It's been awhile...

So, it turns out I've been pretty bad at posting over the last few months. I've had things to keep me busy: one of my actuarial exams, work, RL moving, vacation, getting engaged, etc., so it's not like I'm short on excuses. Nevertheless, I think I should try to post and keep updating this thing periodically.

It seems like interest has waned in the market. I'm not entirely surprised, as most of the markets are rocked by scandal after scandal. New money coming in is kind of rare, as it seems that those who are involved with the markets currently are the only ones who would like to be involved. The lack of liquidity also frightens new investors, as the market value of securities is significantly more than the liquidation value (that is, if you sold all your shares as fast as you could) for almost every security, and even for modest amounts of shares.

For example, take SLR, the company I'm CFO for. (This is in no way a critique of my shareholders, but if I'm going to pick on a company, I might as well hit home.) Suppose I owned 10,000 shares of SLR right now. The market price shown on CapEx is L$6,500. However, if I actually tried to sell all 10,000 shares, I would receive (after commission) L$5,153.02, which is 79.3% of the displayed price. Make it 50,000 shares and I would only receive 12.9% of my displayed market value!!! And we're not talking vast sums of money here - 50,000 SLR shares at market is worth about $120 USD. Enough to care, but not enough to break most of us financially.

You can play this game with almost any stock on any market. There are exceptions, where management has taken care to set aside cash reserves to prevent this from happening, but by and large putting money into the market means you will need to take your time getting money out of the market.

I've heard the idea of market makers being tossed around before. For those of you who don't know, a market maker is a person/firm that makes money off the bid-ask spread in the market. They provide liquidity. However, from my previous actuarial exam (which I passed, by the way!), Modeling Financial Economics, market makers need options in order to protect themselves. There are techniques whereby market makers can insure themselves against large price changes, or even set themselves up to make money if the market doesn't move. However, these require options, which no exchange in SL has been willing to set up yet.

If any exchange in SL is seriously interested in setting up options and market making and similar techniques, please contact me. While I'm sure I'm not the only person in SL who understands how to make it work, I'm likely one of the few, and I would love to help.

I suppose the question is this: How do we revitalize the markets now? I think liquidity is the major issue, but I would like to hear what others think as well.

Options: Lesson 2

Guardian's Note: This is a continuation (though much overdue) of a previous post which I wrote awhile ago. Reading that post will likely be necessary for a good understanding of this one.

Now that you have a good intuitive understanding of what a call and put option on a stock are, and how to use them, let's think about how to price them.

When building a model for options pricing, there tend to be a set of convenient assumptions made to simplify the process. First, there are no transaction costs or taxes. Secondly, you can buy or sell as much of any stock/option without altering the price. Thirdly, volatility (we'll get to that later) will be known and constant. I think that's all I'll need for this lesson.

Certainly, the value of the option is determined by the value of the stock at some given point in time. If the option is European, then the only relevant value is the price at the end of the time period.

Suppose we have a stock at price S₀ currently, and there is a European call option expiring at time 1 with strike price K = S₀. Now, in this particular oversimplified world, the stock can only take on two values at time 1: S_u and S_d, standing for an "up" movement and a "down" movement. Since the option is at strike K = S₀, the option will pay (S_{u -} S₀₎ at S_u and zero at S_d. We'll denote these values by C_u and C_d respectively (representing the value of the call at an up movement and the value of the call at a down movement).

The price of the option can then be calculated as

C_u * P(up movement) * v

Where v is the present value factor to discount the payoff with interest back to time zero. We'll need an interest rate to do that, which we'll call r. We'll also need P(up movement) (the probability of an up movement) to calculate the price.

Through some mathemagic which I think I'll gloss over for now (but if you all want to see it, I'll happily spell it out), a probability which correctly calculates the price can be found using this formula:

P(up movement) = (e^(r-d)*h-d)/(u-d)

Where r is the continuously compounded rate of return, d is the continuously compounded rate of dividend payments, h is the time period (in years), d is the multiplicative factor by which S can decrease over h, and u is the multiplicative factor by which S can increase over h.

There are also formulas for u and d, but if you need those I suggest reading this.

With all of that in place, there is now a formula for pricing a call option where the stock has only two movements, up or down. This model can be expanded to include more periods, use discrete dividends (say the stock pays $10 at time 0.75), handle American options, and do a variety of other nice tricks. However, the more important fact is that this is the backbone of the famed Black and Scholes model, which I will discuss in Lesson 3.


I hope you can see how this all gets very hairy mathematically very quickly. Some of the background I jumped over is done not by mathematical proof, but by economic logic, which may not sit well with some mathematicians. I have also tried to simplify a lot of this to be read by the general audience, whereas for the last four months I've been studying the specifics of this, and more complex models, extensively. If any of you readers are curious about this topic on a deeper level, feel free to post here, IM me in world, or email me at guardian.market@gmail.com. I can't guarantee I'll know the answer (it's a big world out there with options!) but I'll try to at least point you in the right direction.

