Myron Scholes (2011) - Quantitative Finance and the Intermediation Process

Thank you very much and it’s good to see everyone up this morning after a great meal last night and lots of good dancing. It was good to meet, and good conversation, so it’s nice to meet you all and meet some of you and hope to continue to meet you as the time goes on here at the conference. Today I’d like to talk a little bit about sort of the intermediation process and what we don’t understand and what we do understand about the intermediation process, and essentially that it’s a field that’s wide open to research. And if I have a moment at the end, then I would like to talk to you about, sort of some areas that I think are really open to a lot of interesting research and especially for those who are in the PhD programmes at various universities. Basically speaking, I think there are three ways to earn returns in finance or holding in financial assets. One way to make returns is sort of by holding inventory, the idea that when we’re holding inventory that we’re making returns by actually taking systematic risks and the like, and there are various factor returns that we might hold. And the issues, there is a lot of fundamental issues related to inventory risk and how the holding of inventory itself, the risk of inventory changes over time. It’s not necessarily the factor exposures that we measure are constant. They tend to change over time, and understanding why they change and how these risks change is an important part of thinking about risk and modelling. The second area of making returns is the ability to earn returns by forecasting cash flows. And this is, this area means that one is not holding inventory for the sake of just holding a store of wealth for future consumption or future wealth accumulation. What it is, is trying to figure out how to turn over inventory or how the idea to hold securities that themselves will produce greater cash flows in the future and/or have different discount rates that the market has not yet realised. And as a result of that, it’s a way to try to earn returns by taking selected inventory and being short other inventory in such a way as to earn returns by forecasting the future. So it’s a proactive approach to holding inventory. And the third way of earning returns is the idea of providing intermediation services in the market place. That’s the idea of either providing risk transfer services to the market or liquidity provision as it’s sometimes called, where other entities or individuals want to transfer risk and the intermediary steps in and takes the inventory and carries it forward in time or provides the inventory to the market in anticipation of a future demand for that inventory or future supply of that inventory. So this is a way of turning over inventory to meet the market’s asynchronies needs, the idea that, we know in economics that buyers and sellers don’t come to the market simultaneously and the intermediation business is really trying to take, to intermediate these flows, intermediate flows in the market in making money by actually turning over inventory. So the idea, the difference between alpha, which is the prediction of future cash flows, and to do that better than others in the market place, is that, when you have what I call omega, which is the reacting to the ability to make money in the market, by understanding the flows in the market, and why it’s the case others are willing to pay you for the services of transferring risk and moving inventory forward in time. And so the world here, in the omega world, as I call it, is making markets work, or the idea that it’s actually the turning over of inventory reacting to opportunities, that’s where we find, in my view, the world of banks broker dealers, hedge funds and corporations generally. We might not think about it, but the corporation actually is in the business of anticipating future flows by actually building inventory today to meet that demand in the future. And it’s the whole of our society works really enough as a form of the intermediation business. And so when we look at it, the idea that I - many, many hedge funds, as an illustration, provide liquidity or risk transfer service to the market, and even an idea of trying to figure out how to understand exactly how it is that they’re making money on intermediating the cash flows. It’s really trying to get inside or understand actually why the flows are occurring in the market and how long the imbalances will occur before they can liquidate or turn over the inventory. All financial functions that we have, and all finance that we know, has the property of trying to compress time. If we have transacting, all the evolution of transacting in markets over many, many years has been actually to compress time. When we think about financing large scale projects, larger scale than the resources we have ourselves, then we think about the intermediation process, it’s trying to match the teams of individuals or, that can provide for these projects or build these projects with capital. And so the intermediation process is to step in and reduce the time, necessary for individuals or teams with ideas actually to produce the goods or services they want to produce. The idea of saving for the future is compressing the time to do it, or markets compress the time, that enable us to figure out valuations and importantly as well in the risk transfer area, if we want to transfer risk, institutional arrangements are geared to try to reduce the time necessary for us to transfer our risks. If we have a private investment, then it takes a longer time frame than it does to transfer that risk than it does if you