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04/06/2022

Globalization and the Butterfly Effect

By John Edwards

The butterfly effect concept has become important in the finance world as globalization continues to increase and capital markets connect. Volatility in one small area of the international markets can grow rapidly and bleed into other markets, and a hiccup in one corner of the international markets can have global consequences. Improvements in technology and wider access to the Internet has increased the degree to which international markets influence each other. This has led to more episodes of extreme market volatility.

The butterfly effect has become well-known in popular culture, and the concept has clear applications to finance. It and chaos theory may provide a partial explanation for the unpredictability of capital markets.

Origin and Meaning of Butterfly Effect

The phrase “the butterfly effect” was first coined during a scientific meeting in 1972. Scientist Edward Lorenz gave a talk on his work regarding weather prediction models. The phrase suggests that the flap of a butterfly’s wings in Japan could create a small change in the atmosphere that might eventually lead to a tornado in Texas.

Lorenz studied how small differences in initial values led to large differences in weather models at the Massachusetts Institute of Technology. In 1961, he had entered an initial condition in a weather model as 0.506, rather than the precise number of 0.506127, which resulted in a completely different and unexpected weather pattern. In 1963, he wrote a paper on this concept, titled “Deterministic Nonperiodic Flow.” The butterfly effect concept shows how difficult it is to predict dynamic systems, such as weather and financial markets. Study of the butterfly effect has led to advances in chaos theory.

Application of Chaos Theory to Markets

Capital markets go through alternating periods of calm and storminess. However, they are not always chaotic, and the shift between calm and chaos is often sudden and unpredictable. Some believe that these concepts of chaos theory can be used to understand how financial markets operate.

Markets tend to grow bubbles that eventually pop with drastic consequences. Financial bubbles often grow because of positive feedback. When investors make money during a rise in the financial markets, other observers think the investors must have made a smart decision, which leads the observers to invest their own money in the markets. The result is more buying and stock prices going higher. The positive feedback loop leads to prices beyond any logical or justifiable level. The loop eventually ends, and the last investors in are left hanging with the worst positions.

The same concept can explain volatile bear markets. The markets can suddenly shift due to outside factors, which causes investors to pay attention only to negative news. Initial selling leads to more selling as market participants liquidate their positions. The negative feedback loop tends to accelerate quickly, often resulting in a market full of undervalued stocks.

Fractals and the Markets

Prominent scientist Benoit Mandelbrot applied his work in fractals in nature to financial markets. He found that examples of chaos in nature, such as the shape of shorelines or clouds, often have a high degree of order. These fractal shapes can also explain chaotic systems, including financial markets. Mandelbrot noted that asset prices can jump suddenly with no apparent cause.

Many in the markets tend to dismiss the extreme events that occur less than 5% of the time. Mandelbrot argued that these outliers are important and play a significant role in financial market movements. Traditional portfolio theory tends to underestimate how often these high-volatility events occur. While his fractals cannot predict price movements, he argued that they could create a more realistic picture of market risks.

Examples of the Butterfly Effect in Markets

Although technology has increased the impact of the butterfly effect in global markets, there is a long history of financial bubbles going back to the tulip market bubble in Holland during the 17th century. Tulips were a status symbol among the elite. They were traded on exchanges in Dutch towns and cities. People sold their belongings to begin speculating on tulips. However, prices began to drop and panic selling ensued.

There are more recent examples of bubbles. On October 1987, known as Black Monday, the Dow Jones Industrial Average (DJIA) lost around 22% in one trading day, the largest percentage drop ever for that market. There was no apparent cause for the drop, though the DJIA had some large down days the week before, and there were international issues in the Persian Gulf. In retrospect, issues with panic selling and perhaps program trading might be partly to blame.

In 2015, the Chinese stock market encountered significant volatility, dropping over 8% in one day. Similar to Black Monday, there was no single event or cause for the drop. This volatility quickly spread to other markets, with the S&P500 and the Nikkei losing around 4%. Also like Black Monday, there had been weakness in the Chinese markets in prior months.

Chinese officials had begun devaluing the renminbi. However, the main cause was likely the high degree of margin used by Chinese retail investors. When prices began to drop, investors received margin calls from their brokers. Retail investors were forced to liquidate their positions quickly to meet the margin calls, leading to a negative feedback loop of selling. In years prior, the Chinese government encouraged people to put their money in the market. Markets will only become more interconnected as technology continues to improve, and the butterfly effect will continue to be a factor in global markets.

