Friday, May 28, 2010

The Economics of Vanilla Beans in Cambridge

Here is a real life example price variance and inefficiency in the market place:

Nicole found this Cherry Vanilla Bean Milkshake recipe in a recent issue of Eating Well.  It says that you can use vanilla extract, which we have, but she wanted to try it with an actual vanilla bean.

So, while I am doing the grocery shopping, I go to the spice aisle in our chain grocery store which carries a nationally known spice brand.  They will sell me two vanilla beans in a glass jar for $16.  I think that is an expensive milkshake, and I don't buy them.

The next week, we are in the neighborhood of our amazing locally owned spice store, Christina's (they also make great ice cream next door).  We go in to restock our regular spices, but also to see how much they charge for vanilla beans.  They offer us a single bean for $3 or five beans for $10 (wrapped in plastic bags).  We buy five.

So instead of paying $8/bean at a huge company that has notable economies of scale, we pay $2/bean at a tiny spice store with likely razor thin profit margins.  Perhaps the jar is made of crystal?

More likely, product specific economies of scale are at work.  Very few people who visit the big grocery store would buy vanilla beans at any price.  The store stocks a few anyway, but they have an expiration date (they have to throw some out sometimes) and the store buys them already packaged from the spice manufacturer.  The costs for that store to provide vanilla beans are fairly high.  Christina's, on the other hand, probably has people buying vanilla beans fairly often, provides spices to local restaurants, and uses vanilla in their own ice cream business.  They probably buy vanilla beans in bulk, and package them on-site for their retail customers.  They pass their lower costs onto us.

Now we just need to buy the cherries and ice cream.

Tuesday, May 25, 2010

Card Comparison

Check out this useful charge/credit/debit card comparison from Loans & Credit.  I don't think that Debit Cards are quite as good at the "No Temptation" feature as they claim.  Many banks allow you to overdraw on your account with a debit card purchase without any warning.  They are effectively extending you a line of credit "as a convenience."  Then they charge you lots of fees.  I hope this is getting fixed with the new consumer credit legislation.

Sunday, May 16, 2010

The Difference Between Correlation and Causation is Statistically Insignificant

Read this News in Brief from America's Finest News Source.

Clearly, the examples the The Onion gives are ridiculous.  There are plenty of times, though, where real people try to find meaningful connections between data that is simply random correlation. 

A cool example where the correlation is meaningful, though, is the orange market.  The companies that interact in the orange commodities market care a lot about the weather in Florida.  If there is a frost in Florida, oranges die, orange supplies go down, and the price of oranges go up.  These companies generally aren't satisfied with the detail and quality of the weather forecast provided by typical sources, so they hire their own meteorologists to hang out in Florida during the colder months to give private detailed reports.  They then make trades in the orange futures market based on the data they receive.  The result is that when there is a chance of frost during a few days or weeks, the orange futures market is a better predictor of actual frost than the National Weather Service.  If orange futures spike up in price during the afternoon, expect frost that night.

For another post on interpreting data better, read Points are for Sports, Pay Attention to Percentage in Finance.

Friday, May 14, 2010

Religion Driven Financial Innovation

The CBC reported this last week: Manitoba Credit Union 1st to Offer Islamic Mortgages.  Here is Assiniboine Credit Union's announcement.

I didn't know until recently that Islam forbade the payment of interest.  Perhaps I have a reader who can point us in the right direction for more information on that.

I don't fully understand how this system isn't effectively paying interest, with it just hidden as a profit payment.  The credit union gets the money it loans to the home owner from a market that is based on interest rates, so the set profit payment would need to reimburse them sufficiently.  It sounds like a fixed interest rate mortgage.  The product seems to have the endorsement of Winnipeg's Imam, though, so it presumably meets the religious requirements. 

What happens if the home owner defaults?  Typically, the bank would seize the house, sell it, take the money that is still owed to them, and the rest goes to the home owner. Can the owner sell the house before the contract period has ended?  Can the owner make accelerated payments to end the contract early?  These are questions that are easily explained and calculated with a typical mortgage and its amortization table (with an interest rate).

I also think it is interesting that this happened in Canada before the United States.

Wednesday, May 12, 2010

Who Cares About Liquidity?

This is the fourth and final entry in the Liquidity miniseries.  Read What is Liquidity?, What Determines Liquidity?, and How is Liquidity Measured? to catch up.

Everyone cares about liquidity.

Clearly, those who invest in the stock market care about liquidity.  If you place an order to buy a stock, you want to be able to get it for close to its current price.  Similarly, when you sell later, you don't want your sale to push the price down significantly.  Liquid stocks are more attractive for this reason.

Liquidity factors into everyday decisions too.  Consider this example I gave to my family last year (yes, my family has social conversations about this sort of thing; we are all nerds):
The bid-ask spread is one measure of liquidity.  For example, I would be willing pay you $1 for four quarters and you would probably be willing to sell them to me for the same price.  So, the bid-ask spread of four quarters is zero, and US currency is very liquid among its denominations.  This also implies that you and I consider quarters and dollar bills to be equal, which we might not in the real world.  Dollar bills suddenly become less liquid when you are trying to buy a candy bar from a vending machine that requires exact change.  In that case, I might pay you a dollar for three quarters just to get the change.  I am paying for liquidity, in that case.
This is an example of how currency isn't always fungible, which is a prerequisite for liquidity.  Two dollar bills are fungible with each other, but dollars and quarters aren't always.  The same is true for your electronic money in your checking account and cash from your checking account.  There are times when you would gladly pay a $3 fee to turn that electronic money into cash at an ATM.

