Statistics

Dr Michael Martin WelcomesYou to theAge of BigData

Interview

A JourneyWith aDirector atDixonAdvisory

More In This IssueModelling Animal Spirits - Is Economics Due for a Paradigm Shift? By Dr Jose A. Rodrigues Neto

Questions on Belief, Jakub Kielbasa’s Thoughts in the Pursuit of Knowledge

The Way We Were... And the Way We Are - Looking into Organisational Culture

INVESTING IN VOLATILITY

Can Investing in Volatility

Help Meet Your Portfolio

Objectives?

ISSUE 1, 2012

Brought to you by the AFEC Students’ Society.

ENVISION

What I wanted for Envision Daniel Law

Envision is an inde-pendent, student-led publication and has been long time com-ing for CBE students. It is a way in which we as a society can en-courage our members to see their course in context of the world, with the help of our own ANU CBE lec-turers and corporate leaders.The end game for this publication is to help develop stu-dents’ opinions and facilitate a way in which we can share and bask in each oth-er’s wisdom.

Envision is a new resource for cbe students to widen their horizons beyond the scope of course work, with the contribu-tors (lecturers and students alike) sharing their views on contemporary business issues. For me, this new initiative by afec means that anu stu-dents will not just be book-smart, but also street-smart. It encourages stu-dents to think beyond word-based theories and to see what it means to be in the business sector.

STAFF

EditorsDaniel Law, Publications Officer, afec Students’ Society, anu (BCom)Irene Zhen, Publications Director, afec Students’ Society, anu (BCom/llb)

Editorial StaffArchibald Lau, Publications Officer, afec Students’ Society, anu (BCom(Hons))Tina Huang, Publications Officer, afec Students’ Society, anu (BFin/llb)

Production & LayoutAngelina Kim, Marketing Director, afec Students’ Society, anu (BFin)Lynn Li Teo, Design, anu (llb)

FOREWORD

“Education is not preparation for life; education is life itself.”

-John Dewey

Address from the Director of Publications Irene Zhen

CONTRIBUTORSWe are honoured to introduce our contributors of Envision’s very first issue

Dr Geoff Warren is a Senior Lecturer in the Research School of Finance, Actuarial Stud-ies and Applied Statistics. Geoff is the course convenor of finm3005 (Corporate Valuation) and finm3008 (Applied Portfolio Constructions), and was also previously Director of Capital Markets Research at Russell Investments in Australia.

With his extensive experience researching in investment related areas including fund manage-ment, portfolio construction, asset pricing and valuation, Geoff has a remarkable repertoire of publications.

Professor Michael Martin is a Professor and Lecturer in the Research School of Finance, Actuarial Studies and Applied Statistics. As the course convenor of stat2008, Michael’s areas of expertise include Applied Statistics, Financial Mathematics and Statistical Theory.

He has over 30 publications covering the field of Statistics, published in not only Australian, but also International Journals.

Mr Jakub Kielbasa is an Associate Lecturer in the Research School of Economics. Cur-rently completing a PhD at the anu, Jakub is also a tutor in the field of economics.

Passionate for economics research, Jakub wrote a text loosely based on the course ‘Math-ematics for Economics’ which has been used and endorsed by both the University of West-ern Australia as well as the anu.

Ms Rachael Nicholson is Director of Dixon Advisory and Head of Sydney Financial Advisory. One of Dixon Advisory’s foremost experts in developing comprehensive finan-cial strategies, Rachael graduated from a Bachelor of Actuarial Studies and Commerce from the anu.

She is regularly called upon by The Financial Review newspaper to provide comment on superannuation strategies topics.

Ms Irene Zhen is a second year commerce/law student at the ANU. She is currently the Publications Director at afec anu. Hailing from Sydney, she moved to Canberra to pursue her dream of being a barrister (especially in criminal law).

In her spare time, she enjoys piano, sport and writing. She hopes to get a pet cat in the future (even though she’s allergic to cats).

Dr Jose A. Rodrigues Neto is a Senior Lecturer in the Research School of Economics. Completing his PhD in Economics from the University of Wisconsin (us), Jose is has strong research interests in the areas of game theory, law and economics, microeconomic and applied economic theory.

Having several working papers from the anu, Jose has also published several scholarly journal articles covering the fields of economics. Envision is proud to present “Modelling Animal Spirits” on page 15.

CONTENTSMilestones

A Question of BeliefsJakub Kielbasa

Big DataMichael Martin

Investing in VolatilityGeoff Warren

Modelling Animal SpiritsJose A. Rodrigues Neto

What does a Successful Career Progression Look Like?Rachael Nicholson interviewed by Daniel Law

The Way We Were ... and the Way We AreIrene Zhen

...5

...7

...9

...11

...15

...17

...18

Explore some of the defining moments of 2012

THE EURO DEBT CRISISJANUARY2012 Standard and Poor’s downgrades nine Eurozone countries credit ratings, as well as the European Union bailout fund’s, the European Financial Stability Facility. Fiscal pact agreed by eu in December and is signed by 25 members of the new rules, reinforcing rules of breaking budget deficits. The uk and the Czech Republic do not sign.

FEBRUARY2012 Greece coalition government unhappily agrees to pass the demands made by its inter-national lenders, leading to fresh wave of pro-tests. The austerity bill is passed in Parliament as reports of a shrinking Eurozone service sec-tor raises fear of a recession.

MARCH2012 Eurozone backs a second Greek bailout of €130b ($161b aud).

APRIL2012 Italy’s borrowing costs increase as investor concerns turn towards high debt. The coun-try cuts its growth forecast for the economy in 2012.

