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.
Tuesday, November 30, 2010
Sunday, November 28, 2010
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...
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...
Tuesday, November 23, 2010
Monday, November 22, 2010
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!
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!
Sunday, November 21, 2010
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
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.
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.
Thursday, November 18, 2010
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.
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
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 DoubleDim 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!
Thursday, November 11, 2010
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
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.
- 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.
Sunday, November 7, 2010
Hippies. How and why to be one.
Now let me be clear. I never actually completed the transformation into hippydom. I was more of a by-stander who would take part in every part of the lifestyle but never actually be one of the group. If you've seen Almost Famous, then think of my foray into this minimalist culture like William Miller touring with Stillwater.
The Path
It wasn't really my goal to find a counter culture after high school, but it was my goal to find a coolwell paying summer job. After spending several years learning how to kayak I realized with the help of some friends that I was only a couple certifications away from being a raft guide. So me and a buddy packed 3 kayaks, 2 surfboards, plus camping gear, and headed out on the 3,700km trip to begin rafting on the Ottawa River in Ontario.
Now this brings us the the hippy attribute I do the best at. Road trips with lots of gear in small cars, run down vans, or small pickups, is definitely the bohemian mode of travel. A hippy is a nomad of sorts, but because they are short on funds you will always find them on what seem like horridly long road trips in cars that have no A/C. While gas-guzzling america floats by in their 2 ton DVD installed tanks, we putt along - windows wide open, shocks bottomed out - having much more fun.
Now you need a cool job, or better yet a commune. The purists will volunteer with organizations that pay in only food and board. A classic opportunity is found with WWOOF.
Rafting fit the bill for several reasons. It's a hard job, outside in the water all day rowing or paddling people down rivers. Working a easy river requires a lot of rowing and good "raft talk" to keep the clients interested. Hard rivers do a bit more of the work for you, but require small spurts of strength, lots of skill, and the ability to control a crew of clients when their surroundings are total chaos. It's also pretty spiritual, to make it smoothly down the river you need to let the water do most of the work, and that takes learning how to read rapids. When you can predict how each wave will move your boat, you spend most of your time turning the boat for the desired push, not pulling the boat across the river.
The Path
It wasn't really my goal to find a counter culture after high school, but it was my goal to find a cool
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| Everything must go... |
Now you need a cool job, or better yet a commune. The purists will volunteer with organizations that pay in only food and board. A classic opportunity is found with WWOOF.
Rafting fit the bill for several reasons. It's a hard job, outside in the water all day rowing or paddling people down rivers. Working a easy river requires a lot of rowing and good "raft talk" to keep the clients interested. Hard rivers do a bit more of the work for you, but require small spurts of strength, lots of skill, and the ability to control a crew of clients when their surroundings are total chaos. It's also pretty spiritual, to make it smoothly down the river you need to let the water do most of the work, and that takes learning how to read rapids. When you can predict how each wave will move your boat, you spend most of your time turning the boat for the desired push, not pulling the boat across the river.
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When your day job looks like this it's easy to feel bohemian |
Now it's important to remember being a hippy is a lifestyle, not a day job. If your out strawberry picking all day for kindness tolkens but come home to cable tv and running water, you're not a hippy. My summers rafting were 4 month chunks of my year where I worked, slept in a tent, read books by headlamp, and drank to much wine. But as we recall I'm a big faker, and so I lived like a slob...
The 'real deals' do this stuff all year round in an endless summer, and they've figured out how to take care of themselves. While I was rafting many of my friends would turn these platforms into tiny functioning homes, with little patios, doors, and lot's of candles. Come September while I was diving back into profit margins and investment strategies, these folk were heading off to Fernie or Costa Rica to set up shop for the winter and live the dream.
Why be one?
Let's face it, the pay sucks, you're often uncomfortable, the future prospects are much less certain, and after a while everything you own stinks. But in a way that's the point, to take the path less traveled by.
