implied volatility

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The Volatility Smile by Emanuel Derman,Michael B.Miller

Albert Einstein, Asian financial crisis, Benoit Mandelbrot, Brownian motion, capital asset pricing model, collateralized debt obligation, continuous integration, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, diversified portfolio, dividend-yielding stocks, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, incomplete markets, law of one price, London Whale, mandelbrot fractal, market bubble, market friction, Myron Scholes, prediction markets, quantitative trading / quantitative finance, risk tolerance, riskless arbitrage, Sharpe ratio, statistical arbitrage, stochastic process, stochastic volatility, transaction costs, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

As we will see in subsequent chapters, jumps in the stock price are another way to match the steep short-term skew. 377 19% 85 20% 21% 22% 19% 85 20% 21% 22% 19% 85 20% 21% 22% 90 90 90 95 95 95 α=0 Strike Price 100 Strike Price 100 Strike Price 100 105 105 105 110 110 110 115 115 115 19% 85 20% 21% 22% 19% 85 20% 21% 22% 19% 85 20% 21% 22% 90 90 90 95 95 95 α=3 Strike Price 100 Strike Price 100 Strike Price 100 105 105 105 110 110 110 115 115 115 19% 85 20% 21% 22% 19% 85 20% 21% 22% 19% 85 20% 21% 22% 90 90 90 95 95 95 100 α=6 Strike Price 100 Strike Price 100 Strike Price 105 105 105 110 110 110 115 115 115 FIGURE 22.4 The Smile in a Mean-Reverting Stochastic Volatility Model and Its Variation with Time to Expiration and Mean Reversion Strength (Long-Term Volatility = 20%) T=4 T=1 T = 0.25 Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 90 90 90 95 95 95 α=0 Strike Price 100 Strike Price 100 Strike Price 100 105 105 105 110 110 110 115 115 115 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 40% 35% 45% 45% 90 90 90 95 95 95 α=5 Strike Price 100 Strike Price 100 Strike Price 100 105 105 105 110 110 110 115 115 115 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 45% 90 90 90 95 95 95 100 α = 10 Strike Price 100 Strike Price 100 Strike Price 105 105 105 110 110 110 115 115 115 FIGURE 22.5 The Smile in a Mean-Reverting Stochastic Volatility Model and Its Variation with Time to Expiration and Mean Reversion Strength (Long-Term Volatility = 40%) T=4 T=1 T = 0.25 Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility 378 Stochastic Volatility Models: The Smile with Mean Reversion and Correlation 379 COMPARISON OF HEDGE RATIOS UNDER BLACK-SCHOLES-MERTON, LOCAL VOLATILITY, AND STOCHASTIC VOLATILITY We have now investigated two different models of the smile: local volatility and stochastic volatility.

As we will see in subsequent chapters, jumps in the stock price are another way to match the steep short-term skew. 377 19% 85 20% 21% 22% 19% 85 20% 21% 22% 19% 85 20% 21% 22% 90 90 90 95 95 95 α=0 Strike Price 100 Strike Price 100 Strike Price 100 105 105 105 110 110 110 115 115 115 19% 85 20% 21% 22% 19% 85 20% 21% 22% 19% 85 20% 21% 22% 90 90 90 95 95 95 α=3 Strike Price 100 Strike Price 100 Strike Price 100 105 105 105 110 110 110 115 115 115 19% 85 20% 21% 22% 19% 85 20% 21% 22% 19% 85 20% 21% 22% 90 90 90 95 95 95 100 α=6 Strike Price 100 Strike Price 100 Strike Price 105 105 105 110 110 110 115 115 115 FIGURE 22.4 The Smile in a Mean-Reverting Stochastic Volatility Model and Its Variation with Time to Expiration and Mean Reversion Strength (Long-Term Volatility = 20%) T=4 T=1 T = 0.25 Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 90 90 90 95 95 95 α=0 Strike Price 100 Strike Price 100 Strike Price 100 105 105 105 110 110 110 115 115 115 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 40% 35% 45% 45% 90 90 90 95 95 95 α=5 Strike Price 100 Strike Price 100 Strike Price 100 105 105 105 110 110 110 115 115 115 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 45% 15% 85 20% 25% 30% 35% 40% 45% 90 90 90 95 95 95 100 α = 10 Strike Price 100 Strike Price 100 Strike Price 105 105 105 110 110 110 115 115 115 FIGURE 22.5 The Smile in a Mean-Reverting Stochastic Volatility Model and Its Variation with Time to Expiration and Mean Reversion Strength (Long-Term Volatility = 40%) T=4 T=1 T = 0.25 Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility Implied Volatility 378 Stochastic Volatility Models: The Smile with Mean Reversion and Correlation 379 COMPARISON OF HEDGE RATIOS UNDER BLACK-SCHOLES-MERTON, LOCAL VOLATILITY, AND STOCHASTIC VOLATILITY We have now investigated two different models of the smile: local volatility and stochastic volatility.

Figure 9.4 shows how the slope constraints for call and put prices constrain the BSM implied volatility. To develop this idea more quantitatively, 159 No-Arbitrage Bounds on the Smile Implied Volatility Upper bound on implied volatility from call options Implied volatility at index level S Allowed range Lower bound on implied volatility from put options Strike FIGURE 9.4 Limits on Implied Volatility as Strike Increases we write the market price of a call in terms of its BSM parameterization, so that C(S, t, K, T) ≡ CBSM (S, t, K, T, 𝛴), where the implied volatility 𝛴 = 𝛴(K, T) is assumed to vary with strike. Equation 9.4 can then be rewritten as 𝜕C 𝜕CBSM 𝜕CBSM 𝜕𝛴 = + ≤0 𝜕K 𝜕K 𝜕𝛴 𝜕K (9.11) Rearranging terms, we have 𝜕CBSM 𝜕𝛴 𝜕K ≤ 𝜕K 𝜕CBSM 𝜕𝛴 − (9.12) Using the BSM Greeks for non-dividend-paying stocks, we obtain N(d ) e−r𝜏 N(d2 ) 𝜕𝛴 = √ 2 ≤ √ 𝜕K e−r𝜏 K 𝜏N′ (d2 ) K 𝜏N′ (d2 ) (9.13) 160 THE VOLATILITY SMILE Now assume that volatility is small and the strike price is at-the-money for√ ′ ward, so that SF = K.


pages: 408 words: 85,118

Python for Finance by Yuxing Yan

asset-backed security, business cycle, business intelligence, capital asset pricing model, constrained optimization, correlation coefficient, distributed generation, diversified portfolio, functional programming, implied volatility, market microstructure, P = NP, p-value, quantitative trading / quantitative finance, risk free rate, Sharpe ratio, tail risk, time value of money, value at risk, volatility smile, zero-sum game

Finance Inputting data from a text file Inputting data from an Excel file Inputting data from a CSV file Retrieving data from a web page Inputting data from a MATLAB dataset Several important functionalities Using pd.Series() to generate one-dimensional time series Using date variables Using the DataFrame Return estimation Converting daily returns to monthly returns Converting daily returns to annual returns Merging datasets by date Forming an n-stock portfolio T-test and F-test Tests of equal means and equal variances Testing the January effect [v] 156 157 158 159 160 161 163 163 163 164 167 168 169 169 170 171 171 173 174 176 176 177 178 179 180 180 181 182 182 183 183 185 187 190 191 192 193 194 195 Table of Contents Many useful applications 52-week high and low trading strategy Roll's model to estimate spread (1984) Amihud's model for illiquidity (2002) Pastor and Stambaugh (2003) liquidity measure Fama-French three-factor model Fama-MacBeth regression Estimating rolling beta Understanding VaR Constructing an efficient frontier Estimating a variance-covariance matrix Optimization – minimization Constructing an optimal portfolio Constructing an efficient frontier with n stocks Understanding the interpolation technique Outputting data to external files Outputting data to a text file Saving our data to a binary file Reading data from a binary file Python for high-frequency data Spread estimated based on high-frequency data More on using Spyder A useful dataset Summary Exercise Chapter 9: The Black-Scholes-Merton Option Model Payoff and profit/loss functions for the call and put options European versus American options Cash flows, types of options, a right, and an obligation Normal distribution, standard normal distribution, and cumulative standard normal distribution The Black-Scholes-Merton option model on non-dividend paying stocks The p4f module for options European options with known dividends Various trading strategies Covered call – long a stock and short a call Straddle – buy a call and a put with the same exercise prices A calendar spread [ vi ] 196 196 197 198 199 204 206 207 210 211 212 214 215 217 220 221 221 222 222 222 227 228 230 232 232 237 238 242 243 243 247 248 250 251 252 253 254 Table of Contents Butterfly with calls Relationship between input values and option values Greek letters for options The put-call parity and its graphical representation Binomial tree (the CRR method) and its graphical representation The binomial tree method for European options The binomial tree method for American options Hedging strategies Summary Exercises Chapter 10: Python Loops and Implied Volatility Definition of an implied volatility Understanding a for loop Estimating the implied volatility by using a for loop Implied volatility function based on a European call Implied volatility based on a put option model The enumerate() function Estimation of IRR via a for loop Estimation of multiple IRRs Understanding a while loop Using keyboard commands to stop an infinitive loop Estimating implied volatility by using a while loop Nested (multiple) for loops Estimating implied volatility by using an American call Measuring efficiency by time spent in finishing a program The mechanism of a binary search Sequential versus random access Looping through an array/DataFrame Assignment through a for loop Looping through a dictionary Retrieving option data from CBOE Retrieving option data from Yahoo!

In particular, we will cover the following topics: • What is an implied volatility? • Logic behind the estimation of an implied volatility • Understanding the for loop, while loop, and their applications • Nested (multiple) loops • The estimation of multiple IRRs • The mechanism of a binary search • The estimation of an implied volatility based on an American call • The enumerate() function • Retrieving option data from Yahoo! Finance and from Chicago Board Options Exchange (CBOE) • A graphical presentation of put-call ratios Python Loops and Implied Volatility Definition of an implied volatility From the previous chapter, we know that for a set of input variables—S (the present stock price), X (the exercise price), T (the maturity date in years), r (the continuously compounded risk-free rate), and sigma (the volatility of the stock, that is, the annualized standard deviation of its returns)—we could estimate the price of a call option based on the Black-Scholes-Merton option model.

The mean of those discounted terminal values using the risk-free rate as our discount rate would be our option price. [ 303 ] Python Loops and Implied Volatility Exercises 1. How many types of loops are present in Python? What are the differences between them? 2. What are the advantages of using a for loop versus a while loop? What are the disadvantages? 3. Based on a for loop, write a Python program to estimate the implied volatility. For a given set of values S=35, X=36, rf=0.024, T=1, sigma=0.13, and c=2.24, what is the implied volatility? 4. Write a Python program based on the Black-Scholes-Merton option model put option model to estimate the implied volatility. 5. Should we get different volatilities based on the Black-Scholes-Merton option model's call and put?


pages: 345 words: 86,394

Frequently Asked Questions in Quantitative Finance by Paul Wilmott

Albert Einstein, asset allocation, beat the dealer, Black-Scholes formula, Brownian motion, butterfly effect, buy and hold, capital asset pricing model, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discrete time, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, iterative process, lateral thinking, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, quantitative trading / quantitative finance, random walk, regulatory arbitrage, risk free rate, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, transaction costs, urban planning, value at risk, volatility arbitrage, volatility smile, Wiener process, yield curve, zero-coupon bond

Although we have the Black-Scholes formula for option values as a function of volatility, there is no formula for the implied volatility as a function of option value, it must be calculated using some bisection, Newton- Raphson, or other numerical technique for finding zeros of a function. Now plot these implied volatilities against strike, one curve per expiration. That is the implied volatility smile. If you plot implied volatility against both strike and expiration, as a three-dimensional plot, that is the implied volatility surface. Often you will find that the smile is quite flat for long-dated options, but getting steeper for short-dated options.

Stochastic volatility models are better at capturing the dynamics of traded option prices better than deterministic models. However, different markets behave differently. Part of this is because of the way traders look at option prices. Equity traders look at implied volatility versus strike, FX traders look at implied volatility versus delta. It is therefore natural for implied volatility curves to behave differently in these two markets. Because of this there have grown up the sticky strike, sticky delta, etc., models, which model how the implied volatility curve changes as the underlying moves. Poisson processes: There are times of low volatility and times of high volatility. This can be modelled by volatility that jumps according to a Poisson process.

Short Answer Volatility smile is the phrase used to describe how the implied volatilities of options vary with their strikes. A smile means that out-of-the-money puts and out-of-the-money calls both have higher implied volatilities than at-the-money options. Other shapes are possible as well. A slope in the curve is called a skew. So a negative skew would be a download sloping graph of implied volatility versus strike. Example Figure 2-9: The volatility ‘smile’ for one-month SP500 options, February 2004. Long Answer Let us begin with how to calculate the implied volatilities. Start with the prices of traded vanilla options, usually the mid price between bid and offer, and all other parameters needed in the Black-Scholes formulæ, such as strikes, expirations, interest rates, dividends, except for volatilities.


A Primer for the Mathematics of Financial Engineering by Dan Stefanica

asset allocation, Black-Scholes formula, capital asset pricing model, constrained optimization, delta neutral, discrete time, Emanuel Derman, implied volatility, law of one price, margin call, quantitative trading / quantitative finance, risk free rate, Sharpe ratio, short selling, time value of money, transaction costs, volatility smile, yield curve, zero-coupon bond

Usually, the implied volatility of either deep out of the money or deep in the money options is higher than the implied volatility of at the money options. This phenomenon is called the volatility smile. Another possible pattern for implied volatility is the volatility skew, when, e.g., the implied volatility of deep in the money options is smaller than the implied volatility of at the money options, which in turn is smaller than the implied volatility of deep out of the money options. We restrict our attention to solving the problem (8.66) corresponding to the call option, i.e., with the function f(x) given by (8.67), using Newton's method. Note that differentiating the function f(x) with respect to x is the same as computing the vega of the call option.

Assume that the dividend yield q and the constant interest rate r can be estimated from market data. The implied volatility is the unique value of the volatility parameter 0' in the lognormal model that makes the Black-Scholes value of the option equal to the price the option traded at. If we look at (8.64) and (8.65) as functions of only one variable, 0', finding the implied volatility requires solving the nonlinear problem f(x) = 0, (8.66) 268 CHAPTER 8. LAGRANGE MULTIPLIERS. NEWTON'S METHOD. 8.6. IMPLIED VOLATILITY where x = a and 269 Table 8.7: Pseudocode for computing implied volatility (8.67) for the call option, and f(x) = Ke- rT N(-d2 (x)) - Se-qTN(-d1(x)) - P, (8.68) for the put option.