JUNE2012 Spain’s economy minister Luis de Guindos announces formal request for €100b in loans from Eurozone funds in attempt to shore up its banks, after a request from its fourth largest bank, Bankia, for a bailout of €19b. Pessimism sets in as its borrowing rise to the highest rate since launch of the euro in 1999. Gordon Brown, the former uk chancellor of the exchequer warns of a bailout of France and Italy might be required.

JULY2012 Greek Parliament votes in favour of a fresh round of drastic austery measures. A second bailout for Greece is agreed- a comprehensive €155b package designed to resolve the Greek crisis and prevent it from spreading to mem-bers of the European Union.

JUNE2012 One of the challenges the Australian econ-omy is currently facing is its long suffering retail sector. It has become abundantly clear over the years that reform must be imple-mented for the ponderous retail giants, or face extinction. David Jones reported close to a 40% cut in profit during the end of the financial year, and recently Myers was forced to close its Fremantle store.

The million dollar question for investors is how best to innovate operations to ac-count for the change in consumer buying patterns and to compete effectively with foreign interests. The Australian Retailers Association recently noted that 40-60% of goods purchased by Australian consumers are from oversea websites. However, only 5% of total retail sales according to NAB figures are purchased online. While this is up from 4.9% in 2011, there has been a clear slowdown in growth over the past

year. It is clear that the retail sector has the capacity to develop structurally and pursue a multi-channel approach to develop an on-line presence.

Retailers have also been lobbying to have the current GST threshold on internet pur-chases lowered from $1000 purchases for overseas online retailers in an attempt to ‘level the playing field’. Stakeholders claim that the government is losing out on $2.4b in tax revenue that could be potentially earned between 2012 and 2014.

However, this was refused on the grounds that the cost of collecting revenue exceeded income. As Deakin University lecturer Mi-chael Callaghen points out, making home grown retailers marginally more competi-tive it is not the revival that the industry needs. Consumers would hardly be deterred by a 10% rise when they are saving half on their purchases.

THE SLOW DETH OF RETAILERSJULY2012One of the most divisive pieces of govern-ment policy in recent Australian history was passed by 74 votes to 72 through the House of Representatives It should be mentioned that the ‘carbon tax’ is really an emission trading scheme with a temporary fixed price period which all systems of its nature should begin with.On the 1st of July 2012, 300 business were made to pay $23 dollar for every tonne of pollution they produced, rising 2.5% annu-ally plus inflation. This came with tax offsets and credits and compensation for low income earners. Many see the advent of this scheme as a posi-tive step - bringing global warming back to the forefront as one of the most important issues facing the generation.

CARBON TAX

€ €€

MILESTONES*AUGUST2012The so-called “resources boom” of Australia has been attributed to keeping the economic afloat for 21 years. However it shows definitive signs of slowing down, while others take a ‘half glass full’ approach. Glenn Stevens of the Reserve Bank Aus-tralia is one of them, stating that the boom is not quite over yet.The Treasury is cautious with its estimates, stating that higher prices could “encourage greater invest-ment in exploration activities”. However, mining is no longer able to sustain Australia’s economy, a fact which has served to underscore the need for Australia to rely on different mix of exports. This could be fortuitous for the nation as the Asian re-gion’s middle class become richer, and the demand for more Australian knowledge based exports in tourism, financial, business, professional services and education grows.For decades, the boom has fuelled the nations’ two speed economy and the rise of the Australian dol-lar, though this has proven less than a pleasant ex-perience for the retail and manufacturing sectors.

Iron ore has been Australia’s biggest export – 25% of Australia’s exports go to China, of which 60% is iron ore. However, the price of the steel making ingredient has fallen 20% in the past two months and could potentially lower forecasts of mining incomes and by extension, Commonwealth rev-enues.China currently has over two million unsold homes and estimated 30 million under construction, sig-naling a dramatic slowdown of imports. This has sent the mining industry into panic stations, most of which have dramatically slowed capital spend-ing, amidst concern from the investment side to-wards the corporations’ ability to pay off debt. There are still other factors to consider. India’s rate of urbanization is at a third, and in the past 15 years it has risen from the 10th biggest steel pro-ducer in the world to fourth – and consuming vast quantities of quality coking coal. However, this is no excuse planning ahead to start making most of opportunities beyond the boom.

END OF RESOURCES BOOM?

SEPTEMBER2012Amidst the riots, a new dimension has been added to the crisis to the banking and sover-eign debt crisis – a political crisis, ironically striking at the very core what the eu was de-signed to achieve. Spain sits at an unemploy-ment rate of 25%, just as Mariano Rajoy rolls out a new austerity budget which has cut jobs, salaries, pensions and benefits in an attempt to meet targets, sparking violent 6,000 strong protestors.Pressure is mounting for Spain to apply for European Central Bank assistance in order to keep borrowing costs down. Spanish riot po-lice fire rubber bullets and fend off protestors by the thousands with batons as crowds rally in Madrid near the parliament house, scream-ing “Shame!, a scene that echoed the rally in Athens where several hundred demonstrators turned violent – sending stocks to fall dra-matically. A headline in the New York Times details a story where a local government in northeast Spain has announced plans to put locks on garbage bins to stop people from searching for their next meal in them.

SPA

IN IN

STR

IFE

OCTOBER2012Australia’s economic growth has been reason-able of late at 3.7% over the year to the June quarter. However, preliminary forecasts show that growth might slow to around 2.5% over the year ahead. The issue being that mining boom is slowing down just as the other sectors of the economy are in a state of fiscal austerity. Mining investments appear to be peaking next year, as for the first time, June quarter survey of mining investments have not included up-grade plans. Mining profits continue to drop.

AUSTRALIA’S OUTLOOK

7 ENVISION

A QUESTION OF

BELIEFSare moths attracted by lights? Why are some animals active at night, but others during the day? Whenever I asked stron-gly religious people similar questions, the answer returned, over and over, was that “God made it that way”. This was a so-mewhat unsatisfying answer.

