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Analogy between Finance and Evolution

Interesting article. This is how you can link Darwinism to almost everything under the sun...try football clubs...but reading the article provides some important insights into the financial service industry.


The great dying
By Niall Ferguson to run thursday for friday
Published: December 14 2007 02:00 Last updated: December 14 2007 02:00

"Just as some species become extinct in nature, some new financing techniques may prove to be less successful than others."
The remark was made to the US Congress in September by Anthony Ryan, assistant Treasury secretary. Only when we know the true magnitude of the current financial crisis will we be able fully to appreciate the significance of his words.
Analogies between finance and evolution are in themselves nothing new. "The survival of the fittest" is a phrase that aggressive traders like to use. "It's Darwinian out there" is a stock utterance by hedge fund managers after an especially tough week. Back in November 2005, a conference hosted by Goldman Sachs, the investment bank, was entitled "The Evolution of Excellence".
Yet, as became clear at that gathering, when financial practitioners use such terms they seldom understand just how apposite they are. A long-run historical analysis of the development of financial services, going all the way back to the days of Charles Darwin, strongly suggests that evolutionary forces are as much at work in the realm of money as they are in the natural world.
The big question for our time is: are we on the brink of a "great dying" - one of those mass extinctions of species that have occurred periodically in the history of life on earth, such as the Cretaceous-Tertiary crisis that killed off the dinosaurs? It is a scenario that many biologists have reason to fear, as man-made climate change wreaks havoc with natural habitats around the globe. A great dying is also a scenario that financial analysts should worry about, as another man-made disaster - the subprime mortgage crisis - works its way through the global financial system.
* * *
The notion that Darwinian processes may be at work in the economy was raised by Thorstein Veblen, the Norwegian-American economist best known for his Theory of the Leisure Class , as long ago as 1898. There has been an academic journal devoted to the subject for the past 16 years, though most economists remain sceptical about the applicability of Darwin's ideas in the economic sphere. The analogy is in fact surprisingly good in the case of the financial services industry, which has many of the defining characteristics of a true evolutionary system: *"Genes", in the sense that certain business practices perform the same role as genes in biology, allowing information to be stored in the "organisational memory" and passed on from individual to individual or from company to company when a new one is created. *The potential for spontaneous "mutation", usually referred to in the economic world as innovation and primarily, though by no means always, technological. *Competition among individuals within a species for resources, with the outcomes in terms of longevity and proliferation determining which business practices persist. *A mechanism for natural selection through the market allocation of capital and human resources and the possibility of death in cases of underperformance, in other words "differential survival". *Scope for "speciation", sustaining biodiversity through the creation of wholly new "species" of financial institutions. *Scope for extinction, with species dying out altogether.
Financial history is essentially the result of institutional mutation and natural selection. Random "drift" (innovations/mutations that are not promoted by natural selection, but just happen) and "flow" (innovations/mutations that are caused when, say, American practices are adopted by Chinese banks) play a part. There can also be "co-evolution", when different financial species work and adapt together (like hedge funds and their prime brokers).
But market selection is the main driver. Financial organisms are in competition with one another for finite resources. At certain times and in certain places, certain species may become dominant. But innovations by competitor species, or the emergence of altogether new species, prevent any permanent hierarchy or monoculture from emerging. Broadly speaking, the law of the "survival of the fittest" applies. Institutions with a "selfish gene" that is good at self-replication (and self-perpetuation) will tend to endure and proliferate.
The analogy is, of course, not perfect. When one organism ingests another in the natural world, it is just eating, whereas in financial services mergers and acquisitions can lead directly to mutation. Among financial organisms, there is no counterpart to the role of sexual reproduction. Most financial mutation is deliberate, conscious innovation rather than random change. Indeed, because a company can adapt within its own lifetime to change going on around it, financial evolution (like cultural evolution) may be best described not as Darwinian but Lamarckian, after the French biologist who contended that an individual organism could acquire new and heritable traits. Still, the resemblances outnumber the differences - and evolution certainly offers a better model for understanding financial change than any other we have.
Rudolf Hilferding, the German socialist, a century ago predicted an inexorable movement towards more concentration of ownership in "financial capitalism". The conventional view of financial development does indeed see the process from the vantage point of the big survivor. In the successful company's official "family tree", numerous small companies are seen to converge over time on a common "trunk", the present-day conglomerate - the kind of giant "überbank" that Hilferding imagined would ultimately take over the entire financial system. However, this is precisely the wrong way to think about financial evolution. Over the long run, financial innovation begins at a common trunk. Over time, the trunk branches outwards as new kinds of bank and other financial institution evolve. The fact that a particular institution successfully devours smaller rivals along the way is more or less irrelevant. In the evolutionary process, animals eat one another, but that is not the driving force behind evolutionary mutation and the emergence of new species and sub-species.
The point is that economies of scale and scope are not always the driving force in financial history. More often, the real drivers are the process of speciation - when new types of company are created - and the equally recurrent process of "creative destruction" - whereby weaker companies die out or, more commonly, get "eaten".
Take the case of retail and commercial banking, where there remains considerable "biodiversity". North America and some European markets still have highly fragmented retail banking sectors. The co-operative banking sector has seen the most change, with high levels of consolidation (especially following the crisis of the 1980s surrounding the US savings and loans industry) and most institutions moving to shareholder ownership. But the only species that is now close to extinction in developed countries is the state-owned bank, as privatisation has swept the world.
In other respects, the story is one of speciation - the proliferation of new types of financial institution - which is just what we would expect in a truly evolutionary system. Many new "monoline" financial services companies have emerged in commercial banking, especially in consumer finance (for example, Capital One). A number of new "boutiques" now exist to cater to the private banking market. Direct banking (by telephone and internet) is another relatively recent and growing phenomenon throughout the developed world.
