Friday, July 14, 2006

Why call it a maket, anyway?

Who realized there was such a gap between the Washington Post and the Wall Street Journal? The subtitle of the lead business article on the Washington Post's website says that "Up to a Third of Oil's Stunning Ascent Traces to Psychology". The article itself is a marvelous jumble of misunderstood economic half-truths, leading to the general impression that markets are not driven by market forces.

In the article, the reporter quotes a Deutsche Bank economist saying "Supply and demand are not the only things people look at" when they are trading oil futures. What can this possibly mean? Financial exchanges exist to balance supply and demand -- "supply and demand" may not be "what people look at", but they certainly determine price.

The context of the economist's quote was probably that present supply and consumer demand are not the only things people look at. Since an object will trade for the maximum of a current price and the discounted expected mean future prices

D = Max(D1, D2*C2, D3*C3, D4*C4, ...) = S


D = Demand (Bid price)
S = Supply (Ask price)
D1 = current consumer demand
D2 = Next period mean expected price = (D2a * likelihood + D2b * likelihood + ....)
C2 = cost to carry multiplier for period 1
D3 = Second period mean expected price (D3a * likelihood + D3b * likelihood + ....)
C3 = cost to carry multiplier for period 2
...

Of course, anticipated future supply and anticipated future demand affect current price, because present supplies can be set aside to satisfy future demands, so the price will go to the maximum in the discounted stream. The misquoted economist even hints about an algorithm for calculating the affect of potential political, meteorological, and geological shocks on present prices, and attributes about a third of the price of oil to the risk of those events (which the journalist encapsulates as "political and psychological"). But the journalistic personification of the market as "anxious" leads people to ascribe psychological states to purely economic phenomena. Definitially, an anxious person is almost never rational, and misdescribing markets leads people to think markets are irrational.

So, if the journalist had listened to the economist, the subtitle would probably have read "Up to a Third of Oil's Ascent Traces to Carefully Modelled Mathematical Economics and Probability Theory". Recent highs in petroleum inventories bolster a practical rather than psychological interpretation of the current price of oil -- they are holding on to it because they expect to sell it for a higher price in the future.

The chosen subtitle of the article was particularly unfortunate because traders sometimes talk about a psychological compoment in markets, to explain the difference between the theoretical value generated by their model and the price found by supply and demand in a marketplace (this difference is sometimes also called "noise"). Usually, what appears to be a "psychological component" is just a difference in models between different players, each of whom thinks they are economic and rational, while the market is deemed "psychological".

As it is used in the article, "psychological" is about as meaningful as -- and rather more dangerous than -- a term like "Polkadots". When journalists describe the premium in the market as "psychological" rather than "mathematical" or "economic", they lead uninformed readers to think that gas prices would fall, if the traders could just calm down and stop worrying about things that haven't happened yet. But one of the great things about being a human being is that we can plan for the future, and one of the great things about markets is that they do a pretty good job at attaching a number to the mean value of that expected future.

2 Comments:

Anonymous Anonymous said...

knowing that with borrow nothing is not intended, i've spent hours working my puny intellect to decode the intended meaning or reference behind the word 'maket' in the title to this otherwise relatively straightforward post. if only i were a little smarter, i might be able to enjoy borrow's posts at their deepest and most obscure levels. alas.

9:06 AM  
Anonymous Anonymous said...

It looks like he's criticizing a sloppy headline in the Washington Post, with a blog entry that also has a sloppy headline. Quelle Double Standard! Ahena.

11:53 AM  

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