I considered myself a logical, rational person yet I was living an inconsistent life. This realization led me to question why I believed the things that I did (inc-luding science).

Over a period of a few years, I spoke with many people from many different back-grounds about these problems I conti-nued to face. What I learned about my-self was that the majority of my beliefs were based on sensing the environment and generating beliefs consistent with those observations (which is essentially learning), but a small proportion of my beliefs were based on axioms (which is essentially memorization). The incon-sistency arose because the observations

led to the generation of one belief, but that belief clashed with the (axiomatic) beliefs I had memorized as a child. When I figured this out, I was somewhat fear-ful, as the deeper questions I had, about the meaning of life, the existence of the universe, the existence of truth, had very different answers depending on the be-liefs I used. Observations cannot answer these questions unambiguously, and the memorized axioms gave an absolute an-swer, but on so many other levels, were in direct conflict with observations. To live a consistent life in my beliefs, I could either live in uncertainty but consistency with observations, or I could live a life of certainty about the larger questions, but ignore my senses.

Humans have a fear of death, and until recently, life was a struggle to survive and procreate, and so we have been instilled with an innate desire to live. To overcome this, we convince ourselves, perpetually through the generations, that we have control over our lives and there is no un-certainty. I am just another human, so after questioning my beliefs, I wanted to have that certainty. This was a required - and very human - step in my journey of self-awareness of my beliefs. However, after spending the last five years continu-ally observing the world and asking the simple question “why?”, I no longer fear uncertainty, I no longer view uncertainty as unwanted in my life, but rather as an enrichment to it. It is one of the most beautiful aspects of living in this world.

The journey I have taken, and continue with every morning, has led me to find answers to a handful of the big questions I mentioned before. At first, I was uneasy about some of the answers I found, but once accepted, they changed my percep-tion of the world. I cannot tell you what I have found, as the answer comes from, and is, the journey, but I can tell you that I no longer seek money, fame or power; I seek knowledge.

Jakub KielbasaAssociate LecturerResearch School of Economics, College of Business and Economics, ANU

A lmost every weekday in my pri-mary schooling, I would visit the local library before school

began, spending as much time as I co-uld reading books about our solar sys-tem, life on earth, and dinosaurs. I had many questions about what I read, but no one to ask.

Then on the weekends, I would attend church, and listen to the truth spoken by the man at the front. I also had many questions about my faith, most of which were answered to my satisfac-tion at the time. These two aspects of my life meshed in harmony for many years, without me feeling like there was an inconsistency. That was until I star-ted to become curious about evolution.

The more I read about evolution, the more it made sense, and the more I was convinced by the overwhelming evidence supporting it. I discussed the subject with religious friends, and the response I heard over and over again, was that evolution was false, meaning that all the evidence I had read about must have been fabricated. This was the first niggle as to a deeper inconsistency in my underlying beliefs. At the time, I did not realize that this was the begin-ning of the most wonderful journey I have ever experienced, and continue to experience every day.

The evidence for evolution was not only experimental evidence (which the layman or child cannot replicate), but it also consisted of logical arguments for why certain aspects of the natural world are the way they are. I could not ignore this evidence. The questions were simple observations, such as why are there differences in skin color amongst people across the globe? Why

8 ENVISION

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Finity Consulting is Australia’s largest independent actuarial consulting firm. We are specialists across the full spectrum of actuarial roles and we work closely with clients to find new ideas and innovative approaches to situations they’ve never been in before. When we put our minds together, there’s no problem we can’t solve. And the good news is we offer graduate and internship opportunities to actuarial students.

Our graduate programAs a graduate with Finity, you’ll get the chance to develop

your technical abilities and gain confidence working with

others, negotiating and dealing with clients.

Our team structure allows you to work across a diverse

range of clients and real life projects giving you lots of

variety early on in your career.

We have a one week induction program that includes

actuarial techniques, SAS and Excel training – followed

by an ongoing technical training program throughout

your first year. You’ll also be supported by our buddy

system that gives you the confidence to begin your

career with us on a positive note.

We encourage and support our graduates who aim

to formally qualify as actuaries with a generous study

support program and study groups led by our most

experienced actuaries.

You’ll join us on a competitive salary and be rewarded

for good performance through our bonus system.

Our intern program If you’re a penultimate year actuarial student deciding

where to do your internship, it’s hard to go past

Finity. In your 10-week paid placement, you’ll get a feel

for the firm’s culture, meet leaders and experts in the

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an actuary does day to day.

Check out our website for more details – finity.com.au

2014 Graduate IntakeAPPLICATIONS OPEN IN FEBRUARY 2013. Check out our website closer to the time for more information – finity.com.au

9 ENVISION

BIG DATAMichael Martin

Professor of StatisticsResearch School of Finance, Actuarial

Studies and Applied Statistics, ANU

Michael has visited the Big Pineapple, the Big

Merino and the Big Banana and agrees that

they are all, indeed, very big. Just like he likes his

data. Big.

H ere in Australia, we love big things. Take the Big Pineapple in Queensland, for example.

Then there is the Big Merino, just up the road in Goulburn, the Big Banana in Coffs Harbour, the Big Guitar in Tamworth, and dozens and dozens of others. So big are big things down un-der that Wikipedia maintains a list of “Australia’s big things” at http://en.wi-kipedia.org/wiki/Australia’s_big_thingsjust in case you missed some of them. Of course, we aren’t the only nation into big things. The United States has the “Big Apple”, not to mention a Grand Canyon, and it goes without saying that everything is bigger in Te-xas. China has the Great Wall, England has Big Ben, and the universe started with a Big Bang. The Wiggles have a Big Red Car, you can shop at Big W, party at the Big Day Out, and take voy-eurism to new levels with Big Brother. Big deal, you say? Size isn’t everything. Good things, they say, come in small packages. Indeed.

