Sony and Samsung to share patents

This is rather shocking news (WSJ). Sony and Samsung have agreed to cross-license about 90% of their patents (each hold just over 10K US patents alone). It is amazing that relative newcomer Samsung has a patent portfolio of value roughly equivalent to Sony's, considering the latter company has been a consumer electronics heavyweight for a generation now. It just shows how rapidly things move in technology-intensive industries.

For four of the past five years, Samsung has been among the top 10 in U.S. patent applications, and its knowhow in flat-panel manufacturing was a big reason Sony asked to collaborate with it in liquid-crystal displays last year.

I wonder if this agreement covers Sony's new multicore "Cell" chip, which is state of the art.

Hedge fund returns

Below is a graph of recent hedge fund returns (presumably net of fees) vs. the SP500. Doesn't look so great, except that their ability to sell short and use derivatives gave them a big advantage in down markets. Also, reporting of returns is voluntary, and academic studies suggest that very badly performing funds (i.e. ones that blow up) might not appear in the data.

Don't become a scientist!

Says Jonathan katz, a high energy astrophysicist at Washington University in St. Louis.

Leave graduate school to people from India and China, for whom the prospects at home are even worse. I have known more people whose lives have been ruined by getting a Ph.D. in physics than by drugs.

Katz is right on the money. If I had a son or daughter about to embark on a scientific career, I would ask them to read this essay first.

Stability and null energy condition

My collaborator, UO postdoc Roman Buniy, is off to sunny Miami to attend a particle theory conference. His talk is on stability of quantum field theories and the null energy condition.

Recently, cosmologists have discovered that 80% of the energy in the universe is in a very unusual form called "dark energy" (not to be confused with "dark matter," which also exists but is clumped around galaxies, rather than diffuse, and doesn't seem as weird). Dark energy causes the expansion of the universe to accelerate, due to an equation of state with negative pressure. How negative can the pressure be? There is some theoretical prejudice that it cannot be more negative than minus its energy density (in natural units where Planck's constant and the speed of light are unity), even though the data allow for and perhaps even suggest this possibility.

What do I mean by "theoretical prejudice"? Well, I mean many theorists would be shocked if things turned out otherwise. If the pressure is too negative something called the "null energy condition" (NEC) used in general relativity is violated. The NEC says that the contraction of any null, or light-like, four vectors with the stress energy tensor must be non-negative. Assuming the NEC, one can prove a number of pleasing properties of solutions to the Einstein equations. It is believed to be satisfied by any reasonable types of matter.

In our paper we show that, in a broad class of models including any constructed out of interacting scalar and gauge fields, or any model describing a perfect fluid, if the NEC is violated by some configuration of the fields, then that configuration is unstable (i.e., will fall apart). This makes it very unlikely that the dark energy violates the NEC, since it seems to have been stable over billions of years.

Electronic libraries

Google has announced it is scanning large collections of books from academic libraries such as those at Stanford and Harvard. Amazon's search engine A9.com already allows users to search inside many books. Hopefully, with both Amazon and Google negotiating with publishers we will soon have widespread electronic distribution of books. Once search engines have scanned these books, a direct sales channel is opened between publishers and buyers - find the search result in a book, buy it as a PDF file with a single click. Digital rights management will be an issue for popular books, but perhaps not for less commercial academic or technical books. For some obscure volumes, publishers might welcome the extra income from sales of electronic versions, and not be so worried about piracy. Also, the copyrights to many useful books have expired so that they are in the public domain.

Let's see: roughly speaking, 1 letter = 1 byte, 10^3 words per page, 10^6 bytes per book. So 1 GB = 1000 books and a 100GB hard drive (soon to be seen on ipods) will store 10^5 books. Since a decent university library holds about 10^6 books, I can see a day very soon when we can carry our own extensive digital libraries around with us! The main bottleneck is economic, not technical.

Income volatility: data

The LA Times continues its coverage of increasing US income volatility. As I argued in an earlier post, we should think in terms of risk-adjusted growth in incomes, just as one considers the risk-adjusted return on a portfolio. Prosperity, but at what cost?

The impending singularity

I wrote before about what might happen if machine intelligence ever exceeds our own. Here is an amusing graph from an essay by the roboticist H. Moravec of CMU (known for work on mobile robots).