02/06/2022

Cost-Push Inflation Versus Demand-Pull Inflation

By Reem Heakal

Source: Investopedia

Do you remember how much less you paid for things even two years ago? This increase in the general price level of goods and services in an economy is inflation, measured by the Consumer Price Index and the Producer Price Index. But there are different types of inflation, depending on its cause. Here we examine cost-push inflation and demand-pull inflation.

Factors of Inflation

Inflation is defined as the rate (%) at which the general price level of goods and services is rising, causing purchasing power to fall. This is different from a rise and fall in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs. So if the cost of one item, say a particular model car, increases because demand for it is high, this is not considered inflation. Inflation occurs when most prices are rising by some degree across the whole economy. This is caused by four possible factors, each of which is related to basic economic principles of changes in supply and demand:

Increase in the money supply.
Decrease in the demand for money.
Decrease in the aggregate supply of goods and services.
Increase in the aggregate demand for goods and services.
In this look at what inflation is and how it works, we will ignore the effects of money supply on inflation and concentrate specifically on the effects of aggregate supply and demand: cost-push and demand-pull inflation.

Cost-Push Inflation

Aggregate supply is the total volume of goods and services produced by an economy at a given price level. When there is a decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, we have cost-push inflation. Cost-push inflation basically means that prices have been “pushed up” by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation).

Production Costs

To understand better their effect on inflation, let’s take a look into how and why production costs can change. A company may need to increases wages if laborers demand higher salaries (due to increasing prices and thus cost of living) or if labor becomes more specialized. If the cost of labor, a factor of production, increases, the company has to allocate more resources to pay for the creation of its goods or services. To continue to maintain (or increase) profit margins, the company passes the increased costs of production on to the consumer, making retail prices higher. Along with increasing sales, increasing prices is a way for companies to constantly increase their bottom lines and essentially grow. Another factor that can cause increases in production costs is a rise in the price of raw materials. This could occur because of scarcity of raw materials, an increase in the cost of labor and/or an increase in the cost of importing raw materials and labor (if the they are overseas), which is caused by a depreciation in their home currency. The government may also increase taxes to cover higher fuel and energy costs, forcing companies to allocate more resources to paying taxes.

Putting It Together

To visualize how cost-push inflation works, we can use a simple price-quantity graph showing what happens to shifts in aggregate supply. The graph below shows the level of output that can be achieved at each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1 to P2. The rationale behind this increase is that, for companies to maintain (or increase) profit margins, they will need to raise the retail price paid by consumers, thereby causing inflation.

Demand-Pull Inflation

Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four sectors concurrently want to purchase more output than the economy can produce, they compete to purchase limited amounts of goods and services. Buyers in essence “bid prices up”, again, causing inflation. This excessive demand, also referred to as “too much money chasing too few goods”, usually occurs in an expanding economy.

Factors Pulling Prices Up

The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, an increase in government purchases can increase aggregate demand, thus pulling up prices. Another factor can be the depreciation of local exchange rates, which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases, thereby raising the overall level of aggregate demand (we are assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy). Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners. Finally, if government reduces taxes, households are left with more disposable income in their pockets. This in turn leads to increased consumer spending, thus increasing aggregate demand and eventually causing demand-pull inflation. The results of reduced taxes can lead also to growing consumer confidence in the local economy, which further increases aggregate demand.

Putting It Together

Demand-pull inflation is a product of an increase in aggregate demand that is faster than the corresponding increase in aggregate supply. When aggregate demand increases without a change in aggregate supply, the ‘quantity supplied’ will increase (given production is not at full capacity). Looking again at the price-quantity graph, we can see the relationship between aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run, this will not change (shift) aggregate supply, but cause a change in the quantity supplied as represented by a movement along the AS curve. The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to changes in economic conditions than aggregate supply.

As companies increase production due to increased demand, the cost to produce each additional output increases, as represented by the change from P1 to P2. The rationale behind this change is that companies would need to pay workers more money (e.g. overtime) and/or invest in additional equipment to keep up with demand, thereby increasing the cost of production. Just like cost-push inflation, demand-pull inflation can occur as companies, to maintain profit levels, pass on the higher cost of production to consumers’ prices.