have a publicly traded asset. So the interesting part about omega is that basically clients and investors are willing to pay for the services. They knowingly give up returns. They think of their, as being a division of labour, where they transfer to experts, and experts then provide risk transfer services by taking and holding the inventory until such time as it can be sold later on in the market place. But the interesting point, another point is that it’s really not possible to earn extra returns just by holding a liquid asset or holding assets that are not liquid. It’s really the returns are made by understanding how to turn over assets that are not liquid or that there’s a demand for risk transfer services in that, it’s the turn over cost or the cost of turning over these assets and understanding how long it’s going to be necessary to carry the inventory that is actually the main reason why there is a compensation for liquidity provision. There has been in economics for a long time a large debate about whether speculators, and what I mean here is speculation in a good sense, a speculator is someone who actually takes inventory or risk and transfers the risk forward in time. I’m not thinking about it in terms of the way the popular press or regulators talk about speculators, but the classic example of inventory transfer is in the commodity markets, where the farmer actually has the crop, comes in, the farmer takes the crop, transfers the risk to the miller. The miller stores for example the wheat and then, as the wheat is bought or converted into flour so that cakes and the bread can be made by the baker for the ultimate consumers. That basically, the process of intermediation goes from the farmer to the miller to the baker, then to the consumer, the ultimate buyer. So the inventory of wheat has to be stored for future consumption. In the meantime, the miller has two sources of risk. The miller has the idiosyncratic risks associated with the actual inventory they’re holding, whether the inventory will be sold, whether the inventory will be stored correctly etc, and then the miller also has the generalised risks of the economy becoming stronger or weaker, and the demand for bread and cakes changing accordingly, and the miller also has the generalised risks of interest rate changes etc. These generalised risks can be hedged or these generalised risks can be held by the miller. And the evolution is to think about under what conditions it’s less expensive to hold risks or is it less expensive to transfer risks to the market place. So risk transfer or hedging or use of derivatives to hedge, in the case of the miller, the miller would use the future’s market to hedge risks, the miller would hedge generalised risks in the market. The miller cannot hedge specific risks because the cost of hedging specific risks means that the concentration of skills and expertise that the miller had can’t be hedged away. To make money in any business or any activity it’s necessary to concentrate. It’s necessary to concentrate in those things you know or the skills you have. And as a result of that, if you try to hedge away all the risks, then there is no way to make money. So making money is a risk and return. So we think about risk management, it’s not risk minimisation. Risk management is not risk minimisation, risk management is optimisation in combining the idea of returns for the risk one is taking, so that in the hedging, it’s possible to hedge generalised risks, it’s possible to transfer risks that the miller does not have any expertise in, or firms don’t have expertise in, or other entities don’t have expertise in, so that it’s possible to transfer those risks in the market place through using hedging or through using speculators who can understand or have expertise in carrying generalised risks forward in the market place. It’s the separation theorem of idiosyncratic and generalised risks that really leads to, a decomposition in finance and a change in the way we think about finance. Because using hedging or derivatives is not itself, not itself absolute or unique because the miller can have or hold risk capital as a generalised cushion against risk. So the miller can hold generalised capital, hold that capital and has that capital in place. If he can hedge risk however, then the amount of capital it needs to handle generalised risks is reduced because it’s transferred that risk to the market. So the question that we have in finance: Is it less expensive to use hedging through using derivatives or is it less expensive to use equity, and what is the relative cost of each piece? If equity is less expensive, then hedging won’t be used. Equity is the all-purpose risk cushion. If it’s less expensive to hedge, then hedging will be used, or the use of derivatives will be used, so both have costs. It’s not as though, you know, it’s not as though derivatives will replace equity or vice versa and maybe in the future there’ll be whole different ways in which risk transfer will occur, because risk transfer needs institutions in ways of thinking about it in order to understand how to carry this inventory. But the miller, we could have a completely different institutional arrangement where we go to the farmer and buy our wheat from the farmer, the wheat that we’re going to use during the year, and then take it to the miller to actually mill it into flour. And then take the flour to the baker. But we find that the institutional arrangements or the transaction costs are less for us to let the risk transfer occur from the farmer to the miller to the speculator, then to the baker, then to us. And obviously the consumer is paying the cost of all of