Land Prices

Linden Labs announced recently that it would be dropping prices of land sales significantly. New islands, for example, will only cost USD$1,000, down from USD$1,675 as last I recall.

Talk about a way to piss off your most loyal supporters! Everyone currently holding land just took a major hit to their resale value, and my understanding was that land prices had been dropping anyway. While this will certainly encourage new growth, I think there will be a painful period of losses for existing (especially startup) businesses as well. As the new land is sold, those owners can price their rents lower and simply outbid the current ones still paying off their $1,675.

Linden Labs is obviously placing a bet on the elasticity of demand for land. Elasticity, for the uninitiated, is how much the quantity demanded of a good changes with respect to a price change. Some goods, like (some) electronics, are very elastic - small drops in price will produce large sales and vice versa. Other goods, like salt, aren't elastic at all ("inelastic") - you can double the price of salt, and people will still buy about as much as they did before. A few very rare goods, like gasoline, are inelastic in the short run and elastic in the long run...but I'm getting off-topic...

If the demand for new land is elastic, LL will see a large jump in sales for their drop in price. My guess is they're hoping this outweights (a) the amount of anger they're generating, and (b) the amount of extremists who go researching into OpenSim projects.

Let's see how the bet pays off.

Options: Lesson 1

One of my favorite topics in finance is that of options. I've mentioned options in a few previous posts, and I would like to dedicate a few posts to the mechanics of options and option pricing. Coincidentally, this is also the same material that I'm studying for my next RL actuarial exam, exam MFE (Modeling: Financial Economics).

Options are power. There are no markets in Second Life that trade options. Some are afraid investors will use them without understanding them. Others are swamped fixing other bugs so that the thought of including derivatives is nearly impossible at present. Regardless, options exist in real life, and they're useful in real life. Whether they ever exist in SL, these lessons will teach you about what options are, how they operate, and how to price them (at least basically). I'll be using some mathematics for this, and the lessons will build on each other.

For our purposes, we will concentrate on options on an underlying stock. However, you should know that options also exist on futures, currencies, indexes, and even other options. Each of these brings a new caveat to the stage, but for my sanity I'm going to stick to cash and stocks.

There are two broad types of options. I'm going to go over them very slowly:

A call option gives the owner the right, but not the obligation, to buy an underlying stock at a specified strike price (K) by time T.

A put option gives the owner the right, but not the obligation, to sell an underlying stock at a specified strike price (K) by time T.

Read those two sentences again. And again. One more time.

Also know that I'm describing American options in the definitions above. If they were European options, they would have ended with "at time T" instead of "by time T." Some of the pricing models will only value European options, but I'll make sure to warn you ahead of time.

If the price of the underlying stock is denoted as S, then the payoff of the call option is

Call Payoff = Max{0,S-K}

This is because if the stock price (S) is below the strike price (K), then you simply choose not to exercise the option (why buy the stock at K when it's selling at S?). If S > K, though, you can buy at K and then sell at S, netting S-K for yourself. Similarly, the payoff for a put option is

Put Payoff = Max{0,K-S}

If the stock price (S) is below the strike price (K), then you can buy the stock at S and sell it at K, netting you K-S. If S > K, then you would prefer to sell at S, and so it is not advantageous to exercise your put option (and thus the value is zero).

Wikipedia has some nice graphs of a call payoff and put payoff, which I encourage you to look at.

That's it for lesson 1. Subsequent lessons will get into the pricing, and then the all-important parity equation and how that functions. More math coming, I promise!

Please, if you have questions, ASK! This material can be very confusing, even for advanced traders. I'm probably going to speed up, not slow down, in the next lesson, so get questions out of the way now. If you're too shy to post them here (even anonymously), then email me at guardian.market@gmail.com.

Lessons in FM: Part VII - Futures

In one of my previous posts, I mentioned something about the mathematics of futures contracts and asked if anyone would like for me to expound upon the reference I made, and my co-author Samantha Goldflake (as well as other readers) called me out on it, so here goes.


First, I'd like to introduce what a financial derivative is, and from that what a futures contract is and how to value it. A financial derivative has nothing to do with the slope of a tangent line, but rather is an asset which derives its value from some underlying asset. Examples of this include mutual funds, put and call options, interest rate swaps, and futures. These assets all have no value whatsoever on their own, but only derive their value from what some other asset is doing. Many of the stocks in SL are actually financial derivatives.


As a personal note, I love financial derivatives. Financial derivatives are power. I've been asked, and have provided, guides and advice as to how to implement financial derivatives in Second Life to various exchange bigwigs, but so far nothing has come above of it. If any of you are considering doing something with derivatives, please send me an IM - I'd love to be involved.


