How much money do you need?

Very recently the United States government averted the Fiscal Cliff, allegedly the biggest catastrophe that would have drawn its economy back into a recession. Now, you may ask, how would that have happened?It's simple - Bush, during his tenure, had passed on a bill for a tax reduction that was going to expire on 31st Dec 2012 after which the taxes would have gone up. In parallel, the government had raised the debt ceiling in July 2011 that came with a clause to implement a series of discretionary spending cuts beginning 2013 if the Congress is unable to bring down the deficit, which it couldn't. When these two forces combine together it would have caused an increase in the tax rates and at the same time would have lowered government spending that would have threatened to stall economic growth even before it could begin.

In simple terms, the government needs money to function and implement it's policies. That capital comes from income which are largely composed of tax revenue. With the financial crisis and the multiple wars that the Congress had to battle its reserves have been drying up faster than they could have been replenished that led US to borrow consistently. The tax cuts have further reduced its income stream while the unaltered spending has kept its appetite at its peak. Now the debt ceiling is a self proclaimed limit imposed by the Congress on the amount they can borrow which can only be changed by a majority ruling. Although politically complex, economically if US borrows over it's ceiling then it is considered a technical default that can results in a chaos about which I'll talk in a while. To avoid the ensuing chaos and for the government to be able to carry out its activities the debt ceiling was raised in July 2011. Just as it was raised US was deemed a slightly incredible entity to lend money to by one of the rating agencies which is not really surprising since the move is just an artificial measure to increase its borrowing capacity. But what is also surprising is that there was demand for such debt because in the middle of the Euro Crisis it was still considered a safe haven and US sold about $240bn of debt in one day, the largest such sale ever. This also helped keen the interest rates to a very low level.

During 2012 US managed to stay under the modified debt ceiling even after the QE rounds by Fed and the interest rates remained extremely low. The intent was to stimulate the economy and bring it on the path of growth and as we see it did manage to provide the markets with one of the best years that they had seen. But the future of such growth now remains uncertain as with the mismanaged deficit US seems to be drawing close to a debt crisis that could threaten the financial powerhouse of the world.

As for the tax cuts, Bush had enacted the law in 2003 when no crisis was looming and then Obama had a choice of either extending them or letting them expire in Dec 2010. After careful deliberation and analysis it was computed that an increase in rates would lead to an annual increase of about $3000 in middle class income taxes. At the time when the middle class was already grappling with the after effects of the crisis it would certainly have been a challenge, more political than economic, to thrust the public with a larger tax bill. And now, two years later, the same situation looked at the Congress in the face again and this time with an added sword of fiscal deficit hanging on its neck.

As the tax increases are coupled with a fiscal deficit, this time the Congress heeded to Obama's proposal of letting the taxes stay low for the middle class while allowing the tax increase to go into affect for the rich. It indeed seems to help bring in much needed income over the next couple of years while still not taking away any disposable income from the middle class. But the Congress did not get to any agreement on the debt ceiling and it only has two months before it can take a decision on its limit. Now it can be debated whether the increase in taxes would serve the purpose it is meant to as some studies show that the rich were more inclined to pay taxes when the rates were lower than when they are up. But the markets still haven't digested the brunt of the news and are aware of the looming danger of the debt in the coming months. This has led to a drop in the prices of US bonds as investors express their fear in US debt.

I think that this can have an enormous impact on the economy. US debt has been blatantly increasing since the turn of the previous decade without any focus on increasing the revenue. A weak economy led it to ease the burden on the troubled households by lowering the taxes which it was forced to increase a few days ago.  The effects of such actions are not felt in a day or two but they pile up only to explode at some stage. How can the country which cannot pay its obligations assure me of my bank's obligations towards me in the form of deposits? Bank deposits are insured by FDIC and so it might lead to a bank run which would further threaten the entire financial system.

The US debt has been enjoying a stable position with high prices and high demands, especially because of $ being the reserve currency but it seems like that notion is in its reversal. I think that in the next couple of years US treasuries will drop in value and with economic growth yet to come the true value will only be seen in real assets. Gold and other commodities and growth in developing nations would probably be the next target on investors' radar. I think US has started to realize that it needs to tighten it's reign and we should see some contraction in its spending in the coming few months. It's hard to balance that with an ailing economy but it's even hard to lose the faith and trust of being a financial powerhouse.