Likewise, even as giants have formed in the realm of investment banking, new and nimbler species have evolved and proliferated. Although what many recognise as the first hedge fund was established as long ago as 1949, their emergence as big players in global financial markets is a relatively recent phenomenon. In 1992 there were just 400 hedge funds, with $50bn (£24bn, €34bn) of assets under management. By the end of 2006 the number had increased more than 20-fold and assets under management by a factor of nearly 30. And by the second quarter of 2007 there were 9,767 such funds, with $1,740bn under management.
Thanks to leverage, the estimated gross investments of the five largest funds amount to around $100bn. Altogether, hedge funds now account for between one-third and a half of all trading in the US and UK equity and bond markets.
Meanwhile, there has been a somewhat smaller surge in the number of private equity partnerships and the assets they manage, while the rapidly accruing hard currency reserves of exporters of manufactured goods and energy are producing a second generation of sovereign wealth funds.
Not only are new forms of financial institution proliferating; so too are new forms of financial asset and service. In recent years, investors' appetite has grown dramatically for mortgage-backed and other asset-backed securities. The use of derivatives has also increased significantly.
In evolutionary terms, then, the financial services sector appears to be in the midst of a kind of "Cambrian explosion", with existing species flourishing and new species (such as hedge funds and private equity partnerships) increasing in number. Yes, there are giants such as Citigroup. But, as in the natural world, their existence does not preclude the evolution and continued existence of smaller species. Size is not everything, in finance as in nature.
Indeed, the very difficulties that arise as publicly owned companies become larger and more complex - the diseconomies of scale associated with bureaucracy, the pressures associated with quarterly reporting - make it very probable that new kinds of private firm will proliferate. What matters in evolution is not your size or your complexity. All that matters is that you are good at surviving and reproducing your genes. The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model. Both are easier for small firms.
* * *
Mutation and speciation have usually been evolved responses to the environment and competition, with natural selection determining which new traits become widely disseminated. However, the evolutionary process has been subject to recurrent exogenous disruptions in the form of geopolitical shocks, financial crises and regulatory interventions (or lapses). The Great Depression of the 1930s and the Great Inflation of the 1970s stand out as times of major discontinuity, with "mass extinctions" such as the bank panics during the 1930s and the Savings and Loans crisis in the 1980s.
Could something similar happen in our time? Certainly, the sharp change in credit conditions in the summer of 2007 created acute problems for some hedge fund strategies, leaving the funds vulnerable to redemptions by investors. But a more important feature of the recent credit crunch has been the pressure on banks.
More than $60bn of write-downs have so far been acknowledged by the world's leading banks, but it is widely assumed that as much as $300bn of subprime-related losses will eventually come to light. Pressure is mounting on some banks to bring the assets of other novel organisms - conduits and strategic investment vehicles - back on to their balance sheets. Yet the difficulty of pricing these assets in highly illiquid markets and the need to maintain capital adequacy are making this easier to say than to do. In Europe, for example, average bank capital is now equivalent to less than 10 per cent of assets, compared with around 25 per cent towards the beginning of the 20th century. Some banks must sooner or later choose between increasing their capital and restricting their lending.
And what of the market for mortgage-backed securities? This year's events have certainly checked the hopes of those who believed that the separation of risk origination and balance sheet management would distribute risk optimally throughout the financial system. US asset-backed issuance has collapsed since August. So has the issuance of collateralised debt obligations, another relatively novel financial life-form.
Nevertheless, the problems of the banks are simultaneously opportunities for some big hedge funds, particularly those that seized the moment to go public when stock markets were buoyant, and for sovereign wealth funds, which are acquiring stakes in big-brand banks at what seem like bargain prices.
* * *
There is, however, one big difference between nature and finance. Whereas evolution in biology takes place in the natural environment, where change is essentially random (hence the Oxford biologist Richard Dawkins's image of the blind watchmaker), evolution in financial services occurs within a regulatory framework where - to borrow a phrase from anti-Darwinian creationists - "intelligent design" plays a part.
Sudden changes to the regulatory environment are rather different from sudden changes in the macro-economic environment, which resemble environmental shifts in the natural world. The difference is that there is an element of endogeneity in regulatory changes, since those responsible are often "poachers turned gamekeepers", with a good insight into the way that the private sector works. However, the net effect is the same as climate change in biological evolution. New rules and regulations can make previously "good" traits suddenly disadvantageous. The rise and fall of the savings and loans institutions, for example, was due in large measure to changes in the regulatory environment in the US.
The primary focus of most financial regulators is to maintain stability within the sector, thereby protecting the consumers whom banks serve and the "real" economy that the industry supports. Companies in non-financial industries are neither so fundamental to the economy, nor so critical to the livelihood of the consumer. The collapse of a leading financial institution, in which retail customers lose their deposits, is an event that any regulator (and politician) wishes to avoid at all costs - a fact of which the British authorities were painfully reminded by the run this summer on Northern Rock, the mortgage bank.
An old question that has raised its head once again in recent months is how far implicit guarantees to bail out banks create a problem of "moral hazard", encouraging excessive risk-taking on the assumption that the state will intervene if an institution is considered too big - meaning too politically sensitive or too likely to bring a lot of other companies down with it - to fail. From an evolutionary perspective, however, the problem looks slightly different. It is, in fact, undesirable to have any institutions in the category of "too big to fail", because without occasional bouts of what Joseph Schumpeter, the Harvard economist, termed "creative destruction", the evolutionary process will be thwarted. Japan's experience in the 1990s stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite underperformance.
Every shock to the financial system must result in casualties. Left to itself, "natural selection" should work fast to eliminate the weakest institutions in the market, which typically are devoured by the successful. But most crises also usher in new rules, as legislators and regulators rush to stabilise the system and protect the consumer/voter. The critical point is that the possibility of extinction cannot and should not be removed by excessively precautionary regulation.
As Schumpeter wrote more than 70 years ago: "This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted." Creative destruction, in his view, meant nothing less than the disappearance of "those firms which are unfit to live".
The coming months will determine how far, in terms of its economic impact, the current crisis is a true "ice age" as opposed to just a severe winter. It will also determine which among the world's financial groups are the dinosaurs and which are the fittest mammals. The writer is professor of history at Harvard and an FT contributing editor. The Evolution of Financial Services: Making Sense of the Past, Preparing for the Future, by Niall Ferguson and Oliver Wyman, is published today by Oliver Wyman