To me, the most viable financial derivative for Second Life would be a futures contract. A futures contract specifies that an investor will either buy or deliver a set amount of an underlying asset at a set price at a set time. There is no option as to whether or not this sale/purchase will take place - it is set by the contract.


A lot of the numbers you hear tossed about in First Life financial commodities are actually futures numbers. The price of oil, for example, is almost always quoted as a futures price. The same is true with gold, silver, and other precious metals.


So how could you use this in Second Life? Simple - futures on the LindeX. Set up a price and a date, and then you've got a futures contract with USD for L$. Measures would have to be taken to prevent simply bailing out on the contract, but having investors place and x% deposit for taking the contract would probably suffice, depending on what x is.


Regardless, we may wish to know how to price these funky things called futures. It's actually surprisingly simple, and most of the mathematics I've already covered in my first Lessons in FM: Part I - Present Value. Technically, futures contracts with strike prices (the price specified in the contract) equal to the expected cost have zero premium, although in real trading there is always some transaction cost to doing this.

I slipped in the word "expected" to the definition above for a reason. Suppose we're doing a futures contract on a five-year zero-coupon bond yielding 10% per year, costing 1000 now and with an expiration date of 6 months from now. If the strike price is 1000, that contract will actually trade at a premium because 6 months from now the bond is worth more than 1000. We would expect it to be worth

1000*(1.10)^1/2 = 1048.81

So the contract actually has a value of 48.81. For the contract to have zero premium, it must have a strike at the expected price of 1048.81, and then it will have zero premium.

To value these contracts then, you have to figure out your payoff and then discount it back to the present value. That's where my previous post comes into play - present value. The payoff on a forward contract is simply:

Payoff = Price - Strike
With the profit equal to

Profit = Price - Strike - Premium
Therefore, to calculate the value for a futures contract expiring at time t, just calculate

Present Value of E(Profit) = [E(Price) - Strike - Premium] * (1 + i)^-t

Where i is the interest rate being used. i varies depending on what you're valuing. With bonds, it's the interest rate. With stocks, it tends to be the dividend yield. With currencies, it's the interest rate in the currency you're using. So, for my futures contract on the LindeX, we'd have to use the Second Life interest rate (or USD interest rate, if we were buying the Lindens) to discount to present value.

I hope this helps demonstrate what futures are and how they work. As I mentioned above, they're used quite frequently in real-life commodity trading, and almost every farmer in the United States is familiar with them. (They tend to sell futures contracts early in the season to ensure they sell their crop at harvest.) If you have any questions, by all means ask!

GM

Musings

I've been studying more for my next RL actuarial exam, Modeling Financial Economics, and it always makes me think about the depth of subtleties of markets. The lesson on equivalent, or replicating, portfolios that I gave in a Lessons in FM has so much power to it, but is something that is also so hidden very few can see it. Did you know, for example, that you can replicate a call option by simply buying and selling stocks and low-risk bonds? (Specifically, for call options, you borrow some money, aka sell a bond, to buy the stock, and then they become equivalent. Of course, you have to get the proportions right, and that's not exactly easy to do...)

Yet, despite the depth and breadth of these studies, which I just get exposed to the tip of the iceberg on, it saddens me that so few are in on these great secrets. I doubt less than 1% of the avatars involved in the SL finances could tell me what an option delta is. If we make it only CEOs, maybe we can move that up to 20%. Can any fund managers in SL tell me what the volatility of their portfolio is? How is it correlated to the market (aka its beta)? Where is the greatest risk exposure? I laugh (usually aloud) at any prospectus which simply lists SL closing down or the devaluation of the Linden Dollar as the lone risk factors to their business.

Please note, I'm not trying to criticize anyone here. The subjects I'm talking about are definitely high-end mathematics, and would require some study which is not required of CEOs in SL. I'm only sad that although the SL capital markets have come so far in the past year, they still have so very far to go.

Currency Trading

So I've begun my first foray into trading on the LindeX for profit, as opposed to simple conversion. It seems to be going well so far - the worst case scenario is that I could get stuck with surplus US Dollars that I couldn't get rid of. Oh darn.

It seems to me that the profitability at the current best rates (Sell = L$265/USD, Buy = L$276/USD) approaches 0.005 or so as the amount of Lindens trades increases to infinity. This takes into account the 3.5% transaction fee on the sell side, but disregards the $0.30USD fee on the buy side (argument: as the amount of money trades increase, the 30 cent fee becomes insignificant on the total rate of return). Here's the equation, for those interested:

(1 - .035) * 276 / 265 = 1.00506604...