But what is the NBT (Next Big Thing)? As we traverse Global Financial Crises that are numbered like Rocky movies, maybe the time has come and gone for Big Business, and the Big end of town. Maybe it is time to move on, to em-brace that behemoth looking over your shoulder. Maybe it’s time to move into the age of Big Data. Of course, the age of big data is already upon us. Accor-ding to IBM, every day we create 2.5 quintillion (that’s a one followed by 18 zeros – admittedly only a tiny fraction of a googol) bytes of data. And by data, I don’t mean those data sets with 20 data points you might see in a first-year statistics class, I mean a rich stream of numbers, words, audio, video, almost any type of information you can think of. Amazingly, in just two years, we have managed to create over 90% of the data that exists in the world now. Two years! And it is accelerating. Every second, one hour of video data is uplo-aded to YouTube. If you head to http://onehourpersecond.com, you will be able to see just how mind-blowing this

10 ENVISION

fact is. For example, at the current rate, if you watched all the video uploaded to YouTube in the next couple of hours, you’d have time to have a baby – from conception to birth. Don’t try this at home, folks, as the effects on a fetus of constant exposure to YouTube are not yet known.

Yet, as John Naisbitt famously put it, “we are drowning in information, and starved for knowledge”. Having data is one thing (and, oh boy, do we have data!) but doing something useful with it is quite another. The data gathering is relentless. Think about a normal day in your life. You wake up and, bleary--eyed, check your e-mail on your mo-bile phone. Behind the scenes, data is recorded – the time you checked the e-mail is stamped on server logs, who (you claim) you are is preserved there too, the GPS in the phone sends infor-mation on where you are, your IP ad-dress, the e-mail addresses of those who sent you mail, the subject and contents of their messages, and the whole inci-dent is otherwise unremarkable, oc-cupying the first couple of minutes of your day. You stop for a coffee on the way to work, and pay for your coffee using your credit card. Once again, the data gatherers spring into action. Your name, your card number, what you bo-ught, how much it cost, are you over your credit limit – all recorded on some server, somewhere. The coffee really wakes you up, but you’ve already had two big wake up calls this morning – you are being watched, and records are being kept of what you are up to. Off to the supermarket, you fill your trol-ley with the foods you like. Of course, you flash your loyalty card when you go through the checkout – must get that petrol discount! And the data train rolls on: every item you bought leaves a footprint wearing your size shoes. You like chocolate, do you? They know. You read that magazine? They know. Buying toilet paper in bulk? Whatever for? They know. Behind the scenes, a

picture is being built of you. Yes, you. That e--mail-checking, coffee--drinking, chocolate-lo-ving, Kleenex® user – you. Apparently, you are what you eat, just like the say-ing goes. Somewhere, that data that you generated is being used to work out just what it is about you that might make more money for them. They know a lot about you. Sometimes they know more about you than you might be prepared to share with those you

love. Witness the following incredible tale widely reported in the US recen-tly (see this article from Forbes.com: http://www.forbes.com/sites/kashmir-hill/2012/02/16/how-target-figured-out-a-teen-girl-was-pregnant-before-her-father-did/) in which it is related how the retailer Target used statistical data-mining techniques to predict that

one of their customers was pregnant. Target’s statisticians discovered, from trawling through terabytes of data, abo-ut 25 products they sold that seemed to cluster together amongst purchases from pregnant women. This allowed Target to come up with a pregnancy predictor based on purchasing pat-terns, and then to, literally, target their advertising strategy accordingly so that potentially pregnant women would re-ceive information about potentially ap-pealing products at a potentially conve-nient time. Imagine how convenient this seemed to the father of a teenaged girl who noticed that the mail arriving at his house seemed preoccupied with selling his daughter baby clothes and cribs. History reveals that Target was, well, on target. The girl was indeed pre-gnant, but rather than stocking up on baby essentials (as Target intended), she

instead had some explaining to do to her father. But maybe it is Target who should do the explaining…

Of course, the Big Guys are way ahe-ad of you. The nice people at Google (whose corporate motto is “don’t be evil”) and the fast people at Facebook (corporate motto: “move fast and bre-ak things”) know the value of data. Big data = Big value. Ever wonder why you keep seeing web ads for things you just searched for? Google knows. Google works very hard to personalise what you see when you search – those sponsored ads are not magical, they just seem so. Underneath the magic sits an algorithm that draws on associations, patterns in the data Google holds about you, what you like to click on, and about the con-tents of the web, that predict what you want (need) to see, and when (now!). Facebook has ingeniously found a way to get vast numbers of people to give up vast amounts of information about themselves, for free. Human beings are social animals. We need each other, to have contact with other humans, to feel wanted, to feel needed, to feel loved. And giving up a bit of personal infor-mation is a small price to pay to receive even a small slice of Facebook love, ri-ght? I mean, everyone else does it. How can it be bad? As the old saying doesn’t go, you are who you meet (on Face-book, anyway). Leaving aside for the moment that nobody should care that you just ate a sandwich, posting that information may somehow self-valida-te you. It also gives Facebook a reason – just a small one – to send Subway ads your way. And if you keep your 5235 closest friends informed each time you down a foot-long sub, you can be pret-ty sure that you’ll see those Subways ads a lot. Because Facebook noticed. And Facebook cares. It really does. Because it cares for you to see those ads. And to buy. And to eat more sandwiches. And to buy. And to buy. And to buy. Like this? You’d better, because your choice not to like it disappeared long ago.