Here, In d1 = (~) + (r - q + ~) T xVT ~ d ; 2 In (~) + (r ~ q - ~) T ~ xVT The value of a thus computed is the implied volatility corresponding to a given option price. It is interesting to note that computing the implied volatility is a straightforward way of showing that the lognormal assumption, and the BlackScholes formulas derived based on this assumption, are not correct. At any point in time, several options with different strikes and maturities may be traded. If the lognormal assumption were true, then the implied volatilities corresponding to all these options should be equal. However, this does not happen. Usually, the implied volatility of either deep out of the money or deep in the money options is higher than the implied volatility of at the money options.


pages: 241 words: 81,805

The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee, Kevin Coldiron

active measures, Asian financial crisis, asset-backed security, backtesting, bank run, Bear Stearns, Bernie Madoff, Bretton Woods, business cycle, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, debt deflation, disinformation, distributed ledger, diversification, financial intermediation, Flash crash, global reserve currency, implied volatility, income inequality, inflation targeting, labor-force participation, Long Term Capital Management, Lyft, margin call, market bubble, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, negative equity, Network effects, Ponzi scheme, purchasing power parity, quantitative easing, random walk, rent-seeking, reserve currency, rising living standards, risk free rate, risk/return, sharing economy, short selling, sovereign wealth fund, tail risk, Uber and Lyft, uber lyft, yield curve

For realized volatility the curve is of realized volatilities as measured over different time horizons; for liquidity to have a positive price, shorter-term realized volatilities need to exceed longer-term realized volatilities. For implied volatility the curve is of implied volatilities at different forward points; for liquidity to have a positive price, further forward implied volatilities need to exceed nearer forward implied volatilities—and all implied volatilities must exceed all realized volatilities. The slope of realized volatility means that the asset displays mean-reverting behavior. While this mean reversion implies meaningful predictability of price movements, the perspective taken here is that this predictability is not an inefficiency.

Last month’s volatility, most of the time, is a pretty good guess at the distribution of tomorrow’s price change, even though it might not be useful for thinking about daily price changes in a year’s time. Therefore implied volatility, the market’s expectation for future realized volatility, tends to move in line with realized volatility—albeit that implied volatility is normally higher than realized volatility by some margin. In modern financial markets implied volatility can be sold directly. The simplest and most popular way to do this is through VIX futures or through exchange-traded notes (ETNs) that correspond to simple VIX futures strategies. The VIX is an index representing the implied volatility for the S&P 500 over the next 30 days, derived from the prices of options on the S&P 500 index.2 VIX futures are monthly-expiring contracts that settle at the VIX.3 2.

Many other apparent market inefficiencies can be viewed analogously. The slope of implied volatility superficially appears to mean that the market expects price volatility to rise. Since volatility does not on average rise—it is empirically mean reverting to a stable level of long-run volatility—this cannot really be understood as an expectation. Instead this curvature is a risk premium paid to forward implied volatility sellers, that is, forward liquidity providers. In the same way, the gap between implied and realized volatilities makes selling spot implied volatility—selling contracts that pay out depending on realized volatility of the underlying starting immediately—profitable over time, as a risk premium to providers of instantaneous liquidity (which is parallel to the bid-ask spread, according to heuristic arguments outlined in Chapter 9).


pages: 447 words: 104,258

Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues by Alain Ruttiens

algorithmic trading, asset allocation, asset-backed security, backtesting, banking crisis, Black Swan, Black-Scholes formula, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, discrete time, diversification, fixed income, implied volatility, interest rate derivative, interest rate swap, margin call, market microstructure, martingale, p-value, passive investing, quantitative trading / quantitative finance, random walk, risk free rate, risk/return, Satyajit Das, Sharpe ratio, short selling, statistical model, stochastic process, stochastic volatility, time value of money, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-coupon bond

Figure 12.3 Example of autocorrelations calculation (The results in column “lag 1” are obtained by computing the correlation between a data series and the same series, lagged by 1 week; similarly for the “lag 2” column, lagging the data by 2 weeks, etc.). 12.1.2 Volatility curve With respect to the Black–Scholes formula for option pricing, and related pricing models, the implied volatility to be used is a constant, whatever the option maturity is. Practically speaking, the market is using different implied volatilities for different maturities: in other words, the volatility estimate (by the option market maker) is not necessarily the same for the next 3 months as for the next 3 years, for example. Hence, the use of implied volatility curves (or “volatility structure”), just as yield curves (or term structure). For example, in Figure 12.4 is the implied volatility curve of options (of ATM and near to ATM strikes) on the S&P 500, as of 05/03/2011.

So we may speak of an “implied volatility cone”, involving various observed implied volatility curves for a given underlying, showing that the range of possible implied volatilities is usually broader for shorter maturities, as in Figure 12.5. Figure 12.4 Example of an implied volatility curve Figure 12.5 Typical shapes of an implied volatility curve Similarly as a yield curve allows computing forward rates (cf. Chapter 1, Section 1.5), volatility curves allow the computing of forward volatilities. These forward volatilities may be used, for example, for pricing forward option products, or volatility swaps (cf. Section 12.5). The non-arbitrage principle of calculation of forward rates is used here too, as in Figure 12.6.

In case the market maker is selling a call, a similar reasoning leads to a global cost for delta adjustments.8 Hence the importance of the implied volatility chosen by the market maker to price his call: if the market maker has – by means of his implied volatility – underestimated the actual volatility of S up to maturity, he will make an unexpected profit, and in case of selling the call, an unexpected loss, both caused by more underlying price moves than anticipated through the implied volatility. Delta – gamma neutral management, also called “dynamic replication”, does present limitations that should not be underestimated:9 it does not preclude to adequately manage the other market risk factors (vega, theta, rho); in the practice, it is of course impossible to readjust continuously the offsetting position in underlying: beyond the bid–offer costs associated with frequent enough readjustments, discrete readjustments can present huge costs particularly if the underlying price presents important discontinuous variations; this technique is valid only to the extent that the underlying Gaussian process is reasonably verified.


The Concepts and Practice of Mathematical Finance by Mark S. Joshi

Black-Scholes formula, Brownian motion, correlation coefficient, Credit Default Swap, delta neutral, discrete time, Emanuel Derman, fixed income, implied volatility, incomplete markets, interest rate derivative, interest rate swap, London Interbank Offered Rate, martingale, millennium bug, quantitative trading / quantitative finance, risk free rate, short selling, stochastic process, stochastic volatility, the market place, time value of money, transaction costs, value at risk, volatility smile, yield curve, zero-coupon bond

From Taylor's theorem, we have C(K+E,a(K+E)) =C(K - E,or(K -E))+2Ea (K - E,Q(K - E)) au ac (K - E, Q(K - E)) + 0(E2). (7.35) + 2E M a6 7.7 Replication 197 Thus we conclude on letting E tend to zero that the price of the digital call is ac M (K, aQ (K, Q(K)) au (K). If we had just plugged the Black-Scholes implied volatility into the digital call option formula, we would have only got the first term and not the second. The error is therefore the Vega of the option times the slope of smile. The moral here is that one should be very careful in interpreting implied volatilities. Indeed, to quote Rebonato, [125], The implied volatility is the wrong number to put in the wrong formula to get the right price. The point is that the implied volatility has been defined in such a way as to make this tautologically true for call and puts, but not true for any other option.

Find the implied volatility of a call option struck at 110 with the following maturities: 0.5, 1, 1.5, 2. Exercise 6.11 A stock, St, follows geometric Brownian with time-dependent volatility. We have So = 100, and r = 5%, and 10% 0-j(S) = 15% 20% fort < 1/2, for 1/2 < t < 1, for 1 < t. Find the implied volatility of a call option struck at 110 with the following maturities: 0.5, 1, 1.5, 2. Exercise 6.12 A stock, St, follows geometric Brownian with time-dependent volatility. We have So =100, and r = 0%. Call options struck at 100 with maturities 0.5, 1 and 2 have implied volatilities of 10%, 15% and 20%.

This will be non-negative since f is convex and 4 is supported where S is non-negative. As the Gamma is non-negative the value is convex as a function of spot. 15.11 Key points 385 15.10.3 Floating smiles One nice consequence of the homogeneity of call prices is that the implied volatility smile floats. Thus if strike is K and spot is S then the implied volatility function, a (S, K), that is, the implied volatility of a call option struck at K given that spot is S satisfies 6(S,K)=g( ), (15.25) for some function g. To see this observe that if C(S, K, T) = BS(S, K, or, T), then it also true for any A > 0 that C(AS, AK, T) = BS(AS, a,K, a, T), as the ), passes through everything.


pages: 313 words: 101,403

My Life as a Quant: Reflections on Physics and Finance by Emanuel Derman

Bear Stearns, Berlin Wall, bioinformatics, Black-Scholes formula, Brownian motion, buy and hold, capital asset pricing model, Claude Shannon: information theory, Donald Knuth, Emanuel Derman, fixed income, Gödel, Escher, Bach, haute couture, hiring and firing, implied volatility, interest rate derivative, Jeff Bezos, John Meriwether, John von Neumann, law of one price, linked data, Long Term Capital Management, moral hazard, Murray Gell-Mann, Myron Scholes, Paul Samuelson, pre–internet, publish or perish, quantitative trading / quantitative finance, Sharpe ratio, statistical arbitrage, statistical model, Stephen Hawking, Steve Jobs, stochastic volatility, technology bubble, the new new thing, transaction costs, volatility smile, Y2K, yield curve, zero-coupon bond, zero-sum game

Before 1987, in contrast, more light-heartedly naive options markets were happy to charge about the same implied volatility for all strikes, as illustrated by the dashed line in Figure 14.1. Figure 14.1 A typical implied volatility smile for three-month options on the Nikkei index in late 1994. The dashed line shows the lack of skew that was common prior to the 1987 crash. It was not only three-month implied volatilities that were skewed. A similar effect was visible for options of any expiration, so that implied volatility varied not only with strike but also with expiration. We began to plot this double variation of implied volatility in both the time and strike dimension as a two-dimensional implied volatility surface.

When I sat next to Dave in Tokyo that day, his computer screen showed the prices quoted in Black-Scholes implied volatilities. Even today, when no one believes that the Black-Scholes model is absolutely the best way to estimate option value, and even though more sophisticated traders sometimes use more complex models, the Black-Scholes model's implied volatilities are still the market convention for quoting prices. Options are generally less liquid than stocks, and implied volatility market data is consequently coarse and approximate. Nevertheless, Dave pointed out to me what I was already dimly aware of. There was a severe skew in the implied volatilities, so that three-month options of low strike had much greater implied volatilities than three-month options of higher strikes.You can see a sketch of this asymmetry in Figure 14.1.

The local volatility in Figure 14.8 is a local quality of the tree, the microscopically viewed volatility within each single small internal triangle. In contrast, the implied volatility in Figure 14.2 is a global quality, a wide-angle overview of all the internal triangles seen from 30,000 feet. We viewed the implied volatility of an option as the average of all the local volatilities that the index will experience during the life of that option. Consider the option whose expiration and strike correspond to the time and index level at the location of the small flashlight in the nextto-last row of the tree in Figure 14.9. The value of its implied volatility depends upon the values of the local volatilities in the shaded rightstriped triangles; those are the local volatility regions that the index can traverse in moving towards the strike during the life of the option.


Mathematical Finance: Theory, Modeling, Implementation by Christian Fries

Black-Scholes formula, Brownian motion, continuous integration, discrete time, fixed income, implied volatility, interest rate derivative, martingale, quantitative trading / quantitative finance, random walk, short selling, Steve Jobs, stochastic process, stochastic volatility, volatility smile, Wiener process, zero-coupon bond

EXCURSION: INTERPOLATION OF EUROPEAN OPTION PRICES Interpolated volatlities Probability density 1,5E-2 0,40 0,75 1,0E-2 0,30 0,20 density 1,00 volatility price Interpolated prices 0,50 0,50 0,10 0,25 0,00 0,00 5,0E-3 0,0E0 0,75 1,00 1,25 0,75 strike 1,00 1,25 0,75 strike 1,00 1,25 underlying value Figure 6.5.: Linear interpolation for decreasing implied volatility. Conclusion: An arbitrarily fast decrease of implied volatility is not possible. 6.2.2.2. Lineare Interpolation for increasing Implied Volatilities For the example of increasing implied volatility we consider the prices i 2 3 Strike Ki 0.75 1.25 Price V(Ki ) 0.2897 0.2532 Implied Volatility σ(Ki ) 0.2 0.8 Figure 6.5 shows the linear increasing interpolation of the implied volatilities. Interpolated prices Interpolated volatlities Probability density 0,50 1,5E-2 volatility price 0,30 0,20 0,10 density 0,75 0,40 0,50 0,25 1,0E-2 5,0E-3 0,0E0 0,00 0,75 1,00 1,25 0,75 strike 1,00 strike 1,25 0,75 1,00 1,25 underlying value Figure 6.6.: Linear interpolation for increasing implied volatility.

The monotony ensures that these two prices alone do not allow for an arbitrage. 6.2.2.1. Lineare Interpolation for decreasing Implied Volatilities Given are the prices i 2 3 Strike Ki 0.75 1.25 Price V(Ki ) 0.4599 0.0018 Implied Volatility σ(Ki ) 0.9 0.1 The implied volatility decreases with the strike K. Figure 6.5 shows the linear interpolation of the implied volatilities (center). The density (see Figure 6.5, right) shows a large region with negative values, thus it is not a probability density. The reason is a too fast decay of the implied volatility. 95 This work is licensed under a Creative Commons License. http://creativecommons.org/licenses/by-nc-nd/2.5/deed.en Comments welcome. ©2004, 2005, 2006 Christian Fries Version 1.3.19 [build 20061210]- 13th December 2006 http://www.christian-fries.de/finmath/ CHAPTER 6.