I've also noticed that those selling Linden Dollars appear to be smarter than those buying them. The reason is because I sold my Lindens pretty quickly, meaning there were lots of market buys (people trading USD at whatever rate for L$). However, my USD have been sitting tight for over 24 hours now, despite the quantity offered at 276 being much lower than that offered at 265. That means that not as many SL'ers are pushing the "sell at market" button when they go to sell their Lindens. Interesting, and slightly reminiscent of P.T. Barnum.

Any hints for me from those of you out there who have more experience than I do in this realm?

GM

P.S. I have a cute Excel workbook for my trades, if anyone's interested. Appears to be accurate within 0.01USD, although your results may vary.

Is Interest the Devil?

First, go take a look over the 1/15/2008 post in this thread.

Now, several times in that post, Linden Labs appears to take a very anti-interest stance. This is quite curious to me. Interest is usually something considered fairly tame. Precise, but tame.

I happen to be an interest ninja. Not a ninja master, perhaps, but I've done some pretty hard material dealing with interest. I can confirm for you all, after nearly wearing out the decimal point button on my calculator, that interest is not evil.

I think Linden Labs is banking on the idea that the market will not exist if it doesn't have a way to pay itself. That's the only idea I can come up with for a reason to specifically target interest. The line of reasoning must be that if you take away the payout, the money inflow will shrivel up as well.

The question on many people's minds, including my friend Maelstrom, is how much money inflow is leaving SL now. The financial markets brought a lot of cash flow to Second Life, but quantifying that will not be easy. These graphs don't look pretty, though - especially the one about USD spent in Second Life. It's a pretty sharp decline after the gambling ban, and I doubt the banking ban will make things look any prettier when the newest statistics come out.

I don't think Linden Labs will let Second Life die so easily, however. Should incentives be necessary, however, I'll bet LL has a few tricks to play. What I'm wondering is if one of those tricks will be to loosen the Linden Dollar against the USD, and therefore if now would be an opportune time to cash out whatever Lindens can be spared. Thoughts?

Whatever the case, Linden Labs needs to learn a lesson that economists learned centuries ago: markets will not be thwarted. If someone wants to have interest on a loan, they'll have interest on a loan. They might call it something different, or set it up to be sneaky, but it'll happen. Heck, I still get invites to poker tables (I always turn them down, of course). If there are willing buyers (borrowers) and sellers (lenders), the market will find a way to carry on business as it sees fit, no matter how much wrangling it has to do to get there.

BNT: An Example in Expectations

Over on AnCapEx, Brautigan & Tuck holdings has published their quarterly (ok, four-month) financial statements. To quote the announcement,

...while our profits are nothing to boast about, we were able to post nearly 27% growth in NAV despite a downturn in real estate asset values. NAV is now L$ 0.76, above the L$ 0.60 value BNT was at after we restructured our shares and eliminated 67 million of the CEOs personal shares in the largest voluntary elimination of personal wealth in SL history.

The growth in our NAV is confirmation that BNT's long term strategy of no dividends, focusing on growth, has been the right one. Despite an in-world depression, banking crash, and downturn in the capital markets as well as real estate markets, BNT continues to grow, and by growing is returning value to the shareholder the old fashioned way. This share value is not short term gimmickry like those CEOs who fake up big dividends that mostly winds up in their own pockets. This is real value in a real company.

Well, this is an interesting situation. As of this writing, the price of a share of BNT stock is L$0.24, and it has been around that level for some time. If the NAV of this stock is L$0.72 as claimed, why aren't market forces pushing it up to that level?

In my economics classes, we learned about some of the common market forces which affect demand curves, such as income, tastes and preferences, price of compliments/substitutes, and (most mysteriously to me) expectations.

In my finance classes, we learned about why investors choose to invest in a given security or project. We learned that investors prefer more money to less money, money sooner to money later, and less risk to more risk. The interplay of these preferences creates the wonderful stock charts we all know and love from First Life and Second Life.

I think that within these simple concepts lies the heart of the situation above. Despite having assets at three times the share price, investors simply don't expect to get anything from them. To be honest, BNT hasn't given them much to hope for: to my recollection, there has only been one dividend and no buybacks (although Intlibber did eliminate a large swath of his own holdings, this had little effect on the market price since it didn't affect the floating shares) to speak of. The most faithful shareholders of BNT, those that purchased the stock at its IPO on the World Stock Exchange, have lost 76% on their L$1.00 per share investment.

So is it any wonder that the price flutters with the whims of the day traders instead of reaching its NAV? With no history of dividends, buybacks, and little hope of actually getting L$0.72 per share for your BNT, the market seems perfectly justified (to me) in withholding its Lindens from purchasing anything but a token amount of BNT, and so it seems to have progressed.