The Bottom Line

Inflation is not simply a matter of rising prices. There are endemic and perhaps diverse reasons at the root of inflation. Cost-push inflation is a result of increased costs of production, itself a result of different factors. The increase in aggregate demand causing demand-pull inflation can be the result of many factors, including increases in government spending and depreciation of the local exchange rate. If an economy identifies what type of inflation is occurring (cost-push or demand-pull), then the economy may be better able to rectify (if necessary) rising prices and the loss of purchasing power.

02/06/2022

The Difference Between Finance And Economics

By Stephen D. Simpson, CFA
Source: Investopedia

Although they are often taught and presented as very separate disciplines, economics and finance are interrelated and inform and influence each other. Investors care about these studies because they also influence the markets to a great degree. Here we take a look at finance and economics, what they can teach investors and how they differ.

What is it?

Without falling back on dry academic definitions, economics is a social science that studies the production, consumption and distribution of goods and services, with an aim of explaining how economies work and how their agents interact. Although labeled a “social science” and often treated as one of the liberal arts, modern economics is in fact often very quantitative and heavily math-oriented in practice.

How is economics useful?

When economists succeed in their aims to understand how consumers and producers react to changing conditions, economics can provide powerful guidance and influence to policy-making at the national level. Said differently, there are very real consequences to how a nation approaches taxation, regulation, and government spending; economics can offer advice and analysis regarding these decisions.

Economics can also help investors understand the potential ramifications of national policy and events on business conditions. Understanding economics can also give investors the tools to predict macroeconomic conditions and understand the implications of those predictions on companies, stocks, markets and so on. Being able to project that a certain set of government policies will stoke (or choke off) inflation or growth in a country can certainly help stock and bond investors position themselves appropriately.

Economics as a career

For those who choose to pursue economics as a career, academia is an obvious option. Academics not only spend their time attempting to teach students the principles of economics, but also researching within the field and formulating new theories and explanations of how markets work and how their agents interact.

There is also call for economists in the corporate world. Here the concerns of economists are more immediate and near-term. Economists working for major investment banks, consultancies, and other corporations often focus on forecasting growth (GDP, for instance), interest rates, inflation, and so on. These projections may represent a product in their own right (that can be marketed to clients) or an input for managers and other decision-makers within the company.

Economics in the markets

Investors have an erratic history with economists, listening to them carefully at some times and all but ignoring them at others. While some investors may ignore economists’ concerns and pile their investments into the latest booming sector, others will carefully track data on GDP, inflation and deficits to inform their investing decisions. It also matters which market is being considered; bond investors typically tend to pay more attention to economic data than many equity investors do.

FINANCE

What is it?

Finance in many respects is an offshoot or outgrowth of economics, and many of the notable achievements in finance (at least within academia) were made by individuals with economics backgrounds and/or positions as professors of economics. Finance generally focuses on the study of prices, interest rates, money flows and the financial markets. Thinking more broadly, finance seems to be most concerned with notions like the time value of money, rates of return, cost of capital, optimal financial structures and the quantification of risk.

How is finance useful?

While economics offers the pithy explanation that the fair price of an item is the intersection of supply, demand, marginal cost and marginal utility, that is not always very useful in actual practice. People want a number, and many billions of dollars are at stake in the proper pricing of loans, deposits, annuities, insurance policies and so forth. That is where finance comes into play – in establishing the theoretical understandings and actual models that allow for the pricing of risk and valuation of future cash flows

Finance also informs business managers and investors on how to evaluate business proposals and most efficiently allocate capital. Basically, economics posits that capital should always be invested in a way that will produce the best risk-adjusted return; finance actually figures that process out.

Finance as a career

In some respects, a degree or academic background in finance opens more obvious doors than a similar background in economics. A degree in finance is a common denominator among many of those who populate Wall Street, be they analysts, bankers or fund managers. Likewise, many of those who work for commercial banks, insurance companies and other financial service providers have college backgrounds in finance. Apart from the finance industry itself, a degree in finance can be a pathway into and through the senior management of companies and corporations.

In the markets

As finance tries to concern itself with assessing the value of financial instruments, it is not surprising that one of the most common applications of finance in the markets is in the determination of fair value for a wide range of investment products. Stock-pricing models like the capital asset pricing model, option models like Black-Scholes, and bond concepts like duration are all byproducts of applied finance in an investment context.