I also found the original paper by sci fi writer and computer scientist Verner Vinge, who coined the term singularity to describe the unlimited acceleration of technical progress that might result from machine intelligence. Finally, here is another amusing graph from Moravec.

Housing bubble, and possible hedge

Robert Shiller, the Yale economist who coined the phrase "irrational exuberance" to describe the tech bubble, has been advocating new financial instruments that let ordinary people manage the increasing levels of risk in their financial lives. This NYT article describes new derivative instruments designed by Shiller's company that are essentially index funds linked to home prices in certain major markets. They will trade on the Chicago Mercantile Exchange and allow investors to, e.g., hedge against a decline in real estate values in their city.

Interestingly, there will be a pair of derivatives linked to each underlying index, whose prices behave oppositely. This allows bets against the index without requiring a short position that might lead to margin calls or unbounded losses. One mismatch between the Shiller indices and the actual housing markets is the favorable tax treatment of leverage for someone who buys a house (as opposed to the index).

"Volatile markets are increasingly becoming a part of our lives," Mr. Shiller added. "The home market itself is becoming more volatile. We're in the biggest real estate bubble in history, I believe.

Nationwide, home prices rose 7 percent a year, on average, from 1999 to 2003, roughly double the rate for rental prices. Over the previous 15 years, the two rose more or less in tandem, with one outpacing the other for a while before the pattern reversed. I discussed bubble dynamics in a previous post.

Prisoner's dilemma, altruism and Silicon Valley

Prisoner's dilemma is a two player game, in which each player separately and simultaneously decides whether to cooperate with the other, or to defect. It is analogous to the situation a criminal might find himself in: either testify against his accomplice in return for a lighter sentence, or keep quiet and hope that the other guy does as well. The highest point payoff results if both parties cooperate, but if one has no idea what the other party will do it is best to defect. Ironically, if each player follows his best strategy (assuming no knowledge of what the other will do) both will defect rather than cooperate, ending up worse off.

Clearly the prisoners would be better off if they could trust each other. But how does trust arise? An academic at Michigan has been running prisoner's dilemma tournaments between software agents (programs) for some time. Each competitor programs his agent and they play against each other in a round-robin tournament, whose key feature is that the agents will meet repeatedly and can remember what happened in previous rounds. The dominant strategy - that of the winning agents - seems to be a kind of benevolent "tit for tat," in which an agent assumes the other will cooperate when they first meet, but punishes a defection by behaving similarly at the next meeting. This allows altruistic cooperation to develop, and deters bad behavior. I am oversimplifying here because, obviously, the success of a strategy depends quite a bit on the overall distribution of algorithms in the pool of agents. However, it seems to be a fairly robust fact that tit for tat styles of play tend to do well. This observation has been taken as evidence that there might be evolutionary selection for altruism. Humans who don't have at least some instinct for cooperation will have lower survival and reproductive probabilities, and the nice (but stern) genes will eventually predominate.

It's a nice story, and perhaps even has a kernel of truth. Of course, as anyone who has worked in a large organization can attest, there are other, nastier, niche strategies that work well too. (Like, pretend to be a nice tit for tat person but defect as much as you can get away with it.) Interestingly, I find that in the silicon valley world of entrepreneurs, VCs, engineers and salespeople, there is a very strong tendency towards benevolent tit for tat behavior. To first approximation, I can email anyone without ever having met them, introduce myself, and, by making a sufficiently logical case for it, elicit some amount of cooperation. This routinely happens along the lines of "I am researching an idea in this space, and wonder if you know anyone who would talk to me about the (market, competitors, technology, etc.)" It is understood that other agents in this virtual world would do the same under similar circumstances. Sometimes you end up wasting your time, or having your time wasted, but other times you develop very useful additions to your trusted network. A business ecosystem lacking this culture of cooperation would have a hard time competing with silicon valley in terms of innovation or development of new companies.

Life as a Quant

I've been reading Emanuel Derman's memoir, My Life as a Quant: Reflections on Physics and Finance. Derman was trained in theoretical physics, but left for finance after multiple postdocs and a stop at Bell Labs. He had a long and distinguished career at Goldman-Sachs, where he worked closely with Fischer Black of Black-Scholes fame. One of his most famous papers is on the volatility "smile" or skew, which I discussed in previous posts.