this risk transfer in the system, because without the need for reducing the asynchronicity, the asynchronicity between the time the wheat comes, the wheat is harvested and the time we consume it, there is a time-out gap between the two, and as a result of the intermediation process, reduces the asynchronicity such that it is as if I went to the farmer and bought the wheat that I was later going to mill into flour to make my bread and cakes. So the interesting question in finance: Is there, when I look at it, between alpha and omega, omega is the intermediation process, the idea that hedge funds or corporations or millers or any other business concentrates and makes money by understanding idiosyncratic risks and risk transfer in the market place in combination, then the question is, is there a difference between alpha and omega? And I think that most hedge funds, in my view, make money by actually providing intermediation services to the market, being the miller in financial instruments, taking the excess inventory in hedging risks that it doesn’t understand or doesn’t have any competitive advantage in, and holding those risks that it has. And I think the only really sustainable business is the intermediation business, and the intermediation business is not sustainable in the sense that new institutional arrangements come into place that allow for more efficient ways to transfer risk. So we didn’t have derivatives, numbers of years ago in the financial market, derivatives start to compete with actual equity or different forms of capital, and as a result of that over time, they, derivatives tend to displace some of these other forms and institutional arrangements will change going forward to provide more efficient risk transfers. So I think if you ask anyone in the hedge fund world how you’re making returns, everyone will say we’re making returns by alpha or predicting cash flows. But to me the sustainable business in the hedge fund world or in the intermediation business in the banks and other institutions is being able to actually understand the risk transfer business and take risks that others are willing to pay them to take, and make the world synchronise even though the world is asynchronise between the demand and the supply of various inventory. So I think that the reacting to opportunities to me is the sustainable part of the business. And then to do it, it’s necessary to understand why the flows are in the market, to what extent, what the valuation anchor is and to ask the fundamental question of why is it that the flows are in the market and we’re able to intermediate and make a profit for the capital we’re putting into that particular activity. So if we look at the theory of risk transfer, the idea of Demsetz as an early definition of liquidity or risk transfer services, it’s really trying to understand what the price of immediacy is, or the price of to transfer risk in the market. We look at the stock market as being liquid, so we tend to look at bid offer spreads, but really, that’s only one definition of liquidity or the risk transfer costs, because the prices of assets themselves, in my view, incorporate both liquidity or the cost of risk transfer at any particular moment. And the actual evolutionary process or evaluation process that’s unfolding. So I think that the problem with understanding liquidity and how to price liquidity in the market is that the price of liquidity is not constant. The price of risk transfer changes over time and we have to really understand why the price of risk transfer changes over time and then we have to think about the dynamics. And basically, in my view, the state contingent claims market is really incomplete. That all of us looking at the information set, whether we’re running a hedge fund or we’re in a bank or another form of intermediary, has to make an assumption about where the location of the underlying process is, and make assumptions about understanding the flows and to what extent, times and place they’re going to want to have immediacy or provide immediacy to the market place. And what I mean by that is that when an intermediary is asked to carry inventory forward in time into the market, then it has, if it really wants to hedge its risks, then it has to decide on when it’s the case. It’s going to want to sell its assets and at what level it wants to sell. And basically that’s a very complicated problem because it’s very hard to define the states in advance. If it’s possible to define the states in advance, then we can price liquidity as an option. It’s a self liquid, because if we buy for example a put option on an asset, that, as the value of the asset goes down, the value of the underlying put goes up, so eventually, as the value of the asset falls enough, then it’s exactly a liquidating position. So we’ve liquidated our position by buying a put option. So we know there’s an option component to the liquidity or the demand for immediacy in the market place. The problem is that we can’t define the initial conditions, when we’re going to want to buy, what type of payoff function we want and when we’re going to want that particular payoff function. And so this is why it makes it very difficult to define the price of liquidity in advance. And so the problem is, additionally, that the myopic plans of investors depend really on the hedging or the completeness of the hedging demands of others. And in the market place there is an aggregation problem. In a sense that if I define the states of nature that I’m going to want to liquidate my positions or create risk transfer, then it’s necessary not only for me to understand my particular demands, but it’s also necessary to