Of course, if you can’t beat ‘em, why not just join ‘em? It’s easy – learn sta-tistics! Statistics is all about finding the signal amongst the noise. All that data may seem like utter chaos, but inside it lies structure that richly – and in many cases accurately – describes, well, you. Finding the structure is the trick – and it is a statistical trick, not magic, that unlocks the secrets hidden in the data. You see, the world is experiencing a mi-ning boom – a data-mining boom! We have seen the future, and it is data. Big Data.

YET, AS JOHN NAISBITT FAMOUSLY PUT IT,

“WE ARE DROWNING IN INFORMATION,

AND STARVED FOR KNOWLEDGE”.

11 ENVISION

INVESTING IN VOLATILITY

Chart 1: Realized versus Implied Volatility

Dr Geoff WarrenSenior LecturerResearch School of Finance, Actuarial Studies and Applied StatisticsAustralian National University

I nvestors have a myriad of instru-ments in which they can use to meet their targets, one of which is to in-

vest directly in volatility through cer-tain derivatives. The aim of this note1 is to overview the payoffs on volatility exposure, and how they are viewed in the academic literature. It also discus-ses how different investors might ad-opt different approaches to volatility exposure. The discussion focuses on the following derivative products based around the S&P 500 Index:

VIX futures – These contracts are ba-sed around the VIX index, a measure of implied volatility for S&P 500 in-dex options of one month to expiry. The payoff on these contracts, if held to expiry, depends on the difference

between the futures contract price and the VIX at the expiry date.

Variance swaps – These are swap con-tracts between parties based around the level of realized variance over a forthco-ming period, for instance 1-month or 3-months. If the variance of daily S&P 500 returns over the period turns out greater than the agreed ‘strike rate’, the party going long receives a payoff from the party who shorted.

Forward variance swaps – These are swap contracts based around the price at which a variance swap may be pur-chased in the future. The payoff hence reflects changes in the variance swap rate.

Three key features of volatility pay-offs stand out. First, (long) exposure to volatility has traditionally provided an equity market hedge. This reflects that fact that volatility tends to incre-ase when the equity market declines.

Second, realized volatility has been less than the implied volatility priced into the market on average. This aligns with the so-called volatility or variance risk premium (VRP). Hence, long volati-lity exposure has been associated with negative payoffs on average, i.e. it has cost to hedge. Third, the magnitude of the VRP has varied significantly across products, being most clearly manifest in shorter-dated VIX futures and va-riance swaps. Chart 1 gives a sense for the VRP by plotting realized2 versus implied volati-lity as measured by the VIX. From Ja-nuary 1990 to March 2012, the average difference between realized and implied volatility was -4.3%. It was positive in just 16% of months, typically associa-ted with equity market sell-offs. Va-riance swaps give direct exposure to the VRP. Because variance swaps are priced and hedged by investment banks with reference to portfolios of S&P 500 in-dex options designed to replicate pay-

1 This note draws upon a recent paper by the author in the Journal of Portfolio Management (Warren, 2012).2 Realized volatility was estimated by annualizing trading day returns, consistent with typical terms for variance swaps.

12 ENVISION

Table 1: Payoffs on Selected Volatility Products

offs on realized variance, their prices are tethered to the options market and mirror the VIX.

Table 1 reports estimated payoffs from long positions in selected volatility products. The payoffs and percentage of positive periods for variance swaps broadly mimics the data in Chart 1, i.e. negative on average and across the large majority of periods. Negative payoffs of a much lower magnitude appear for for-ward variance swaps and 1-month and 2-month VIX futures which are rolled monthly. Largely insignificant payoffs are evident on rolled longer-dated VIX futures. Meanwhile, all contracts have a meaningfully negative correlation with the S&P 500 of between -0.5 and -0.8. Hence all volatility products examined provided an equity market hedge, but the ‘cost’ of that hedge varied signifi-cantly across products. Forward varian-ce swaps and long-dated VIX futures give the appearance of offering a very cheap, if not costless, hedge.

What has the academic literature made of these findings? Most attention has been paid to the VRP, the magnitude of which has been viewed as something of an anomaly. Authors have noted that the VRP appears larger than can be explained by standard risk factors such as market beta (i.e. CAPM), the three--factor and four-factor models, and after allowing for loadings on factors such as the term structure and default spread (see Bondarenko, 2007; Hafner and Wallmeier 2007; Carr and Wu, 2009). Explanations for the VRP mi-

ght be classified into two main camps. The first is that it relates to ‘mis-pricing’ in the index options market stemming from supply-demand pressures (Bol-len and Whaley, 2004; Gȃrleanu et al, 2009). Specifically out-of-the-money options, particularly puts, may be ‘over--priced’ because market-makers cannot accommodate investor demand. This in turn finds its way into pricing of va-riance swaps. The second camp argues that the VRP reflects compensation for non-normalities in returns, such as jumps or tail risks (e.g. Bollerslev and Todorov, 2011; Dreschler and Yaron, 2011). It seems fair to say that the re-ason for the large VRP remains an open issue.

The inconsistencies across volatility products has received less formal at-tention, although it does surface in the work of Egloff et al (2010), Brière et al (2010) and Warren (2012). These pa-pers highlight the potential gains from ‘spread strategies’ involving going short in either short-dated VIX futures or va-riance swaps, and long in longer-dated contracts or forward variance swaps. Such spread strategies appear to captu-re the bulk of the VRP while hedging out a large portion of the volatility risk, hence approaching an arbitrage trade. This is another anomaly that is yet to be investigated in depth.