It is debatable as to what would happen. It's not easy to lose faith in US. As China works to keep US bonds in its reserves and investors around the world don't find a safe asset to invest in, US would continue to enjoy the position of being a safe haven.


[Update]
An interesting read: http://www.bloomberg.com/news/2013-01-02/ten-things-you-should-know-about-the-cliff-deal-so-far-.html

Statistical Arbitrage!

With my experience in statistical analysis and after further gaining information on equity markets I was curious to explore the possibility of generating alpha by combining the two skills. I got an opportunity where I worked on a similar idea and then I extended it on the data I had downloaded from yahoo.
In this strategy I try to find a statistical equivalent of pairs trading and try to extract inefficiencies in price movements.

Abstract

The objective of this analysis is to obtain an alpha that is based on statistically exploring ineffi ciencies in stock prices. The strategy involves decomposing stock prices in each industry into principal components that explain the most variance and then regress the stock prices on those components to obtain the stock's  dependence on them. Next the components are forecasted using GARCH model and hence the forecasted evolution of the stocks is also obtained based on the regression results. Based on these forecasts I will create a long-short neutral arbitrage strategy with the aim of achieving high risk adjusted returns.

Statistical Arbitrage on US Equity
https://github.com/kunalrajani/statistical-arbitrage

Disclaimer: Please read
Please note that this is my independent work where I have used data from yahoo finance to explore statistical concepts from a course I took in statistics. It may inadvertently have an overlap with a work that somebody else has already done and I have no intentions of replicating it. I would be glad to know of any such clash and post a clarification on this post.
I am open to having my work being redistributed or used but only after due credit and a reference has been made. Feel free to contact me to avoid any misunderstandings or if you need more details from this paper. 

*The analysis is still underway and the conclusions are under review

President's TheBait

It was the first time that I saw the incumbent and an aspirer to the most powerful position in the world battling out each other in a 'people's court' to gain confidence and hence the vote to be the next President of the United States. Being from a nation with multi-party politics this seems somewhat infeasible in India but there are many other reasons that I think hinder such an event. There is a lot that can be said about these debates, their pros and cons, modifications that can lend more credibility to their outcomes, their inheritance to other democracies, etc. and I will try to touch briefly on each of them.

I think that there are many shortcomings that such a debate faces that go unnoticed in the sequence of events.   The biggest drawback I think of this format is the inability to verify the facts. I remember very vividly how Obama kept on insisting about the $7 Trillion increase in deficit that Romney's policies would lead to while Romney consistently kept on denying any such proposal from his end. Had there been a team on both the sides well equipped to verify and crunch out the details of any statement it would have been an expedient revelation of the accuracy of the debate. I'm not questioning the feasibility of such a setup but lack of such checks allows the candidates to revolve around the truth with their confidence lending credibility to their statements. The common man who doesn't have the resources or the capability to analyze the debate and connect it with the facts from the campaign is liable to fall prey to such falacies and create an incorrect opinion based on them. For eg. it seems a no brainer to vote to have your taxes cut, but, that leading to more jobs and hence, on the contrary, an overall increase in tax revenue is a hypothetical assumption and one that is prone to the dynamics of the economy. Of course Obama must have computed the impact of such a move based on which he came up with the $2 Trillion figure but, at the moment of Romney's repudiation, had there been a team that could have presented their findings and hence challenged Romney, it would have once and for all exposed the impact of his policies. These statements can lead to an incorrect assessment of the manifesto of the candidates especially by those who don't go deeper into their analysis. In another case during the debate on foreign policies when Romney brought up the controversy over the Benghazi attack and how inefficient the white house was in investigating the situation and make statements his entire accusation was responded by a confident "Get the transcripts governor." And it is this confidence that can mislead a big electorate who care about such issues to align with Obama and trust him with their vote.

We know that its all politics and the truth, even if told, will be presented in a manner that would benefit the speaker. An excellent example of this was when Romney accused Obama of visiting the middle east region and leaving out Israel that he considers as the most important American Ally in the area. This was dramatically turned around by Obama who stressed that the importance of such tours was not centered around publicity and election campaigns but more so to be on the ground and learn from the hardships that people face. He highlighted that he had indeed visited Israel earlier during the Lebanon War and had offered his condolence and help to the families affected by the war. In another situation where Romney pointed to the inability of Obama administration to contain the rise in oil prices and vowed to bring them down to 'pre-Obama' levels, Obama struck back cleverly pointing to the low prices being reflective of the failed Republican policies that brought the entire economy to a halt. It seemed Obama learnt really well from the first debate on how to turn around the reason for a shortfall in any economic indicator to his predecessor.