An entire chapter of the book is devoted to volatility, and ends with Derman admitting that no one really knows the fundamental cause behind the smile. His work had to do with extracting "local" volatility from an implied vol surface that is itself extracted from option prices over a range of strikes and expirations. One tantalizing fact I learned from the book is that prior to the 1987 crash there was no vol smile in SP options. This strongly suggests to me that the smile is at least partially caused by crash-averse portfolio managers buying puts as insurance and selling calls to defray the cost of that insurance (or simply to enhance profits). Puts would then be overbought while calls are oversold. (I took advantage of this in 2004 by buying a lot of long-dated SP calls, which are now in the money.)

I recommend this book to anyone interested in theoretical physics, mathematical finance or derivatives. Derman has a very down to earth writing style, but is also very insightful. This book is particularly valuable to students and postdocs in physics who want an insider's view of what a career in finance might be like.

Lenovo (Legend) buys IBM PC unit

Lenovo, the largest PC maker in China, paid $1.25B (about equal amounts of cash and stock) for IBM's PC unit. Lenovo's market cap is about $3B so this amounts to a 19% stake for IBM in Lenovo. For those non-geeks out there, the IBM Thinkpad was long regarded as the best Windows laptop line.

Lenovo, originally known as Legend, had its origins in the Chinese Academy of Science. This acquisition vaults it to no.3 in the world in PCs (after Dell and HP) with a 9% world market share. Integration of the IBM unit should prove quite challenging. However, it does provide Lenovo with key ingredients that even leading Chinese companies have thus far lacked: a recognized brand, sophisticated product design and worldwide distribution.

Earlier I noted that both Schwinn (bicycles) and RCA (electronics) brands were now in the hands of Chinese companies.

Sustainability of China economic growth

A reader commented that my earlier estimates for the emergence of a middle class might be optimistic. My main assumption was that the differential in growth rates between China and developed countries would average about 5 percent per year. (e.g. 7% vs 2%)

Below are some figures from the IMF, which suggest that China's rapid economic growth could continue for some time. Determinants of growth, such as savings, investment and opportunity for reallocation of human capital, compare favorably with Japan or other NIEs (Korea, Singapore, Taiwan) at a similar stage of development.

Labor vs technology arbitrage

The Times business section today has special coverage on China. The piece about venture capital in China is right on the money - despite all the dynamism there I think there are better VC investments to be made in the US right now. Most opportunities in China are based on labor arbitrage, not technology innovation.

Labor arbitrage is illustrated very clearly by the two profiles, of a textile worker in Georgia, and another in a factory town north of Shanghai. With 150 million excess rural workers in China, and modern supply chains connecting factories there to US markets, how long can a 30x disparity in pay ($15 per hour vs $4 per day) persist?

Executive summary

This Economist article is the best summary I have seen yet of the US current account situation and its likely effect on the dollar.

An interesting point about a looming reversal in net payments:
So far America's hefty debt has not been a burden on its economy, mainly because it has pulled off an extraordinary trick. Although it is a large net debtor, it does not have to make net payments of interest and dividends to the rest of the world. Instead, America still enjoys a net inflow of investment income because it earns a higher average return on its foreign assets than it pays on its liabilities. Returns on foreign direct investment and equities are higher abroad than at home, and America has benefited from unusually low interest rates on its borrowing in recent years. Unlike in previous periods of dollar decline, bond yields have remained low—largely thanks to those huge purchases by foreign central banks. But as interest rates rise in future and net foreign debt mounts, America's net investment income is likely to turn negative, probably next year. Not only will that swell its current-account deficit, but it will also exert an increasing drag on the economy.

I expect the dollar-yuan exchange rate to follow the pattern below in the next decades. This is why, assuming further progress in China, the PPP exchange rate is a better indicator than the current pegged exchange rate.


Net foreign liabilities are about $3 trillion, or 30% of GDP. Half of this is held by Japan and China.