There has been some comparison of BNT to Microsoft (NYSE:MSFT) in the past. I can't link to it because I don't think it has been explicitly written down before, but trust me on this one. However, the differences are beginning to show between the technological juggernaut and BNT holdings:

• Microsoft has split nine (!!!) times in its history. BNT has split zero times.
• MSFT increased its stock price 273% (!!!) in its first year out of IPO. BNT has lost 76% to date (true, it hasn't been out a year yet, but at 3/4 of the way through the year, MSFT was still up about 160%).
• MSFT made no theories or announcements about how people were out to get them in their first year of operations (to my knowledge). BNT has made a few.

Let me make myself clear here: I think IntLibber Brautigan has a lot of good traits. He's a dynamic speaker, and incredibly persuasive at that. He's a visionary and has built a tremendous empire. I've had quite a few nice conversations with him, and he's always answered my questions patiently. I just think Brautigan could do a better job listening to his investors and rewarding them for holding BNT stock. Until then, the boasting announcements are uncalled for, as there is not much to celebrate for a faithful BNT shareholder.

Street Name

I would like to throw a new idea about the representation of shareholders in the SL Capital Markets out there. Ironically, this idea is currently in place and my suggestion is to remove some of it (how's that for backwards!). The idea is registered shareholders, and my suggestion is to add shares in street name to the mixture.

First, why? There has been longstanding debate between (long-term) investors and (short-term) day traders in the SL Capital Markets. I think both sides have their merits (and profitability) but its clear that the interests of the two parties are entirely different. A day trader probably isn't interested in long-term matters of the corporation, whereas an investor is very interested in those issues.

So what does adding street name do? If investors could voluntarily register their shares with a corporation, then that corporation would know it needs to pay attention to them because they're interested for the long haul. If the shares are in street name, then the company can be less concerned (not unconcerned, but less so) with these shares, because they will change hands frequently. As to voting, I think the street name share should abstain from votes, since that is basically why they are street name shares.

There should also be some (nominal) fee and some incentive to registering shares: the fee to show you're serious, the incentive to reap the benefits thereof. Perhaps a fee of L$10, but then you have the ability to sell share directly to the company during a buyback, or they refund part of your trading fees if you sell directly to the corporate treasury. Obviously this would require some changes to existing exchange coding, but I think there are benefits to be had as well.

Thoughts?

IPO Hesitations

Sometimes when a new initial public offering (IPO) comes out in the Second Life capital markets, I may read the prospectus and then decide that this company is a worthwhile investment, with a good business plan and solid management. Other times, I have reservations about buying an IPO for various reasons, some of which have become more common and so I thought I would list here. Maybe I'm off-base with my hesitations, or maybe I haven't seen something I should have. Read on, and let me know what you think of my reasons, and maybe add some of your own.

1. Big IPO with a Long Duration

In short, if I think this IPO will take a long time coming to the trading room, I won't buy it. At least not until it's much closer to selling out, and probably not even then. (A good current example of this is the ACE IPO on the Ancapistan Capital Exchange. 7,000,000 shares, with the majority of shares owned by the massive BNT? I think that will take awhile to sell out.)

The reason is because when an IPO takes a long time to sell out, investors who bought in early get nervous. Maybe First Life situations create a demand for cash from Second Life, maybe they find better investments they wish to try, but whatever happens, they suddenly have an urge to trade their shares for cash. This often causes long-standing IPOs who move to the trading room to drop below their IPO price almost instantly. Therefore, the prudent investor looking to maximize returns will wait until that price drops and buy at 90%, 80%, 50% of the IPO price.

2. Existing Businesses Suddenly Becoming Generous

"We've been in Second Life for 3 years and now we want to share the wealth!" Uh-huh. Sure you do. When I read this I think to myself that this is either a business in serious trouble or an outright "poof" scam (the CEO goes "poof" with all the money). Neither is good for my ROI, so I'll stay away from these.

3. Banks

When I see a bank IPO, a huge, flying, shimmering red flag goes up in my mind. Unless there is some major project requiring capital expansion, this screams "I can't pay my interest" to me. That's not my type of investment.

There has been some discussion as to whether or not JTF will IPO on the SLCapEx forums. Should JTF IPO, I will reduce my cash and stock holdings significantly within JTF in anticipation of its failure. The reason is because I don't think JTF needs money to IPO. They're already huge - why would they need another L$1, 5, 10 million to expand when they have somewhere in the neighborhood of L$80 million on deposit, last I heard? That doesn't make sense, and therefore taking JTF public would be a major sign of insecurity to me. Once again, readers, please comment if you have a different analysis.

4. Multiple Companies under one CEO or Brand

While this could be perfectly legitimate, it also runs the risk of "robbing Peter to pay Paul." This is a criticism I have of the LNL brand, as well as the BNT brand and (basically) it's spin-off, ACE. I would have added the Delicious brand to that list, but they recently combined their tickers into the DDE ticker on the WSE.