You meet people with amazingly different ideas, live in some of the coolest environments on earth, and do things most people don't know exist. Once you imbibe the 'live in the moment' attitude you feel all the stresses that plague the average joe melt away. You wake up at 6am not because you need to be at the office for 7, but because you want to surf the morning break before the wind picks up. When you have a day off, you go on a ski tour because you have the energy and there is nothing to do in your shack. While you might miss out on 'dancing with the stars', at least you get to have turns like this.
and views like this
Why not?
When I compare a multi-week adventure I've had with my endless summer kayaking friends, and what I imagine life to be like as a first year i-banking analyst, it seems like I'm moving from very extreme ends of the lifestyle spectrum. Oddly it's a choice I've thought very little about until recently.
I always thought of my summers on the water, and my winter adventures as vacations from life. Although I saw people living those vacations year round, I never really seriously considered it as I choice I could make as well. On reflection I think this comes from 2 major flaws (in my opinion) in the drifting lifestyle: a lack of goals, and a lack of challenge. While simply living to enjoy the joys of life seems appealing, it falls apart when you think about scale. Climbing Everest is a hippy thing to do, but spending 3 years building a company that sets up organized trips up Everest, is not. In both, you climb Everest, in the latter you have enough income to climb K2 and the other peaks as well.
I think that with a real job I will be able to have all the adventures the free spirit me dreams of, but I will need to sacrifice some duration for exposure. I'll be able to afford to do a fly in kayak trip on the Homathko, but after that week it's back to the office, not a follow up trip on the Dean.
The trick will be keeping the existential frame of mind. The business world is news obsessed, and more than once I've forgotten the big picture. Even now I spend 14 hours a day in front of a computer, while some hippies touch a computer once every 2 weeks at an internet cafe or public library. By filling my weekends with 'into the wild' adventures, hopefully I can strike a balance of extremes that gives me enlightenment in both worlds. Sounds a lot like modern portfolio theory...
Saturday, November 6, 2010
Motivation for the CFA
It's that time of the year again. The curriculum arrived months ago, and after getting through Ethics and Quantitative Methods it was promptly forgotten, but now Financial Reporting and Analysis needs to be cracked and I need to re-find my CFA motivation.
The Big Picture
First I remind myself why I am taking this certification. Matched with my MSc Finance these three letters should allow me to side step the MBA in the future. After transitioning from candidate to member, career doors should swing open, and salaries should double. I should be able to consider myself an expert in my trade, and wield financial analysis like lawyers or doctors wield subpoenas and scalpels.
Big picture thinking only gets you so far, especially when it's so intangible. If passing my level II exam were to give me a 1997 Porsche 993 GT2, then hey, print the poster and I'm motivated! But when it's going to further career goals I'm already hacking away at with academic credentials it gets a little harder. Add on top the fact that I have 4 years to pass the last two exams because I still need the work experience, and working the 7-12 shift after schoolwork is not appealing.
But it's still important. Most people in this industry are perfectionist, workaholic, status freaks, and failure is no option. While I like to think this only partially describes the finance side of me, lately this side has bullied all the other me's into submission - so let's feed the beast. Let's pass the hardest of the 3 tests in a year where school stretches through June, and getting the grade is already stealing time away from the dinner time internet break. If nothing else, the challenge itself should motivate!
Tools for the Weary
One of the fun things about Finance is the visual presentation of data. Throw stock prices into a graph and a plain column of numbers tells a story of hard times and good times, surprises, impending doom or unrestrained growth; these are the stories we will tell our kids, picture books full of MACD trends and bollinger bands. Something I discovered while studying for lvl I, was that the same thing that I enjoyed learning could in fact help me learn it!
Pop open a new excel sheet and start tracking your hours. With some in-cell if statements you can make tables populate how much time you've spent on each section, and how much time you have left to your ### hour goal. The most important graph however is the hour tracking graph. By plotting date on the x-axis and hours studied on the y-axis you can visually see how your performance is trending. Be careful to use a bar chart, a line graph gives you the impression you are studying between periods. In fact run a 14 day MA chart below it, and you can see where your work tapers off. Basically the whole goal is to keep the graph trending up, piling more and more hours in each week as the exam gets closer. Make yourself look like a 1998 tech company; for me coaxing this graph upwards gave me more of a reason for "one more hour" than anything else I was doing.