How might investors respond to the opportunities in volatility derivatives? On one hand, short positions in varian-ce swaps or perhaps short-dated VIX futures provide scope to capture the

VRP and hence enhance returns across a majority of periods. However, such positions can generate large negative returns on occasion, typically during equity-market sell-offs. On the other hand, long positions in longer-dated VIX futures or forward variance swaps appear to offer an equity market hedge for what seems a relatively modest cost (providing history repeats). However, long strategies can detract from returns in a majority of periods. Alternatively, spread trades appear tantalizing as a means of capturing the VRP while li-miting the risk. To analyze the possibilities, the hypo-thetical impact was estimated of adding various volatility strategies to a baseline portfolio3 over the analysis period un-der differing objectives:

Total portfolio performance, evalu-ated by studying 3-monthly portfolio returns as represented by mean, stan-dard deviation and performance in the lower tail; and through estimating the utility associated with total port-folio outcomes over 12-month and 36-month holding periods.4

Benchmark-relative investing, with performance evaluated by examining mean active return, tracking error and the percentage of periods of underper-formance versus the baseline portfolio as the ‘benchmark’.

Liability-aware investing, evaluated by the impact on the funding ratio for a defined benefit pension fund with as-

3 The portfolio comprised 42% US equities, 18% international equities, 10% listed real estate and 30% f ixed income.4 Change in the utility associated with end-period wealth was estimated for a range of risk aversions under power utility.

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Table 2: Impact of Adding Volatility Exposure

sets invested in the baseline portfolio and liabilities which track the Citi Pen-sion Fund Index.

Table 2 presents a snap-shot of results for the more attractive long and short strategies plus a spread strategy - refer Warren (2012) for further details. All strategies reported improve the risk/return trade-off under a traditional me-an-variance perspective, as indicated by increased Sharpe ratios. Nevertheless, a closer look reveals that payoffs are hi-ghly non-normal. The major hedging gains to long volatility exposure and key losses to short strategies occur only in the lower tail of the distribution. Short strategies otherwise generate po-sitive payoffs across the large majority of periods. Further, if losses are essen-tially incurred over short periods while gains accumulate over the longer term, then investment horizon may matter. The utility-based analysis helps address these issues by placing a value on each point in the distribution. This analy-sis reveals the role of risk aversion and investment horizon. Return-seeking short strategies increase utility for inve-stors with low risk aversion and longer horizons; while long hedging strategies are beneficial to more risk-averse inve-stors who are worried about short-term losses.

Investors concerned with benchmark--relative performance have an entire-ly different perspective, which could lead them to find return-seeking short strategies as enticing. Whereas short strategies add to tracking error, high information ratios5 suggest they gene-rate attractive returns for this risk, whi-le delivering outperformance over the large majority of periods. On the other

hand, long volatility strategies also add to tracking error, but generate only mo-dest information ratios at best, and de-liver underperformance over a majority of periods (67%-plus). Thus investors focused on their benchmark-relative performance may see little benefit from long volatility exposure, even though it may hedge the overall portfolio and lead to outperformance during times of equity market weakness.

For liability-aware investors, volatili-ty exposure has a different impact yet again. Short volatility exposure has had a modestly positive correlation with the Citi Pension Liability Index. This indicates potential to capture the VRP coupled with a modest reduction pen-sion funding risk. Analysis reveals that a defined benefit pension fund with assets invested in the baseline portfolio and liabilities tracking the Citi Pension Liability Index could have enhanced their funding ratio by 0.33 over the pe-riod March 1996 to June 2010 through shorting 1-month variance swaps, albe-it at the cost of exacerbating any dete-rioration during equity bear markets.

In summary, volatility derivatives offer intriguing anomalies for researchers to investigate, and interesting opportuni-ties for more sophisticated investors. How investors might respond to the-se opportunities depends on their cir-cumstances. Considerations include their portfolio objectives, risk aversion, investment horizon, and the reference portfolio.

References:

Bollen, Nicholas P.B. and R.E. Whaley (2004). “Does Net Buying Pressure Af-

fect the Shape of Implied Volatility Func-tions?”, Journal of Finance, 59 (2), pp. 711-753.

Bondarenko, Oleg (2007). “Variance Trading and Market Price of Variance Risk”, Working paper, University of Illi-nois, December.

Brière, Marie, A. Burgues and O. Signori (2010). “Volatility Exposure for Strategic Asset Allocation”, Journal of Portfolio Management, 36, 3 (Summer), pp. 105-116.

Carr, Peter and L. Wu (2009). “Varian-ce Risk Premiums”, Review of Financial Studies, 22 (3), pp. 1311-1341.

Egloff, Daniel, M. Leippold and L. Wu (2010). “The Term Structure of Variance Swap Rates and Optimal Variance Swap Investments”, Journal of Financial and Quantitative Analysis, 45 (5), pp1279-1310.

Garleanu, Nicolae, L.H. Pedersen and A.M. Poteshman (2009). “Demand-Ba-sed Option Pricing”, Review of Financial Studies, 22 (10), pp. 4259-4299.

Hafner, Reinhold and M. Wallmeier (2007). “Volatility as an Asset Class: Eu-ropean Evidence”, European Journal of Finance, 13 (7), pp. 621-644.

Warren, Geoffrey J. (2012). “Can Inve-sting in Volatility Help Meet Your Portfo-lio Objectives”, Journal of Portfolio Ma-nagement, 38 (2) (Winter), pp. 82-98.

5 Information ratio = excess return / tracking error, both relative to the benchmark.

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15 ENVISION

MODELLINGANIMAL SPIRITS

Dr Jose A. Rodrigues-NetoSenior LecturerResearch School of Economics, College of Business and Economics, ANU

E conomics is a social science: as such, it tries to incorpora-te the causes and consequences

of human behaviour. The academic movement of behavioural economics attempts to make hypotheses about be-haviours that are psychologically well--founded and as realistic as possible. It departs from the classical economics tradition of modelling perfectly ratio-nal agents. Therefore, behavioural eco-nomists believe that we should develop new methods and models to learn what realistic human behaviour is. A part of the work surrounding behavioural eco-nomics is the examination of the rese-arch of psychologists and other social scientists. The area is also connected to decision theory, experimental econo-mics, neuroeconomics, and bounded rationality concerns.