I would rather see one conglomeration than two or more separate and distinct companies building into the same brand. For one, bookkeeping costs (or time spent bookkeeping) is likely to be significantly less under one ticker symbol than two or more. Secondly, if the businesses are combined, then divisions doing well can help divisions which need more capital infused into them to succeed.

Also, remember that Jasper Tizzy controlled three tickers at the time of his departure, and it has since been discovered that he used the deposits of the bank (one ticker, AVC I believe) to pay for the land purchases of another (CGI). I am not accusing IntLibber or Lindsay of these dishonest actions, but I simply ask investors to be wary of the possibility and to do their homework when dealing with these companies (which they should be doing anyway).

5. Incompetent Management

If you're really hoping to hold on to this security for a few months (long-term in Second Life), then chat/talk with the CEO before purchasing. Ask them questions. Hard questions. Ask them where the money is going, what it is going to be used for, how much they expect to bring in, low estimates, high estimates, share price targets, "what ifs," etc. If they can't at least attempt to handle your questions, or worse yet blow you off, then run away fast. So long as you ask in a respectful manner, they should respond likewise.

Every company I own I've either contacted the CEO or read enough of their blog to know they're competent. One of my biggest hints that Tao Group Bonds (formerly WSE:TGB) was going to fail was that Chao Mu, the former CEO, became rather frustrated with my questions and started giving sarcastic responses. That was a big red flag to me, and I sold before my money got completely "WTFed."

These are my principal reasons why I do not participate in a new IPO on an exchange. Certainly I have missed some opportunities from my caution, but I feel that prudence is the better part of valor, and I know I've also saved myself some Lindens with these rules of thumb. As always, comments are welcome here or in-world.

Security Regulation in Second Life

Guardian's Note: This was also published at SLReports.net

By Samantha Goldflake and Guardian Market

The transcript of the 12/12/2007 meeting of the Second Life Exchange Commission (SLEC) is not very encouraging. It shows an organization struggling with its own identity, leadership, and purpose in the virtual world, all the while public voices are growing increasingly critical of the abilities of the SLEC, as well as the conflicts of interest which reside with its leadership. Two different schools of thought appear to be forming within the SLEC - one which looks at a system of punishment for companies and markets not compliant with the SLEC's regulation, the other which argues for rewarding the companies and markets which are compliant.

The first idea, that of punishment, is a natural one to strive for. It is, after all, how governmental regulatory bodies operate. If a company does not comply with their rules, they can fine, imprison, or seize assets as justified. However, in Second Life this is simply impractical. Although some systems have been constructed to incorporate this system of punishment into the mixture (such as ACE requiring that its companies who own land use BNT land, so that that asset may be seized if necessary), it simply does not carry the same weight that it does in First Life. The bottom line is that even if you do everything you can to an avatar: take their money, land, inventory, maybe even ban them from Second Life - it simply does not carry as much weight as any one of those actions would in First Life.

The second idea, that of a reward system, also has many examples in First Life. Some examples include Underwriters Laboratories (UL), The American Institute of Certified Public Accountants (AICPA), The American Academy of Actuaries and numerous others all over the world. Each of these organizations has a set of rules and standards by which membership may be granted. In exchange for abiding by these rules and keeping in good standing with the organization, a designation is awarded. For example, the AICPA awards the Certified Public Accountant (CPA) designation, which is widely recognized throughout the United States. The only form of "punishment" which the AICPA can offer is to take away the right to use that designation, and yet this is punishment enough to keep the entire organization membership in line because of how well-respected (and valuable) that designation is.

This idea, the idea of awarding a designation to those who (voluntarily) follow the set standards, is indeed practical within Second Life. What standards, how the designation is awarded, and what the designation looks like is the concern of the marketing department of the organization awarding it. The World Wide Web Consortium (W3), for example, gives links or icons to be placed on well-constructed websites which then link back to the W3 explaining what the designation means and why the website is using it. When visiting a site displaying one of those icons, then, the user knows that the designer has taken the time to make their site compliant with the W3's standards (and this usually indicates a careful and advanced web programmer as well). A similar system could be put in place for the SLEC or other investor protection entity.

The concept of a regulatory body in Second Life is impractical. However, the concept of an organization which publishes well-founded standards, evaluates applications, and awards designation(s) to those who adhere to the standards published is entirely practical within Second Life. Such an organization could earn the trust and respect of investors, as well as gain publicity through publishing said designations. This method of honoring those who abide by their standards, rather than criticizing those who do not adhere to them, could (in time) grow to be an effective method of market regulation, support, and education.

So far so good, but one should always look at the whole picture. The aforementioned theoretical organization should be formed by people with a relevant First Life background, not by self-certified or wannabe public accountants. Also it should be unbiased and not partial. Is this an obvious statement? It sure is, however it's a good thing to recall this concept, as it's a good thing to recall that actual, apparent and even perceived (by the general public) conflicts of interests should be avoided at all costs.