Both the parties have the goodwill of the Americans in their heart and, striking out misuse of power by corruption for personal gains, both the leaders would aim to uplift the standards of the Americans if elected. (The striking out of corruption is a very critical factor that separates the politics in developing countries like India where numerous scams result from exploitation of power and personal motives play a big role in candidates vying to be elected.) In that scenario it is difficult to imagine any disparities in their policies and its the inability to identify that that can lead an average Joe swing in one direction or the other simply by the confidence and the gut factor. But inspite of these shortcomings I think that these debates provide a crucial platform to witness the vision and its depth that the candidates have for the future. Especially interesting are the issues where both the candidates take strikingly opposite views and then debate to defend their stances. Two key issues to report in this aspect are the taxes and medicare. When you truly have opposing views it makes it easier to get closer to the vision of the candidate and question their thinking. In the case of taxes it makes it easy to distinguish that Romney wishes to lower tax rates while Obama doesn't show any actionable inclination in that regard. For medicare Romney proposes the insurance to be in the hands of the private players without any hindrance from the state and relies on competition as the platform to provide different products while Obama proposes a government enforced program to ensure that everybody has insurance. These two facets seem to point to deregulation and capitalism as being reflective of a Republican and to the liberal and progressive nature of a Democrat and even though both the parties have the best intentions at heart their radically different means can lead to quite different outcomes.

For the well informed and educated these debates provide a good insight into the minds of the leaders themselves among whom one would be voted. It is this insight of a concise agenda of the parties and the knowledge about the leadership that I think is missing in Indian politics. Hence the political parties are able to take advantage of the unaware masses who cannot think and analyze, beyond their short term needs, about the economy, jobs, growth and income. They are contented with the promises of factories that would provide them employment, irrigation measures for their farms, development of roads, hospitals, etc. Although that these are essential measures to promote growth and well being of citizens it would be helpful if they promote their manifestos and highlight their vision than the next project. Agreed that with such a huge electorate, a diverse set of cultures, different geographies and varied needs, add on top the multi-lingual regions, it makes it extremely difficult for a common debate to make sense for a majority of those watching. I think before talking about the debate political parties also needs to put a face to their campaign than install puppets managed by family run politics. A strong leader needs to be able to instill confidence into the people about his ability to take the country forward and be available to answer to people. Once the parties have a leader who is also a contender for the Prime post I think it is possible to have them present their views on the key problems being faced by the country which can probably be dubbed or have subtitles and be telecasted across the nation.

Without such leaders and their visions it would be hard to uproot dirty politics out of government and any discussions or debates would act as the baits to attract the people based on their immediate needs.

Understanding Factor models and Cone programming

This was a very interesting project we undertook. Not because its result was any enormous value addition but because it helped in grasping concepts and procedures critical to function in practice. It helped in going through the rigorous process of data cleaning and implementing factor models and checking their significance to predict stock returns. Further on we explored optimization using cone programming, which is a special case of interior point methods, to maximize the sharpe ratio and obtain a market beating portfolio.

Here is the Abstract:

The goal of our project is to utilize factor models to explain returns and optimize the Sharpe ratio to create a portfolio that outperforms the S&P 500. After re fining our data we have a universe of 335 stock in which we can invest. We re-balance our portfolio quarterly and incorporate factor models and Sharpe ratio optimization through cone programming to form the portfolio. The rest of the paper is organized as follows: Section 1 is a short introduction of our paper, Section 2 gives a brief idea of the data available and what kind of choices we made to reach the final universe of stocks, Section 3 gives an idea of the general methodology used in the paper, Section 4 describes the results that we have reached, Section 5 presents the significance test we performed, Section 6 presents the results of different sensitivity analysis and Section 7 summarizes the project and gives suggestions for further research.

Investment Allocation using Factor models and Cone programming optimization

Let's get on the street - Part II

Furthering my experimentation with the real world data, I delved into the minds and psychology of investors. I had taken a course on Behavioral Finance that explains certain irrational phenomena that governs the nature of humans when then invest. This nature has certain shortcomings that are overcome by what has emerged to be known as systematic investing where a computer algorithm makes the decisions rather than a human who can be misguided by emotions.