Streuung des Wertes des Replikationsportfolios bei wöchentlichem Rehedging mit falscher Zinsrate . . . . . . . . . . . . . . . . . . . . 112 2.1. 2.2. 2.3. 2.4. 2.5. 2.6. 2.7. 2.8. 2.9. 2.10. Arbitrage-free option prices . . . . . . . . . . . . . . . . Linear interpolation of option prices . . . . . . . . . . . . Linear interpolation of implied volatilities . . . . . . . . . Spline interpolation of option prices and implied volatilities Linear interpolation for decreasing implied volatility . . . Linear interpolation for increasing implied volatility . . . 415 This work is licensed under a Creative Commons License. http://creativecommons.org/licenses/by-nc-nd/2.5/deed.en . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113 116 117 Comments welcome. ©2004, 2005, 2006 Christian Fries Version 1.3.19 [build 20061210]- 13th December 2006 http://www.christian-fries.de/finmath/ LIST OF FIGURES 7.5.


pages: 320 words: 33,385

Market Risk Analysis, Quantitative Methods in Finance by Carol Alexander

asset allocation, backtesting, barriers to entry, Brownian motion, capital asset pricing model, constrained optimization, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, fixed income, implied volatility, interest rate swap, market friction, market microstructure, p-value, performance metric, quantitative trading / quantitative finance, random walk, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, statistical arbitrage, statistical model, stochastic process, stochastic volatility, Thomas Bayes, transaction costs, two and twenty, value at risk, volatility smile, Wiener process, yield curve, zero-sum game

If n1 is the number of days to expiry of the prompt futures contract and n2 is the number of days to expiry of the next futures contract, then the linearly interpolated 30-day futures price on that day is n2 − 30 P1 + 30 − n1 P2 n2 − n1 For instance, if the prompt futures price is 10 and it has 5 days until expiry, and the next futures price is 12 and it has 36 days to expiry, then the constant maturity futures price is 6 × 10 + 25 × 12 = 11 613 31 Similarly, linear interpolation can be applied to construct constant maturity implied volatility series from the implied volatilities of options of different maturities. The next example illustrates this application. Example I.5.3: Interpolating implied volatility Suppose we have two options with the same strike but different maturities: option 1 has maturity 10 days and option 2 has maturity 40 days. If the implied volatility of option 1 is 15% and the implied volatility of option 2 is 10%, what is the linearly interpolated implied volatility of an option with the same strike as options 1 and 2 but with maturity 30 days?

But the regression R2 is only 0.1995 and there is a high degree of multicollinearity between the equity index return and the change in implied volatility. In fact in our sample their correlation is −0829, and the square of this is 0.687, which far exceeds the regression R2 . To remedy the multicollinearity problem we can simply drop one of the collinear variables from the regression, using either the equity return or the change in implied volatility in the model, but not both. If we drop the implied volatility from the regression the estimated model becomes ŝ = 002618 − 21181 r − 05312 R 00610 −10047 −139069 The equity return alone is actually a more significant determinant of changes in credit spread than the model (I.4.57) would indicate.

To give just a few common examples:2 • • • • • The Black–Scholes–Merton (Black and Scholes, 1973; Merton, 1973) model gives an analytic solution for the price of a standard European option under certain (rather unrealistic) assumptions about the behaviour of asset prices. However, it is not possible to invert the Black–Scholes–Merton formula so that we obtain an analytic solution for the implied volatility of the option. In other words, the implied volatility is an implicit function, not an explicit function of the option price (and the other variables that go into the Black–Scholes–Merton formula such as the strike and the maturity of the option). So we use a numerical method to find the implied volatility of an option. The allocations to risky assets that give portfolios with the minimum possible risk (as measured by the portfolio volatility) can only be determined analytically when there are no specific constraints on the allocations such as ‘no more than 5% of the capital should be allocated to US bonds’.


Mathematical Finance: Core Theory, Problems and Statistical Algorithms by Nikolai Dokuchaev

Black-Scholes formula, Brownian motion, buy and hold, buy low sell high, discrete time, fixed income, implied volatility, incomplete markets, martingale, random walk, risk free rate, short selling, stochastic process, stochastic volatility, transaction costs, volatility smile, Wiener process, zero-coupon bond

However, in the real market, σimp depends usually on (T, K) (and on the type of option), and the implied volatility differs from the historical volatility. In this case, we can conclude that the Black-Scholes model does not describe the real market perfectly, and its imperfections can be characterized by the gap between the historical and implied volatilities. Varying K and T gives different patterns for implied volatility. Similarly, the evolving price S(t) gives different patterns for implied volatility for different t for a given K. The most famous pattern is the so-called volatility smile (or volatility skew) that describes dependence of σimp on K.

(It follows from Lemma 7.3 that VBS(σ) is a strictly increasing function in σ, so this equation is solvable.) The solution σ=σimp of the equation is called implied volatility. Definition 7.5 A value σimp is said to be implied volatility at time t=0 for the call option given K, r, T, if the current market price of the option at time t=0 can be represented as HBS,c(S(0), K, T, σimp, r), where HBS,c(S(0), K, T, σ, r) is the Black-Scholes price for call, where K is the strike price, σ is the volatility, r is the risk-free rate, and T is the terminal time. The definition for the implied volatility for a put option is similar. © 2007 Nikolai Dokuchaev Implied and Historical Volatility 135 If a market is exactly the Black-Scholes market with constant σ, then σimp does not depend on (T, K), and it is equal to this σ (which is also the historical volatility).

Problem 7.10 Calculate the implied volatility using a code. Assume that the price of a call option with strike price K=100 is 25, and r=0.05, S(0)=100, T=1. Problem 7.11 Assume that r=0.05, S(0)=100, T=0.5. The price of a call option with strike price K=90 is 25. Calculate the implied volatility. Problem 7.12 For the market model described in Section 7.3, calculate the implied volatility for K=S0±0.1, ±0.2, ±0.3 given (S(0), r, T, p)=(1, 0.03, 1, 0.45). © 2007 Nikolai Dokuchaev 8 Review of statistical estimation In this chapter, we collect some core facts from mathematical statistics and statistical inference that will be used later to estimate parameters for continuous time market models. 8.1 Some basic facts about discrete time random processes In this section, several additional definitions and facts about discrete time stochastic processes are given.


pages: 1,088 words: 228,743

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, Bernie Madoff, Black Swan, bond market vigilante , Bretton Woods, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, central bank independence, collateralized debt obligation, commoditize, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, G4S, George Akerlof, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, information asymmetry, interest rate swap, invisible hand, Kenneth Rogoff, laissez-faire capitalism, law of one price, London Interbank Offered Rate, Long Term Capital Management, loss aversion, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, performance metric, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, Robert Shiller, savings glut, selection bias, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, stocks for the long run, survivorship bias, systematic trading, tail risk, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond, zero-sum game

The cross-sectional implication of BSM assumptions (constant volatilities, no market frictions, etc.) is that all options across all strike prices should have the same implied volatility. Thus, real-world deviations from BSM assumptions should explain observed smile effects and other apparent violations of no-arbitrage pricing. (The smile refers to the appearance of a plot of implied volatility on the y-axis against strike prices or option moneyness on the x-axis, where moneyness is the degree to which an option is in the money.) The BSM analysis taught investors to infer implied parameters such as implied volatility from market prices, always given a particular model or set of assumptions. In the risk-neutral world, implied volatility reflects the market’s volatility expectations.

Figure 19.3 is a stylized graph that makes three points about option skew (implied volatility levels across strike prices):• Index options have much lower implied volatilities than typical single-stock options, thanks to diversification, but their skew is much more pronounced. • At least this was the case after the 1987 crash. Before the crash, the implied volatilities of index options exhibited a symmetric smile rather than a one-side smirk as both OTM calls and puts had higher volatilities than ATM options. After the crash, realized fluctuations of the index have been reasonably symmetric but implied volatilities disagree: they implicitly forecast a much higher probability of a large downside move than of a large upside move.Figure 19.1.

From a theoretical perspective, the tendency for a strategy of selling volatility and/or correlation risk to lose money in bad times suggests that these risk premia should be negative (so that selling these risks is profitable in the long run). (ii) In modeling terminology, the smirk in implied volatilities (higher Black–Scholes implied volatilities for OTM puts and lower implied volatilities for ITM puts than for ATM puts) corresponds to skewed risk-neutral distribution for index returns, in contrast to relatively symmetric realized return distribution. This finding suggests that a greater real-world frequency of downward jumps, or higher downside volatility due to higher downside correlations across stocks, is not the primary reason for option-pricing asymmetries.


Trading Risk: Enhanced Profitability Through Risk Control by Kenneth L. Grant

backtesting, business cycle, buy and hold, commodity trading advisor, correlation coefficient, correlation does not imply causation, delta neutral, diversification, diversified portfolio, fixed income, frictionless, frictionless market, George Santayana, implied volatility, interest rate swap, invisible hand, Isaac Newton, John Meriwether, Long Term Capital Management, market design, Myron Scholes, performance metric, price mechanism, price stability, risk free rate, risk tolerance, risk-adjusted returns, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, two-sided market, value at risk, volatility arbitrage, yield curve, zero-coupon bond

To elaborate further on the associated pricing implications, the execution of an options trade at a 10% volatility implies that the parties in question expect the underlying security to exhibit an annualized standard deviation of 10% over the life of the option. How does all of this pertain to the applicability of options implied volatility to our efforts to estimate portfolio risk? As it turns out, because implied volatility is quoted in the exact manner that historical volatility is expressed (i.e., in annualized terms), for the purposes of 88 TRADING RISK estimating price dispersion, the terms can be used interchangeably. In fact, implied volatility can be viewed very explicitly as the options market’s attempt to predict what historical volatility will be in the future. We can therefore substitute options volatilities for historicals in order to size our associated exposure.

Options implied volatility thus has the advantage over historical volatility of encompassing not only historical time series information but also “qualitative” data and prospective economic inputs into its estimates of price dispersion. The measure gains further credibility through the fact that options traders are actually risking financial capital on the basis of implied volatility valuations. Take my word for it—this type of reality dose does wonders for the accuracy of financial models. From these perspectives, implied volatility arguably is the superior measure. However, like everything else in our statistical tool kit, it has shortcomings. First, because the implied volatility statistic is derived entirely from the manner in which options are priced, it is subject to the same idiosyncrasies that characterize the options markets themselves.

For example, during periods of extreme market duress, prices and volatilities for all types of options are often bid up to levels beyond what would be justified by the underlying economic data; and the use of implied volatility as an exposure input might lead to inaccuracies in these instances. In addition, there is a well-known concept within the universe of option trading, referred to as the volatility skew, or smile, that describes the tendency for out-of-the-money options to trade at higher implied volatilities than those that are at, near, or in the money. It is therefore necessary to understand the relationship between the strike price and the underlying market price (i.e., the “moneyness”) for the option on whose implied volatility you are relying. As a practical matter, I recommend the volatility for the at-the-money strike as the best approximation of future price dispersion, as this is the part of the options market that is least impacted by market inefficiencies.


Risk Management in Trading by Davis Edwards

asset allocation, asset-backed security, backtesting, Bear Stearns, Black-Scholes formula, Brownian motion, business cycle, computerized trading, correlation coefficient, Credit Default Swap, discrete time, diversified portfolio, fixed income, implied volatility, intangible asset, interest rate swap, iterative process, John Meriwether, London Whale, Long Term Capital Management, margin call, Myron Scholes, Nick Leeson, p-value, paper trading, pattern recognition, random walk, risk free rate, risk tolerance, risk/return, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, statistical model, stochastic process, systematic trading, time value of money, transaction costs, value at risk, Wiener process, zero-coupon bond

More recent estimates are weighted more than older estimates. 154 RISK MANAGEMENT IN TRADING Volatility Equally Weighted Historical Volatility Implied Volatility Historical Volatility Exponentially Weighted Historical Volatility GARCH Historical Volatility FIGURE 6.4 ■ ■ Types of Volatility Estimates GARCH Historical Volatility. Short for Generalized Auto‐Regression Conditional Heteroskedacity, GARCH introduces a mean‐reverting term into an exponentially weighted calculation. Implied Volatility. Implied volatility from options markets is used to estimate returns. Equally Weighted Historical Volatility For a single asset, parametric VAR requires estimating a single parameter— the volatility of asset prices.

However, there is only one reason to sell options and take on additional risk—because the price of the option is sufficiently high. An empirical comparison of equal weighted historical volatility to forward implied volatility shows that both methods give similar estimates. Market‐implied volatility generally has more day‐to‐day variation than historically calculated volatility. It also responds (both up and down) more quickly than historical volatility. (See Figure 6.7, Implied Volatility.) More sensitive numbers can be helpful in some cases to give an early warning about possible market volatility. However, it can also cause operational problems that exacerbate risky situations since a major use of VAR is to set position limits and calculate regulatory capital requirements.

If a coin is flipped twice, 162 RISK MANAGEMENT IN TRADING S&P 500 Implied Volatility 7/ 1/ 20 13 7/ 1/ 20 12 7/ 1/ 20 11 7/ 1/ 20 10 7/ 1/ 20 09 7/ 1/ 20 08 7/ 1/ 20 07 7/ 1/ 20 06 7/ 1/ 20 05 7/ 1/ 20 04 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 Simple Historical Volatility Crude Oil FIGURE 6.7 01 3 28 6/ /2 28 6/ /2 01 2 01 1 28 6/ /2 28 /2 01 0 9 6/ 28 /2 00 8 Implied Volatility 6/ 28 /2 00 7 6/ /2 28 6/ /2 28 6/ 00 6 00 5 00 /2 28 6/ 6/ 28 /2 00 4 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 Simple Historical Volatility Implied Volatility KEY CONCEPT: HOW SENSITIVE DOES VAR NEED TO BE?


Solutions Manual - a Primer for the Mathematics of Financial Engineering, Second Edition by Dan Stefanica

asset allocation, Black-Scholes formula, constrained optimization, delta neutral, implied volatility, law of one price, risk free rate, yield curve, zero-coupon bond

Assume that the risk free interest rate is constant at 6%. (i) Compute the implied volatility with six decimal digits accuracy, using the bisection method on the i口terval [0.0001 , 1]' the secant method with initial guess 0.5 , and Newton's method with initial guess 0.5. 190 CHAPTER 8. LAGRANGE (ii) Let MULTIPLIER丘 NEWTON'S METHOD. σ问 be the implied volatility previously computed method. Use the formula σ usi吨 Newtor内 r-.JV2在 C 一与庄s r-.J百万 imp ,approx to compute an approximate value compute the relative error σimp, apprωfor the implied volatility, and |σzmp, αpprox 一 σ vzmp σimp Solution: (i) Both the secant method with ♂ -1 = 0.6 and Xo = 0.5 and Newton's method with initial guess Xo = 0.5 converge in three iterations to an implied volatility of 39.7048%.

