Working for the Empire - Convincing family and friends that i-banking is moral

Christmas has passed, marking the mid way point of another winter vacation and the conclusion of two great nights of debate with the extended family. Christmas eve was devoted to the virtues and problems of wikileaks, religion, foreign policy, Canada's involvement in Afganistan, and the motivations behind joining the army. Christmas day however centered largely on one topic, the financial crash and the gross immorality of investment bankers.

Before I resign myself to the idea that my years ahead will be spent reporting to Lord Vader on how I managed to squeeze $30M out of 5 deals that were not in the underlying firms interest, I think my trade needs me to give it the chance to be moral and just.

My fathers side of the family is composed of many families that have made their living in C level careers in the oil in gas industry. They are in essence a good composition of my future clients, and it's a bit startling to learn how much my future customers might secretly hate me.

Their main gripes center around two issues: the money, and the incentive. On the macro level they feel that the high pay draws away bright minds from engineering, medical, and policy careers that the country needs more. On the micro level they feel that salaries give i-bankers a false sense of superiority and invincibility. Make millions when times are good, get government bailouts when times are bad.

I argue that the money is good because few are up to the task of doing the work. There is no oligopoly in the investment banking world, it is highly competitive on all levels and in all areas. With so much competition, and so much interest in becoming an i-banker, if the workers didn't hold some element of a scarce resource their salaries would be squeezed away to keep the firms margins high. But it is the people who drive the business, and when one person manages to bring in $10M of revenue their salary becomes justified.

What I have more trouble explaining is why the business itself is so profitable. How has the ~3% spread stayed so high if there really is so much competition. The obvious answer is risk, but my uncles seem convinced that the i-banks of today have almost completely eliminated their exposure. I'm sure the next 12 months will shed some light on the issue. If in fact the industry has been able to collude and keep these historical premiums while managing to eliminate the risk (and the costs that come with it) then maybe the industry isn't so "fair". But it's a industry wide phenomena, and one that is admirable to any capitalist as long as there is not some anti-capitalist framework keeping it in place (government relationships, or true collusion). Over time the markets should correct for these non-normal profits and my future paycheck should get a bit slimmer.

The incentives are another issue because they really are a product of the individual i-bankers business conduct. My firm will make money when a deal is done. It will make more money if the deal is big, and it will make more money on more deals. Thus the big incentive is to have i-bankers drive as many big deals as possible. Deals are IPO's, bond issuance's, mergers, acquisitions, consolidations, spin offs, carve outs, and LBO's. It is my uncles contention that i-bankers advise companies to do deals when they shouldn't, and that when the deal is going through the i-banker isn't thinking about the firm, but instead how to maximize their cut.

I think the biggest point of issue is that business men know how to run their business, and if they are good, they know how to run it well. Unfortunately finding oil reserves and getting to them efficiently, doesn't have a lot to do with a bond deal or a takeover. Very smart individuals get caught in a world they don't understand and it's their baby at stake if things go sour. When you don't have a good grasp of the playing field it's natural to feel like its slanted against you. And sadly it is natural for it to be slanted against you. Businesses need capital, and so they need i-bankers, and i-bankers need businesses to need capital. This symbiotic relationship should ensure that neither side screws the other on the macro level because each side can permanently avoid the other on an individual level. If an i-banking team gets a rap for being sleazy and underhanded they won't get business. If a business gets a rap for providing faulty information and trying to screw their bankers, they won't get capital. These 'jungle rules' keep both parties from the extremes, but I would agree that the balance of power is in the i-bankers court. Tough.

Neither of these business realities are immoral. I truly believe that an i-banker that screws his clients, is not long for his job, and definitely not destined for riches in the long term. Like any service industry the client is king, and the i-banker that does right by his clients, will win their trust and lead them through the really bid deals when the time comes.

How do YOU DCF?

Many a young financier becomes enraptured with the power of the discounted cash flow model in their third year finance classes, and student investment funds are teeming with DCF models that do three way sensitivity, have 4 growth stages, and model 20 years into the future. However quickly students feel cheated by this tool that promises to value everything with a income statement.

At first it's the baseline figures; what should the beginning change in net working capital be, what if it's been on a negative growth path for the last 3 years. Back in 2009, baselines were really ugly; what should you do with deferred tax loss, a negative NOPAT, uncertain CapEx expenditures. Then it's growth rates, which are especially tricky for growth companies. Soon you end up with a value per share for Google at $103 and you wonder where you went wrong.

I'll outline how I approach some of the many DCF decisions and then I'll talk about where the DCF really shines - when it's used backwards.

Revenue
This is the best line item to spend the majority of your time modeling because it's the hardest to fake. Managers can push and pull on SG&A, depreciation, tax expense, and really everything else before net income, but there is very little you can do (legally) to move the top line around.


I like to use one of three approaches to model revenue growth, regressions, market share & growth, and historical. Regressions are by far my favorite, especially for resource companies. How much correlation do you think there is between Nobel Energy Corp's historical revenue and the yearly price of oil multiplied by the barrels of oil produced per year? 85%.

Yes it's a very short development period, but it tells a good story, and it makes sense (when oil price drops so does revenue). The biggest plus is with regressions you are able to use industry data to forecast the company. In this Nobel Energy example I used the EIA oil forecast (see my "must have links" post) and with this I can model out 30 years if I desire. If the company you are tackling has been pretty stable for the last 10 years (no M&A or spin offs) you'd be best to create your model in a development period and then test it on recent ex ante data to see how it performs. For example create the formula on data from 2000 to 2006 and then see how it performs from 07 to 08. Or develop through 08 and test 09 to the TTM. Most models might break through the crash period, so give your power tests some slack if you use this as your test period.

If you are valuing a consumer goods or manufacturing business you will be most interested in market share and market growth. Analysts produce a lot of research on which companies are likely to gain or lose market share, and how much the entire market is expected to be worth today and tomorrow. The gathering and aggregating of this data will be much messier than resource data, but if you are able to put it all together I'd bet your model power would be far stronger than just extrapolating on historical data.

Sometimes you need to use what you have in the company, and although it hurts there are ways to make the best of it. The big first step is to dive deep into the MD&A and scour past conference calls to get a good idea on managements expectations for growth. Any negative expectations should be taken very seriously, any very positive expectation should be taken with a grain of salt.

NWC, CapEx, Dep, EBIT
So after spending all that time on modeling revenue, must we do the same for each DCF component as well. I say we do not! Whittling to our free cash flow using the formula:

[Rev-Exp=GM-Dep-Tax=EBI+Dep+Chg_NWC-CapEx=FCF] 

We are just left to consider proportions and margins before the terminal cash flow. If management gives firm CapEx projections than you can hard code those in if you feel they will happen, otherwise look closely at the CapEx proportion to revenue over a historical period that represents the future 5/10 years. Same should be done with depreciation, NWC and the profit margin to EBIT to estimate expenses. Generally if the company is doing more business all of these items should increase roughly linearly. The exception of course is if the business is shifting from one business cycle to another. If you feel the company is losing its "core competency" or competitive edge then you should make some adjustments to the EBIT margin you assume in the future. This is tricky business and you might want to look at a historical example. For instance you might look at Microsoft's margins coming into 2000, to model Google's next 10 years.

Terminal Cash Flow
This whole calculation is a headache in itself, but extremely important as it usually makes up ~2/3 of the firm value. If the firm is steady state you could probably do the terminal cash flow anywhere from 5 to 10 years out. Theory and historical data suggests that the profit margin should squeeze that the firm will increase dividend payments (or start them) so your plowback is smaller. If the firm is growth, you might want to go through the exercise of smoothing to a mature stage over a 10 to 15 year horizon. Generally this is a messy business and it is hard not to feel like you are crudely making up growth factors when it's 2021.