The origins of behavioural economics date back to Simon and goes over the partnership work of Kahneman and Tversky, Vernon Smith, and others. These scientists documented a number of systematic biases in decision-ma-king that most people exhibit in their behaviour. Take, for instance, the case of confirmatory bias, where individuals ignore or misinterpret selectively new information in order to support a pre--established opinion or idea that they have. In other words, once a person has formed an opinion about a subject, then s/he will try to adjust the evidence so that reality fits into their view of the world, when the correct would be the opposite; that is, to adjust your views in light of new evidence. To do so, indi-viduals may choose to ignore contrary evidence or overvalue favourable infor-mation (supporting evidence). A typi-cal example would be religious matters. Another common example is given by

The Wall Street Bull

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agents with strong ideology in politics.Some economists believe that a radical change in classical economics is needed along the lines suggested by contem-poraneous behavioural economists, while others are very skeptical about the new approach. As usual, the truth lies somewhere in between these extre-me viewpoints. In some situations, it is very advantageous - from the modeler’s perspective - to use psychological bia-ses that humans exhibit in their deci-sion-making. After all, there are some well-tested biases that survived the test of time such as instantaneous gratifi-cation, procrastination, and so on. In other contexts, classical economics will suggest the use of simple, elegant mo-dels that provide the best insights abo-ut relevant phenomena. In many cases, rational agent models will capture the market equilibrium really well even if there are irrational agents on the mar-ket. It is argued that aggregate beha-viour is “as if ” all agents were perfectly rational. Another major advantage of classical economics lies in the simpli-city of its models: simple, elegant and robust models approved by the test of time.

The debate is very important because there is more at stake than just the aca-demic prestige of researchers and care-ers - at stake is our understanding and future directions of the field of econo-mics. Because economics is the central and most important social science, and the core discipline for business and po-licy studies, the methodology used by economists tend to become dominating in many other disciplines. The conse-quences of any change of paradigm in economics are enormous and spill over all of these numerous areas.

At the ANU course on behavioural economics, we try to provide a balan-ced position: one that avoids dogmati-sms and presents both sides - classical economics and behavioural economics. We show videos of current leading re-searchers in both sides of the debate,

ANOTHER MAJOR ADVANTAGE OF CLASSICAL

ECONOMICS LIES IN THE SIMPLICITY OF

ITS MODELS: SIMPLE, ELEGANT AND ROBUST MODELS APPROVED BY

THE TEST OF TIME.

and provide an unbiased history and a precise presentation of the theore-tic tools and models used by econo-mists, focusing on how economic agents make decisions.

References:

Amos Tversky; Daniel Kahneman (1986), “Rational Choice and the Framing of Decisions,” The Journal of Business, Vol. 59, No. 4, Part 2: The Behavioral Foundations of Economic Theory, pp. S251-S278.

Kahneman, D., and Tversky, A. (1979), “Prospect theory: An analysis of decision under risk,” Econometrica, Vol. 47, pp. 263-91.Ariel Rubinstein, Modeling Bounded Rationality, MIT Press.

Craig Hanson, Thinking about Addic-tion: Hyperbolic Discounting and Re-sponsible Agency, Editions Rodopi B. V., Amsterdam – New York, NY 2009.

Peter P. Wakker, Prospect Theory for Risk and Ambiguity, Cambridge.

Richard H. Thaler, The Winner’s Curse: Paradoxes and Anomalies of Economic Life, Princeton University Press.

Rubinstein, Ariel (2003), Economics and Psychology? The Case of Hyperbolic Di-scounting, International Economic Re-view 44, 1207-1216. Available at http://arielrubinstein.tau.ac.il/vitae.html

Rubinstein, Ariel (2006), Comments on Behavioral Economics, in Advan-ces in Economic Theory (2005 World Congress of the Econometric Society), Edited by R. Blundell, W.K. Newey and T. Persson, Cambridge Univer-sity Press, vol II, 246-254. Available at http://arielrubinstein.tau.ac.il/pa-pers/76.pdf

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WHAT DOES ASUCCESSFUL CAREER PROGRESSIONLOOK LIKE?

Rachael Nicholson tells EnvisionInterviewed by Daniel Law

One of the industry’s leading experts in creating comprehensive financial strategies, Rachael Ni-cholson’s has enjoyed a meteoric career rise thro-

ugh the ranks in one of Australia’s leading independent financial advisory firms. Her accolades include a Graduate Diploma of Financial Planning from Finsia and Certified Financial Planner (CFP). Rachael also has membership at Women in Business and Finance and Women in Super. Her name makes a regular appearance in The Financial Review on topical subjects relating to superannuation and wealth accumulation strategies.

Rachael also happens to be ANU alumni, whom like many before her, completed a double degree of Actuarial Studies and Commerce at the Australian National University. She took on the graduate role with Dixon Advisory in 2006 and it was not long before she was moving on to loftier heights “In 2007, I jumped at the chance to be part of a new team in the Sydney office. As a Financial Analyst, I worked alongside senior Financial Advisors to develop financial strategies for a diverse range of clients with a focus on personal finances, superannuation and portfolio management.”

Rachael never stopped looking for more opportunities to add to her arsenal of skills. Under a support and training regime courtesy of Dixon Advisory, she was promoted to the position of Financial Advisor in 2008. As the Sydney team of analysts and advisors grew, she took on the responsibility of managing and mentoring junior staff and looked at deve-loping system inefficiencies.