Testing
Beyond some soul soothing excel playtime, the biggest thing I took away from level 1 was how much testing early helped. I don't have the time to start studying 2 months before the exam and devote major time daily, so I need to start really early. Because of this my ethics reading in September will suffer some major retention depreciation over the winter. By doing some tests along the way, and then doing nothing-but the month before, you are forced to keep things fresh, and you get feedback on where you failed to learn the first time. The CFA questions do an okay job at this, but the Stalla questions (or Schweiser I presume) poke at the content with enough of a different approach that you will quickly realize what was memorized and what was learned. And then in the last month, surround yourself with others writing the test. Me and a buddy would study all day on the weekend and then throw the hardest questions we had encountered at each other. It made it competitive which always helps with motivation, and provided an element of fear on a regular basis which helped us burn the oil in the week ahead.
Will add more through the winter, for now Reading 22 needs its due attention.
The Big Picture
First I remind myself why I am taking this certification. Matched with my MSc Finance these three letters should allow me to side step the MBA in the future. After transitioning from candidate to member, career doors should swing open, and salaries should double. I should be able to consider myself an expert in my trade, and wield financial analysis like lawyers or doctors wield subpoenas and scalpels.
Big picture thinking only gets you so far, especially when it's so intangible. If passing my level II exam were to give me a 1997 Porsche 993 GT2, then hey, print the poster and I'm motivated! But when it's going to further career goals I'm already hacking away at with academic credentials it gets a little harder. Add on top the fact that I have 4 years to pass the last two exams because I still need the work experience, and working the 7-12 shift after schoolwork is not appealing.
But it's still important. Most people in this industry are perfectionist, workaholic, status freaks, and failure is no option. While I like to think this only partially describes the finance side of me, lately this side has bullied all the other me's into submission - so let's feed the beast. Let's pass the hardest of the 3 tests in a year where school stretches through June, and getting the grade is already stealing time away from the dinner time internet break. If nothing else, the challenge itself should motivate!
Tools for the Weary
One of the fun things about Finance is the visual presentation of data. Throw stock prices into a graph and a plain column of numbers tells a story of hard times and good times, surprises, impending doom or unrestrained growth; these are the stories we will tell our kids, picture books full of MACD trends and bollinger bands. Something I discovered while studying for lvl I, was that the same thing that I enjoyed learning could in fact help me learn it!
Pop open a new excel sheet and start tracking your hours. With some in-cell if statements you can make tables populate how much time you've spent on each section, and how much time you have left to your ### hour goal. The most important graph however is the hour tracking graph. By plotting date on the x-axis and hours studied on the y-axis you can visually see how your performance is trending. Be careful to use a bar chart, a line graph gives you the impression you are studying between periods. In fact run a 14 day MA chart below it, and you can see where your work tapers off. Basically the whole goal is to keep the graph trending up, piling more and more hours in each week as the exam gets closer. Make yourself look like a 1998 tech company; for me coaxing this graph upwards gave me more of a reason for "one more hour" than anything else I was doing.
Testing
Beyond some soul soothing excel playtime, the biggest thing I took away from level 1 was how much testing early helped. I don't have the time to start studying 2 months before the exam and devote major time daily, so I need to start really early. Because of this my ethics reading in September will suffer some major retention depreciation over the winter. By doing some tests along the way, and then doing nothing-but the month before, you are forced to keep things fresh, and you get feedback on where you failed to learn the first time. The CFA questions do an okay job at this, but the Stalla questions (or Schweiser I presume) poke at the content with enough of a different approach that you will quickly realize what was memorized and what was learned. And then in the last month, surround yourself with others writing the test. Me and a buddy would study all day on the weekend and then throw the hardest questions we had encountered at each other. It made it competitive which always helps with motivation, and provided an element of fear on a regular basis which helped us burn the oil in the week ahead.
Will add more through the winter, for now Reading 22 needs its due attention.
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