Making the DCF do something useful
So after playing with your DCF and making it produce a price that fits your thesis, it's hard to think that the model is anything more than a elaborate way of making up a stock price. And honestly, without rich financial data, a professionally developed model, and a team of 7am to 11pm working analysts your not going to generate alpha. You can however make the model do something useful.

By accepting Semi Strong Form Efficiency instead of WFE we can say that the stock price is the correct price. This allows us to chose a different output variable, like equity risk premium for our DCF model (hope you soft coded it, so you can use solver). The beauty of it is, if the output variable is a 'common variable' (not firm specific) we can use several different firm DCF models to narrow down on a more accurate value. It's like triangulation in mountaineering, but in finance! For instance by modeling all of the big companies in the auto sector (and yes going through the work of regressions and margin estimates for each of them) we can turn all the models around and figure out what equity holders demand as a risk premium. Of course adjustments for outliers will be needed and you may want to weight your average to focus on 'pure' peer firms in the industry. Boil this down through all the sectors and you have completed a much more robust and market sensitive estimate of E[Rm], which we can feed back into either the CAPM or Famma French Model to make passive investment decisions. The power obviously would be found in narrow sub sectors where you are likely to be have some added information, but the method is actually a widely used practice.

What actually keyed me onto this method was a paper by Aswath Damodaran. You can find the paper here, and it nicely details some of the implications of the E[Rm] DCF solution method near the last third.

Some Gradschool Greats and Gripes

Last final tomorrow afternoon - time for a breakdown.

Great things about Gradschool
The people. It sounds cliche, but gradschool is a further tightening of the social spectrum one relates to, and it's always fun to hang out with people who are like minded. When you think about it's probably the pinnacle of optimal social settings till the retirement home.

Think about it this way; you start life in grade school. The school is filled with people from all sorts of different persuasions; as put in Ferris Bueller's Day Off you have "The sportos, the motorheads, geeks, sluts, bloods, wastoids, dweebies, [and] dickheads". Plus while you are co-mingling with the masses you also are constrained by your history. If you did something memorable in grade 9 (either good or bad), that has bearing on your identity for the next three years. I'm not saying I had a bad high school experience, but there are benefits of going to university. When you go to your undergrad, you are amongst the masses - able to reinvent yourself - and as you focus in on your major your circle of friends become even more like minded. By the time I finished my undergrad, I probably had 15 close like minded friends; when you go to a grad school which you were on the edge to get into, you find nearly everyone in the program is "your people". As we move into careers the age spectrum will jump out at us, and depending on the business it might be hard to find 100 friends with a passing glance around a room.

The pace. Everything pre-gradschool moves so slowly. Actually most other grad school experiences (engineering, math, history, etc) are equally slow, b-school really is an exception. I'd rather be busy than bored, and balancing 4 quarters of classes, a job search, professional designation exams, and a social life, makes time fly by.

The facility. Coming from a middle class upbringing, and a public university that fed heavily on in-city students, I'm still a bit star struck by the grandeur involved in private universities in America. As an international student, I was going to be paying upwards of ~50,000 no matter where I went , and so it made sense to go to a school where every student ponied up the same amount (instead of state schools which are subsidized for domestics). The result is me spending my days in rooms that resemble Hogwarts. It also has an impact on the undergraduate student body. Graduate students are all driven individuals but undergrads can be... less so. Although there is a lot more 'valley girl' presence in the halls here, generally the students conduct themselves with a bit more class then I am used to, and it's oddly motivating. If all the undergrads are quietly holed up in the library, then I surely am meant to be working.

The material. I'm not taking a Ph.D. developing masters. If I were I'd be eye deep in math and worrying about "quals". Instead I'm learning the why's and how's of industry practiced finance. My undergrad brought me halfway there, but there still was an emphasis on the academic delivery and testing of the material. Now I'm not doing my work by hand, I'm doing it on excel. When I'm doing stats exams I have a laptop in front of me, all of the work involves real world data and situations, and the solution is delivered as a memo, not a proof.

The Gripes
THE DOORS. Oh my goodness, it gets to me every day. For some reason this school loves closed doors. Doors, in its' halls, tunnels, some vestibule doors, doors just there to be doors. On my walk to from my locker to the library I open 8 doors. It's a 2 minute journey! Locker to squash court is 16 doors. The student body has adapted by constantly slapping the handicap buttons to force the doors open for 10 seconds at a time, but I have a much simpler solution. Every interior hall/tunnel door is affixed open by an electromagnet. If a fire alarm is pulled the power is cut to the magnets and all the doors shut. Problem solved. (Ahh real motivation for post appeased)

America. I really like the people I interact with on a day to day basis, but this country can bring a man down a bit. Money in and out is a hassle. Air travel is a hassle. AT&T is a hassle. F1 visa is a hassle. Having to think about 'saftey' is a hassle. Being separated from my CAD licensed car is a hassle. Domestic politics and it's influence on the world is depressing. H1B sponsorship is nearly impossible. And seeing the wealth and race divide is sad.

At my previous university the student body was composed of students from a middle to lower class background. Although this added to the 'riff-raff', it also meant that the people working the cafeteria, washing the floors, and staffing Tim Horton's, were all peers who were just doing some part time work. Here the only establishments that seems to employ students are Starbucks and the libraries, everything else is employed by primarily Black or Hispanic middle aged men and women who show the cultural characteristics of being on the wrong side of the wealth divide. This said I am acutely aware "great" paragraph 4 is in part a direct pairing with this gripe, and I can't have my cake and eat it too.

And those are the big ones. Next post from Canada, where health care is free, strangers high-five, nobody thinks my dance moves are "elaborate", airport security is just a slip and slide, and roads are paved with candy frogs and internet memes.

Business Majors - The Personality Test

I finished my accounting final about 3 hours ago, and like many of my previous undergraduate accounting exams as soon as I started I couldn't wait for it to be done. I usually do well in accounting, but the it's always been an unpleasant experience. After the exam I began studying investments and the last three hours have been a huge contrast in pain, to the same three hours spent yesterday. When I think about it, the business majors all have a personality of their own, and the people who thrive in them seem to exhibit certain attributes. So for what its worth, here's my take on the major - personality match up!

The Accountant

Oh accountants. So neat, so orderly, so... anal. I hate because I lack these qualities, and some of them I really do which I had. The biggest thing accounting has taught me is how to view a rigid puzzle, and to appreciate tolerate all the checks and balances that are involved in financial reporting.

At first you learn how the 3 major financial statements link together. How the cashflow statement is a throwback to cash-basis accounting and reconciles cash from revenue, financing, and investment. How income from one year is gathered in retained earnings during closing, and how working capital accounts interact with revenue and expenses. It's all pretty elegant really, and with purchases all taking place on January 1st, life is a hunky dory place.

But then come the exceptions. Inventory = FIFO, LIFO, WA, Specific Identification. Depreciation = Straight Line, DDB, Sum of the Years, Units of Production. Investments = Held for Trading, Held to Maturity, or Available for Sale. Leases = Operating or Capital. Building Costs = Expensed or Capitalized. Foreign Currency Translation = Temporal Method, Current Rate, Hyper-Inflationary. The list goes on. The beauty of the simplicity, is replaced by ad hoc rules and standards dictating which method is appropriate and you end up tearing it all with imparments and re-statements anyhow. A rage begins to boil up inside me as I memorize the pointless completely offsetting joural entries involved in cash flow hedges, and I just want to scream "WHO CARES"... And that's why I'm not an accountant.