understand the demands of others in the market place as well. If I want to sell my home in Lindau, and I think sell my home might take a few months to do that or a few weeks to do that before I can create synchronicity with the buyers that are in the market place. Then it could be the case that others, simultaneously, want to sell their home. And unless I can take account of their, others’ demands at the same time I have my demands, it’s very hard to define the demand for immediacy or the demand for liquidity at a particular time. So in deciding on capital that’s necessary for investment positions, or capital necessary to support positions, when you have the demand or potential demand for transferring risk, when you’re holding assets, financial assets, or physical assets, it is necessary to try to take account of what is the option that is necessary, or what is the protection in capital that’s necessary to be able to sustain the position over that period of time. Additionally, the idea that we think of volatility or market risks and when the demand for immediacy or the demand for liquidity or risk transfer will come into being, as being actually exogenous, but a lot of volatility is endogenous because we have individuals involved and when it’s the case that intermediaries really change, those who are holding inventory change, actually the volatility and correlation structure, as they act either to intermediate, or they change their supply of intermediation services. So basically the intermediation services, as I’ll talk about in a moment, causes there to be changes in the level of volatility that we see in the market. So as the price of liquidity changes, that increases or decreases the volatility that we actually see in underlying prices in the market place. So actually the intermediation business is really not understood, and we don’t have models yet that really encapsulate what the intermediation business is and its evolution. But I think that basically, that what is necessary is to think that an intermediary has an anchor or has evaluation, and then intermediates flows in the market. And really that, the intermediation business is a form of a mean reversion business where prices deviate or flows come into the market place and they deviate from equilibrium values, and as the flows come into the market and prices deviate more, then an intermediary will step in and take those flows and carry them forward in time, so that in deciding on how the crucial part of intermediation is deciding how to scale into positions, how to add to your inventory positions over time, and when to actually scale out of positions. Obviously, as the flows increase in the market, demand for intermediation services increase, then it’s the case that the intermediary is asked to take more inventory in, and as the prices fall, they’ll tend to acquire more of that particular asset. So the typical intermediation process of using a process such as Ornstein–Uhlenbeck process, as an example of a stochastic process, just to illustrate this, is that this is - I use R is just the change in price or the change in profits or whatever - is that basically, if we assume on some location, some location B where is the - that is the equilibrium value of the underlying asset or price – and that the current value R, say is below that particular price, at what rate, A or Lambda, is it mean reverting back to its equilibrium value? So over time you can think of this as some type of profit function where there’s a normal profits B or a location B, where there’s an anchor where the intermediary is intermediating, and understands that to be the value, and today the value is below that, and so, as a result of that, the intermediary would acquire a position and over time it would mean revert at rate a back towards the equilibrium value. And, additionally, then there is the stochastic component, which is represented by … (Inaudible 29:00) to the Sigma and a DZ or DW process, which is just random noise. Now, actually, what this says is that if it’s possible to know the anchor location in A, to know the rate of decay or how fast it’s going to decay just the same way as the miller knows if it stores inventory now normally over time, the bakers will come and buy the flour at a rate Lambda or A, such that over time the inventory will disappear and they’ll be able to make profits, and there’ll be stochastic intervention in that process. Now the interesting problem, as the flows come into the market place, the intermediary initially might be actually losing money because the demand for its services is increasing and the prices are falling in the market. The difficulty comes into play, however when it’s the case that the intermediary no longer has an understanding of location B, or no longer has confidence in the rate of decay A. Or the degree of mean reversion A. And this is why it’s a computationally very difficult problem. It’s actually an NP-complete problem, because most intermediaries to intermediate, whether they’re hedge funds or millers or corporations, actually have to decide on location and the rate of decay. As soon as it’s the case that the intermediary loses confidence in location B or how fast the process is going to mean revert, the intermediary then starts, cannot intermediate. It has to withdraw capital from the market place. And what I mean by that is that to intermediate flows in the market, to create synchronicity from asynchronicity, it’s necessary to have a fixed point. It’s necessary to have a valuation fixed point or an anchor and an understanding of how one is making money. The greater the volatility, then the more uncertainty there is, then it tends to affect