Benchmarks in China development: emergence of a middle class

The emergence of Chinese consumer markets - in particular, a Chinese "middle class" - is often discussed, but without quantifying exactly what is meant by middle class. Below I describe some rough calculations that suggest a population of 300M could emerge by 2020 with per capita buying power similar to that in developed countries. One could characterize this as equivalent to adding an extra EU or United States to the world economy.

2003 China GDP per capita (PPP) is $4K. Assume 5% differential between PRC and developed-world GDP growth rates (e.g. 7% vs 2%), or a doubling time of about 14 years. This is consistent with sustained performance of Japan, Taiwan or Korea during similar periods in their development. (Current growth rate differentials are larger - as much as 7% - so our estimate is not aggressive.)

To catch up with developed nations in GDP per capita (e.g., Korea, Greece or Portugal, currently at $16-18K per year) would require 30 years. (A more aggressive 6% growth differential would imply 24 years.)

Now assume income inequality similar to that of the US: 80th percentile family income is twice average income (this is conservative as actual income inequality in China is likely to be more uneven). Then, in 14 years there will be a "middle class" in China of 300M people whose household income is at developed country levels. In 20 years this middle class will easily be larger in population than either the US or EU. Note that while we refer to this as a middle class it actually comprises the richest 20-25% of the Chinese population.

Keep in mind that these figures use PPP (purchasing power parity) and not nominal exchange rates. But I expect an FX equilibration to occur over these same timescales (i.e. appreciation of the renminbi just as with the yen in previous decades), resulting in a gradual closing of the gap between PPP and nominal exchange rates. (For those not familiar with PPP, it is an exhange rate computed by comparing the local currency costs of a common basket of goods in two countries. At the PPP rate the two baskets cost the same.)

If one uses a more generous definition of "middle class" - say, GDP per capita of $10K at PPP - then there are already 200M such people in China.

Wal-Mart facts

From The New York Review of Books:

With 1.4 million employees worldwide, Wal-Mart's workforce is now larger than that of GM, Ford, GE, and IBM combined. At $258 billion in 2003, Wal-Mart's annual revenues are 2 percent of US GDP, and eight times the size of Microsoft's. In fact, when ranked by its revenues, Wal-Mart is the world's largest corporation.

...As of last spring, the average pay of a sales clerk at Wal-Mart was $8.50 an hour, or about $14,000 a year, $1,000 below the government's definition of the poverty level for a family of three.[4] Despite the implied claims of Wal-Mart's current TV advertising campaign, fewer than half— between 41 and 46 percent—of Wal-Mart employees can afford even the least-expensive health care benefits offered by the company.

Half of US productivity growth from 1995-2000 was in retail and wholesale distribution. Part of that comes from containing payroll costs, but IT and logistical efficiency are also key to Wal-Mart's success. Hopefully most of these clerks are only part-time workers and not sole breadwinners of their families. We noted before that Wal-Mart accounts for 10% of US imports from China.

NYT on JPN,CHN central banks and traders

This article profiles central bankers in Japan and China. A couple of important points: the majority of Japanese dollar holdings are in US Treasury debt: $720B out of $812B, whereas the PBOC only holds $180B of its $600B in dollar reserves in Treasurys, with the rest in agency debt (Fannie, Freddie), mortgage backed securities, etc. China views its dollar reserves as a component of national wealth, so has been managing it for return, not just as a strategic instrument of trade, which explains the greater diversification.

...In Beijing these days, one of the fastest-growing fortunes the world has ever seen is managed by fewer than two dozen traders, chosen for showing mathematical brilliance at China's top universities.

...In contrast to Japan, China's money managers, while selling little of their existing Treasury holding, have not been buying much more. China's foreign currency reserves rose by $111.3 billion in the first three quarters of the year, according to official Chinese data. But its Treasury holdings, American filings show, climbed by only $16.4 billion.

Instead, officials at the State Administration of Foreign Exchange in Beijing have been seeking higher yields by plowing billions of dollars a month into bonds backed by mortgages on houses across the United States, according to bankers who help Beijing manage the money. By helping keep mortgage rates from rising, China has come to play an enormous and little-noticed role in sustaining the American housing boom.