But some do care. If you like organization, putting everything in it's place, and naturally follow the rules to the letter in all of life's activities then accounting is for you. Some of the best accountants I know were group mates that "tut tut'd" when I wrote formatted "align left" instead of "justify", I didn't even noticed, it was a big deal to them. (Hence my solute to them with the justification of these paragraphs). You hear of things in big accounting organizations like "pen hierarchy" where newbies get one colour, mid levels get another and top level get the red pen. When reviewing work all the colours trickle down, with each level trumping the next. If I walk up to my i-banking boss and he tells me that red pens are reserved for managers, I'd shit a brick.

Marketing

I see marketers as exactly opposite to accountants. They are free spirits and their major focuses on instilling the primal business spirit into students, contrary to most other majors which focus on skill creation. It does have one thing in common with finance, most marketing majors don't end up in marketing, they end up in some sort of sales. I'll break it down into these two factions, but as a student who's always been on the numbers side, my view into these functions are not as strong.

The pure marketer usually exists in three organizations: corporate, consulting, or PR/Gov. Within these organizations most of the work is on the PR side along with event planing, but a lucky few really get to become creative and craft the firms message. The creators will be very smart, but maybe not a numbers fan. Their profession is essentially behavior analysis and psychology of the masses. They need to figure out what their consumers are trying to tell them or what they think of them, and then what steps they need to take to move those perception in the desired direction. To me it's voodo magic and often a unjustifiably high expense (look at the difference between Gross Margin and Net Profit with a company like Coke), but it works. Economically I understand what they are trying to do, scarce resource creation to allow for price discrimination. How it's actually done is much more of an art, with a ton of market analysis to drive decisions.

Sales

Sales is what makes the world go round. Small business owners, lemon aid stands, traders, corporate 'client services', it's all sales. Sales personnel from the marketing background tend to be the best at talking the talk. Students who aren't particularly academic but have good business instinct fit this mold well. I would describe this person as a very popular, well spoken person who above all can influence people. The slick salesman who no-one likes won't go very far, especially in corporate, it's the super networkers that keep reaching new heights.

In corporate it's usually the salemen with a background in the technology that the firm sells that really excel. This is because B2B selling is focused on a very knowledgeable customer, and the engineer turned salesman will both understand their needs, and also may have formed a relationship with them before flipping to the money side.

Traders are salesmen with all the tools of a more typical finance worker. Sometimes they actually don't talk to their end customer, but they understand their customer better than any profession because it's the relationship between the two that creates the profit, not the product. The customer of course is who ever may be on the other side of the traders trade. The trader must understand where the customer is wrong in their understanding of the product (read: security or asset) and he is right. Traders are self confident, very intelligent, risk taking individuals. Unlike most salesmen, traders don't need to be particularly social or nice, but most of the ones I've met are.

For the rest of the world, small businesses are filled with owners who read some sort of book on marketing and sales, because generally your brand and your core business is the one thing you can't outsource.

Finance

Okay that's a trader which is really sales but the picture is too good. Finance is for the soothsayers of today, the entire profession is based on an estimation of risk and reward. Accountants hate looking forward, and most estimates they do, they shop out to the treasury department. Financiers need to have a very strong understanding of accounting but it's always from the view point of what's next. What are the nasty surprises likely to come, does a regression with average barrels per day and average oil price do a good job modeling revenue - will it in the future as well?

A good financier can think big picture. When they learn subjects they really 'get it' when they understand the why's and how's, not when they memorize the method. The world works by methods, rules, and convention, but there is a little sloppyness to all of this; a financier who truly grasps the underlying framework will see when the convention does not hold and profit from it. This means that financier has a strong grounding in statistics, economics, accounting, and econometrics. It is a service industry so they must also be a good communicator, and be able to understand what the client is asking better than they do. This is a bit caveat'd by which side of the firm you are. A Ph.D. physics background quant may have few communication skills and still thrive, and those more on the sales side may get by with less fundamental knowledge of the products they are selling.

On the personal level my commentary on what makes a good financier is obviously biased but I'll take a stab. Those in finance are usually curious about the world. They are well read, like the news, and like to think about how seemingly unrelated events might fit together. How might a missile strike on North Korea affect the USD or gold? How would a dividend cut at RBC affect BMO? This comes through an understanding of systematic risk, everything is connected on the base level, and every event is an additional piece of information that may have value on predicting any future events. Financiers are usually competitive, relatively hard working, and quick witted. A professor once told me that in finance it's not good enough to be right, you need to be right and first - something I have really taken as a personal goal. 

I'd like to say that financiers aren't incredibly detail orientated, but I think it's just that I am not incredibly detail orientated. As I read more about the work of investment banking, there doesn't seem to be much room for error, and so this year has included a focus to drop that pesky 5% margin of error from stupid mistakes. Interestingly a very competitive bell curve has naturally given that goal a fair bit of incentive!

Major's I'm leaving out include Operations and Information Systems. Operations folk are an odd mix between engineer and accountant. It's a study of efficiency, and although I always enjoyed the math, the issues were a bit boring. I/S majors are a mix between marketing and computer science engineers. I worked in a high tech company, and am a big fan of internet culture, so I definitely sympathize with these folks, I'm just not that interested in web design or database management.

Aging through music.

After writing a punishing Sunday afternoon final I have been slipping between accounting studying for tomorrows exam, and severe procrastination. Seems like a perfect opportunity to make a relaxed post.

I am going to try to post the song that best represents what I was listening to from age 10 to now.

1997 - The Verve's Bittersweet Symphony  - Discovering how much I like classical pop fusion


1998 - Big Pun - I'm not a player - Here comes adolescence.


1999 - Pink Floyd - Another Brick in the Wall - Peer influenced I'm sure


2000 - Jurrasic 5 - Concrete School Yard - Finally find Hip Hop


2001 - Metallica - Fade To Black - Really learning to enjoy songs that crescendo


2002 - Iron Maiden - Number of the Beast - Here comes the football pump-up song era


2003 - Groove Armada - Easy - Here comes electronica!


2004 - Lemon Jelly - Homage to Patagonia - Finding instrumental DJ music is huge in Europe


2005 - Dr Dre - The Housewife - The peak of my misogynistic music collection


2006 - Samuel Barber - Adagio for Strings - Still my number 1 classical song


2007 - DJ Shadow - You can't go home again - Probably #1 favorite artist


2008 - Ada - Each and Everyone - Still a favorite


2009 - Weezer - Only in Dreams - Hit these guys a bit late


2010 - Bag Raiders - Shooting Star - And we are drifing back to indi/electronic

Framing an Investment Decision - A Top Down Approach

I'm no expert, but here is my take on the road map one could take to make an investment. As a preface to those financially educated, I have been educated in "chicago" style investing (efficent market), believe the market fails at Semi Strong Form Efficiency, and I follow Top Down methodology.

I'm going to start from the point that an asset manager would start at. The client service representative (or you, if your doing it alone) would have already determined your risk/riskfree split based on your risk aversion and investment horizon. The discussion from here on out will be an approach to investing in risky assets without horizon constraints and with a reasonable risk appetite constraint.