The average person rarely notices liquidity when dealing with liquid goods, which most goods are.  People's decisions in aggregate make changes in the market, but these are hard to perceive at ground level.  One of your best opportunities to experience illiquidity is to do something like bid on a house, sell a used car at an auction, engage in salary negotiations at a new job, or buy a thinly traded stock.

Monday, May 10, 2010

Thursday Went Out Swinging

In case your media source is so preoccupied with the Oil Spill that you didn't hear, Thursday, May 6 was a historic day in the stock market.  The Dow recorded its biggest intraday drop ever. At one point, the Dow was down 9.2% from Wednesday's close.  The Nasdaq was down 9.0%.  The S&P 500, 400, and 600 were down 8.6%, 8.3%, and 7.6%, respectively.  All of these indexes recovered quite a bit during the day, still ending down for the day, but significantly higher than their lows.  Look at this Google chart for a visual representation:

We're still trying to figure out exactly what happened.  The market was depressed all week by concerns about Greece and the Euro, so it wasn't surprising the market was heading down on Thursday.  Something happened around 2:30pm, though.  There was speculation that a trader accidentally entered a trade for a billion instead of the intended million; this has not been confirmed.  It could be that the initial problem was related to Proctor & Gamble or 3M, who together made up a huge chunk of the Dow's drop.

Whatever started the drop, the continuation was likely caused by quantitative, computer executed portfolios.  Some asset managers run portfolios by creating models that are then executed automatically by a computer.  They might have rules in place that say something like "if P&G goes down more than 3% in 10 minutes, then sell a third of our holdings."  This sort of trade would push the price of P&G even lower.

Clearly, other asset managers, either manually or via other quantitative models (probably both), jumped on the sudden drop and started buying.  This brought the market back up close to its earlier levels.  Also, some of the trades that happened during this 20 minute window are being canceled.

The markets continued to suffer on Friday, and the volatility of the S&P 500 hit its highest in over a year.  At the time of this posting on Monday, May 10, though, the markets are up between 3.8% and 4.5%, and volatility is down over 34%.

Saturday, May 8, 2010

How is Liquidity Measured?

This is the third part of my miniseries on liquidity.  Start with What is Liquidity? and What Determines Liquidity?.

As I discussed in those posts, how much the price of a good moves when people buy and sell it is one way to measure the liquidity of that good in the market.  This can be observed in a formal art auction easily, but can also be observed in other markets, like the example of gasoline.

The stock market has liquidity measures that are easy to observe.  The stock market is an ongoing auction with many buyers and many sellers.  Each stock is very fungible (one share of Apple's stock is the same as another), so that prerequisite for liquidity is achieved.  Some companies have more shares of stock in the market available for trade, which increases the potential liquidity.  This is why you might hear people talk about how one company's stock is more liquid than another.  For example, consider Dell (with 1.96 billion shares) and Super Micro Computer (with 35.9 million shares).  Dell's stock is potentially more liquid than Super Micro Computer's stock.  Note: this is different than a business' internal liquidity, which is related to how much cash they have on hand, a topic for a different post.

If you wanted to put the effort in, you could watch each trade for a stock as they happened and measure how much the price changed.  There is an easier way for many stocks:

Look at this detailed quote of Google on Yahoo Finance.  Check out the numbers for the Bid and the Ask.  The Bid is the highest latest price someone has offered to buy the stock, and the Ask is the lowest latest price someone has offered to sell the stock.  The difference between these two numbers is a measure of liquidity.  The closer these two numbers are, the more liquid the stock.  You can imagine, that if these two numbers were always the same, people would buy and sell the stock freely and the price would never change.  That is the definition of perfect liquidity.

What actually happens, though, is a buyer decides that the seller's Ask is good enough (or vice versa), and a trade is made.  The latest price for the stock is set to that trade's price, and the next lowest seller's offer becomes the new Ask.  The farther apart the Bid and Ask are, two things happen: it is less likely for someone to decide that an offer is good enough to make a trade, and when that trade does happen the price moves more.  In other words, lower liquidity.

Wednesday, May 5, 2010

What Determines Liquidity?

This is the second part of my miniseries on liquidity.  If you haven't already read What is Liquidity?, then do it now.

So what makes one product very liquid and another illiquid?  There are a number of factors that contribute to the overall liquidity of a thing:
  1. Higher fungibility generally leads to higher liquidity.  A perfectly fungible good is identical to and interchangeable with other such goods.  Barrels of oil, $100 dollar bills, and gallons of tap water are usually very fungible.
  2. Higher volume of trade of a good leads to higher liquidity.  The gasoline example in my last post speaks to this.  There are rarely large price jumps in the gasoline market.  Longer periods of time between trades often leads to larger price jumps when those trades happen.
  3. In order to have the potential for high trading volume, you need high availability of the good.  There are lots of $100 bills and barrels of oil to be traded.  There are very few Picasso paintings.