An award is as good as the reputation of the awarding organization. Of course everybody has to start somewhere and public trust isn't earned overnight, so at the beginning the life of an organization dealing with accounting and business standards could be hard. However, by following some guidelines problems should be greatly reduced. The organization:

• must be formed by people with relevant First Life backgrounds and enough SL experience (there are differences between the two)
• must be unbiased and not partial to any SL financial institution
• must keep at any time open communication channels with SL financial institution and the general public
• must pursue at any time consistent, coherent and continued communication about its mission, acts, targets and such
• must strive to earn and keep SL financial institutions and the general public trust
• and, its members must avoid any actual, apparent or perceived conflicts of interests.

That given, then everything is possible. After all, it's a matter of business ethics. An ethical organization will be able to win the hearts of both SL financial institutions and the general public.

The idea of an organization publishing standards and assigning designations to those who adhere to those standards is admirable and achievable. There is a big problem, however: that organization must really be unbiased and independent. It must also earn public trust. In the SL financial world we see pretty much the same faces everywhere. If not those faces, we see their friends. Are there people we can trust to form an unbiased and independent organization? Time will tell if the SLEC will be that organization, or if another must be formed to accomplish that end.

Land Supply

Disclaimer: I'm a land dunce. By that, I mean that I've never owned any land, only have a basic understanding of tier, and do not know the history of the market.

In spite of the above, I still found this SL blog post a few days ago interesting. It looks like Linden Labs has an actual target for land prices, somewhere around L$6.3 / m, as noted in the article. The question that remains is if the market will believe that price. Any land owners here wanna help me out on this one?

The interesting aspect of this article is that in some ways, it resembles setting an target price by Linden Labs for its major commodity: land. Although Ginsu Linden warned of these economic comparisons, I still persist in my observation because of how First Life markets can react to price targets.

Think about it: when you hear a price target for a stock, car, or anything else, what comes to mind? I think the first question is whether or not the source you hear it from is credible. The bum on the corner rambling about how Google will hit $1,000 per share probably isn't your best source, but if Morningstar said the same thing, you'd pay more attention...or at least I would. In this case, I think we can classify Linden Labs as a reputable source on the matter.

However, the next item to consider is whether that price target will be accepted by the market. If the price is too far out of the current range, the market will simply ignore the target. In some of the comments on that Linden Labs blog article, it seemed as though some already have. If the market believes that price target, then it becomes a self-fulfilling prophesy, with sellers trying to sell above the price and buyers going below it, hopefully reaching equilibrium at or around the price target. However, if the market doesn't believe the price target, then they simply go on as is, and it is up to Linden Labs (who control land supply only - not demand) to attempt to get to their target.

So then, if we revisit this topic in say, two or three months, the land prices could serve as a proxy for the combined influence of two variables: how much the landowners in Second Life trust the words of Linden Labs, and how well Linden Labs controls land supply. Two variables are hard to decompose, but it still answers the general question, "can Linden Labs precisely control the land market?"

There are, of course, a myriad of other factors which could come into play in this market, and I am yet unexperienced in it. Comments are very welcome on this article, as I would love to learn about the land scene in SL.

Trends in the Second Life Economy

Awhile ago, Intlibber Brautigan brought up to me the idea of the SL economy having a cycle based on the college year, with recessions in the summer and more economic activity during other parts of the year. While data certainly supports that this year, there may also be some confounding with the gambling ban.

I meant to do a statistical test on this awhile back, but forgot. Sad, but true. Anyway, I remembered the idea, and thought I'd give it a shot. Unfortunately, I promptly ran into the limits of Excel before recalling that my Regression and Time Series class used specialty software to do its magic. Does anyone out there know of a good, free, and somewhat easy-to-use statistical analysis package?

In consolation to my lack of findings with the seasonal analysis, I did at least find that the Total Hours data fits very well to an exponential curve. However, it doesn't take a statistical analysis to see that - just to quantify it. For those interested, the formula turned out to be

62293.35 + e^(.124155t), where t is months since August 2003

and the significance values were all under 10^-40. The saving grace for Intlibber's proposition, however, is the residual plot which seems to demonstrate some autocorrelation that could mean seasonality.

You can find the Google Spreadsheet here. (Scroll down a little to see the graph of the residuals. I'd like to make it prettier, but I'm still learning Google Spreadsheets for now.) Again, anyone who knows of nice, free software for statistical analysis, please comment.

Why bank in SL?

As often happens to me when I'm poking along on the SLCapEx forums, I came across a thread with a good question. The question is simple enough, and is the title of the thread: "Why should I put my money in an SL bank?"