Wind at Your Back
The first point of research to be done is entirely macro, and then you get into looking at specific assets. You need to figure out where the general economy is going, where the future risks may lie, and what industries are likely to be favorable in the future, then which companies will capitalize on the environment. This involves a lot of reading, I would suggest checking out some of the research reports that are put out by banks and information agencies, there are a lot of links in my "must have links" post. The general process is:

• Where are we in the economic cycle? If interest rates are high moving investments over to low risk, debt could be very prudent. Recall that as interest rates fall bond prices rise, but you only will receive this benefit if you are in bonds before the market anticipates a shift to lower interest rates. Also bonds have two major risks, interest rate risk and default risk. Unless you plan on buying CDS insurance on your debt investments you will want to be invested in firms (or governments) that are both liquid and solvent, as interest rates usually only fall in market crashes.
• Obviously it feels as though we are at a bottom now, but we have already had a good rally. I would say that in a long term view there are still plenty bottom buying opportunities to be had, but there is a good chance we will find ourselves lower than we are today over the next 3 years.
• Where are industries in their business cycles? Oil and gas in North America both have a lot of inventory in waiting. Dot-com has been roaring ahead for a long time now and there is a lot of talk about another internet bubble forming. Paint this picture for each of the major industries by using economic data and research reports. Banks and government bodies often have very good free reports. The Economic Intelligence Unit (the data side of The Economist) is a good source as well. When you see a industry that you think is bottoming you are likely to find Value opportunities. When you see an industry that has bottomed and is growing strong you are likely to find Growth opportunities. Industries that are nearing their top or are falling will have short strategy opportunities (puts). This the first big area asset managers really add value, being able to spot a difference in the true business cycle and the one priced in by the market can make a lot of money for the long term investor. 
•  So now that you have your industries classified as value, growth, or short you can start looking at actual stocks OR you can make the appropriate plays with indexes. This could be as basic as buying the value and growth industries and not buying the short industries, or as exotic as finding ETF's that give you exposure to high Book Value / Market Value stocks in the value industry and low Book Value / Market Value stocks in growth industries. (MV/BV is a value/growth measure typically used in the Famma French Four Factor Model). 
• Finding value stocks is done many ways, and this is the second major area that asset managers make their pay check, finding the diamond in the rough. A very simple way of identifying these assets is to look at comparable multiples. A multiple is generally a market derived item divided by a financial statement item (or sometimes vice versa). Examples include: Price/Earnings Per Share, (P*Shares Outstanding)/EBIT, EV/EBIT, P/(E*G), MV/BV. Multiples are always compared to the median value of the firm's closest peers (companies generally do not form normal distributions when grouped by multiple and so means are skewed by outliers). How many you choose is a bit discretionary but usually more than 10 and less than 50 is common.  From a value standpoint you want to find companies that have low [market/book] multiples and investigate further. Sometimes these companies will have justifiably low ratios - they might be poor businesses. These can still be candidates because poorly run firms can be bought up by another firm, leaving shareholders with a sizable premium, but this can take a long time. If you find a stock that has a low multiple and it seems to be a solid business with low default risk and growth rates comparable to its peers then you might have found yourself a value stock to buy. An efficient market theory is that all firms will revert to the mean, your low multiple firm should converge to the median multiple over time, which means that either the numerator (price) will grow, or the denominator (assets/earnings) will shrink. Firms love to get bigger so usually it is the price that moves.
• Finding growth stocks is similar, look for high multiple candidates. This is less in line with EMH principles but there is research that suggests firms who have performed well in the past seem to enjoy persistence in their performance, and yield higher returns compared with their peers longer than theory would suggest. This is almost always because they hold a scarce resource their peers do not, (think Apple and Google). There is some evidence that these growth stocks although desirable, are not the true winners. The real high flying stocks will be "value with growth characteristics". Value stocks with the low multiples are usually your blue chip businesses, but everyonce in a while a low multiple company will take off as a growth stock and become a high multiple company. This transition is very profitable and finding these companies is the explicit goal of many Bottom Up investment approaches. 
• Valuation. You can do it easily with the multiple approach briefly described above by taking the firms denominator item in the multiple and multiplying it by the median multiple to find the expected Price or EV (enterprise value) if the company were to revert to the mean. The second major way is to create a discounted cashflow model of a company. I plan to discuss both of these valuation methods at length in a future post, but for now here is the coles notes of a DCF. A stock is a fractional ownership of a company. A company is made up of assets (buildings, machines ect) that make money. This money belongs to two entities, debt holders, and the companies owners. A firms worth can be considered the sum of all future cash flows it will make by doing its business discounted at the firms cost of borrowing the money to do business. This discount rate can be thought of an opportunity cost of the owners and the debt holders. Subtract debt from this sum and you are left with the value of the company that belongs to the owners; divided by the number of shares an you have a share price. DCF valuations require a lot of assumptions because they are computed off of future figures, so they are fairly useless in business that have a lot of uncertainty in their future cash flows, but can be very valuable in very stable businesses. If you price derived from valuation is higher than the market price, buy baby buy!
• Highly priced firms (highly priced relative to their firms using multiples, the actual stock price has absolutely nothing to do with it) which you suspect to fall in price are good targets for short strategies. You can identify these through multiple analysis (high multiple stocks), or just through economic intuition. The safest way to short is to buy puts on the security you think will fall. You will pay a premium up front for the opportunity to make money if the stock falls, or if volatility in the stock increases. If the stock rises in price you don't lose any more money (like you would if you actually shorted the stock). 
• The key point to all of these strategies is you have to have information that the seller of the security does not. If the stock was definitely going down, who would want to buy it? If it was definitely going up, who would sell? Most of the shares in the market are traded by institutional holders who put a lot of time into being on the right side of the trade. There is some "dumb money" in stocks, so your chances of playing someone for a fool are at least not 0, but the option market is almost exclusively written by institutions so when you are buying that put you are calling some quant jock at Goldman a fool. The good news is that historically the markets go up, so if you are net long your playing a game where everyone will win. 
• Now it's time to buy the stock. You need to put on your portfolio analysis hat now and think about how the security will affect your diversification. How much should you buy? Should you sell something that holds a similar market niche as this company to make room for it? How will it change the risk profile of your whole portfolio. You also might want to get your technical analysis hat on too. EMH theory, valuation, and economic analysis can find you good stocks to buy, but there is no denying that there are some optimal and less than optimal times to buy. Look for events in the stocks future like earnings announcements. Take a look at momentum indicators and make a play at the fools game of bottom picking. If you're even a little successful you could have just added 5% onto your yearly return. A way to avoid this task is to simply scale into the stock over a moderate period of time. The law of averages should make sure you aren't totally screwed on entry.
• Or don't buy the stock. Maybe it's not the best way for you to make money. If through your economic reading you've found a stock that you think has a great opportunity to make money over a short period of time, you could consider event play strategies. These involve calls and puts and include, bull spreads, bear spreads, straddles, strangles, and lots more. Each has their purpose and don't require that much background knowledge to understand. Pay attention to the break even points, and remember, you are trying to beat a bank, don't do it on a whim. 

If this sounds like a lot of work, maybe you should do what I plan on doing. Buy the market and become the benchmark that all these jokers are going to try to beat. Theory suggests they won't in the long run, although I'm not sure if the S&P is going to be getting up to that 8% annual return all the pension funds are predicting...

Pacifism and Objectivism for World Peace

Okay this is a direct product of finals week. The harder I study finance the more I want to think about big picture idea's instead. Below is an essay that roughly details a way of thinking that I think could solve a lot of the worlds problems.

The TL:DR is that by de-stressing the importance of patriotism and focusing on improving your immediate community you will naturally lead both a more fulfilling life, and conduct yourself in a manner in which all of your actions have pure intentions.

A Framework for Pacifism.

While studying in the US I have become cognizant of national pride, both American pride and my own pride of being a Canadian. While I have seen many of the traditional American values I am unconvinced of their superiority because they seem both shallow and conditional. Although I say this my overarching thought is that we are often taught to think of nations this way, better and worse. I propose that if we dehumanize our macro communities and focus on personalizing people instead of organizations/nations, we will live in a more harmonized world. 

