scholes

How to Compress Time in the World of Finance

There’s a new Greek letter in the world of finance, one so powerful it can even compress time.

Called “omega,” it refers to reducing market resistance through liquidity provision and risk transfer, said Nobel laureate Myron Scholes, MBA ’64, PhD ’70, chairman of Platinum Grove Asset Management, an alternative investment fund that specializes in providing liquidity to global wholesale capital markets.

Scholes, who is also Frank E. Buck Professor of Finance Emeritus at Stanford University, spoke at the Charles M. Harper Center on April 27 as part of the Distinguished Speakers Series, sponsored by the Graduate Business Council, the George J. Stigler Center for the Study of the Economy and the State, and the Initiative on Global Financial Markets, which is funded by the CME Trust.

The more resistant a market, the less liquid it is. “To hold less liquid assets, one garners a higher rate of return,” Scholes said. For example, real estate is low on liquidity and so has a long-term high rate of return. If you want to sell your house immediately, you could do so on E-bay, he points out, but you would expect much lower returns than normal.

Omega generators include private equity firms, real estate, and hedge funds, he said.

What omega does is “move liquidity forward in time,” Scholes said. He said he took the name from the symbol for Ohm’s law. An ohm is a unit of electrical resistance.

One way omega providers make money is by providing liquidity, particularly if the transaction involves a long horizon. However, the price of liquidity does not remain constant, Scholes said. The more resistant the market, the less liquidity there is, and the higher the price of liquidity. Market shocks also affect liquidity. Omega reacts to changes in liquidity price, he said.

Risk transfer is another part of omega, Scholes said. Such markets as commodities, reinsurance, and securities are examples where risk transfer is used.

Companies generally carry two types of risk: idiosyncratic risk, which pertains to the specific business of the company—for example, a miller grinding flour and selling it; and general risk, which is related to the general economy—for example, the changing price of wheat, Scholes said.

“You cannot transfer idiosyncratic risk in the marketplace,” he said, “because if you transfer, or diversify everything and get rid of it, you won’t be able to make money.”

But it’s less expensive to transfer generalized risk, such as that associated with changing interest rates or commodity prices. Businesses are willing to pay intermediaries to accept these risks.

“If you hedge generalized risk, you need less equity capital” than you would if you retained that risk, Scholes said. “So there’s a trade-off between the cost of equity capital and the cost of hedging.”

“Omega providers expect to earn money because hedgers are willing to pay speculators to carry risk forward in the marketplace,” Scholes said. Omega can be considered “the price of intermediating over time.”

For example, normally, by making flour the miller dissipates his inventory of wheat over time, but customer demand for bread and cakes made from the flour may come some distance in time away from when the flour is made. People in the omega business are able to “compress time” or bridge the time gap between supply and demand.

“When the farmer sells the wheat (directly) to us, the consumers, and we go to the miller to mill it, I know exactly how much wheat I need for my bread and cake,” Scholes said.

By compressing time, omega providers make markets more efficient, Scholes said.

Scholes also discussed omega opportunities in the pension plan business, brought on by new regulations enacted in Europe that change accounting practices. The same regulations are expected to arise in the United States as well.

First-year student Nilay Shah, external relations chair for the Graduate Business Council, called Scholes’ discussion of omega “eye-opening” and “a new way of looking at how risk is handled in today’s market.”

“Just understanding the importance of omega and the role that liquidity providers can play in the financial markets, how important they are in terms of handling the risks but also generating return, is huge,” Shah said.

 –By Mary Sue Penn