Wednesday, May 12, 2010

Futuristic Assumptions and Finance

First of all welcome back all my readers and followers. Sorry for being in hibernation for so long, at least a year. To start with I would come up with a very different set of approaches to how financiers forecast the assumptions.
See if you can answer these questions:
  1. In 1950, a computer cost $1mn. In 1990, it came down to 5000$. Now its just a pack of some hundreds of dollars. Can you forecast the cost 50 years down the line?

  2. With growing concentration of Democratic alliances globally, can you predict the total concentration of countries 50 years down the line who would shift to the democracy setup?

Using extrapolation and deriving the values using the past data forming a trend analysis function may help the least. The reason may be explained though an example:

Consider yourself in 100 AD and if you are said to forecast the development and sustainance of Roman Civilization, using past data every person may have opted for a rapid spread of roman culture. But taking into consideration the present scenario it is now just a part of 3 small nations.

It appears easy for most people to use extrapolation, as people default to physics when predicting social trends. Its a common understanding that momentum will remain static unless acted upon by an external force. Like when a person threw a rock on another person in his compartment, second person ducked. He ducked because his mind had inherited and learned the consequences of the law of Conservation of Momentum. The rock would not veer off course because there was nothing between the two persons to act upon it, nor a rock has mind to do it.

Its always been said that gold is a good inflation hedge. So as to find the impact of inflation and its correct development the money supply present helps considerably. With more money supply more will be the purchasing power in hands of people leading to high lift fir inflation. As Gold is considered to be a stable currency and a good inflation hedge people often resort to Gold in times of Inflation of Stagflation.

Values of M1

Values of Gold

The figure above shows that the money supply tripled while the value of gold steadily decreased. In other words, gold failed to keep the promise of being an inflation hedge as its value or demand may have decreased or in other matter, inflation and gold acted to work in opposite direction. Hence we can see the physics paradigm in science is not that applicable in finance.
Let us see the various factors:
  1. Momentum- it determines the basic rule of movement.
  2. Correlation- sometimes helps in development of the trends

There are many more which will be covered in detail afterwards.