Stepping back to my perception of America, an example of the weak foundation for its national pride is seen in the American dream. The idea of the American dream is a middle class living that is easily available to the masses; where the modern family lives fulfilling lives with modern conveniences. ‘Death of a Salesmen’ showed us the flaws in the 50’s, and the American dream is a total mockery today. The middle class is now obese children growing up on junk media to hit the further solidifying glass ceiling of class and wealth in adulthood. As adults they will come home to watch television channels that either pacify any real desire for personal achievement, or spin lies for them to repeat at the water cooler about how the world works, and what their government is doing for/to them. 

Canadians grow up in a very similar culture, but there is difference. First is the wealth split; “the have and have not’s” spreads beyond wage discrepancy, as vast swaths of the populous receive substandard education, healthcare, and have little opportunity for betterment in the states. The worst is that American’s still feel an entitlement to the rat race they’ve constructed as their lifestyle. In America man is either “taking what is rightfully mine”, or screaming bloody murder because someone “took what belonged to me”. This childhood mentality of righteousness plays out before our eyes on Fox News, The Wall Street Journal, Tea Party speeches or Republican Senators. Some Americans live a great life, and they have a great incentive to keep the party going, stooping to any level to protect it. Stooping hurts though, so through mass programming the rich get the little man to fight their battles for them.

The second difference with Canadians is we are a bit quieter about our pride of feeling we are the best. I think that doing away with this national pride altogether actually would bring a greater societal good.

This is where pacifism comes in. I think that a complete refusal to fight for your nations’ gains will lead to individual enlightenment and a global re-alignment of the human race’s goals and future achievements. If we downscope our sense of community to the people not the national framework, we will have much more clarity in our values because we will be focusing on a network we can conceptualize (you care about your close friends because you know them, you do not ‘know’ your nation).

Before I break the theory down in examples I need to flesh out a major identity change for this to work. We need to go back to tribal identification when we think about our personal roots. For example, I am not a Canadian; I just currently have legal residency status in Canada. I identify as a member of my parents clans, and my community is my family first, close friends second, and co-workers, professional network, and acquaintances last. I don’t identify with a faith, an organization, a country, I only identify with people. 

Now for why pacifism needs to be such root goal, we must think existentially. Death is unbelievably terrifying. Currently we all sit here, alive and conscious, with no idea how we got here or where we are going. This unbelievably bizarre event has spawned hundreds of religions, and huge factions of science and social studies that all seek to explore why. I think it is sufficient to say that before we know the why us, and what next, the thing that must be avoided at all cost is death. It is an unbelievable - in fact an unknowably extreme - evil to end someone’s life even an instant before it needed to end. One should be able to show the masses that to kill is the ultimate wrong, and to die in vain is the biggest loss. 

The last assumption needs to be how we make decisions. We need to be objectivists that chose paths in life based on value, and we need to value life above all else. We also need to value our own life above all else. All other decisions tradeoffs based on individual value judgments. Remember value is a function of both rationality and emotion and it is not naive. I don’t choose to go on vacation instead of taking care of my sick wife, because I value my time and my personal duty to my wife, more than the enjoyment that I would receive on the vacation. Group think, and long term planning still works because we rationally value the lives of our offspring and our closer community. For instance environment action is rational to the extent its’ harm on our quality of life is justified by its’ probability of helping our long term prospects - and to the extent we value our children - their long term prospects. 

I feel no value in ending my own life early in order to fight for the life of another. Martyrdom is irrational, because at the end of the day our time on earth is our own, and none of us can fathom the importance of our time spent conscious, beyond knowing that it is extremely important to us. Even in the best case scenario, where a soldier helps a community against a deluded killer, does the payoff from his humanitarian activities outweigh the loss of 40 years of life when killed. Think about 40 years of life in the context of all the time you have, and will end up, not living. Each iota of time is incredibly valuable. As I discuss below I firmly feel these ‘optimal’ war motivations are nearly never pure, mainly because the deluded killer is both almost never deluded, and very likely there because of the confrontational nature of foreign troop deployment.

First off let me say I think that war breeds war. When we go over to Afghanistan with the aim to protect the citizens from ‘bad guys’ and establish order we are really just stoking the fire. Less than 100 years ago war meant global conquest, as it did for thousands of years before that. We are just seeing a re-packaged form of the same thing. Everybody knows that on the individual level fighting never leads to successful terms negotiation, I can’t see why we fool ourselves into thinking it has any chance of working on a bigger scale. There are no bad people, just strong rational motivations and misguided thoughts of martyrdom. The only road to peace is through knowledge not suppression. We see this vividly in many macro examples, an obvious one being how much a family’s quality of life is improved when the mother is educated. War is barbaric, discoursed is civilized. We rarely wish ill on anyone we know, but somehow those we do not know are easy targets. If we stop thinking of people in collectives, in “them”, “the Taliban”, “the enemy”, and only think of people as people with lives, goals, families, and histories, then violence seems much eviler. The roots of pacifism lie in disaggregating our way of identifying strangers from a model of collective/national identification to personal or small community identification. If there is no sense of national identity, there is no nation to war against. 

So if the middleclass were to adopt this form of identity and a strict pacifism stance, foreign or domestic wars would get a lot tougher. The ruling rich (rich referring to wealth, knowledge, class, and opportunity) wouldn’t be able to protect their national interests because the citizens who usually join the army no longer find any value in that activity. So they would conscript. And we would leave. If the US wants war, then Americans draft dodge to Canada. If Canada wants war, we draft dodge to Brazil. We would move with those we value, to the extent that our values aligned. 

If I wanted to move to avoid the draft but my mother wanted to stay because she valued her surroundings more than being with me, then I would have to make a probability defined choice. I would weigh the value I have for my dear mom, against the probability of being forced into a circumstance of ultimate sacrifice. Obviously this gets complex, but remember you have a lifetime to make these decisions. However to make these decisions you need to base your decision off your personal values, not what the TV tells you to do. Thinking for one self is a tiresome task, but I think it’s worth it!

Staying big picture, I now propose that this form of thinking won’t just lead towards a life running away from national responsibilities, as we constantly move to ‘grass is always greener’ pastures. If the idea takes hold society will take a much more socially libertarian form, the model conceptualized by Switzerland, not bastardized by the States. Taxation won’t disappear because we will both appreciate the conveniences of the traditional state run infrastructure, and we will have a high appreciation for life so health care focused initiatives should have a high funding for all. With no national pride there is no hold on citizenship, countries simply become a conduit of value creation activities. If one country is receiving more citizens, other countries adapt to its policies, much like businesses respond to competition. Faith can be a rational value, but it must be for the sense of community, not to be a martyr for a greater cause, because that defeats the rational outlook individuals and society must have for the system to work. 

Although I talk about this on a large scale it really is an individual driven idea. It also fits very nicely with the current societal framework we have; following this line of thinking breaks no law. It’s also a concept well tread by philosophers, from Ayn Rand (dare I call her a philosopher?) to Murray Bookchin, and Robert Nozick. I’m sure there are still holes; an interesting argument would be what would happen to charity overseas with a narrow community mindset. I think generally if you value helping those most in need, it is a rational choice to do so. Just make sure you are doing it because you value it, not because you want recognition for doing such selfless work, or worse, because you wish to incite guilt in others with a display of altruism. The payoff must be intrinsically derived within, anything else is too risky. We’ve got one shot here; aim to make it a fully satisfying action packed journey.

Diversifing on Style, not Assets

I haven't put new money into investments in a long time. In fact I think the last of my buying spree was mid 09, where I sunk everything I could into the rallying market. Since then it's been strictly withdrawals, and as I approach my lifetime record high debt date this June, Me Inc.'s asset composition might be: 0 marketable securities and a 3 digit cash balance. But then it will all turn around, I'll start earning a salary and I'll have to begin to make some decisions on how I want to maximize my return.