们}R2 I x ~ 0 , 1 三时 2 , 1 才三 2} Sol仰on: The change of variables 8 = xy and t rF = 0 7. For the same maturity, options with different strikes are traded simultaneously. The goal of this problem is to compute the rate of change of the implied volatility as a function of the strike of the options. In other words , assume that S , T , q and r are given , and let C (K) be the (known) value of a call option with maturity T and strike K. Assume that options with all strikes K exist. Define the implied volatility σimp(K) as the unique solution to ~ is equivalent to when x 主 o and y ~三 O. This change of variables maps the domain D into the recta吨Ie n = [1 , 2] x [1 , 2]. It is easy to see that 6.

θS2 Problem 7: For the same maturity, options with different strikes are traded simultaneously. The goal of this problem is to compute the rate of change of the implied volatility ωa function of the strike of the options. In other words , assume that S , T , q and r are given , and let C(K) be the (know叫 value of a call option with maturity T and strike K. Assume that options with all strikes K exist. Defi 缸 fine 也 t he implied volatility σ 叽inη1以 K) 创 as the unique solution to C(K) = CBs(K, σimp(K)) , S2 飞 T-t θF\ 一一一一. T2 θy2 T θy) Then , the PDE (7.27) for V(S , I , t) becomes the followi鸣 PDE for F(y , t): o= θVθ V 一一 + 1 ')~')护 VθV 1口 S 一一 +一 σL.


pages: 321

Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

algorithmic trading, asset allocation, automated trading system, backpropagation, backtesting, barriers to entry, business cycle, buy and hold, capital asset pricing model, constrained optimization, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial intermediation, Flash crash, implied volatility, index arbitrage, index fund, intangible asset, iterative process, Long Term Capital Management, loss aversion, market design, market microstructure, merger arbitrage, natural language processing, passive investing, pattern recognition, performance metric, Performance of Mutual Funds in the Period, popular capitalism, prediction markets, price discovery process, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, risk/return, selection bias, sentiment analysis, shareholder value, Sharpe ratio, short selling, Silicon Valley, speech recognition, statistical arbitrage, statistical model, stochastic process, survivorship bias, systematic trading, text mining, transaction costs, Vanguard fund, yield curve

VOLATILITY SKEW A useful source of information on the direction of the options market is the implied volatility of stock options. This is the value for the volatility of the underlying instrument such that, when the value is input in an option pricing model (such as Black–Scholes), the model will return a theoretical value equal to the current market price of the option. In the case of equity options, a plot of the implied volatility against the strike price gives a skewed surface. The volatility skew is the difference in implied volatility between out-of-the-money, at-the-money, and in-themoney options. The volatility skew is affected by sentiment and supply– demand relationships, and provides information on whether fund managers prefer to write calls or puts.

Bollen and Whaley and Gârleanu et al. attribute the “shape of observed volatility skew and its predictive ability to the buying pressure due to the information possessed by option traders.” Bollen and Whaley find that “contemporaneous changes in daily implied volatilities are driven by changes in net buying pressure.” Options traders with expectations of positive news create an excess of buy-call trades and/or sell-put trades, which causes 172 Finding Alphas Volatility skew 30 Implied volatility 28 26 24 22 20 18 80 90 100 110 120 130 140 150 160 170 180 190 200 210 220 230 240 250 Strike price Figure 23.4 Sample volatility skew in equity options markets prices and implied volatilities of call options, relative to put options, to rise. Similarly, options traders with expectations of negative news create an excess of sell-call trades and/or buy-put trades, which causes the prices and implied volatilities of put options, relative to call options, to rise.

This phenomenon can be used to find stocks to short long–short equity alphas on longer and shorter time scales. Figure 23.5 shows the performance of an alpha on the Russell 1000 universe of stocks. The alpha uses the slope of the implied volatility curve to measure the skew. The idea is to buy stocks that have shown a decrease in the slope of the implied volatility curve (or decrease in volatility skew), and vice versa. 2 Alpha = −(change in slope of the implied volatility curve). 174 Finding Alphas VOLATILITY SPREAD The put-call parity relation states that in perfect markets, the following equality holds for European options on non-dividend-paying stocks: C P S D.K where C and P are the current call and put prices, respectively; D is the discount factor; K is the strike price; and S is the spot price.


pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

activist fund / activist shareholder / activist investor, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Bear Stearns, Black-Scholes formula, Brownian motion, business cycle, buy and hold, buy low sell high, buy the rumour, sell the news, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, money market fund, mortgage debt, Myron Scholes, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk free rate, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stocks for the long run, stocks for the long term, survivorship bias, systematic trading, tail risk, technology bubble, time value of money, total factor productivity, transaction costs, two and twenty, value at risk, Vanguard fund, yield curve, zero-coupon bond

This level of stock volatility is called the implied volatility. According to the Black–Scholes–Merton model, the implied volatility of all options on the same underlying stock should be the same, namely the stock’s true volatility. Therefore, option prices can be more easily compared by looking at their implied volatilities. If one option has a higher implied volatility, it is more expensive relative to its fundamental Black–Scholes–Merton value—and a candidate for short-selling. Option arbitrageurs look to short-sell options with implied volatility above their assessed true volatility and buy options with implied volatility below the true volatility.

For instance, they trade swaptions, caps, floors, and options on bond futures. This involves both directional volatility trades and relative value trades. A directional volatility trade means comparing a derivative’s implied volatility with the arbitrageur’s own prediction of actual volatility and buying the derivative if the implied volatility is low, while hedging the interest rate risk with bonds, bond futures, or swaps. Conversely, if the implied volatility is high, the arbitrageur will reverse the trade and short the derivative. Fixed-income arbitrage traders also perform relative-value volatility trades, in which they compare the pricing of different derivatives and go long–short based on the relative attractiveness.

In particular, real stock prices can suddenly jump and the volatility varies over time, features that are not captured by the standard Black–Scholes–Merton model (but can be captured in extensions of the basic model). Such potential jumps in the stock price can explain why implied volatilities tend to be higher for out-of-the-money put options, especially for index options, a tendency called the implied volatility “smirk.” Hence, this smirk is not just an arbitrage opportunity but also a reflection of a real crash risk. As in the binomial model, we can derive the option replicating portfolio in the Black–Scholes–Merton model. If a hedge fund short-sells an option, it will hedge its position by buying Δt shares, where Since Δt is changing over time, the hedge fund must keep adjusting the number of shares held, which is called dynamic hedging.


pages: 443 words: 51,804

Handbook of Modeling High-Frequency Data in Finance by Frederi G. Viens, Maria C. Mariani, Ionut Florescu

algorithmic trading, asset allocation, automated trading system, backtesting, Bear Stearns, Black-Scholes formula, Brownian motion, business process, buy and hold, continuous integration, corporate governance, discrete time, distributed generation, fixed income, Flash crash, housing crisis, implied volatility, incomplete markets, linear programming, mandelbrot fractal, market friction, market microstructure, martingale, Menlo Park, p-value, pattern recognition, performance metric, principal–agent problem, random walk, risk free rate, risk tolerance, risk/return, short selling, statistical model, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process

APPENDIX B.2: STEP-BY-STEP EXPLANATION OF THE CONSTRUCTION OF VIX USING STOCHASTIC VOLATILITY QUADRINOMIAL TREE METHOD Here we use quadrinomial tree model to compute the price of a synthetic options with exact 30 days maturity using distribution of implied volatility obtained from S&P500 as input. Then by Black and Scholes (1973) formula, we obtain the implied volatility of this synthetic option. We want to study whether or not this implied volatility multiplied with 100 can better reflect the market volatility. References 115 There are four steps in the construction of this VIX as follows: • Compute the implied volatilities of entire option chain on SP500 and construct an estimate for the distribution of current market volatility. The implied volatility is calculated by applying Black–Scholes formula. • Use this estimated distribution as input to the quadrinomial tree method.

Obtain the price of an at-the-money synthetic option with exactly 30-day maturity. • Compute the implied volatility of the synthetic option based on Black–Scholes formula once the 30-day synthetic option is priced. • Obtain the estimated VIX by multiplying the implied volatility of the synthetic option by 100. Please note that the most important step in the estimation is the choice of proxy for the current stochastic volatility distribution. REFERENCES Black F, Scholes M. The valuation of options and corporate liability. J Polit Econ 1973;81:637–654. Bollen N, Whaley R. Does net buying pressure affect the shape of implied volatility functions? J Finance 2004;59(2):711–753.

However, since a number we need to provide the idea of this approach is to produce the price of a synthetic one-month option with strike exactly the spot price and calculate the implied volatility value corresponding to the price we produce. The real challenge is to come up with a stochastic volatility distribution characteristic of the current market conditions. In the current work, we take the simplest approach possible. We use a proxy for this ϕt calculated directly from the implied volatility values characterizing the option chains. This is used in conjunction with a highly recombining quadrinomial tree method to compute the price of options.


pages: 367 words: 97,136

Beyond Diversification: What Every Investor Needs to Know About Asset Allocation by Sebastien Page

Andrei Shleifer, asset allocation, backtesting, Bernie Madoff, bitcoin, Black Swan, business cycle, buy and hold, Cal Newport, capital asset pricing model, coronavirus, corporate governance, Covid-19, COVID-19, cryptocurrency, discounted cash flows, diversification, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, fixed income, future of work, G4S, implied volatility, index fund, information asymmetry, iterative process, loss aversion, market friction, mental accounting, merger arbitrage, oil shock, passive investing, prediction markets, publication bias, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Feynman, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, sovereign wealth fund, stochastic process, stochastic volatility, stocks for the long run, systematic trading, tail risk, transaction costs, value at risk, yield curve, zero-coupon bond, zero-sum game

Covered call writing gives exposure to the volatility risk premium, one of the “alternative betas” that have risen in popularity recently. The strategy relies on the predictability in the difference between implied volatility (embedded in options prices) and realized market volatility. Historically, implied volatility has almost always been higher than subsequent realized volatility. Hence, when appropriately hedged, the strategy sells implied volatility and buys realized volatility, without any (or with very little) direct market exposure. As mentioned by Roni Israelov and Lars N. Nielsen in “Covered Call Strategies: One Fact and Eight Myths” (2014), “The volatility risk premium, which is absent from most investors’ portfolios, has had more than double the risk-adjusted returns (Sharpe ratio) of the equity risk premium.”

But if the puts are overpriced because of the demand for protection, calls should be overpriced as well, through put-call parity. Indeed, dealers can replicate the put with the call and a short forward position. As long as no arbitrage occurs, demand for protection will also drive up the call price. The history of implied volatility for US stocks is consistent with the fact that investors crave protection. Historically, implied volatility was almost always higher than realized volatility. This spread loosely explains the performance of covered call writing. Second, beyond the “demand for hedging” theory, a simpler explanation for the volatility risk premium has been proposed: it may simply represent compensation for its tail risk.

It’s hard to argue that one specific model should perform consistently better than to simply extrapolate recent volatility. Aside from a slight advantage for volatility estimates derived from options prices, Poon and Granger find that across 93 academic studies, there’s no clear winner of the great risk forecasting horse race. And option-implied volatilities aren’t a silver bullet either. Options don’t trade for a wide range of assets anyway. In contrast with Poon and Granger’s conclusion, Marra’s results reveal that the option- implied approach performed the worst out of the eight models he backtested. Of course, while no single model has surfaced as the most effective, some models perform better than others for specific asset classes and during specific time periods or market regimes.


pages: 353 words: 88,376

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

Albert Einstein, asset allocation, asset-backed security, Brownian motion, business cycle, business process, buy and hold, capital asset pricing model, clean water, collateralized debt obligation, computerized markets, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, fixed income, implied volatility, index fund, intangible asset, interest rate swap, inventory management, London Interbank Offered Rate, margin call, money market fund, mortgage debt, Myron Scholes, passive investing, performance metric, risk free rate, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

During these times, holders of illiquid securities may find themselves unable to unload them at all or unable to do so without losing a lot of money. 133 134 The Investopedia Guide to Wall Speak Related Terms: • Intrinsic Value • Law of Supply • Marketable Securities • Law of Demand • Liquidity Implied Volatility (IV) What Does Implied Volatility Mean? The estimated volatility of the price of a security. Investopedia explains Implied Volatility In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets. In addition to known factors such as market price, interest rate, expiration date, and strike price, implied volatility is used in calculating an option’s premium. IV can be derived from a model such as the Black Scholes Model.

IV can be derived from a model such as the Black Scholes Model. Implied volatility sometimes is referred to as vols. Related Terms: • Beta • Options • Volatility • Black Scholes Model • Stock Option In the Money What Does In the Money Mean? The state of a call option when its strike price is below the market price of the underlying asset. For put options, it is the state when the strike price is above the market price of the underlying asset. Investopedia explains In the Money In other words, this is when a stock option is worth money and the investor can turn around and sell or exercise it for a profit. Related Terms: • Call Option • Premium • Strike Price • Common Stock • Put Option The Investopedia Guide to Wall Speak 135 Income Statement What Does Income Statement Mean?

Related Terms: • Capital • Initial Public Offering—IPO • Private Equity • Capital Structure • Mezzanine Financing VIX (CBOE Volatility Index) What Does VIX (CBOE Volatility Index) Mean? VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which numerically expresses the market’s expectation of 30-day volatility; it is constructed by using the implied volatilities of a wide range of S&P 500 Index options. The results are meant to be forward-looking and are calculated by using both call and put options The VIX is a widely used measure of market risk and often is referred to as the investor fear gauge. There are three variations of the volatility indexes: (1) the VIX, which tracks the S&P 500, (2) the VXN, which tracks the Nasdaq 100, and (3) the VXD, which tracks the Dow Jones Industrial Average.


pages: 819 words: 181,185

Derivatives Markets by David Goldenberg

Black-Scholes formula, Brownian motion, capital asset pricing model, commodity trading advisor, compound rate of return, conceptual framework, correlation coefficient, Credit Default Swap, discounted cash flows, discrete time, diversification, diversified portfolio, en.wikipedia.org, financial innovation, fudge factor, implied volatility, incomplete markets, interest rate derivative, interest rate swap, law of one price, locking in a profit, London Interbank Offered Rate, Louis Bachelier, margin call, market microstructure, martingale, Myron Scholes, Norbert Wiener, Paul Samuelson, price mechanism, random walk, reserve currency, risk free rate, risk/return, riskless arbitrage, Sharpe ratio, short selling, stochastic process, stochastic volatility, time value of money, transaction costs, volatility smile, Wiener process, yield curve, zero-coupon bond, zero-sum game

It is called the implied volatility method and it generates the implied volatility estimator. The idea behind implied volatility is that the Black–Scholes formula embodies an implicit volatility estimator. If we compare market option prices to Black–Scholes model option prices, we can extract the Black–Scholes implicit volatility estimator. Since option prices incorporate a wide variety of forward views of volatility, implied volatility could be a better estimator of unknown volatility than the historical estimator, which is a backward looking estimator. B. The Implied Volatility Estimator Method Volatility is one of the key parameters in the Black–Scholes formula, but it is unobservable.

