It was the American economist Arthur Bloomfield that once said, ‘a substantial measure of direct control over private capital movement, especially of the so-called hot-money varieties, will be desirable for most countries not only in the years ahead but also in the long run.’ In this article I would like to assess the principle having a strategy (a confirmed approach) for pursuing economic trajectories and their effectiveness.
To begin with, let us consider the case of the case of Myron Scholes and Robert.C.Merton, two Nobel Award winning ‘quantitive analysts’ whom felt, as I did before writing this, that financial markets can be regarded as perfectly efficient. They assumed whilst living on ‘Planet Finance’[1] that markets where fully adaptable to crises, had no influence of investor biases and where also fully continuous. For that reason, in 1933, these two quants developed a revolutionary profitable strategy to price options which would adapt itself via 5 variables: the current market price of the stock, the future price at which the option could be exercised, the expiration date of the option, the risk-free rate of return of the economy and most importantly, the annual volatility of the stock. With the big expectation that people, whom were clueless on how to price an option, would dominate the market, they ventured to create Long Term Capital Management. This diversified portfolio fund tended to attract big banks, the likes of Merrill Lynch and UBS with a minimum investment of $10 million since with a four-year investment, that minimum $10 million would have been converted shy of $40 million. As evident, by 1997 the net-capital stood proud at $6.7 billion. Importantly, a majority of capital used by LTCM was in fact borrowed; nevertheless the mathematicians were adamant their strategy would only post returns considering their incredibly diversified portfolio of up to different 7,600 positions. Long-term capital management flourished on the general premise of price inconsistencies. Their strategy grasped on to identical assets with fractionally different price points.
As mentioned before Long-Term Capital Management were living on Planet Finance, and in 1998 the real world caught up. After a series of economic and political failures, Russia was driven to default thereby having sequential effects on other emerging and developed markets. Predictably, as stock equities plunged, volatility has gone through the roof to 29% and later to 45%. Despite their reassured confidence and diversified strategies to prevent losses at any cause, LTCM has posted a loss of $550 million in a week’s time. To buy back some assets the quants scrambled searching for large sums, they were in dire need of help and even contacted the likes of George Soros.
George Soros was the embodiment of the message that quantitative analysts advocated against. He was a firm believer of the theory of reflexivity which was built upon the foundation that feedback loops existed within markets, and the volatility of prices were dependent on perceptions of reality. ‘According to Soros’s theory of reflexivity, financial markets cannot be regarded as perfectly efficient, because prices are reflections of the ignorance and biases, often irrational, of the investors.” Not only do market participants operate with a bias”, Soros argues, “but they’re bias can also influence the course of events”.[2] Via the mechanism of perception, Soros profited largely from taking numerous short positions, his most remarkable being his bet against the British pound in the 1990s. In this historic case, Soros was adamant that the rising reunification cost for Germany would drive up the Deutschmark. He linked this to the ERM where Conservative policy dictated that the pound would shadow German currency, and concluded that when Great Britain would forcefully remove itself from the ERM that the pound would fall. His confidence, a trait we saw with LTCM, led him to bet $10 billion on this depreciation. He was correct. Britain left the ERM and Soros’s fund earned over $1 billion in a single transaction.
The question we ask ourselves is who was triumphant. On the one hand, Soros earned what can only be seen as a fraction of LTCM’s initial revenue via prediction. On the other hand, whilst Soros maintained this, LTCM had lost theirs due to calculation. To an extent, we can we can argue they both parties used strategy, albeit different forms. The problem, however, laid in the timely effectiveness other strategy. The Scholes-Merton formula had only considered the previous five years of data. Have they gone back another 11 years, their formula would have stumbled upon 1987 stock crash, and a further 80 years would’ve captured the Russian default. This leads us to think that a more pragmatic approach to formulating strategy in economics can lead to a far greater deal of success. Nevertheless, it is imperative to point out that is pragmatism will always be fuelled by perception.
The meaning the ‘defined’ strategy is tenuous, however considering these two examples, a strategy insofar as being eloquently adaptable is well worth the bet.
Economics Relate 