Constraints
There will be a couple constraints I will need to work with first, the big ones being:

• Time - i-banking ain't no 9 to 5.
• Horizon - I'll be house eager before I'm 30.
• Legality - I will be working with businesses in my favorite investment industry, large cap energy; when I'm reviewing targets for selection any shares held in the selection pool biases my analysis. 
• Return - In the short term any investment return needs to outperform my LOC interest rate. If not it's best to just pay down the debt.

Strategy Considerations
Given these constraints I am considering the following strategies:

• Passive equity & passive debt. Asset mix (D/E) rebalanced yearly based on macro expectations.
• Equity MSCI World Index.
• Debt Mix of Corporate Investment Grade and Government.
• Managed Passive
• Equity a mix of index tracking ETF's. Rebalanced throughout the year based on Macro outlook.
• Debt Corporate as boom picks up, shifts to gov as boom turns to bubble building.
• Buy & Hold
• Single Security pick up in non sensitive areas. Value objective with 5 year holding horizon. ETF energy sector.
• Debt selective corporate high yield.
• Use of option strategies to compliment both debt and equity positions.
• Handoff
• As capital builds invest in professionally managed funds (hedge, no mut's).

Expectations
As to which strategy I will choose will be a decision for this winter, but I'm leaning towards the simplicity of Managed Passive, and Handoff some when my investable assets reaches 6 figures.

As of now I have several expectations that I will base my weighting on.

Short Term

• Low yields will continue to favor equity, especially emerging markets
• Debt opportunities available in euro sovereign market.
• Bullish Oil, Bearish LNG, Generally bullish commodities.
• CAD will stay near parity.
• Major indexes will slow-grow through 2011.

Long Term

• China is the next asset bubble. Matched with a political meltdown its a recipe for the next recession
• Precious metal bubble.
• Aggregate buy in on renewable energy from governments, returns will be cushioned by normalizing multiples.
• Increased cross border acquisitions from emerged economies on N/A businesses - resource especially.
• Common currency relationship drags on European economy in the long run, they make it through the current debt crisis.
• China "plus one" nations to be the new investment boon (Vietnam, Cambodia ect), Africa soon to follow.
• Unlikely to significantly surpass S&P500 high of 1550 before 2015. 
• Because of increased awareness to downside protection strategies, next financial crash will be even faster. Possible insurance play: hold long, buy deep in the money puts OR buy far out of the money VIX calls.
• When interest rates are above 4% be sure to have a good debt component and shift towards government. (see graph). (Assuming inflation under control).

 Those are my thoughts for now, I'm looking forward to having money to put it into action come fall.

Wikileaks - for good or evil?

I have eagerly followed Julian Assange and his organization Wikileaks for about the last year, and this last week has been full of debate on the man and his mission.

First off the guy is actually really fascinating. I found an old blog he wrote that talks about a lot of his motivations. Along with a couple interviews (here is a good one) I have begun to feel a lot of admiration for the man - I can't believe he is still alive. In a way he is a modern day Robin Hood, stealing (well actually just distributing) information from the knowledge rich, and handing it to the spin-free information deprived masses.

Part of the reason I think his mission resonates so strongly with me is because I have really begun to see the evil of mainstream news this last year. Fox Business plays 24 hours a day in the halls of my school, and I have subscribed to the Wall Street Journal to round out my academic reading. It is disgusting the level of spin that is layed on through both outlets (I know... same owner) and I am surprised how often I am directly lied to. Liberal Viewer Presents does a good job of highlighting some of the more grievous errors, and NewLeftMedia does a good job showing how it impacts the voting public.

So when an organization releases pure fact news. No spin, no opinion, just fact, it's the Reuters of politics. That seems very good, in fact it's hard to see the downside. I guess the catch is that sometimes people get hurt. The leakers go to jail, or sensitive military information is released. But the more I dig, the more it seems that the good far outweighs the bad.

First off the information is usually fairly stale (no troop movement for next week documents), and Wikileaks seems to be pretty careful about only putting things out that are controversial, instead of private. For instance, a conversation between diplomats who represents nations is published, personal information about staffers is not. But there are still people who are caught in the cross hairs, whistle blowers, or parties unknowingly aiding the corrupt. My view is that in almost all cases the net good of the release outweighs the individual cost (good ole utilitarian logic I guess). It's really nice to hear the Afghanistan story unfiltered through intelligence reports, instead of wrapped up in "mission completed" rhetoric on Fox or even CBC. 

I will admit a small transgression. I hardly read the leaks. Does that make me just as bad as the Fox News watcher? In a way it kinda does, if I prefer packaged media to fact driven media, I'm willfully ignorant and that is a true evil. But I rationalize it this way. Wikileaks so far has published mostly geo-political stories, I'm not terribly interested (and currently have no real time for) geo-politics, so for me knowing that those with interest finally have a good outlet is enough. For now the geo-political news stories I do read in the WSJ are compared with the corresponding article in The Economist, and I assume that both have some spin.

This said Assange was quoted by Forbes saying that the next leak will be on banks. I will definitely read those with interest.

The Virtues of Finance

There has been a lot written lately about the insider trading scandals in the states, particularly the one involving Raj Rajaratnam and his old hedge fund Galleon Group. I did my 4th year business ethics term paper on Raj, and I have kept an eye on the events as they've unfolded. The big takeaways I've gathered are that: in business it often boils down to intent, and that although painted black and white these scandals are often very grey.

For instance think about the whole purpose of hedge funds. Their goal is to achieve returns above the market return. If they are able to do this with less risk then they have just disproven either Semi-Strong Form (SSF) or Weak Form efficency (ie. are they arb, valuation, or trading based). Market crashes aside, the market seems to be fairly SSF efficent, and so any hedge fund manager making ground must be cheating.

Galleon group had expert panels. This seems like an obvious must to a firm whose strategy is valuation. Talk to industry participants about where they think the industry is going, and then tailor your investments accordingly. If industry expert A says "I think that the semi conductor industry is ready for a comeback, data warehousing is going to bring in a huge demand force. If I were you, TriQuint would be a hot buy right now - they are really poised to sell into data warehouse demand.", then that's pretty above board advice. But what if expert A is telling you this and his firm is a data-warehousing firm, who is about to make a big play for a TriQuint. A lot shadier.  This is were it can come down to intent, and the court gets to decide your motives, not you.

In finance this is painted with a much broader brush against the whole industry, and I experience it in conversations all the time. People on the capital side of the business are seen as the fat cats, who care about nothing except personal gain. Why?

Umm what do you do exactly?
Focusing on investment banking, I think it gets it's reputation for several reasons. First it's confusing. The general public has very little concept of how a investment banker adds value. It's easy to think you understand what an astronaut, firefighter, tax accountant, surgeon, does in a day, or how a car company makes money. Even trading seems somewhat understandable, but what in the hell do those i-bankers do to make 6 figure salaries right out of college? The average joe either just envisions an open excel spreadsheet, or a golf course. They don't see any output, there is no product, it's just really really hard to think of what the work is.

When I began talking to my parents about roles I was considering, or where I landed, I saw first hand the difficulties in explaining the business. Now that we've switched over to Skype to ease the international phone bill, I can literally see their eyes gloss over when I talk about how I plan on valuing a target oil company for a Chinese bidding firm.

Now my laymen one liner is: "I attempt to put a price on a really large business by predicting, as accurately as possible, how much it will make from now to forever." or if I'm feeling quippy "I price the future", "I value things that are hard to value", and if I'm trying to pick up, "Come back to my place and I'll tell you what you're worth" (bet she's not imagining the excel filled night I am....).