Then, if we take the market’s (not the model’s) option price we can equate Ct,Black–Scholes to Ct,Market, and obtain a non-linear equation in σ that can be iteratively solved for the implied volatility estimator, which we will denote by σIV. The brief version of this procedure is, Ct,Black–Scholes=Ct,Market implies σIV. End of Chapter Exercises 4 and 5 implement this procedure. The IV estimator turns out empirically to be a better estimator than the historical σ, which is probably not too surprising. Unfortunately, whether we use the historical volatility estimator or the implied volatility estimator, we are still stuck with the constant σ assumption. If σ is constant, then it is also constant across options with different exercise prices and σIV should not depend upon which exercise price K is used to estimate it.

There is no immediate and completely adequate empirical fix for the constant σ assumption, except to throw out Black–Scholes’ assumption of a stationary log-normal diffusion, and search for a viable (smile-consistent) underlying stochastic process among the vast set of alternatives, many of which will lead to incomplete markets. Black–Scholes and its modifications, however, still have tremendous appeal, especially among traders, who use Black–Scholes calibrated to an implied volatility surface. Traders use ATM options to imply volatility, since these are the most liquid, and therefore most informative about future volatility. Furthermore, there are exotic and American options for which the log-normal GBM remains the workhorse. This is for the simple reason that it is difficult (or so far impossible) to price these complex options for any processes other than a standard GBM.


pages: 701 words: 199,010

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Black-Scholes formula, business cycle, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, John Meriwether, Kickstarter, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, Mitch Kapor, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sam Peltzman, Savings and loan crisis, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, survivorship bias, systematic trading, tail risk, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

To execute this trade, one might buy 5-year call options on 10-year swaps in Deutschemarks and sell 1-year call options on 10-year swaps in the right proportion to hedge away unwanted risks, such as risks from overall interest rate movements. Figure 4.7 graphs the difference between the implied volatility of 5-year options and 1-year options. When this went up, LTCM made money. When this went down, LTCM lost money. FIGURE 4.7 The Difference between Implied Volatility on 5-Year Options and 1-Year Options on 10-Year Euro Swap Rates Source: Goldman Sachs. Around June 1998, the implied volatilities of short-term and long-term options were about the same. Then, as LTCM predicted, the implied volatility on the 5-year increased, making LTCM profits. Then came the Russian crisis, when Russia defaulted on its debt.

LTCM’s idea was good, but in August and September 1998 it was not practical. Figure 4.10 plots the implied volatility (according to market prices) of 12-month options on the S&P 500 and the Nikkei, as well as the rolling 20-day and rolling 5-year historical volatility of the S&P 500. FIGURE 4.10 The Implied Volatility of 12-Month Options on the S&P 500 and the Nikkei 225 Source: Goldman Sachs. It’s clear that the Russian default and LTCM’s crisis pushed both short-term actual volatility and one-year options’ implied volatility sharply up. On August 3, 1998, the implied volatility on short-term options was 24%, 20-day historical volatility was 16%, and 5-year historical volatility was 12%.

With a formula that relates an option’s price to the underlying security’s volatility, a trader could convert the option’s price into a volatility consistent with that price. This is called implied volatility. The Black-Scholes formula, discovered in 1973, is most commonly used for this purpose. It is named after one of LTCM’s principals, Myron Scholes, and the late Goldman Sachs partner Fischer Black. LTCM made volatility trades in both fixed income and equities. In the fixed-income arena, they noticed in 1998 that the implied volatility of 5-year options (i.e., options with five years to maturity) on German-denominated swaps was trading much lower than actual realized volatility. Option prices were trading with an implied volatility of 3 basis points per day, while the realized volatility in the marketplace was closer to 5 basis points.


pages: 512 words: 162,977

New Market Wizards: Conversations With America's Top Traders by Jack D. Schwager

backtesting, beat the dealer, Benoit Mandelbrot, Berlin Wall, Black-Scholes formula, butterfly effect, buy and hold, commodity trading advisor, computerized trading, Edward Thorp, Elliott wave, fixed income, full employment, implied volatility, interest rate swap, Louis Bachelier, margin call, market clearing, market fundamentalism, money market fund, paper trading, pattern recognition, placebo effect, prediction markets, Ralph Nelson Elliott, random walk, risk tolerance, risk/return, Saturday Night Live, Sharpe ratio, the map is not the territory, transaction costs, War on Poverty

The volatility assumption embedded in the market price is called the implied volatility. If option prices are a better predictor of future volatility than is the recent past volatility, then the question of whether an option is overpriced or underpriced is not only irrelevant but actually misleading. In essence, the question Joe Ritchie / 357 posed above is equivalent to asking whether there is any reason to assume that the strategy of buying options priced below their fair value and selling those that are above their fair value has any merit.] Implied volatility seems better to me. Conceptually or empirically? To me it seems pretty obvious conceptually.

That raises an interesting question. Since theoretical values are based on historical volatility, doesn’t that approach imply that historical volatility is a better predictor of future volatility than implied volatility? [For a detailed discussion of the concepts underlying this question, see the Joe Ritchie interview, pages 356-574.] No. Actually, empirical studies have shown that implied volatility is better than historical volatility in predicting the actual future volatility. 376 / The New Market Wizard Then how could you make money by trading based on mispricings relative to your model? The real key is relative value.

I always tried to be relatively hedged. in a takeover situation, however, you might think that you are hedged, but the price move occurs so quickly that you really aren’t. You mentioned that speculators are usually on the buy side of options. In general, do you believe there is a mispricing that occurs because people like to buy options? If you compare historical graphs of implied volatility versus historical volatility across a spectrum of markets, you will see a distinct tendency Blair Hull / 379 for implied volatility being higher—a pattern that suggests that such a bias exists. Does that imply that being a consistent seller of options is a viable strategy? I believe there’s an edge to always being a seller, but I wouldn’t trade that way because the implied risk in that approach is too great.


pages: 313 words: 34,042

Tools for Computational Finance by Rüdiger Seydel

bioinformatics, Black-Scholes formula, Brownian motion, commoditize, continuous integration, discrete time, implied volatility, incomplete markets, interest rate swap, linear programming, London Interbank Offered Rate, mandelbrot fractal, martingale, random walk, risk free rate, stochastic process, stochastic volatility, transaction costs, value at risk, volatility smile, Wiener process, zero-coupon bond

The volatility σ determined in this way is called implied volatility and is zero of f (σ) := V − v(S, τ, K, r, σ). Assignment: a) Implement the evaluation of VC and VP according to (A4.10). b) Design, implement and test an algorithm to calculate the implied volatility of a call. Use Newton’s method to construct a sequence xk → σ. The derivative f (xk ) can be approximated by the difference quotient f (xk ) − f (xk−1 ) . xk − xk−1 c) For the resulting secant iteration invent a stopping criterion that requires smallness of both |f (xk )| and |xk − xk−1 |. Calculate the implied volatilities for the data T − t = 0.211 , S0 = 5290.36 , r = 0.0328 Exercises 55 and the pairs K, V from Table 1.3 (for more data see www.compfin.de).

(1.39) Then (1.37) becomes Comparing this SDE to (1.33), notice that the growth rate µ is replaced by the risk-free rate r. Together the transition consists of µ P W → r → Q → Wγ which is named risk-neutral valuation principle. The advantage of the “risk-free measure” Q that corresponds to (1.38) is that the discounted process e−rt St is drift-free, 6 For the implied volatility see Exercise 1.5. 1.7 Stochastic Differential Equations 37 d(e−rt St ) = e−rt σSt dWtγ . This property of having no drift is an essential ingredient of a no-arbitrage market and a prerequisite to modeling options. For a thorough discussion of the continuous model, martingale theory is used.

The following single-loop algorithm is recommended: α1 := x1 , β1 := 0 for i = 2, ..., M : xi − αi−1 αi := αi−1 + i (i − 1)(xi − αi−1 )2 βi := βi−1 + i a) b) Show x̄ = αM , s2M = MβM −1 . For the ith update in the algorithm carry out a rounding error analysis. What is your judgement on the algorithm? Exercise 1.5 Implied Volatility For European options we take the valuation formula of Black and Scholes of the type V = v(S, τ, K, r, σ), where τ denotes the time to maturity, τ := T −t. For the definition of the function v see Appendix A4, equation (A4.10). If actual market data of the price V are known, then one of the parameters considered known so far can be viewed as unknown and fixed via the implicit equation V − v(S, τ, K, r, σ) = 0 . (∗) In this calibration approach the unknown parameter is calculated iteratively as solution of equation (∗).


Analysis of Financial Time Series by Ruey S. Tsay

Asian financial crisis, asset allocation, backpropagation, Bayesian statistics, Black-Scholes formula, Brownian motion, business cycle, capital asset pricing model, compound rate of return, correlation coefficient, data acquisition, discrete time, frictionless, frictionless market, implied volatility, index arbitrage, Long Term Capital Management, market microstructure, martingale, p-value, pattern recognition, random walk, risk free rate, risk tolerance, short selling, statistical model, stochastic process, stochastic volatility, telemarketer, transaction costs, value at risk, volatility smile, Wiener process, yield curve

In options markets, if one accepts the idea that the prices are governed by an econometric model such as the Black–Scholes formula, then one can use the price to obtain the “implied” volatility. Yet this approach is often criticized for using a specific model, which is based on some assumptions that might not hold in practice. For instance, from the observed prices of a European call option, one can use the Black–Scholes formula in Eq. (3.1) to deduce the conditional standard deviation σt . The resulting value of σt2 is called the implied volatility of the underlying stock. However, this implied volatility is derived under the log normal assumption for the return series. It might be very different from the actual volatility.

(6.25) 6.9 JUMP DIFFUSION MODELS Empirical studies have found that the stochastic diffusion model based on Brownian motion fails to explain some characteristics of asset returns and the prices of their derivatives (e.g., the “volatility smile” of implied volatilities; see Bakshi, Cao, and Chen, 1997, and the references therein). Volatility smile is referred to as the convex function between the implied volatility and strike price of an option. Both out-ofthe-money and in-the-money options tend to have higher implied volatilities than at-the-money options especially in the foreign exchange markets. Volatility smile is less pronounced for equity options. The inadequacy of the standard stochastic diffusion model has led to the developments of alternative continuous-time models.

It might be very different from the actual volatility. Experience shows that implied volatility of an asset return tends to be larger than that obtained by using a GARCH type of volatility model. Although volatility is not directly observable, it has some characteristics that are commonly seen in asset returns. First, there exist volatility clusters (i.e., volatility may be high for certain time periods and low for other periods). Second, volatility evolves over time in a continuous manner—that is, volatility jumps are rare. Third, volatility does not diverge to infinity—that is, volatility varies within some fixed range.


pages: 300 words: 77,787

Investing Demystified: How to Invest Without Speculation and Sleepless Nights by Lars Kroijer

Andrei Shleifer, asset allocation, asset-backed security, Bernie Madoff, bitcoin, Black Swan, BRICs, Carmen Reinhart, cleantech, compound rate of return, credit crunch, diversification, diversified portfolio, equity premium, estate planning, fixed income, high net worth, implied volatility, index fund, intangible asset, invisible hand, Kenneth Rogoff, market bubble, money market fund, passive investing, pattern recognition, prediction markets, risk tolerance, risk/return, Robert Shiller, Robert Shiller, selection bias, sovereign wealth fund, too big to fail, transaction costs, Vanguard fund, yield curve, zero-coupon bond

Using the Black-Scholes option pricing formula we can obtain the implied volatility. Looking at the implied volatility for options with various maturities we can see how volatile traders expect the market to be in future. In the past, the implied volatility of index options have been better predictors of future market volatility than using the historical volatility of the stock market. For the S&P 500 index you can look at the VIX index, which gives the implied volatility for that market for the coming month, but expect the implied volatility to be very different depending on the market, maturity and strike price you are looking at. 2 You can look up the probabilities associated with various standard deviations and get a fuller explanation of standard deviation in general, on Wikipedia.


pages: 483 words: 141,836

Red-Blooded Risk: The Secret History of Wall Street by Aaron Brown, Eric Kim

activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, Asian financial crisis, Atul Gawande, backtesting, Basel III, Bayesian statistics, Bear Stearns, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Black Swan, business cycle, capital asset pricing model, central bank independence, Checklist Manifesto, corporate governance, creative destruction, credit crunch, Credit Default Swap, disintermediation, distributed generation, diversification, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, experimental subject, financial innovation, illegal immigration, implied volatility, independent contractor, index fund, Long Term Capital Management, loss aversion, margin call, market clearing, market fundamentalism, market microstructure, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, natural language processing, open economy, Pierre-Simon Laplace, pre–internet, quantitative trading / quantitative finance, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, special drawing rights, statistical arbitrage, stochastic volatility, stocks for the long run, tail risk, The Myth of the Rational Market, Thomas Bayes, too big to fail, transaction costs, value at risk, yield curve

Two options with similar terms will have similar implied volatilities, but not necessarily similar prices. So we can use implied volatilities of options we know the prices of to estimate the implied volatilities, and hence the prices, of options whose prices we do not know. We can graph option implied volatility versus time or moneyness (the ratio of the strike price of an option to the underlying price) and get the same kind of insights we get from yield curves and credit curves. We can take the derivative of option price with respect to implied volatility, known as vega, which some forgotten trader thought was a Greek letter.

Both views are valid for different purposes. In this context, it is important to understand that the Black-Scholes-Merton option pricing model is not really a pricing model. It tells us one thing we don’t know, the price of an option, in terms of another thing we don’t know, the volatility of the underlying stock. Solving for the implied volatility (the volatility that gives the option its market price) from the price is exactly analogous to solving for the yield to maturity of a bond from its price. Both are conversions, like from Fahrenheit to Centigrade temperatures. They are mathematical transformations with no economic content. The reason people solve for the yield to maturity of bonds is that two bonds with similar terms and credit qualities will have similar yields, but not necessarily similar prices.