In 2012, Rachael was promoted to Associate Director and more recently, Director of the Financial Advisory team, while simultaneously completing her Graduate Diploma of Financial Planning and CFP designation.

Her financial advisor role involves substantial client inte-raction and advising her clients the best way to achieve their desired financial and lifestyle objectives. As a Director, she is also responsible for the training and development of new staff and finding innovative ways to improve the way her team dispenses advice to her clients. “I enjoy empowering and educating my clients…so they can meet their personal lifestyle, improve their financial situation. Bringing peace of mind to a client is a very rewarding experience.”

Climbing the corporate ladder was not without its mo-ments of stopping and taking stock of where she was going. The introduction of FOFA (Future of Financial Advice Re-forms) required her to step away from her familiar role of servicing clients to one solely focused on the development and management of the team. But Rachael is game to adapt, enthusing “I will be taking a new direction with my care-er… it will be challenging and will broaden my skills and expand my career opportunities.”

Her advice for ambitious students? “Take a risk! Do some-thing even if it’s not within your comfort zone – it’s those life decisions that tend to be the most rewarding, some pe-ople are reluctant to heed constructive criticism… but I am constantly assessing my own performance and taking advice from others who are more senior and experienced than I am.”

She cautions not to do activities just because it might look shiny on paper. “Rather, explore new sports, hobbies and activities you actually think you will enjoy. Learning about you, what you are good at and socializing with a variety of different people in the process will be of greatest benefit.”

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THE WAY WE WERE… & THE WAY WE ARE

Irene Zhen Publicatons DirectorAFEC Students’ Society, ANUBComm/LLB

Iwas casually surfing the net the other day (procrastinating as usual) when I came across an interesting

opinion piece. Titled ‘Why I Am Le-aving Goldman Sachs’, the piece gave a slice of the cruel reality within one of the top investment firms in the world.

‘Today is my last day at Goldman Sachs,’ Greg Smith, former director of Goldman Sachs, begins. This intrigues me. What is it like to be on the other end of the life chapter that most CBE students hope to be at the beginning of? Our dreams and aspirations (for most of us anyway) hinge on the chan-ce of scrubbing the shoes of CEOs and CFOs.

So what exactly drove a successful se-curities trader to quit his position at Goldman Sachs? Two words: organi-

sational culture. The vibe within Gold-man Sachs became ‘toxic’. Money was the heartless currency that was valued above anything else. Now here is where you would say that firms such as Gold-man Sachs are all about money. They are supposed to invest your pennies and turn them into big pots of gold for you to take home. However, it has become the reality that all it matters today is the bottom line at the end of year financials, as opposed to meeting clients’ needs.

Now organisational culture is, in simple terms, the way things are done within an organisation. It is the fact that you talk to your boss like old friends, the parties you have at the end of the year, the crazy chants you and your colleagu-es do for someone’s birthday. It can also be the fact that you are never to interact with others outside your team, the idea that you are never to finish before your shift and the fear of your superiors’ vo-ices. It is how things are done within a company. It is simply how things are.

Case studies have demonstrated again and again the significance of the impact that a good organisational culture can impact an organisation’s success. Con-sider Microsoft for example. Whilst money is not the driving factor of its organisational culture, competition has long been a defining aspect; whether it be externally with competitors, or in-ternally amongst its employees. Micro-soft had introduced an appraisal system where individual employees would be recognised for their achievements. This resulted in a work environment so com-petitive and so secretive that there was a sense of enmity amongst colleagues. Now within an industry that thrived on creativity, this was not Microsoft’s most glorious hour.

Contrast this with the likes of Pixar. A temple of innovation today, Pixar was struggling to make ends meet a decade ago. Steve Jobs then had the headquar-ters designed so all the restrooms were at the centre of the building. Everyone, from the top of the flock to the lowliest

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interns, had to use those restrooms and was encouraged to talk to colleagues that they would otherwise never en-counter. This resulted in an explosive amalgamation of ideas that largely ac-counts for the company’s success today.

Google has a different sort of organisa-tional culture. It encourages a relaxed atmosphere in the workplace; with ca-sual dress codes and sometimes roller hockey competitions within the com-plex itself. Health and well-being were emphasised with a gym and massage therapists available to the employees. Employees were encouraged to bring aspects of their personal interests and hobbies into the employee community. The result? A highly innovative, moti-vated workforce that strives for success as whole unit.

What do these two latter cases have in common? They always remember

that employees are human. Humans with emotions, quirks, interests, valu-es, wants and needs. An organisational culture which focuses on employees tearing each other down is not as heal-thy as one which encourages autonomy and social interactions. Better organi-sational cultures mean that employees’ needs and wants are provided for. In return, employees will be happier and more motivated working for the orga-nisation.

The importance of organisational cul-ture is not new in the industry. Even so, many organisations, such as Goldman Sachs, fail to create a good organisa-tional culture. There are a few reasons for this; one of them being that even leaders of world-class organisations are human. It is a very common for people at the top of large firms to lose per-spective of their employees’ needs and wants, and will then facilitate a cultu-

re that is too focused on results rather than the people. Others continue to rely on traditional methods of leading with force rather than by inspiration. It is often found that this is due to gene-ration gaps between the leaders and the newly recruited.

For whatever the reason, leaders must remember that organisational culture originates from individual employees’ behaviour. As W. Edwards Deming once said, ‘quality can be no better than the intent from the top’. Chan-ge in organisational culture is no easy feat, and only with good leadership can it happen. The first step in any change would be to acknowledge that there is room for improvement and a desire to see that change actioned. Is it too late for the leaders of Goldman Sachs to turn their stance around? Only time will tell.