Okay so how does this help anybody?
Or put bluntly by a friend, "explain to me why you're not increasing world suck". This is a bit harder to defend because you do hear about situations when you can be forced between a moral choice and a profitable choice. I conceed this point, but I'd point out that every job has the ability to hurt society from time to time. Think car mechanic. Sometimes your mechanic may overcharge you for the work, or replace things that don't need replacing. This is because there is a large information asymmetry - you know nothing about your car. The thing is some mechanics will do it the right way, and they'll quickly be recommended by their customers, so although you may know nothing about your car, you do end up getting to know who is a good mechanic. The mechanic may add to world suck everyonce in a while, but too many fraudulant transactions and he's lost his business.

It has to be the same way in the business world. If someone is going to pay me, I have to be helping someone. I see the M&A i-banking role contributing two things. The first big one is information. Through my days toiling at the office I am creating information where none existed, I am lessening the information asymmetry between the bidder and the target (or on the issuance side the investor and the company).  A creator of knowledge is a pretty good thing to be, and although I'm not curing cancer, I may be contributing to the process that gets the money to the person who does. And this is the second big point. Investment banking let's people invest. My team is tasked with lining up good ideas that need money, with money that needs good ideas.

I may not be producing energy efficient solar cells, rice bags for the poor, or biomedical advances, but I am part of a system that lets those things happen, and without that system, none of those things would be possible. The catch is every once in a while, I may inadvertently (or maybe even knowingly) help line up capital for an idea that is not a net good for society. My defense is that these idea's need demand, and people don't pay for what hurts them. Sometimes they do, but they do it unknowingly. I argue for the system to work, these bad idea's, bad mergers, bad companies, must be few and far between, because if they were common consumers would lose trust. When you lose trust, you lose consumption, which leads to layoffs, which leads to depression. We all work around the principle that everyone is contributing to society, not taking away from it. It's a sound principle and it guarantees virtue in every profession if it holds.

Why so much money?
I haven't developed a good explanation to this yet. I'd still pursue finance if it paid a fraction of what it does; I'm made for the trade, what is more fun than predicting the future! Finance is my plan A,professor B, and helicopter pilot plan C. After that I would start thinking about professions that were "jobs" that could pay for other things in life I enjoy, but for now I'm looking for a career that is the life I enjoy. Chris Rock explained it this way.

So why the money. Well economically it should be because supply of the job is much higher than demand. But this isn't true, thousands of people apply to 1 opening, statistically each applicant has 0% of getting in, the wage should be dead low, because if you don't want it the firm can just give it to the next applicant. Before we ditch economics lets drop the assumption that every applicant is the same. Maybe out of the 1000 applicants, there are only 50 that could do the job? I don't know the answer to this one, but I'm sure it plays a part of the story, there are 4 rounds of interviews after all.

The hours need to be factored in as well. If you are working 90 hour weeks for 51 weeks a year, you are making under $22.00 an hour. Averaging a 90 hour a week is a bit steep, but I'd wager most i-bankers are making less than $30.00 an hour before bonuses in their first 2 years.

And let's not forget what employers are asking for here. Quants with presentation skills. It's not that hard to find a very well spoken university grad from a liberal arts degree. It's not that hard to find a quantitatively sharp university math major. It is hard to find someone who has both. Many business students are good speakers, decent on the business skills but lack the fundamentals in statistics. I-banking is high powered sales, you need the best of both worlds if you are going to solve and explain business combination investment problems.

The Image
I'll admit, I've read the blogs (for example the leveraged sellout), and seen the movies (Wall Street... the first one), and I can concede that those with less than admirable intentions may flock to the profession of i-banking. But I will say that I plan on leading a life of virtue (maybe a bit on the Ayn Rand side of the definition sure), and after speaking to my to-be team in the interview rounds I'm left with the impression that they do as well. It's never like the movies anyways...

Q1 Gradschool. The BComm entrant experience.

CFA level II so far

So I finished the FSA book a couple days ago, which marks about the 1/3 point through the curriculum and I have to say - The CFA II material is surprisingly interesting!

I remember level I being such a slog, and extremely picky in it's questions. After finishing accounting - my least favorite section in level I - I was impressed with how applicable everything was and I was also encouraged by the practice questions. The material is taught at a 4th year undergrad level, but the questions stay fairly theme based (as opposed to memorization or plug & chug) and don't try to trick you. Not to say I'm aceing everything, but on the first pass I'm usually scoring above 70, which as we know is the supposed floor. I think I will stick to just the curriculum till the new year and then I'll do my second pass and testing with Stalla for the easy stuff, and use both for the harder stuff.

As for pace I'm a bit behind schedule. I'm averaging 0.91 hours per day, and I need 1.1 to make my 250 hour goal, and I still need to thump several readings to take my big holiday push reading-per-day average below 1.5.

Visually the stats look like this:

 An hour evening investment feels about max right now with a full course load, but im hoping to do some 10 hour days over the break that should really lighten the load for the winter semester. Of course testing will really pick up come the spring semester, and I'll likely need more like 300-350hrs to feel 100% on everything.

For all the other studiers and December writers, best of luck!

Books

I watched the seventh Harry Potter last night and I was pleasantly surprised. The series grew up a bit, had better acting (although Daniel Radcliffe who plays Harry continued to be a bit awkward) and stayed very true to the book. I remember reading the series as a kid at camp, and I remember downloading the books to listen to during my several cross country road trips. Now that I'm clocking finance from 9 to 9, seven days a week, it's all I can do to keep on top of my economist and crawl through a novel a month. But when I was growing up reading played a big part of how I formed my identity, and so I'm going to quickly reminise the novels that formed the pre-finance me.

Pre-High School
After going through the Bearnstein Bears type books it was time to get into some of the real adventure novels.

I think the first series I read myself was Narnia. I remember it started out great, but I almost dropped the series on the book in the desert with the cat. It took several years to realize C.S. Lewis's habit of making his stories metaphores for stories from the old testimate.

After Narnia I think I went straight into the Golden Compass trilogy. A lot of people dropped this after the first book, but the Subtle Knife and Amber Spyglass held their weight. This series was followed quickly with Tolkens Hobbit and LOTR, a few Dragon Lance novels and of course Potter, but in general I was getting a bit more interested in feeding some more tangible desires.

Around grade 5 or 6 I read my first Christopher Pike novel. These were page turner murder mystery / horror novels written for a high school audience. I don't think my parents realized I kept asking for Pike novels because they consistently had soft core sex scenes, not because I really liked solving the mystery.

High School
At about grade 10 I read my first Ayn Rand novel - Fountain Head - and it hit me at exactly the right time. I ended up reading Atlas Shrugged, Anthem, and her essays (virtue of selfishness being the best), but Fountain Head's Howard Roark and Elsworth Toohey really struck a cord with me and I continue to see her characters in the leaders of today. It definitely led to a lot of introspection on what I wanted in life and how I planned on getting it. Of course over time I have found lots of places her theory of "objectivism" doesn't work, and that nobody really could ever be any of her characters, only a mixture of all of them. Still her work is a metaphor for a way of life I still identify with, and although my quote marked book is back in Canada here is an 'essence' quote.

Howard Roark - Protagonist

The egoist in the absolute sense is not the man who sacrifices others. He is the man who stands above the need of using others in any manner. He does not function through them. He is not concerned with them in any primary matter. Not in his aim, not in his motive, not in his thinking, not in his desires, not in the source of his energy. He does not exist for any other man -- and he asks no other man to exist for him. This is the only form of brotherhood and mutual respect possible between men.