Hedge funds Herbert, Zbigniew Heteroskedasticity Hirsh, Michael Historical simulation VaR History of Statistics, The (Stigler) Hoffer, Richard Hong Kong on Air (Cohen, Muhammad) House of Cards (Cohan, William) How Big Banks Fail and What to Do about It (Duffie) Hugh-Jones, Stephen Humphrey, Caroline Iceberg Risk (Osband) IGT. See Investment growth theory (IGT) Ilmanen, Antti Implied volatility Index funds Inflation Inside the Black Box (Narang) Inside the House of Money (Drobny) Internet. See Bubble investors Investment growth theory (IGT): EMH and equations, MPT and IGT CAPM fairness and IGT CAPM and MPT CAPM virtues of Inviting Disaster (Chiles) Is God a Mathematician?


pages: 272 words: 19,172

Hedge Fund Market Wizards by Jack D. Schwager

asset-backed security, backtesting, banking crisis, barriers to entry, Bear Stearns, beat the dealer, Bernie Madoff, Black-Scholes formula, British Empire, business cycle, buy and hold, buy the rumour, sell the news, Claude Shannon: information theory, cloud computing, collateralized debt obligation, commodity trading advisor, computerized trading, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, diversification, diversified portfolio, Edward Thorp, family office, financial independence, fixed income, Flash crash, hindsight bias, implied volatility, index fund, intangible asset, James Dyson, Jones Act, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, money market fund, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, quantitative easing, quantitative trading / quantitative finance, Right to Buy, risk free rate, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Rubik’s Cube, Savings and loan crisis, Sharpe ratio, short selling, statistical arbitrage, Steve Jobs, systematic trading, technology bubble, transaction costs, value at risk, yield curve

When volatility gets very low in a market, we consider that a very interesting time to start looking for ways to get long volatility, both because volatility is very cheap in an absolute sense and because the market certainty and complacency reflected by low volatility often implies an above-average probability of increased future volatility. Do you favor long-dated options? Often, the longer the duration of the option, the lower the implied volatility, which makes absolutely no sense. We recently bought far out-of-themoney 10-year call options on the Dow as an inflation hedge. Implied volatility on the index is very low. The Dow companies would be in the best position to pass along higher prices. There is also an interest rate bet implicit in buying long-term options that can be quite interesting when interest rates are very low, as they are now.

A primer on mortgage-backed securities and their role in the financial crises is provided later in this chapter before our conversation related to Cornwall’s short trade in collaterized debt obligations (CDOs). 5Mai explained that the typical quoting convention for implied volatility in interest rate markets, known as “normalized volatility,” is the number of absolute basis points reflecting a one-standard-deviation event, as opposed to the standard convention of quoting implied volatility in other asset classes in terms of percentage changes in the underlying security. Normalized volatility of 100 basis points equals a much smaller volatility, as measured in “traditional” percentage terms, when rates are high than when they are low—a characteristic that may have been an additional factor amplifying the anomaly. 6The expected value is the sum of the probability of each outcome multiplied by its value.

At the time, the current Brazilian interest rate was around 8 percent and the 6-month forward rate was over 12 percent. The 6-month forward option prices were distributed around the forward rate of over 12 percent. In other words, the option prices implicitly assumed the 6-month forward rate as the expected level. The implied volatility at the time was around 100 basis points normalized, which meant the market was assigning the odds of nothing happening for the next six months or so— that is, rates staying near 8 percent—as over a four-standard-deviation event.5 We did not have conviction about the future direction of Brazilian interest rates, much less the actual levels.


pages: 385 words: 128,358

Inside the House of Money: Top Hedge Fund Traders on Profiting in a Global Market by Steven Drobny

Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, business cycle, buy and hold, buy low sell high, capital controls, central bank independence, commoditize, commodity trading advisor, corporate governance, correlation coefficient, Credit Default Swap, diversification, diversified portfolio, family office, fixed income, glass ceiling, high batting average, implied volatility, index fund, inflation targeting, interest rate derivative, inventory management, John Meriwether, Long Term Capital Management, margin call, market bubble, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, Nixon triggered the end of the Bretton Woods system, oil shale / tar sands, oil shock, out of africa, paper trading, Paul Samuelson, Peter Thiel, price anchoring, purchasing power parity, reserve currency, risk free rate, risk tolerance, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, tail risk, The Wisdom of Crowds, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond, zero-sum game

I just had to laugh. I said to him,“Volatility has nothing to do with it.Volatility is a stupid concept. We all know that it probably will not happen and that probability is very, very high, but Long Term Capital also thought there was a 1 in 6 billion chance that their portfolio could blow up.” Implied volatility is based on historical volatility, but who cares about historicals? They’re irrelevant.The point is, things can happen for the first time that aren’t in your distribution so they can’t be priced. If it’s never happened before, how can you hedge yourself? The only way to hedge the unknown is to cut off tail risk completely.

When things move up by whatever definition you use, you should sell and when they move back down, you should buy. On average, over time you’re going to make money or earn risk premia. In sum, you overpay for options but don’t mind overpaying? Correct, especially when you move out past one-month options.There is a tendency to believe that people overpay for options because the research shows that implied volatility is higher than realized volatility.That has to be the case for the seller to be willing to write you an option—he’s got to make some money.The difference is, he’s going to delta hedge and you’re not, so 1.30 Dollars per Euro 1.20 1.10 1.00 0.90 M ay Ju 01 nJu 01 lAu 01 gSe 01 pOc 01 tNo 01 vDe 01 cJa 01 nFe 02 bM 02 ar Ap 02 rM 02 ay Ju 02 nJu 02 lAu 02 gSe 02 pOc 02 tNo 02 vDE 02 cJa 02 nFe 03 bM 03 ar Ap 03 rM 03 ay Ju 03 nJu 03 lAu 03 gSe 03 pOc 03 tNo 03 vDe 03 c03 0.80 FIGURE 4.2 Euro, 2001–2003 Source: Bloomberg.

THE FAMILY OFFICE MANAGER 57 you are going to have to pay a little bit extra so that work gets compensated.You have to realize ex ante that yes, you are overpaying.The interesting thing is that you are not delta hedging nor are you paying the seller to do all the work.The market is.The seller is making his money off the delta hedge, and you are paying him a little bit by paying him more than what realized volatility is, but ex ante no one really knows what realized is. We had a study done on the foreign exchange options market going back to 1992, where one-year straddle options were bought every day across a wide variety of currency pairs.We found that even though implied volatility was always higher than realized volatility over annual periods, buying the straddles made money. It’s possible because the buyer of the one-year straddles is not delta hedging but betting on trend to take the price far enough away from the strike that it will cover the premium for the call and the put.


The Trade Lifecycle: Behind the Scenes of the Trading Process (The Wiley Finance Series) by Robert P. Baker

asset-backed security, bank run, banking crisis, Basel III, Black-Scholes formula, Brownian motion, business continuity plan, business process, collapse of Lehman Brothers, corporate governance, credit crunch, Credit Default Swap, diversification, fixed income, functional programming, hiring and firing, implied volatility, interest rate derivative, interest rate swap, locking in a profit, London Interbank Offered Rate, margin call, market clearing, millennium bug, place-making, prediction markets, short selling, statistical model, stochastic process, the market place, the payments system, time value of money, too big to fail, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

In order to look at the shape of market data over time, we need to use a threedimensional object, usually referred to as a surface. A typical example is implied volatility. Although volatility is generally regarded as a reflection of the way prices move, it can also be a source of market data. This is because premium prices of an option infer the volatility (known as the implied volatility). The typical behaviour of options is that they are have greater implied volatility when deeply in or out-of-themoney. In or out-of-the-money is a function of price. So in order to model the market data we need three dimensions – value, price and time. By observing market data for implied volatility across different prices and times, we can construct an implied volatility surface.

For end of day, the middle office will have used data supplied by the traders. But at end of month, this is corrected to the independent value. If the traders have (deliberately or otherwise) used skewed values, these will be corrected by means of a provision. For example: A trader’s P&L comes out as EUR 1 million using his implied volatility data. At end of month, using the independent market data it is revised to EUR 700,000. So a figure of negative EUR 300,000 is added to his accounts as a provision to correct the P&L. He now carries that provision for the coming month until the next time the independent market data is used. It generally takes somewhere in the region of three to four working days each month to derive and verify the end of month valuations and to report them to the relevant audience.

By observing market data for implied volatility across different prices and times, we can construct an implied volatility surface. It is important to recognise that future curves and surfaces generated from current market data are only a market-implied snapshot of how asset prices will move. They change as market prices change and therefore implied future prices have volatility. They are, in essence, current market data for spot and future instruments – they are not actual future prices. 24.6 MARKET DATA Let us consider the universe of market data required to handle all of a financial entity’s trade processes and calculations. 314 THE TRADE LIFECYCLE Sets of market data Different sets of market data can be applied depending on the business function and the type of operation being performed.


pages: 354 words: 26,550

High-Frequency Trading: A Practical Guide to Algorithmic Strategies and Trading Systems by Irene Aldridge

algorithmic trading, asset allocation, asset-backed security, automated trading system, backtesting, Black Swan, Brownian motion, business cycle, business process, buy and hold, capital asset pricing model, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, computerized trading, diversification, equity premium, fault tolerance, financial intermediation, fixed income, high net worth, implied volatility, index arbitrage, information asymmetry, interest rate swap, inventory management, law of one price, Long Term Capital Management, Louis Bachelier, margin call, market friction, market microstructure, martingale, Myron Scholes, New Journalism, p-value, paper trading, performance metric, Performance of Mutual Funds in the Period, profit motive, purchasing power parity, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, Small Order Execution System, statistical arbitrage, statistical model, stochastic process, stochastic volatility, systematic trading, tail risk, trade route, transaction costs, value at risk, yield curve, zero-sum game

Market crashes and other negative shocks have been shown to result in higher subsequent volatility levels than rallies and other news favorable to the market. This asymmetric property of volatility generates skews in volatility surfaces constructed of option-implied volatilities for different option strike prices. Engle and Patton (2001) cite the following example of volatility skews: the implied volatilities of in-the-money put options are lower than those of at-themoney put options. Furthermore, the implied volatilities of at-the-money put options are lower than the implied volatilities of out-of-the-money options. Finally, volatility forecasts may be influenced by external events, such as news announcements. In foreign exchange, for example, price and return volatility of a particular currency pair increase markedly during macroeconomic announcements pertaining to one or both sides of the currency pair.

Tick data usually has the following properties: r A timestamp r A financial security identification code r An indicator of what information it carries: r Bid price r Ask price r Available bid volume r Available ask volume r Last trade price r Last trade size r Option-specific data, such as implied volatility r The market value information, such as the actual numerical value of the price, available volume, or size A timestamp records the date and time at which the quote originated. It may be the time at which the exchange or the broker-dealer released the quote, or the time when the trading system has received the quote.


pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

3Com Palm IPO, asset allocation, Bear Stearns, Bernie Madoff, Brownian motion, buy and hold, collateralized debt obligation, commodity trading advisor, computerized trading, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, negative equity, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, tail risk, transaction costs, two-sided market, value at risk, yield curve

Beta. 3. Percentage of up months in down markets. 4. Average return in down markets. 1 Figure 9.1 is a hypothetical, simplified illustration. In actual markets, the pattern would not be symmetrical, since declining prices would likely increase implied volatility, further exacerbating losses, while rising prices would likely reduce implied volatility, mitigating losses. 2 The hypothetical fund returns examples (Funds A, B, and C) used in this chapter are artificial and not meant to be representative of any actual funds. The return statistics have been created specifically to highlight some key concepts related to the properties of correlation. 3 Although this is an artificial and unrealistic return series, it is useful in helping to illustrate the concept that high correlation does not necessarily imply a large price impact. 4 Mathematically, beta is equal to correlation times the ratio of the investment standard deviation to the benchmark standard deviation.

(In contrast, the time remaining until expiration and the relationship between the current market price and the strike price can be exactly specified at any juncture.) Thus, volatility must always be estimated on the basis of historical volatility data. The future volatility estimate implied by market prices (i.e., option premiums), which may be higher or lower than the historical volatility, is called the implied volatility. On average, there is a tendency for the implied volatility of options to be higher than the subsequent realized volatility of the market till the options’ expiration. In other words, options tend to be priced a little high. The extra premium is necessary to induce option sellers to take the open-ended risk of providing price insurance to option buyers.


pages: 442 words: 39,064

Why Stock Markets Crash: Critical Events in Complex Financial Systems by Didier Sornette

Asian financial crisis, asset allocation, Berlin Wall, Bretton Woods, Brownian motion, business cycle, buy and hold, buy the rumour, sell the news, capital asset pricing model, capital controls, continuous double auction, currency peg, Deng Xiaoping, discrete time, diversified portfolio, Elliott wave, Erdős number, experimental economics, financial innovation, floating exchange rates, frictionless, frictionless market, full employment, global village, implied volatility, index fund, information asymmetry, intangible asset, invisible hand, John von Neumann, joint-stock company, law of one price, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, market design, market fundamentalism, mental accounting, moral hazard, Network effects, new economy, oil shock, open economy, pattern recognition, Paul Erdős, Paul Samuelson, quantitative trading / quantitative finance, random walk, risk/return, Ronald Reagan, Schrödinger's Cat, selection bias, short selling, Silicon Valley, South Sea Bubble, statistical model, stochastic process, stocks for the long run, Tacoma Narrows Bridge, technological singularity, The Coming Technological Singularity, The Wealth of Nations by Adam Smith, Tobin tax, total factor productivity, transaction costs, tulip mania, VA Linux, Y2K, yield curve

In practice, it is very difficult to have a good model for market price volatilities or even to measure it reliably. The standard procedure is then to see what the market forces decide for the option price and then determine the implied volatility by inversion of the Black and Scholes formula for option pricing [294]. Basically, the implied volatility is a measure of the market risks perceived by investors. Figure 7.4 presents the time evolution of the implied volatility of the S&P 500, taken from [84]. The perceived market risk is small prior to the crash, jumps up abruptly at the time of the crash, and then decays slowly over several months. This decay to “normal times” of perceived risks is compatible with a slow power law decay decorated by log-periodic 237 autopsy of major c r a s h e s 90 80 70 σ 2 (S&P 500) 60 50 40 30 20 10 0 87.6 87.8 88.0 88.2 88.4 Time (year) 88.6 88.8 Fig. 7.4.