My failed attempt at writing a research paper

It's a terribly flawed model....after a massive attempt to answer a simple classwork question. The result ended up building a model that is biased and perhaps because of suiting the model to answer an ambiguous model, I have not defined clearly what my aims are. Conversely, after properly defining my aims, I find that I am not really answering the question because it can be interpreted in many ways.

And whatever it is, I have wasted 4 hours. Many people will not attempt to think creatively because they are not willing to end up looking stupid. I just did. If you think it's excessive, you definitely belong to the type.



Q1. A successful firm like Microsoft has consistently generated large profits for years. Is this a violation of the Efficient Market Hypothesis?

Efficient Market Hypothesis (EMH) states that prices reflect all available information, that the market responds only to new information and it is not possible to forecast price changes.

Under a direct perspective, the generation of large profits is not a violation of the EMH. The company is able to generate great profits for years due largely to superlative business performance such as a favourable macroeconomic environment, innovations leading to new technology widely subscribed by consumers, patents and monopoly power as for the case of Microsoft.

To see whether the generation of large profits for years violates EMH, we need to test that, under the information set that of companies that consistently generate large profits for years explains higher share price, there is no arbitrage opportunity, that is, prices fully reflect the known value of firms generating large profit for years.

Formally, Ri – E[RiI] = 0 for EMH.

Following, ‘I’ can be defined as information that the discounted cashflow valuation[1] of firms provides an accurate valuation of the firm’s market price. Alternatively, ‘I’ can be defined as the knowledge that firms with higher profit margins yield a higher return on average when compared to firms with lower profit margins for a given length of time (or a number of years)[2].

After defining, we test for the validity of ‘I’ by running a regression reflective of the hypothesis of the information set. Then we proceed to calculate the abnormal returns (AR) of a firm in the given information set.