After Rand I was coaxed to read some more of the classics, Crime and Punishment, East of Eden, and period pieces like Shindler's List. Although they had good messages, I still liked the brute philosophy in fiction approach more. This lead to reading a bunch of Friedman, Capitalism and Freedom being the favorite.

Since then my studies pushed me towards a lighter plate, and so from the top of my head here's a list of books good enough to read twice.

• The Giver - Aimed at a highschool audience but good message. Similar to Harrison Bergeron by Vonnegut
• Life of Pi - A good metaphor about faith
• Ishmael - Existentialism in fiction 
• Zen and Art of Motorcycle Maintenance - Same
• Logic of Life, Freakanomics - New age behavioural economics
• Liars Poker - A 'get jazzed about wall street' book
• Fooled by Randomness - Taleb's book about asset bubbles.

And that's about it for now. I am definitely looking forward to graduating when I will finally have time to... oh wait... 10k's are pretty good reads too I guess.

Progress on the Implied Distribution Project

So some success has been had since the last post. After talking to a professor I was steered towards the big Hull options book for Hull's solution to creating a risk neutral implied distribution from option prices.

His solution involved using the butterfly spread payoff to construct the distribution on the segments between strikes, and then march along all traded exercise prices to map out the full curve. For instance the formula for the expected likelihood of the stock reaching $6.5 would be = (e^(T*rf)*(Call_Price@6 + Call_Price@7 - 2*Call_Price@6.5))/(0.5^2)

He was using Derivagem to price his calls (including the never-to-be-traded 6.5) and everything worked out peachy keen.

Well it didn't for me. After running through several different stocks I concluded that this method either doesn't make sense in the real world, or is being badly abused by my hackneyed knowledge for probability density functions.

I went back to the drawing board and decided to go big or go home. Here is a screen shot of my option calculator.

 

I know you can't see anything so it basically is 35 replications of this

So now at the touch of a button I run this code

Sub Button1_Click()

Dim min As Double
Dim target As Double
Dim vol As Double
Dim i As Single

Application.ScreenUpdating = False
Sheets("BS MODEL").Activate
i = 0
Do
    target = 0
    Range("b14").Offset(0, i).Value = 0.0001
    vol = 0
    min = Range("b16").Offset(0, i).Value
    ' we have reset the implied volatility to 0, and are ready to min the difference between bs call and market    call
    Do
    vol = vol + 0.0001
    'we step the implied vol by 1
    Range("b14").Offset(0, i).Value = vol
    min = Range("b16").Offset(0, i).Value
    'bs theory tells us the market call must be larger than a bs call with a lower volatility so we can use an absolute inequality
    Loop While min > target
'we now solve the call/put of the next strike
i = i + 2
Loop While i < 31

Sheets("IMPLIED DIST").Activate
Application.ScreenUpdating = True
End Sub

And we solve for 35 implied volatiles at the same time... COOOOL!

With some =1-Normsdist() work I was able to back out the implied likelihood for each strike and was left with this implied distribution for Apple from now to December 17th. 

Woo Hoo! This rough cut of the apple distribution tells a good story. The left tail is significantly fatter than the right tail (recall the stock is trading at 300), and there is some skew. The skew bothers me a little bit because I think it is partially a product of where I chose to switch from calls to puts. 

Remembering that options have a volatility smile we know that deep in the money options are biased upwards in volatility. Theoretically the smile should look something like the black line below. 

If the intersection between the put volatility smile and the call volatility smile is at the stock price then if you switch from out of the money calls to predict volatility, to out of the money puts as you cross the stock price your predicted volatility should have a pretty seamless transfer (think about just always using the lowest black line). Unfortunately I am  seeing a much higher put volatility in options with exercise ~ stock price than in calls. I show this with the red line above, but this is with the assumption that the puts are "to high" at the stock price and the calls have the true volatility. It could just as easily be reversed where exercise = stock price calls could have too low of a volatility and the puts have the true volatility.

This whole scenario forces me to make a judgment call. Do I a) accept that the distribution has a 10% stdev jump, b) use calls and switch over at a lower exercise price where the volatiles cross, or C) average into (smooth into) the new volatility around the stock price. Some definite thinking time.

When I get that part figured out I'm going to modify the model to be plug and play with bloomberg exported option data, and I want to solve the distribution for all the option expiry periods simultaneously so I can create something that looks like this:

Comments, suggestions, corrections welcome!

Using Options to Estimate Future Asset Distributions - An Idea in Progress

Researchers have spent a lot of time discussing how past return distributions have taken significant departures from the "normal distribution" both in squewness and kurtosis. (think 1987, 2001, 2008). Banks put a lot of investment into developing strong Value at Risk model to predict risk. Hedge funds base entire strategies off of differences observed from what they believe to be the true distribution and the distribution observed on assets in the market.

In the last 48 hours I've stumbled upon an idea that links Value at Risk methodology with put call parity and implied volatility from the Black Sholes model. The essence of the idea is that we can use the prices in the derivative market to construct the expected return distribution on the asset from now to the options expiry. After talking to a prof, I've realized although new to me, this idea has been thought up and proven nearly a decade before I was born. The upside is that it works, and seems to beat most of the other main models, like the normality assumption or the historical distribution assumption. An excellent professional paper that explains all this can be found here, but for now I will walk you through my thought process of the solution.

Remember the Black Sholes model? Before the binomial pricing model it was the way to price options. One of it's major flaws was that the formula relied on the normal distribution to describe prices.

In the middle of my corporate finance class last night I remembered that you can use the B/S model backwards to find the implied volatility of an asset. If a stock is trading at $12.34, and you have a call with a strike at $16 that costs $0.49 you know the expectations of the market that the stock will get to $16 by the options expiry (August in this case). Using the b/s model backwards you can solve for the implied volatility (which is the same as saying the standard deviation of returns) of the stock (turns out to be 0.35). Then using this information you can say under the normal distribution the market expects the likelihood that the stock will reach the strike price is 27% (by cracking out that Z table, or =normsdist() in excel).

But this isn't the fun part. Knowing the implied volatility you should be able to use put call parity to find the put price for the same strike. When I was trying this out I noticed that I was always overestimating the price of the put for the same strike. Logically this means that the market believes the stock will go down easier than it will go up, the left tail is fatter than the right tail.

The really cool part about this is by taking puts and calls of all different out of the money strikes you can begin to map out the expected distribution by paying close attention to the deviation from put call parity. You need to use out of the money options to avoid the bias the volatility smile will bring into your model. After mapping the distribution ( a step I still need to learn how to do), you have a distributions that reflects the markets expectations for the asset performance (the stock) from now to the expiry date.

Jackwerth and Rubinstein's Findings

Now I just need to figure out how to efficiently code it for excel, and I'll have a much better risk/reward picture for any asset I'm looking at for investment or analysis at work, assuming it has a well traded derivative tree. Stumbling blocks I dealing with now include

• Making sure my current Black Sholes model is efficent enough to avoid estimation error.
• Getting historical option prices and weeding out low volume offers that will have a significant bid ask spread.
• A way to automate the process using VB in excel to construct a model that can be run over several days to measure shifts in distribution expectations.
• Some more education to understand how the implementation of the methods used in the paper provided above could work in excel.

Once I have a working model I will be able to do a variety of cool things

• I can peg a dynamic and empirically accurate probability on a target price I come up with for a stock.
• I can have a better idea of what the expected Value at Risk likelihoods are.
• By observing changes in the distribution overtime I can start thinking of applications of the second and third order "Greeks" in adding forecasting information to my analysis.

Idea's, suggestions, comments welcome!