In other words, we should be able to document the existence of a critical exponent as well as log-periodic oscillations on relevant quantities after the crash. Such a signature in the volatility of the S&P 500 index, implied from the price of S&P 500 options (which are derivative assets with price varying as a function of the price of the S&P 500), can indeed be seen in Figure 7.4. The term “implied volatility” has the following meaning. First, one must recall what an option is: this financial instrument is nothing but an insurance that can be bought or sold on the market to insure oneself against unpleasant price variations. The price of an option on the S&P 500 index is therefore a function of the volatility of the S&P 500.

The perceived market risk is small prior to the crash, jumps up abruptly at the time of the crash, and then decays slowly over several months. This decay to “normal times” of perceived risks is compatible with a slow power law decay decorated by log-periodic 237 autopsy of major c r a s h e s 90 80 70 σ 2 (S&P 500) 60 50 40 30 20 10 0 87.6 87.8 88.0 88.2 88.4 Time (year) 88.6 88.8 Fig. 7.4. Time evolution of the implied volatility of the S&P 500 index (in logarithmic scale) after the October 1987 crash, taken from [84]. The + represent an exponential decrease with varFexp ≈ 15. The best fit to a power law, represented by the monotonic line, gives A1 ≈ 39, B1 ≈ 06, tc = 8775, m1 ≈ −15, and varpow ≈ 12. The best fit to expression (15) with tc − t replaced by t − tc gives A2 ≈ 34, B2 ≈ 09, tc ≈ 8777, C ≈ 03, ≈ 11, m2 ≈ −12, and varlp ≈ 7.


pages: 416 words: 39,022

Asset and Risk Management: Risk Oriented Finance by Louis Esch, Robert Kieffer, Thierry Lopez

asset allocation, Brownian motion, business continuity plan, business process, capital asset pricing model, computer age, corporate governance, discrete time, diversified portfolio, fixed income, implied volatility, index fund, interest rate derivative, iterative process, P = NP, p-value, random walk, risk free rate, risk/return, shareholder value, statistical model, stochastic process, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

This concept of volatility can be seen from two points of view: historical volatility and implied volatility. Historical volatility is simply the annualised standard deviation on the underlying equity return, obtained from daily observations of the return in the past: n 1 σR = J · (Rt − R)2 n t=1 Here, the factor J represents the number of working days in the year; n is the number of observations and Rt is the return on the underlying equity. It is easy to calculate, but the major problem is that it is always ‘turned towards the past’ when it really needs to help analyse future developments in the option price. For this reason, the concept of implied volatility has been introduced.

The value of the option premium is determined in practice by the law of supply and demand. In addition, this law is linked to various factors through a binomial model of valuation: pt = f (St , K, T − t, σR , RF ) or through Black and Scholes (see Section 5.3). The resolution of this relation with respect to σR defines the implied volatility. Although the access is more complicated, this concept is preferable and it is this one that will often be used in practice. 5.2.3 Sensitivity parameters 5.2.3.1 ‘Greeks’ The premium is likely to vary when each of the parameters that determine the price of the option (spot price, exercise price, maturity etc.) change.

The above formula provides a very simple means of determining the number of equities that should be held by a call issuer to hedge his risk (the delta hedging). This is a common use of the Black and Scholes relation: the price of an option is determined by the law of supply and demand and its ‘inversion’ provides the implied volatility. The latter is therefore used in the relation (C) = (d1 ), which is then known as the hedging formula. Options 173 The other sensitivity parameters (gamma, theta, vega and rho) are obtained in a similar way: φ(d1 ) (C) = (P ) = √ St σR τ  St σR φ(d1 )  − rKe−rτ (d2 )   (C) = − 2√τ  S σ φ(d )   (P ) = − t R√ 1 + rKe−rτ (−d2 ) 2 τ V (C) = V (P ) = τ St φ(d1 ) ρ(C) = τ Ke−rτ (d2 ) ρ(C) = −τ Ke−rτ (−d2 ) In finishing, let us mention a relationship that links the delta, gamma and theta parameters.


pages: 317 words: 106,130

The New Science of Asset Allocation: Risk Management in a Multi-Asset World by Thomas Schneeweis, Garry B. Crowder, Hossein Kazemi

asset allocation, backtesting, Bear Stearns, Bernie Madoff, Black Swan, business cycle, buy and hold, capital asset pricing model, collateralized debt obligation, commodity trading advisor, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index fund, interest rate swap, invisible hand, market microstructure, merger arbitrage, moral hazard, Myron Scholes, passive investing, Richard Feynman, Richard Feynman: Challenger O-ring, risk free rate, risk tolerance, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, statistical model, stocks for the long run, survivorship bias, systematic trading, technology bubble, the market place, Thomas Kuhn: the structure of scientific revolutions, transaction costs, value at risk, yield curve, zero-sum game

In this case, a 4-factor model is used to predict risk and return on each predetermined allocation. The four factors are: Strategic, Tactical, and Dynamic Asset Allocation ■ 103 1. Current level of credit risk premium (CR) compared to its historically normal level 2. Current level of term premium (TP) compared to its historically normal level 3. Current level of S&P 500 implied volatility as measured by VIX compared to its historically normal level 4. Recent return to each allocation Estimation Strategy. A quantitative approach is adopted to estimate the lead-lag relationship between the performance of each allocation and the factors mentioned above. E [Rt +1 ] = f (CRt , TPt , Rt , VIXt ) ■ In this case, five years of monthly returns are used to estimate the model.

Consider the case of a family business, which currently has an investment of $200 million in a well diversified portfolio of traditional global equity and fixed income assets as well as alternative investments. The five-year historical volatility on the portfolio’s pro-forma return has been 10%, while during the same period the average implied volatility of U.S. equity market has been around 18%. This means that the portfolio’s volatility has been about 55% of VIX. Once the portfolio is constructed, the portfolio manager will need to monitor the VIX. If there is a significant increase in VIX, the portfolio manager will use index futures to hedge out some of the portfolio’s volatility such that its expected volatility remains close to the target.

In light of the growing investment interest, the CBOE has recently introduced a number of buy-write indices based on a variety of equity indices such as the S&P 500, the Dow Jones 207 Risk Budgeting and Asset Allocation Industrial Average, the NASDAQ 100 and the Russell 2000. In addition, a number of funds based on a buy-write strategy have been introduced over the last five years.2 As illustrated in Kapadia and Szado (2007), the excess risk-adjusted performance of the passive buy-write strategy is primarily derived from selling calls at an implied volatility that exceeds the subsequently realized volatility. In fact, they find that if the calls were sold at the Black-Scholes price corresponding with the realized volatility, the buy-write strategy would underperform the underlying index. In this sense, the buywrite is providing something more than a simple return distribution truncation; it is also providing an additional source of returns—the option volatility risk premium.


pages: 206 words: 70,924

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

"Robert Solow", Albert Einstein, Bayesian statistics, Bear Stearns, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, Myron Scholes, Paul Samuelson, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk free rate, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, Thales and the olive presses, Thales of Miletus, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

However, all tools depend on what is known because it has been observed, not on what is not yet known because it has yet to occur. 122 The Rise of the Quants Estimates of past volatility, for instance, may not be representative of future volatility. We can observe the movement of options prices based on current market conditions to derive an implied volatility, and analysts can at least compare current volatility trends against historical patterns. While the Black-Scholes equation demonstrated that measures of volatility affect options prices, the expected rate of return µ of the underlying security does not. This means that analysts can differ in their valuation of a stock, but not in their valuation of its associated option.

In fact, Monte Carlo simulations of options prices as the underlying stock price is allowed to evolve show that the option price remains remarkably stable for different rates of drift of the underlying stock. This tendency of options to measure market volatility rather than market strength has been enshrined through the Volatility Index (VIX) tallied by the CBOE. This implied volatility is calculated by solving for the volatility that justified the prevailing options price, based on the underlying security price. The measure is derived from Black-Scholes calculations as a gauge of the volatility perceived by the market. This volatility is implicitly incorporated by the market into the prices of options contracts.

If the bond price rises above a certain level, the seller of the call must sacrifice the underlying bond and in turn sacrifice the gain above the exercise price, but is able to book some profit with certainty. Assuming that these fixed-income options are properly priced in an efficient market, we can even calculate the implied volatility by solving the Black-Scholes equation for the volatility necessary to generate the prevailing price. This technique allows the Federal Reserve to measure point volatility in bond markets, or analysts to obtain a measure for the perceived level of volatility in a securities market. Playing with financial fire While options can be used as a legitimate way to share and hedge risk, their highly leveraged nature can also be dangerous.


Principles of Corporate Finance by Richard A. Brealey, Stewart C. Myers, Franklin Allen

3Com Palm IPO, accounting loophole / creative accounting, Airbus A320, Asian financial crisis, asset allocation, asset-backed security, banking crisis, Bear Stearns, Bernie Madoff, big-box store, Black-Scholes formula, break the buck, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, Carmen Reinhart, carried interest, collateralized debt obligation, compound rate of return, computerized trading, conceptual framework, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cross-subsidies, discounted cash flows, disintermediation, diversified portfolio, equity premium, eurozone crisis, financial innovation, financial intermediation, fixed income, frictionless, fudge factor, German hyperinflation, implied volatility, index fund, information asymmetry, intangible asset, interest rate swap, inventory management, Iridium satellite, Kenneth Rogoff, law of one price, linear programming, Livingstone, I presume, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, market bubble, market friction, money market fund, moral hazard, Myron Scholes, new economy, Nick Leeson, Northern Rock, offshore financial centre, Ponzi scheme, prediction markets, price discrimination, principal–agent problem, profit maximization, purchasing power parity, QR code, quantitative trading / quantitative finance, random walk, Real Time Gross Settlement, risk free rate, risk tolerance, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, Silicon Valley, Skype, Steve Jobs, sunk-cost fallacy, Tax Reform Act of 1986, The Nature of the Firm, the payments system, the rule of 72, time value of money, too big to fail, transaction costs, University of East Anglia, urban renewal, VA Linux, value at risk, Vanguard fund, yield curve, zero-coupon bond, zero-sum game, Zipcar

If the Black–Scholes formula is correct, then an option value of 126 makes sense only if investors believe that the standard deviation of index returns is about 25% a year.16 The Chicago Board Options Exchange regularly publishes the implied volatility on the Standard and Poor’s index, which it terms the VIX (see the box on page 551). There is an active market in the VIX. For example, suppose you feel that the implied volatility is implausibly low. Then you can “buy” the VIX at the current low price and hope to “sell” it at a profit when implied volatility has increased. FINANCE IN PRACTICE ● ● ● ● ● The Perfect Payday* On an October day in 1999 the shares of the giant insurer United Health Group sank to their lowest level of the year.

Yermack, “Good Timing: CEO Stock Option Awards and Company News Announcements,” Journal of Finance 52 (1997), pp. 449–476, and in E. Lie, “On the Timing of CEO Stock Option Awards,” Management Science 51 (2005), pp. 802–812. BEYOND THE PAGE ● ● ● ● ● An uncertainty index brealey.mhhe.com/c21 You may be interested to compare the current implied volatility that we calculated earlier with Figure 21.6, which shows past measures of implied volatility for the Standard and Poor’s index and for the Nasdaq index (VXN). Notice the sharp increase in investor uncertainty at the height of the credit crunch in 2008. This uncertainty showed up in the price that investors were prepared to pay for options.

How close is your calculated value to the traded price of the option? b. Your answer to part (a) will not exactly match the traded price. Experiment with different values for the standard deviation until your calculated values match the prices of the traded options as closely as possible. What are these implied volatilities? What do the implied volatilities say about investors’ forecasts of future volatility? MINI-CASE ● ● ● ● ● Bruce Honiball’s Invention It was another disappointing year for Bruce Honiball, the manager of retail services at the Gibb River Bank. Sure, the retail side of Gibb River was making money, but it didn’t grow at all in 2009.


How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Bear Stearns, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business cycle, business process, butter production in bangladesh, buy and hold, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, commoditize, computerized markets, corporate governance, correlation coefficient, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Donald Knuth, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Myron Scholes, Nick Leeson, P = NP, pattern recognition, Paul Samuelson, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Stallman, risk free rate, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

American retail investors wanted to bet that the Nikkei would fall from its then-stratospheric heights, but there was nothing they could trade (the U.S. government, which upholds the right of its citizens to bear arms, draws the line at derivatives). The loophole was that American investors could trade Canadian warrants after the warrants had traded for 90 days in Canada, so Gordon Capital created Nikkei put warrants, quantoed into U.S. or Canadian dollars. I remember smugly marveling at the huge implied volatilities those dumb investors paid for the warrants. However, the dummies got the last laugh when the Nikkei finally crashed. (Fortunately, it was not at our expense. We were hedged.) This taught me that there a lot of different ways to make (and lose) money in finance. Things ended badly at Gordon Capital due to deals it was my privilege to unravel.

Utilizing a database of closing daily FX rates over several years, I set up a simulation study of how FX options written for many different strikes, starting dates, and tenors would have fared using BlackScholes delta hedging, rehedging only at the end of each day. The results showed that there was almost no dependence between profit and loss and where FX rates ended the day. There was a great deal of variance in P&L, but this could virtually all be attributed to whether realized volatility was higher or lower than the implied volatility at which we assumed the option would be priced. I could, therefore, use these simulation results to demonstrate that hedging based upon the Black-Scholes theory could produce reasonable results without assuming continuous trading and with a frequency of hedging that would not involve ruinous transactions costs.