Comments on volatility

The comments below are from a practitioner in quant finance. I find his explanation of why implied vol is so low to be persuasive. The "technical" cause he mentions (people writing a lot of covered calls) leads to skew - asymmetry of the implied prob. dist., with upward moves of the spot less probable than downward. I'm a bit confused about whether this affects the relation between implied and realized vol - it depends on why the calls are being sold. BTW, I also recently learned that one can directly trade realized vol through CBOE variance futures.

I speak to volatility brokers on a daily basis, and whilst their opinions can vary considerably in detail, they seem to have generally the same explanation as to why market volatility has been going down over the last 18-24 months.

On the fundamental side, corporate deleveraging has caused a drop in vol. if you view a company as a leveraged series of cashflows, where cashflows are representative of net earnings, then balance sheet deleveraging means that the magnification of perceived earnings volatility should decrease. in this sense credit and vol have moved together, more or less.

On the "technical" (meaning non-fundamental) side, one thing that has increased in the last few years has been corporate call overwriting. that is, companies with large cross share holdings writing OTM calls on part of their holdings. the seller wants to sell the stock, but isn't particularly bothered about exact timing or the exact level, so may sell that option to the market and get paid. unicredito italiano went from an implied vol of 40% to under 15% mainly because of this effect!

for a very long time there has been call overwriting by money managers with moderate sized positions, but this has increased as well recently. contrary to popular belief by some derivatives traders and hedge fund traders, many intelligent people work in normal equity funds, and these people have learned that call overwriting can produce extremely good returns. as intelligent people they are likely to increase this activity in the future.

...in my opinion there are too many vol traders out there who look only at statistics and think "vol was historically higher and vol reverts to the mean, therefore i should buy it". whilst many senior traders don't fall into the mean-reversion trap, more vol traders need to think about the game theory aspect of what they are doing. if everyone who delta hedges is long gamma, there will have to be an extra large volatility shock for implied vol to increase, as everyone will want to try and take profits by selling their options! and if nobody sells their options, everyone will delta hedge against market moves, as discussed, and decrease implied vol.

it is like people who play poker and only look at their own hand, just playing the statistics. they should look around them and think about what other people are likely to do, given the information available.

El-Erian on emerging mkts

Mohamed El-Erian is PIMCO's resident guru on emerging market bonds. These comments are excerpted from a Financial Times editorial of today.

We should keep in mind that for most of history, with the exception only of the last few hundred years, world economic activity was concentrated in the near and far east, so any predominance of "emergent" economies would only be a reversion to the historical norm.

The strengthening of emerging economies is undeniable and has triggered talk of a "new paradigm". Instead of constituting a source of volatility for the global system, these economies are now seen as providing an element of stability. They are also reducing their historical vulnerability to disruptions from abroad. It comes at an opportune time for a world that has become overly dependent on debt-financed growth in the US. The current improvement in emerging economies differs from earlier advances that proved unsustainable, because it involves a set of self-reinforcing enhancements in economic, financial, policy and institutional factors.

...The history of emerging markets has rarely seen the present combination of current account surpluses, surging international reserves, declining public sector debt and improved domestic growth conditions... These economies now account for almost half of global economic activity in terms of purchasing power parity; they represent the most dynamic portion of international trade; their low cost structures have enabled the world to contain inflationary pressures emanating from the surge in oil prices; and, through their large purchases of dollar-denominated financial instruments, they have helped keep interest rates low for now. This comes at an appropriate time for the global economy. The US, which has carried the burden of being the global growth locomotive, has done so at the cost of high household indebtedness, a sharp deterioration in government finances and an unprecedented current account deficit.

Wealth Inequality

Here are some disturbing statistics. Many studies focus on income, but the distribution of wealth is probably more revealing. The average net worth of the wealthiest 1% of Americans is $10M. The threshold net worth to be in the top 1% is probably a few million dollars. (This means easily more than a million households of millionaires.) Most studies show the level of inequality today to be at an all time high, rivalling only the period just before the great depression.

The US wealth distribution is the most unequal among all developed countries (the UK is second). Americans tend to tolerate this inequality, confident that our society allows for more economic mobility and is more meritocratic than others. I have heard rumors of recent studies showing that this is no longer the case. If so, it is only a matter of time before the have-nots in this country begin to resent the status quo.

I discussed income volatility in a previous post.

Current account history

Looks like we need a Plaza Accord II to sustain Bretton Woods II.

