Protension: the online journal of Tom Elgin

I think we’re all familiar with the adage that “Biology is really chemistry, chemistry is really physics, physics is really math (and math is really hard).” That is, to work on biology you have to spend a lot of time understanding the chemistry involved.

After taking some finance courses from accounting through derivatives pricing it seems like the same thing holds in finance. Mathematical models of finance are all well and good (actually, most have crippling limitations that a lot of people choose to ignore), but when it comes to practicing finance, what you really need to understand are transaction costs, taxes, and regulation.

As a concrete example, check out this part of an April speech by the current Director at our SEC who regulates mutual funds, including money market funds. Money market funds try to keep their price (like a stock price) at a constant $1.00 per share. When the fund earns money, investors either get a cash payout or more shares and the value of each share stays the same. They try really hard never to lose money. However, the fund’s price obviously fluctuates a little as the bonds and other investments they hold change. They’re not required to tell you this until the change is greater than 0.5% (i.e. the value becomes closer to $1.01 or $.99 than to $1.00).

Andrew J. Donohue, Director, Division of Investment Management, U.S. Securities and Exchange Commission (April 2, 2009):

[T]his lack of sensitivity to volatility affords investors, particularly large investors, the opportunity to take advantage of the fund and its other shareholders. An example might be helpful here. Assume a money market fund has a loss on investments of 0.40% so that its NAV is now $0.9960, which is $1.00 and within the one-half percent deviation permitted under current rules. If investors who own 25% of the fund redeem at $1.00, the NAV is now $0.9947 or $0.99 per share. Sophisticated investors know this dynamic and will redeem their shares in the fund quickly, leaving the loss for the remaining shareholders. What had been a loss of 40 cents on $100.00 for remaining shareholders is now $1.00 on $100.00 because they did not abandon the fund quickly enough. I question whether this is appropriate and whether it increases the possibility and probability of a run on a money fund.

… As with the previous example, an investor purchasing at $1.00 when the NAV was $0.996 had no way to know that he (she) was at risk of losing 1% in one day merely because of redemptions by others or other minor valuation moves.

I think it’s funny that the proposed solution to this problem is to change the target value of money market funds to $10.00 instead of $1.00. This would probably be “good enough” because if someone abusing the system could only make 0.05% (vs 0.5% currently), it usually wouldn’t be profitable after considering transaction costs. But really, are these people using computers so old that they can’t just add more decimal places to $1.00? My guess is there’s some rule that says something like “only price changes of more than 1/2 cent must be reported to investors,” and this amount happens to be 0.5% of $1 (deemed “too insensitive”) and 0.05% of $10 (deemed “acceptable”).

Regulation is goofy.

This entry was posted on Tuesday, May 5th, 2009 at 12:58 PM and is filed under Thoughts, Work. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.