Finance also offers new theories about the “right” way to do things, whether that is the optimal dividend or debt policy for a corporation or the proper asset allocation strategy for an investor.

It can also be argued that finance affects the markets with a seemingly constant stream of new products. Although many derivatives and advanced financial products have been maligned in the wake of the Great Recession, the fact remains that many of these instruments were designed to address and solve market demands and needs.

The Bottom Line

It is important for investors to avoid “either/or” arguments regarding economics and finance; both are important, and both have valid uses and applications. In many respects, economics is “big picture” (how a country/region/market is doing) and concerned about public policy, while finance is more company/industry-specific and concerned about how companies and investors evaluate and price risk and return. Historically, economics has been more theoretical and finance more practical, but this has changed in the last 20 years.

It is interesting to note, though, that the two disciplines seem to be converging in some respects. It seems that academics in finance are trying to incorporate more and more theory into their work and appear more academically rigorous. At the same time, there is at least a movement within some schools of economics to lean more heavily on math and appear practical and applicable to everyday business and policy decision-making processes.

At some fundamental level, there will always be a separation, but both are likely to remain very important to the economy and financial markets for some time to come.

31/05/2022

Walt Disney

Walt Disney was born on December 5, 1901. Disney became one of the best-known motion picture producers in the world. He is particularly noted for being a film producer and a popular showman, as well as an innovator in animation and theme park design.

Disney is famous for his contributions in the field of entertainment during the 20th century. His first success was through the series, Oswald the Lucky Rabbit which was created by the Disney studio for Charles Mintz of Universal Studios. When Disney asked for a larger budget for his popular Oswald series, Mintz refused and Disney had to quit. Later, Disney and his brother Roy O. Disney started from scratch and co-founded Walt Disney Productions, now known as The Walt Disney Company. Today, this company has annual revenues of approximately U.S. $35 billion. This success is largely due to a number of the world’s most famous fictional characters he and his staff created including Mickey Mouse, a character for which Disney himself was the original voice.

Disney won 26 Academy Awards out of 59 nominations, including a record four in one year, giving him more awards and nominations than any other individual. He is also the namesake for Disneyland and Walt Disney World Resort theme parks in the United States, as well as the international resorts in Japan, France, and China.

Disney died of lung cancer in Burbank, California, on December 15, 1966. The following year, construction began on Walt Disney World Resort in Florida. His brother Roy Disney inaugurated The Magic Kingdom on October 1, 1971.

31/05/2022

Education

Education encompasses both the teaching and learning of knowledge, proper conduct, and technical competency. It thus focuses on the cultivation of skills, trades or professions, as well as mental, moral & aesthetic development.

Formal education consists of systematic instruction, teaching and training by professional teachers. This consists of the application of pedagogy and the development of curricula.

The right to education is a fundamental human right. Since 1952, Article 2 of the first Protocol to the European Convention on Human Rights obliges all signatory parties to guarantee the right to education. At world level, the United Nations’ International Covenant on Economic, Social and Cultural Rights of 1966 guarantees this right under its Article 13.

Educational systems are established to provide education and training, often for children and the young. A curriculum defines what students should know, understand and be able to do as the result of education. A system of policies, regulations, examinations, structures and funding enables teachers to teach to the best of their abilities. Sometimes educational systems can be used to promote doctrines or ideals as well as knowledge, which is known as social engineering. This can lead to political abuse of the system, particularly in totalitarian states and government.

Primary (or elementary) education consists of the first years of formal, structured education. In general, primary education consists of six or seven years of schooling starting at the age of 5 or 6, although this varies between, and sometimes within, countries. Globally, around 70% of primary-age children are enrolled in primary education, and this proportion is rising.

In most contemporary educational systems of the world, secondary education consists of the second years of formal education that occur during adolescence. It is characterized by transition from the typically compulsory, comprehensive primary education for minors, to the optional, selective tertiary, “post-secondary”, or “higher” education (e.g., university, vocational school) for adults.

Higher education, also called tertiary, third stage, or post secondary education, is the non-compulsory educational level that follows the completion of a school providing a secondary education, such as a high school or secondary school. Tertiary education is normally taken to include undergraduate and postgraduate education, as well as vocational education and training. Colleges and universities are the main institutions that provide tertiary education. Collectively, these are sometimes known as tertiary institutions. Tertiary education generally results in the receipt of certificates, diplomas, or academic degrees.