The following Abstract gives a brief overview of the analysis:

There are many instances when a stock price experiences a sudden jump or a decline and, besides the financial crisis, it has to do with a fundamental change in the business of the stock. Eg. the consumer reaction to netflix's fee structure or a revelation of the revenue reporting mechanism of Groupon or the billions of dollars of trading losses by a bank or the passing of a law that gives huge tax incentives to renewable energy. These events cause almost an immediate reaction by the market reflected by the stock price changes and then as these events are studied in depth and their true impact is understood, the stocks migrate towards their true valuation. The relationship between a surge or a drop and the later migration is something that interacts with human nature and, if understood well, can be leveraged to generate investment idea. In this paper I shall explore such drastic movements and try to understand what their impact is on the stock prices. This is more complicated than it seems because of a change in investors' perceptions after the financial crisis and because of different nature of information dissemination for firms in different segments.

Investing on Behavioral bias

Disclaimer: Please read
Please note that this is my independent work where I have used data from yahoo finance to explore time series concepts from a course I took in statistics. It may inadvertently have an overlap with a work that somebody else has already done and I have no intentions of replicating it. I would be glad to know of any such clash and post a clarification on this post.
I am open to having my work being redistributed or used but only after due credit and a reference has been made. Feel free to contact me to avoid any misunderstandings or if you need more details from this paper.

*The analysis is still underway and the conclusions are under review

Let's get on the street - Part I

Now that I'm in my third semester of my program I've started to apply a few concepts that I learnt in my earlier courses to see if they actually make sense in the real world. It's hard to digest the fact that even doing an "a+b" in the real world is not that easy - acquiring data, ensuring that it is exactly what you want, cleaning it, checking if it makes sense and clipping out those that don't and still be left with enough meaningful numbers  involve a series of massive challenges that only a practitioner would comprehend. And that is exactly why I ventured on this endeavor, to map classroom coaching to real world implementation.

I would have actually wanted to branch off from this blog since it has mostly been about life at Cornell but for now I think I would include all my analysis here until I figure out the best way to split the two different topics. In this post I attempt to implement ARMA time series model on large cap stock returns in an attempt to predict their future returns. It's a first attempt but nevertheless gives an excellent idea about the issues I described above and if the time series concepts work by a brute force methodology.

ARMA model for large cap stocks returns

Disclaimer: Please read
Please note that this is my independent work where I have used data from yahoo finance to explore time series concepts from a course I took in statistics. It may inadvertently have an overlap with a work that somebody else has already done and I have no intentions of replicating it. I would be glad to know of any such clash and post a clarification on this post.
I am open to having my work being redistributed or used but only after due credit and a reference has been made. Feel free to contact me to avoid any misunderstandings or if you need more details from this paper.