I shall elaborate on the testing using alternative information set. First, we rank a basket of companies with high profit margin to low profit margin. We shall take the top 25% as the representative companies with high profit margin yielding an average return of rHt on share price at time t. The bottom 25% will be the representative companies with low profit margin yielding an average return of rLt on share price at time t. In the basket, we shall need companies that consistently generate low profit margins or high profit margins in consecutive quarters.

Next, we run the following regression: ri = α + β(rH – rL)

Thereafter, we begin to test for cumulative abnormal profits of Microsoft shares in the above model. Parameters are estimated for α and β, and we test for the hypothesis... ...



Disclaimer: This essay is in true reflection of my ideas and do not seek to ridicule, or in any other way, understate your effort in enriching the knowledge of your students. If in any case you think the thesis of the essay is deficient, then obviously, I do not understand the question, or you need to rephrase the questions (or a third explanation is a fundamental explanatory error on my part that is not related to the thesis of the essay). However, I do agree that I attempted to refine the question. This is in most truly the product of my curiosity.
[1] DCF is based on predicted price, hence analogous to semi-strong form efficiency
[2] Similarly, this is analogous to weak form efficiency since past prices are used predict the model.

Excuse me, Where is the ATM?

I met a crazy woman yesterday.

Walking into a 7-11, I asked the cashier where is the nearest ATM.

Before she could answer...a crazy woman in jogging outfit said,' She's new here. HAhahahahahAHa...'

The cashier then gave me the direction. As I turned to the crazy woman, she was already gone. So I stepped out of the shop, caught a glimpse of the crazy woman speeding off round the corner...

Sketching

Script.

Black. Glass crashing...flickers to dim setting of man sweeping glasse, cans, bottles off the tabletop in a frenzied attempt as he loses his strength, sliding off and and leaning against the cupboard and quick fade to dark...quick fade in to constant flickering light...the floor was already a bloody mess...and the man thrusts a shard of glass into his arm, pierces through the flesh, the tissue, veins, arteries carrying the warmth of his lifeform...pain to cure his sorrow, angst, despondence, disillusion...flickering light reveals the expanding pool of red viscosity...in a decrescendo, the light fails for darkness and for his life.

Credits, music (piano). White screen, distant single tree bearing of golden zest and esprit. Camera roves in slightly to stop. Man enters and strolls, discovering the conglomeration of sunshine, sparkles, tone of brilliance. He walks, through the space splendid brilliance, through his space of emptiness, wanders through his unoccupied mind.

Where am I? Why is this dazzle, briliiance...

Comes a man in equally brilliance. Come my friend, you are of the free, the separation of the feeble, the embrace of light, happiness. In Heaven.

Man enters a paradise of happiness after he severes himself from the shackles of life. He is, a matter of fact, in a new world of only joy, and joyfulness. The man who welcomes him, shows him into more of this world, where 2007 years ago, all man worked an extra harder, and worked in concert with no conflict or separation in a precedence, created ideas, solutions, works that translated into machines that last a lifetime, producing abundance, supply of what anyone can ask for, an infinity of supply to an infinite want. It became no hunger, no greed, there becomes satisfaction, peace, Utopia.

Man transits into this, world of paradise, bears the joy of whom that exists to share this happiness in this infinity. Small, side stories of man exposed to this abundance of joy.

So then, it struck on him, on his existence, of the past that he severed to his present ecstasy. He remembers his sorrow, his disappointed self, the loves he had failed. He is to feel sorrow for the first time in this world but was not to occur as he could not tear. He feels a detached reference to the history and feels happiness in this paradise. After all, he has everything he has wanted, friendship, love, materials, he feels happy, or happiness, or a detached nothing, or to happiness.

He stays in the heaven of goodness. He asks fellow Men, and women, of the joy, and they share.

Then one day, he stops, he asks, he considers... there is no sorrow without happiness, no warmth without cold, no weak without bold, no sun without moon, no hate without love... ...

This is an infinity of the null in this infinity. The relevation is not in this world, this heaven, Utopia. There was the conjuring of his life, his sorrow, his misery, his cold, the darkness, the unmoving, the hated. So much was for the experience of his joy, warmth, sunshine, butterflies, love. Came a drop of tear from the slide of the eye.

The dim, the evolution, the birth, born into the world, the first cry, in the cuddle of parentage, familial love, angst of growing, first kiss, sexual ecstasy, first million, greed, non-satiation, hurt, sorrow. Man is back, his unchanged perception, in the pool of red viscosity, he cuts himself again...fade to dark.

End

Life stops at waiting... but time doesn't.

Knowns & Unknowns (Or Ujloijlkjnowifhnjgno)

As we know
There are known knowns
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don't know
We don't know.

Prof Frank Cowell quotes Donald Rumsfeld in a Department of Defense news briefing on 12 Feb 2002 to start off the chapter on 'Information' in Microeconomics.

What an encouraging opening to the chapter...!