China climbing value chain: chip design

We know all about the billion dollar fabs under construction near Shanghai, but the growing number of chip design firms tend to get less coverage.

WSJ: Morris Chang, chairman of Taiwan Semiconductor Manufacturing Co., the world's biggest contract manufacturer of chips, compares China's design industry to an object with "zero speed but infinite acceleration." His company this year opened a nearly $1 billion plant in Shanghai, its first in China, in part to cater to local design companies.

"If you look at the large number of small design companies created here, you are seeing the foundation of an industry created," said Craig Barrett, Intel's chief executive, during a trip to China in November.

As I mentioned before, China's future economic growth will be based on more than just low-cost manufacturing. See also this Guardian article on radical progress in China using fetal cell tissue to treat paralysis.

Bubbles and timescales

It seems to me that the persistence of a financial bubble is related to temporal limits on the arbitrage process. In the strong efficient market view (which I don't subscribe to), there are no bubbles because the price incorporates all available information (questionable, due to information asymmetries and bounded cognition) and arbitrage acts to eliminate any mispricing. However, even if all parties are smart and have equal information, it is not always possible to sustain a bet against a bubble long enough to collect.

During the tech bubble of a few years ago, many investors strongly believed that the market was mispriced (I was convinced by '99). But, it takes mucho cojones to sustain a bet against the market for several years - the best I was able to do is just stay away from techs during this period. An institutional investor is in an even worse position, as he or she may have performance-based compensation that effectively precludes trades taking more than a quarter or perhaps a year to reach fruition.

This conclusion is supported by a recent paper in the Journal of Finance, which shows that hedge funds were riding the tech bubble, not betting against it. Hedge funds are subject to redemptions by investors over quarterly (or at most yearly) timescales, and managers are compensated based on annual performance, so again really long-term bets are off the table. It seems to me that in the financial markets there are almost no actors capable of taking long term bets against a persistent bubble. (To be more precise, the fraction of total capital controlled by such actors is very small.)

The current housing bubble is an even more egregious example. Because real estate is not a very liquid investment - the typical family has to move and perhaps change jobs to adjust to mispricing - the timescale for popping a bubble is probably 5-10 years or more. Further, I am not aware of any instruments that let you short a real estate bubble in an efficient way.

Finally, one can consider the FX case. Everyone thinks the dollar will have to fall on a trade-weighted basis over the coming years. But one doesn't know when or how, due to possible intervention by central banks. Any individual hedge fund that leverages up and bets against the dollar is taking a big risk. We won't see large moves until a critical mass of capital is willing to take that risk.

The market can remain irrational longer than you can remain solvent!

First real lie detector?

I've been waiting for this for a long time! Apparently, functional MRI can be used to tell when someone is lying. Of course, it is possible that a determined and practiced deceiver might fool the machine - further testing will be required. But just imagine the societal implications of a reliable, portable lie detector! (I can't decide whether it would more useful in business meetings or on first dates :-)

Overall, it seemed to take more brain effort to tell the lie than to tell the truth... Lying caused activity in the frontal part of the brain - the medial inferior and pre-central areas, as well as the hippocampus and middle temporal regions and the limbic areas.

Bretton Woods II and ASEAN summit

WSJ: Meeting on the sidelines of a regional gathering in Laos, the leaders of South Korea, Japan and China agreed on the need for exchange-rate stability, according to a statement issued by the South Korean presidential office. A separate meeting of finance-ministry officials from the three countries to discuss the dollar's decline led to an "understanding," though no agreement on any concerted action, South Korean Deputy Finance and Economy Minister Chin Dong Soo told reporters in Seoul.

...South Korean President Roh Moo Hyun met with his counterparts, Prime Minister Junichiro Koizumi of Japan and China's Mr. Wen, on the sidelines of the Asean summit yesterday. A statement from Mr. Roh's office quoted the Korean president as telling Messrs. Koizumi and Wen that "a dramatic change in exchange rates is not appropriate" and that "currency stabilization is important for the economies in this region." According to the statement, Messrs. Koizumi and Wen agreed. The statement paraphrased Mr. Koizumi as saying there should be cooperation and joint efforts among the three countries to stabilize the currencies.

See previous discussion of Bretton Woods II.