At first brush, this may seem to be a simple and scared n00b asking a question because they're scared. However, ultimately this is a question that every investor has to answer: Why trust your Lindens anywhere outside your avatar?

When you put your money outside of your own control, you're exposing yourself to the risk of loss for a variety of reasons. There are the multitude of frauds that can and have occurred in Second Life, but also there's the genuine chance that the security you've chosen will simply fail to be successful. For this risk, you demand payment, which usually comes in the form of interest, dividends, or capital growth, depending on your preferences. How much growth is enough to make your Linden dollars stray from your pocket is up to you and your own private discussion with utility curves.

I'd like to bring something completely from left field into this discussion however: game theory. I've just recently gotten into the most basic concepts of game theory, and I'm loving every minute of it. Specifically, I'd like to call to mind a simple game called a "trust game."

Here's the gist of how a trust game works: You are given an initial allocation of $X. (Almost always, this is real money - if you ever have a chance to volunteer for a game theory experiment, do it! You'll probably get lunch money out of it.) You are then given a choice to pass an amount T to another player, T>=0. This amount T, once under control of the other player, earns a rate of return r, r>1 (usually r is 1 or 2, in the games I've read about). Then, the other person gets to divide the amount they now control, which is T * (1 + r), between you and themselves however they choose. There are no restrictions on how that money they now control is to be divided. That's why it's called a trust game. (If any of you are really interested, you can find an instructor's script for a trust game here.)

For the less math-oriented, let's do a quick numerical example. You sit down and someone hands you $10. You can then choose to give any part of that to me that you wish, with the understanding that it will triple as soon as you hand it to me and then I can divide it between us however I choose. You choose (as an example) to give me $5, which then becomes $15, and I, being grateful, choose to return $7 to you. You get $12 and I walk away with $8.

Here's the interesting thing, though: there has been at least one study done which links trust (as a culture) to wealth. (Apologies for the link not going directly to the paper - the paper costs money to get to, as near as I can tell.) The concept is simple enough: the more risk you take, the more return you get, and therefore the richer you become. I'm not well enough versed in the topic to attempt to argue it as this paper has done, but you get the idea: risk begets reward.

So, does this work in Second Life? Time will tell. Certainly blind trust will just get your Lindens stolen, as many lemmings have proven. However, well-placed trust could be the secret of success behind some of Second Life's most well-known names. That is a bit of mind candy I leave for you to chew on.

Lessons in FM: Part I - Present Value

I'm going to start a series of educational posts about the basic concepts of Financial Mathematics, my major. These are not intended to be overly complex and I will do my best to keep the calculus out of it. There will be a mix of mathematics and economics, and the symbols used will likely be actuarial in nature. This convention won't bother those who are new to the topic, but might if you have some familiarity with it already from another discipline, like Finance.

Present value tells you the value of some amount at one point in time at another point in time. Usually, you're trying to bring payments at some future time back and find out what they're worth today. To find this, you need the future value(s) of payments (FV), the interest rate (i), and the times at which these payments will be made (t or t_k). We'll work with just one payment for now, and we'll also be using compound interest.

The equation we start with is pretty basic:

Present Value * Interest = Future Value

in symbols,

PV * (1+i)^t = FV

To solve for PV, we divide both sides by (i+i)^t. However, remember that actuarial notation I mentioned? Actuaries use this method (dividing by the interest factor) so often that they have their own symbol for it, v ("vee").

Definition: v = 1 / (1 + i)

Using this notation, we solve for PV and get

PV = FV * v^t

And that's it! Just plug your numbers in after that! So long as you have three of the variables, you can solve for the fourth.

So that's great and all, Guardian, but what if I have more than one payment? Well, fortunately, you can just add them up. Say you have two payments - one at time t = 1 and the other at time t = 3. To find what they're worth today, just add them. You get

PV₁ = FV₁*v¹
PV₃ = FV₃*v³

PV₁ + PV₃ = PV_total = FV₁*v¹ + FV₃*v³

The tricky thing is finding the interest rate which makes that equation balance. This is a problem that often has no direct solution and must be done iteratively using numerical methods. That's part of that scary math I promised I wouldn't get into. (As an aside, if people really want to see that mathematics, comment that you do and I'll whip something up.)

So what good does this do in the Second Life capital markets? Well, theoretically (and in Second Life, I mean very theoretically), that is what all the stock prices are based on. Investors value securities according to what they think the future value of it is, discounted with interest (this interest rate likely has a risk premium built into it, however). Whether that future value is based off of reselling the security, dividend payments, or both is something that each investor must decide for themselves. However, if you know your own preferences and you can make guesses as to the dividend amounts and/or stock prices, you can use this method to value what "your" price of the securities is and whether or not it's a good buy for you.

So what if there are a lot of payments, but they occur in regular intervals? I'll tackle that one in Part II.