the intermediation business. In a sense, same thing as optionality does, but then the crucial aspect is knowing how to intermediate flows and if the business of intermediation is intermediating flows, not carrying inventory, trying to create synchronicity, then as soon as the intermediary loses confidence in either B, the location of the process, or loses confidence in how fast it’s going to mean revert back to equilibrium values, then the intermediary actually withdraws capital from the market because until you again establish a fixed point, then it’s the case that it’s very difficult to intermediate. So when we have shocks in the market that occur, wherein the intermediaries can no longer understand the normal flows and the normal evolution of the processes, such that they can intermediate this asynchronicity, markets cease up, because the intermediaries withdraw capital from the market, rationally until such time as they have a new information set or a new way to establish valuation. So we know in the standard macrofinance, macroeconomic literature, where it’s the case that there’s the view that, actually, if the central bank would step in and provide liquidity to the market, then it’s the case the market would then revert back to equilibrium prices and the market would be able to continue to evolve going forward. But that’s wrong, because the problem is that if it was just liquidity or just the idea of providing liquidity to the market, then the prices wouldn’t fall because the intermediaries would step in and intermediate those imbalances. So it has to be, when a shock occurs in the system and the market has to find a new location, a new B and a new R rate of mean reversion, then in that point of time, what happens until a new evaluation is found, time stops. What I mean by that is, finance is compressing time, but at the time of shocks, then time expands because intermediaries need to re-establish in this information set, which is vast, a new location and a new rate of decay before they can intermediate. So I call this really the Heisenberg Uncertainty Principle of finance in the sense that flows are intermediated, and as long as you know location, you can continue to intermediate. But once shocks occur, then it takes time and we don’t know the length of time. It doesn’t know the length of time until, until we have those re-intermediation. It’s sort of the same thing that, just an illustration, it’s children in a playground and all in various clusters and all of a sudden they start to move together and there is an attractor, and what is the attractor that’s attracting the children, and the flows are going in one direction. Then at the top, maybe there is an ice cream truck and they’re all leaving the playground going to that ice cream truck, but then there is the intervention. As they go to the ice cream truck you might have regulators, such as teachers and others, intervening and then where do they return to? They don’t return to the same spot. It’s impossible to think they would return to exactly where they were before, so actually it’s finding out where they’re going to return to. Once they return to the new location, then intermediation process actually will continue. So I think there needs to be really a lot of understanding of the intermediation process, because what it really means a lot in finance is that, you know that Granger causality views probably are incomplete because they’re an approximation and because of the information set being very large, and it being NP complete in the sense that locations change. And it really implies a whole new research in trying to understand how much capital is necessary to withstand these shocks until a time is in which, new locations or new fixed points are established in the market place. And just last is that, basically at the same time, that intermediaries withdraw capital from the market place, the demand for liquidity services increases. So the idea of optionality or how much flexibility to build into financing and operating programmes is really a function of liquidity or risk transfer. And none of our risk models yet take into account, should it be proactive or reactive in terms of valuing the option. So I think that it’s necessary to understand that markets work. Markets work, they intermediate flows and because they’re intermediating of flows and things look quiet and markets tend to be working, does not mean that when things are chaotic, markets are not working, because markets are always working to intermediate flows. And if the intermediaries can have a fixed point, but we have to try to understand what happens. Why the fixed point breaks down and the rate of mean reversion changes. And when that time period occurs, markets are working as they should until that relocation or that new point is found. So thank you and we’ll talk more.

Myron Scholes (2011)

Quantitative Finance and the Intermediation Process

Myron Scholes (2011)

Quantitative Finance and the Intermediation Process

Abstract

Discuss ways in which to earn returns in finance and the role of quantitative finance in each. Intermediation is one way to earn returns, and is the entire backbone of all of economics and business. To intermediate, entities must decide on these major issues: (i) levels of capital, (ii) capital structure, (iii) optimization technologies, (iv) level of risk taking, (v) compensation policies, (vi) feedback systems, (vii) management systems. Many of these need to be augmented and developed in quantitative finance. These map into questions associated with bank capital (under Basil III) and financial regulatory policy.

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