Welcome NYC

So after a remarkably memorable stay in the small town of Ithaca it was time to leave the confines of the walls that Mr. Ezra had originally intended all of us to stay in. The idea was that away from all the city congestion and distractions students will get a chance to mingle among themselves in an academic setting that would help foster an enriching learning environment. I guess he did not conceive of this stream of Financial Engineering that inevitably brought Cornell closer to NYC until 2007 when a small part actually branched off and landed on wall street.
Now I wasn't going to begin studying anytime soon and if fate had it's way I might not have even been here so early but here I was, for my internship. I have been a city boy all my life. I grew up in Delhi, India, studied in Mumbai and lived in Bangalore. All these megacenters are one of the most populous cities in India and with an ever increasing immigration population and the progressing boundaries the population density doesn't seem to stabilize.They are home to people either scrambling to get onto that bus to reach their workplace, to catch that last spot on the train trying to make an errand or just to people that exist trying to make your life more complex! But in return, to serve the entire array of different classes of people from different backgrounds and tastes, you get a host of amenities that sometimes seem customized to your need. Be it a restaurant that serves your favorite entre, a pub that plays just your music, a coffee shop that blends to your taste or even a  tailor that stitches to your body.
BUT... all this comes when are in a state to really enjoy what they have to offer. And you certainly cannot be in that state of mind when you are in no man's land and trying to find a place to crash for the night. Home. I have looked for a place twice back home and once here in Ithaca, NY. In each instance I took the time (I would now say I had the luxury of time) to look at a few apartments, weigh them based on different criteria and then decide on the one that passes all the screening. Now this process typically took me a week or two and I was fortunate enough to have my cousin living in the heart of the city where I could crash for that time while I looked at other listings. So I log onto craigslist and try to rank the listings based on the location, distance, furnishings, utilities and my understanding of the safety and fun of the neighborhood. My office was at Grand Central and my next term was to be in downtown. To avoid being sucked into Manhattan's expenses and at the same time have a clean, fun and safe neighborhood I chose Astoria in Queens. It was the end of May and the search threw numerous results of places being available in a couple of weeks for the summer. Even after filtering for what clearly was spam there seemed to be a good number of listings checking which could keep me occupied for a few days.
So, being the diligent person I am, I jotted a few places and mapped my route and headed off. Now what you hear or see about a place can be quite different from what you witness with your own eyes, or in my case, ear. My first stop was north east of Williamsburg and I was pleasantly surprised to see the train ride on an elevated platform. But that soon turned into a blare as I stepped out and it was further disappointing to know that the listing was right around the corner and the noise of the train would deem an alarm unnecessary. Next I took the 7 back to take the N/Q and go into Astoria. The same problem persisted though the area was quite widespread and open to take away that claustrophobic feeling of elevated tracks and the blaring sound. They were all 2 storey row houses with a shop on the 1st floor and along with the curbside restaurants and clean streets it gave the town a pre-modern European look. It seemed like a giant chopper had chopped off all Manhattan sky scrapers from 3rd floor up but then you could still see the city across the river. It was a love at first sight and I knew I was going to live in that neighborhood.
Unfortunately I was still not familiarized with how "big" the rooms really are when they say that on craigslist. My first destination was at a place where 3 men, each over 40, resided. The room was as big as the size of a store room, the living room finished before it even started and the kitchen cabinets were locked because no one cooked. As if that wasn't enough the guy listed all the rules of the house as minute as cleaning the floor and I never thought about that place after that. This way I rejected a few other houses of the day and the next morning I was really considering taking up the first place I saw. When I called up to check I was surprised to know that it was taken up already. That got me on my foot and I started carrying my cheque book along to be able to sign off a place as soon as I saw it.
I was glad to have the assistance of a smart phone all this while. I could always check craigslist for any new sublets and I had that page with my search filter always open. I spent the next week looking over each sublet listing and each time something prevented me from committing to it at that very instant. One was perfect but was available only for 2 months. Another was well furnished but was too far from the closest subway. Then another was also very well furnished but it turned out to be a home to a 50 yr old and his dog and I used to curse them for not being clear about such descriptions on craigslist. The ones that had a good location were either too small or were in a dingy apt or were unfurnished. After about a week I became quite stressed of the situation and restless of living out of a suitcase. I expanded my search to downtown and brooklyn as well thinking that it would be better in the long run when my term begins in the fall on wall street. With the constraint on my budget I could only find apts in Chinatown that appeared like sleazy makeshift dorms that could break away any time or others in brooklyn with so much mess that my trash can seemed cleaner.
Finally I struck gold one day with an apt in Jackson Heights that was well connected by an express train, was in a nice neighborhood and had a big and well furnished room and that too for just $600. I immediately contacted the person and was there in 30 mins - a good test to measure the daily commute time I was going to have. I had been tired the past few weeks and being the middle of June the listings were thinning out and I was really hoping for this to work out. When I reached it turned out that the guy was living with his mother and they had had an Indian tenant before so we struck very well and we all had a good conversation for over an hour. We both liked each other and they began typing the sublet contract and I took out my cheque book. I had been warned to verify the credentials before entering any transaction and so I asked to check their papers and showed them my id, etc. Somehow that sort of upset the lady and she started having second thoughts. Now, I wasn't too impressed with the rest of the apt or its distance as well but I really liked the room and already under pressure I wanted to sign it off. So I tried to work it out well enough and left assured that the guy will be able to convince her mom.
Hardly did I know that it was a blessing in disguise for the next day, while I was holding on to them and still trying to find a better place, I struck gold again and this time I really felt that it was the one! Within 40 minutes of the ad I was in the apartment to check it out. Hardwood floors, big enough and furnished with bed, sofa, tv, desk, chair and AC, two large windows, well stocked kitchen and an orderly living room with a 52" screen and psII. I was all over and when I actually handed an advance cheque and got the receipt I could feel a heavy weight suddenly off my head.
I moved in about a week later and I would say that I love the neighborhood and this house was definitely worth the wait.

PS: A word of advice - when looking for apts in NYC be ready to commit on the spot, especially when its a sublet. The market is very rapid and dynamic and it pays to be a bit flexible and strike a place as it comes.