render your choice rational.Both risk and risk aversion are concepts that were once well defined, but are now in danger of becoming Aetherized. Stocks that earn surprisingly high returns are labeled as risky, because in the theory, excess returns must be accompanied by higher risk. If, inconveniently, the traditional measures of risk such as variance or covariance with the market are not high, then the Aetherists tell us there must be some other risk; we just don’t know what it is.Similarly, traditionally the concept of risk aversion was taken to be a primitive; each person had a parameter, gamma, that measured her degree of risk aversion. Now risk aversion is allowed to be time varying, and Aetherists can say with a straight face that the market crashes of 2001 and 2008 were caused by sudden increases in risk …

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Issue:  The new tech bubble Fly Title:  Commodities (2) Rubric:  The world’s commodities flow through Asia, but prices are set elsewhere Location:  Hong Kong Main image:  Golden opportunity Golden opportunity IN OTHER places the talk may be of consolidation but in Hong Kong the number of exchanges is rising. On May 18th the brand-new Hong Kong Mercantile Exchange will begin trading a dollar-denominated futures contract tied to the physical delivery of gold. It hopes to follow with contracts for petroleum, grains and every other commodity that can be imagined. Does the world really need another commodities exchange? Perhaps not, but China does. The world’s largest consumer of commodities has already created futures exchanges in Dalian, Zhengzhou and Shanghai that have collectively become the largest in the world. But for all their successes these markets have failed in one critical respect: huge volumes have not led to their playing a central role in price discovery. Traders say futures are still priced off smaller markets in London and …

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MONEYMEN have yet another fat document from regulators to chew over. On Friday October 1st, America’s Securities and Exchange Commission and its Commodity Futures Trading Commission issued a joint report on the “flash crash” of May 6th. That afternoon, American share and futures indices went into a seemingly inexplicable tailspin, falling 10% in a matter of minutes, with some blue-chip shares briefly trading at a penny, only to recover most of the lost ground before the end of the trading day. The short-lived plunge raised awkward questions about whether trading rules had failed to keep up with markets that now handle orders in milliseconds.Weighing in at more than 100 pages, the report provides a thorough account of what happened that day, based on masses of data pulled from trading firms and exchanges. In the hours before the nosedive, volatility was unusually high and liquidity thin, thanks to a barrage of unsettling political and economic news. The main trigger for the sudden decline, the report suggests, was a large sell order in “e-mini” futures on the S&P 500 index by an unnamed mutual-fund group (reportedly Waddell & Reed). Because this automated “algorithmic” trade was programmed to take account of trading volume, not price or time, it was executed unusually rapidly: in 20 minutes, instead of the several hours that would be typical for such an order.This is …

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Issue:  Shifting sands Fly Title:  Goldman Sachs Rubric:  The world’s pre-eminent investment bank has more than just image problems to worry about Location:  NEW YORK Main image:  201029fnp001.jpg »Bombmakers bombarded An uneasy calm The out-of-towners That bloated feeling

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Fly Title:  The VIX volatility index Rubric:  The volatility index has jumped in recent weeks Location:  THE clearest measure of recent investor uncertainty is the VIX or volatility index, traded on the Chicago Board Options Exchange. The index shows the price investors are willing to pay to insure themselves against substantial market moves. Having declined pretty steadily since the middle of 2009, the VIX has more than doubled in May and hit its highest level for over a year last week as it became clear that the euro-zone’s rescue package on May 10th had not steadied government-bond markets as much as was hoped. Another concern for investors is fiscal policy. While they want governments to cut their deficits, they also worry about the impact of many developed countries doing so at once.

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IT IS a rum do when the French think the Germans are being too harsh on the markets. Christine Lagarde has made it clear France will not follow Germany’s lead in banning naked short sales of government bonds and CDS. And just to prove that Anglo-Saxons are not the only people against the ban, here is the analysis of the French business school Edhec. The German plan is impractical, it says, because  It will be impossible for intermediaries and ultimately for regulators to verify investors’ holdings of the securities representative of the risk the credit default swaps are assumed to cover. A strict obligation to use credit default swaps to hedge the risk of sovereign debt would prevent sovereign nations from issuing long-term debt, as the CDS market for hedges of more than ten years is relatively illiquid. This prohibition makes it harder for countries to manage the interest rate risk on their debt actively, as their counterparties are no longer able to hedge the country risk of the interest rate swaps they may have entered into. This active management of the yield curve is a major component in the optimisation of the cost of public debt. By making the market for hedging default risk more complex, the markets may be deprived of the debt of countries with low ratings, of investors, and thus of liquidity, which will inevitably increase the cost of this …

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Issue:  Acropolis now Fly Title:  Financial regulation in America Rubric:  Banks face up to a tougher derivatives regime than many had expected Location:  NEW YORK Main image:  201018fnd001.jpg »A pox on your swaps Sachs and the shitty Something’s not working

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Issue:  The data deluge Fly Title:  Rubric:  Location:  The default rates in chart 3 of our special report on financial risk (“The gods strike back”, February 13th) were for asset-backed securities, not CDOs made up of those instruments. Sorry. In this sectionRisk redefined Surf’s up Hole sale Low definition

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Issue:  The gods strike back Rubric:  Why some banks did much better than others Location:  JPMORGAN CHASE managed to avoid big losses largely thanks to the tone set by its boss, Jamie Dimon. A voracious reader of internal reports, he understands financial arcana and subjects staff to detailed questioning. PowerPoint presentations are discouraged, informal discussions of what is wrong, or could go wrong, encouraged. These “soft” principles are supplemented by a hard-headed approach to the allocation of capital. Though the bank suffered painful losses in leveraged loans, it was not tripped up by CDOs or structured investment vehicles (SIVs), even though it had been instrumental in developing both products. Nor was it heavily exposed to AIG, an insurance giant that got into trouble. This was not because it saw disaster coming, says Bill Winters, former co-head of the firm’s investment bank, but because it stuck by two basic principles: don’t hold too much of anything, and only keep what you are sure will generate a decent risk-adjusted return. The bank jettisoned an SIV and $60 billion of CDO-related risks because it saw them as too dicey, at a time when others were still …

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IF you think the film 2012 was apocalyptic, just read the following: “The US economic and systemic solvency crises of the last two years are just precursors to a Great Collapse: a hyperinflatioary great depression. Such will reflect a complete collapse in the purchasing power of the US dollar, a collapse in the normal system of US commercial activity, a collapse in the US financial system as we know it, and a likely realignment of the US political environment.”Those are the views of John Williams, who runs the shadow government statistics website, and makes this blogger seem like a ray of sunshine. Mr Williams has for years been doggedly attempting to expose the flaws in government statistics by, for example, reporting what the inflation data would have shown had the methodology not been changed on numerous occasions.His view is based on the idea that the Fed will choose to print dollars to deal with America’s massive debts, rather than default (although the effect would be bad either way) and naturally he throws in the Weimar Republic and Zimbabwe to bolster his argument. He believes disaster will strike in the next five years. My instincts, for what they are worth, is that Japan is the more likely template, since it too has seen zero interest rates, massive deficits, a rapidly expanding money supply and all the rest. Despite all that, it has not …

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