27/05/2022

The Old Man and the Sea

The Old Man and the Sea is a novel that was the last major work of fiction to be written by Ernest Hemingway and published in his lifetime. It is considered to be one of his most famous works and was awarded the Pulitzer Prize for Fiction in 1953 and was cited by the Nobel Committee as contributing to the awarding of the Nobel Prize in Literature to Hemingway in 1954.

The Old Man and the Sea is the story of a battle between an old, experienced Cuban fisherman and a large marlin. The novel opens with the explanation that the fisherman, who is named Santiago, has gone 84 days without catching a fish. In fact, he is so unlucky that his young apprentice, Manolin, has been forbidden by his parents to sail with the old man and been ordered to fish with more successful fishermen. Still dedicated to the old man, however, the boy visits Santiago’s shack each night. On the eighty-fifth day, Santiago sets out alone, taking his skiff far onto the Gulf Stream. He sets his lines and, by noon of the first day, a big fish that he is sure is a marlin takes his bait. After a long struggle with the fish Santiago manages to strap the marlin to the side of his skiff and heads home, thinking about the high price the fish will bring him at the market and how many people he will feed. While Santiago sails back to the shore, sharks are attracted to the trail of blood left by the marlin in the water. Despite his efforts to ward off the sharks, they have almost devoured the marlin’s entire carcass, leaving a skeleton consisting mostly of its backbone, its tail and its head. Once home, he slumps onto his bed and falls into a deep sleep. The next day, a group of fishermen gather around the boat where the fish’s skeleton is still attached. Manolin, worried during the old man’s endeavor, cries upon finding him safe asleep. The boy brings him newspapers and coffee. When the old man wakes, they promise to fish together once again. Upon his return to sleep, Santiago dreams of his youth – of lions on an African beach. The old man feels very unwell and also coughs up blood a few times towards the end of the story. He doesn’t tell the boy.

The novel has received so much praise and is considered to be one of the best novels in American literature. Santiago fights the creatures of the sea and some readers think that the story is about man’s battle against the natural world. However, the novel can be viewed as the story of man’s place in relation to nature. In the story, Santiago and the marlin show similar qualities of pride, honor, and bravery, and both are subject to the same eternal natural law – they must kill or be killed. Santiago himself says:

“man is not made for defeat . . . [a] man can be destroyed but not defeated.”

27/05/2022

Greece’s Debt Crisis and the Future of Europe

Finance ministers from the euro area met in Poland in the middle of September to discuss the Greek debt crisis. American Treasury Secretary Tim Geithner joined them. Fabian Zuleeg, chief economist at the European Policy Center in Brussels, said the United States was right to get involved. “The intervention from the US has also shown at least a risk that the stability of the financial system as a whole — the global financial system — might be under threat again.” Earlier, the leaders of France, Germany and Greece held a conference call to discuss how to contain Europe’s deepening financial crisis. Germany and France are Europe’s two largest economies. Seventeen European Union countries use the euro as their currency. On September fifteenth, five major central banks agreed to lend additional dollars to European banks in the euro zone. The European Central Bank says the three-month loans will provide as many dollars as the banks need. The operations will end in December. The European Central Bank is acting with the United States Federal Reserve, the Bank of England, the Bank of Japan and the Swiss National Bank. The announcement helped lift European bank shares and major European stock lists. The Paris-based Organization for Economic Cooperation and Development has lowered its growth estimates for the euro area. In Greece the economy has shrunk this year. German Chancellor Angela Merkel urged eurozone nations to do everything possible to avoid an “uncontrolled insolvency” by Greece. On September thirteenth, she warned that problems would quickly spread if Greece failed to pay its international rescue loans. And, she said, “If the euro fails, Europe fails.” The next day, European Commission President Jose Manuel Barroso spoke to the European Parliament. He announced that the commission would propose creating “eurobonds.” The idea is for euro zone governments to jointly guarantee their debts. Germany and France have opposed such bonds. Mr. Barroso also said the current system that lets individual countries easily block policy is not working. “I am convinced we need a deeper and more results-driven integration. A system based purely on intergovernment cooperation has not worked in the past and will not work in the future.”

Adapted VOA Special English Economics Report from a radio program broadcast 16 Sep 2011.

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