Option modeling in those days was Black-Scholes based, though the market knew a lot about fat-tails, and so winger options would trade above Black-Scholes values. Everyone also knew that option volatility, an important parameter in the Black-Scholes model, moved around like crazy. In those days, the market concentrated on measuring, interpreting and forecasting at-the-money option implied volatilities. Although matter-of-fact today, we recognized something was amiss here. Volatility moving around was a given. At-the-money options, however, have zero volatility curvature. But out-of-the-money options do not. [Out-ofthe-money options, hedged with at-the-money options, were therefore sources of free gamma, unless the out-of-the-money options were priced to reflect this gamma.]


pages: 537 words: 144,318

The Invisible Hands: Top Hedge Fund Traders on Bubbles, Crashes, and Real Money by Steven Drobny

Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, backtesting, banking crisis, Bear Stearns, Bernie Madoff, Black Swan, bond market vigilante , Bretton Woods, BRICs, British Empire, business cycle, business process, buy and hold, capital asset pricing model, capital controls, central bank independence, collateralized debt obligation, commoditize, Commodity Super-Cycle, commodity trading advisor, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, debt deflation, diversification, diversified portfolio, equity premium, family office, fiat currency, fixed income, follow your passion, full employment, George Santayana, Hyman Minsky, implied volatility, index fund, inflation targeting, interest rate swap, inventory management, invisible hand, Kickstarter, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, market microstructure, moral hazard, Myron Scholes, North Sea oil, open economy, peak oil, pension reform, Ponzi scheme, prediction markets, price discovery process, price stability, private sector deleveraging, profit motive, purchasing power parity, quantitative easing, random walk, reserve currency, risk free rate, risk tolerance, risk-adjusted returns, risk/return, savings glut, selection bias, Sharpe ratio, short selling, sovereign wealth fund, special drawing rights, statistical arbitrage, stochastic volatility, stocks for the long run, stocks for the long term, survivorship bias, tail risk, The Great Moderation, Thomas Bayes, time value of money, too big to fail, Tragedy of the Commons, transaction costs, two and twenty, unbiased observer, value at risk, Vanguard fund, yield curve, zero-sum game

But in some cases, the logical correlations were overridden by market technical factors. At the time of the Lehman collapse we owned some long-dated fixed income options where volatility was trading at all-time lows. But volatility actually fell further, a rather strange occurrence, since all other implied volatilities in the marketplace increased sharply for obvious reasons. Yet the reason for this was very technical: These cheap long-dated, long vega positions were held by leveraged players who were forced out of their positions under stress, and there were few natural buyers on the other side. That is a typical example of why you want to have your cash cushion to be able to put on or add to positions in times of stress as we did in this example.

To use an actual example from my past, buying a stock with an annual volatility of 30 percent with a plan to risk 1 percent and a goal of making 10 percent in a week is madness. Statistically, it is almost guaranteed to get stopped out. Yet, this kind of logic is very prevalent in macro, and admittedly I was guilty of it as well. You leave pennies on the table by overusing stops without understanding the implied volatility required to keep you in the trade. My approach has evolved such that I am now more concerned about how my overall portfolio does in what I call “the Titanic scenario,” where everything goes down, fundamental logic escapes the market, and risk aversion rules. I am concerned with how much I lose at the organization level if there is a repeat of the Asian crisis, if the bond market sells off like it did in 1994, or if the dot-com boom/bust or other cathartic experiences reproduce themselves.

If your pension fund’s base currency is gold and gold falls out of favor reverting to its supply and demand price of $42 an ounce, will your pension fund be down 95 percent? I would be an active user of options if I were running a real money portfolio. We have had a significant retrenchment in implied volatility, creating opportunities to manage exposures using option premium. The direction depends on the skews in the volatility market at any given time. Having a hard asset base exposure provides a potential natural hedge because people will still need the basic elements that drive economic existence.


pages: 571 words: 105,054

Advances in Financial Machine Learning by Marcos Lopez de Prado

algorithmic trading, Amazon Web Services, asset allocation, backtesting, bioinformatics, Brownian motion, business process, Claude Shannon: information theory, cloud computing, complexity theory, correlation coefficient, correlation does not imply causation, diversification, diversified portfolio, en.wikipedia.org, fixed income, Flash crash, G4S, implied volatility, information asymmetry, latency arbitrage, margin call, market fragmentation, market microstructure, martingale, NP-complete, P = NP, p-value, paper trading, pattern recognition, performance metric, profit maximization, quantitative trading / quantitative finance, RAND corporation, random walk, risk free rate, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, Silicon Valley, smart cities, smart meter, statistical arbitrage, statistical model, stochastic process, survivorship bias, transaction costs, traveling salesman

Table 2.1 shows the four essential types of financial data, ordered from left to right in terms of increasing diversity. Next, we will discuss their different natures and applications. Table 2.1 The Four Essential Types of Financial Data Fundamental Data Market Data Analytics Alternative Data Assets Liabilities Sales Costs/earnings Macro variables . . . Price/yield/implied volatility Volume Dividend/coupons Open interest Quotes/cancellations Aggressor side . . . Analyst recommendations Credit ratings Earnings expectations News sentiment . . . Satellite/CCTV images Google searches Twitter/chats Metadata . . . 2.2.1 Fundamental Data Fundamental data encompasses information that can be found in regulatory filings and business analytics.

Figure 18.1 Distribution of entropy estimates under 10 (top), 7 (bottom), letter encodings, on messages of length 100 Distribution of entropy estimates under 5 (top), and 2 (bottom) letter encodings, on messages of length 100 Second, we can use the above equation to connect entropy with volatility, by noting that . This gives us an entropy-implied volatility estimate, provided that returns are indeed drawn from a Normal distribution. 18.7 Entropy and the Generalized Mean Here is a practical way of thinking about entropy. Consider a set of real numbers x = {xi}i = 1, …, n and weights p = {pi}i = 1, …, n, such that 0 ≤ pi ≤ 1, ∀i and . The generalized weighted mean of x with weights p on a power q ≠ 0 is defined as For q < 0, we must require that xi > 0, ∀i.

Using daily values, how does this differ from the standard deviation of close-to-close returns? Using dollar bars, for an average of 50 bars per day, how does this differ from the standard deviation of close-to-close returns? Apply the Corwin-Schultz estimator to a daily series of E-mini S&P 500 futures. What is the expected bid-ask spread? What is the implied volatility? Are these estimates consistent with the earlier results, from exercises 2 and 3? Compute Kyle's lambda from: tick data. a time series of dollar bars on E-mini S&P 500 futures, where bt is the volume-weighted average of the trade signs. Vt is the sum of the volumes in that bar. Δpt is the change in price between two consecutive bars.


pages: 364 words: 101,286

The Misbehavior of Markets: A Fractal View of Financial Turbulence by Benoit Mandelbrot, Richard L. Hudson

Albert Einstein, asset allocation, Augustin-Louis Cauchy, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black-Scholes formula, British Empire, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, carbon-based life, discounted cash flows, diversification, double helix, Edward Lorenz: Chaos theory, Elliott wave, equity premium, Eugene Fama: efficient market hypothesis, Fellow of the Royal Society, full employment, Georg Cantor, Henri Poincaré, implied volatility, index fund, informal economy, invisible hand, John Meriwether, John von Neumann, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market microstructure, Myron Scholes, new economy, paper trading, passive investing, Paul Lévy, Paul Samuelson, Plutocrats, plutocrats, price mechanism, quantitative trading / quantitative finance, Ralph Nelson Elliott, RAND corporation, random walk, risk free rate, risk tolerance, Robert Shiller, Robert Shiller, short selling, statistical arbitrage, statistical model, Steve Ballmer, stochastic volatility, transfer pricing, value at risk, Vilfredo Pareto, volatility smile

In the end, the paper was rewritten and published in the Journal of Political Economy—but only after two friends from the University of Chicago, Fama and Merton Miller, lobbied the journal’s editors to give it a second look. Their article appeared in print just after the opening bell on the Chicago Board Options Exchange in 1973. It met an eager audience. Within a few years, options dealers had incorporated its esoteric terminology, of “deltas” and “implied volatilities,” into their daily language. Texas Instruments began advertising its latest calculator as just the thing for a quick Black-Scholes calculation on the fly. An entire industry grew. With the help of the Black-Scholes formula and its many subsequent amendments, corporate financiers now routinely buy insurance, or hedge, against unwanted market problems, and not just in stocks.

Normally, to calculate an options price, you plug in a few numbers, including your estimate of how much the underlying stock price or currency rate fluctuated in the past; the suggested price falls out the back end of the formula. But if you run the equation in reverse, plugging real market prices into its back and pulling from its front the volatility that those prices would imply, you get a nonsense: a range of different volatility forecasts for the same options. A graphic example is below. It shows the implied volatility for several different flavors—different maturities and different strike prices—of the same kind of option. If Black-Scholes were right, this would be a very boring picture, one flat line for all the varieties. Instead, you see a whole range of errors, wandering across the chart. Indeed, the mistakes have a Rococo structure of their own, worthy years of study.

Heresies of finance deceptive markets as flexible time as future volatility odds estimate as inevitable market bubbles as market time/place equality as market uncertainty as prices leap as risky markets as ten turbulent markets as value limited as Hermite, Charles Herodotus Heterogeneous markets Hilbert, David Hippocratic Oath Hölder, Ludwig Otto Hollywood Houthakker, Hendrik S. House fires Human Behavior and the Principle of Least Effort (Zipf) Hurst, Harold Edwin Abu Nil as birth of brief biography of Cairo arrival of formula of New York rainfall measured by water storage project of Hydrology. See Nile river flooding Implied volatility Income cotton price curve compared to curve of Pareto’s study of Index of Market Shocks Inflation Information theory probability in Initiator fractal geometry Insurer profits Intellectual property Internet bubble Bachelier influencing Cisco in risk seen in valuing options with Introduction to Mathematical Probability (Upensky) Investment bubbles inevitability of market behavior with research need for IQ bell curve of James, Jessica January effect Jegadeesh, Narashimhan Johns Hopkins Joseph Joseph effect introduction to multifractal model with Journal Business Journal of Political Economy Journal of the Royal Statistical Society Joyce, James Kendall, Maurice G.


pages: 350 words: 103,270

The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, Black Swan, Black-Scholes formula, bonus culture, break the buck, buy and hold, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, diversification, Edmond Halley, facts on the ground, financial innovation, fixed income, George Akerlof, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, John Meriwether, Kenneth Rogoff, Kickstarter, Long Term Capital Management, margin call, market bubble, money market fund, Myron Scholes, Nick Leeson, Northern Rock, offshore financial centre, Paul Samuelson, price mechanism, regulatory arbitrage, rent-seeking, Richard Thaler, risk free rate, risk tolerance, risk/return, Ronald Reagan, Savings and loan crisis, shareholder value, short selling, statistical model, The Chicago School, Thomas Bayes, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve, zero-sum game

The banks that lent money to hedge funds solemnly promised the Fed and other regulators that they would not make this mistake again.10 Yes, Wall Street proclaimed, derivatives markets had seized up temporarily in September 1998, and Alan Greenspan had been forced to cut the federal funds rate by an emergency three-quarters of a percentage point to get them started again. But the positive, information-transmitting qualities of new derivatives markets had not gone away. In the same way that implied volatility from option prices became a useful fear gauge for the market, transparency and consensus about more complex derivatives pricing would bring in new radar signals, as well as an assurance that the markets were safe. To allay fears that their secret webs of over-the-counter derivatives had increased the uncertainty in the market, the dealers took several measures.

That was meant to shift credit risk off J.P. Morgan’s balance sheet, but Bill Winters and his derivatives marketers wanted to adapt it so that they could create new deals for clients, and Anshu Jain and Rajeev Misra were following close behind. The recipe was called the Gaussian copula, and just as the “implied volatility” of the Black-Scholes formula provided a shorthand for the market’s perception of risk, this model became common currency among dealers who began calling themselves correlation traders. Moody’s and the other ratings agencies had already come up with a crude way of estimating how bundles of bonds or loans might default together, by modeling them as dice or coins according to the binomial expansion technique (BET).

Like Moody’s BET, the Gaussian copula appeared to be just another actuarial rule of thumb, only in this case, Li was using it to connect one set of market prices to another. The difference was that while the Moody’s BET was an inflexible rule book administered by a ratings agency, the mysterious correlation parameter in the Gaussian copula put the trader in control. Like the implied volatility that emerged from the Black-Scholes formula as the market’s fear gauge, here was the tantalizing prospect of a new risk shorthand in CDO prices that supposedly broke open the complexity of the CDO. The Gaussian copula quickly became the lingua franca of credit derivatives traders, who dubbed it the Black-Scholes of credit.


pages: 1,202 words: 424,886

Stigum's Money Market, 4E by Marcia Stigum, Anthony Crescenzi

accounting loophole / creative accounting, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Bear Stearns, Black-Scholes formula, Brownian motion, business climate, buy and hold, capital controls, central bank independence, centralized clearinghouse, corporate governance, credit crunch, Credit Default Swap, currency manipulation / currency intervention, David Ricardo: comparative advantage, disintermediation, distributed generation, diversification, diversified portfolio, financial innovation, financial intermediation, fixed income, foreign exchange controls, full employment, high net worth, implied volatility, income per capita, intangible asset, interest rate derivative, interest rate swap, large denomination, locking in a profit, London Interbank Offered Rate, margin call, market bubble, market clearing, market fundamentalism, Money creation, money market fund, mortgage debt, Myron Scholes, offshore financial centre, paper trading, pension reform, Ponzi scheme, price mechanism, price stability, profit motive, Real Time Gross Settlement, reserve currency, risk free rate, risk tolerance, risk/return, Savings and loan crisis, seigniorage, shareholder value, short selling, tail risk, technology bubble, the payments system, too big to fail, transaction costs, two-sided market, value at risk, volatility smile, yield curve, zero-coupon bond, zero-sum game

The Black-Scholes formula includes the volatility of the underlying asset. This volatility should be constant regardless of the terms of any options that are written on it. However, it is an empirical fact that the implied volatilities of in-the-money and out-of-the-money options are typically higher than the implied volatilities of at-the-money options. This is known as the volatility smile. Typically, the implied volatility also depends on other characteristics of the option such as its maturity. SHORTCOMINGS OF BLACK-SCHOLES One of the failures of the Black-Scholes formula—an empirical one—is discussed above.

Traders will typically choose some historical time horizon and use a weighted average of historical volatilities to get an unbiased estimator of the volatility. However, this is highly dependent on the horizon and weighting chosen. Implied Volatility The above discussion suggests plugging our estimate of volatility into the Black-Scholes formula and comparing the resulting price with the actual price in the market to decide whether we think the option is cheap or expensive. An alternative method would be to take the actual market price of the option (from financial news sources) and the four easily obtainable variables to “back out” the implied volatility: the volatility that the market is incorporating into the current price. Specifically, given the readily available information on an option, the price of the underlying stock, and the risk-free rate, what is the volatility of the underlying stock that would make the Black-Scholes formula true?

Because of this fact and the fact that all the variables from the Black-Scholes formula are readily available except the volatility, traders often quote options in terms of implied volatilities. When they buy an option, they are buying volatility. In this sense, options can be thought of as a bet on the future volatility of the underlying stock. This is why professional options traders are often known as “vol traders.” Can we calculate implied volatility for different options with the same underlying asset? The answer is yes, but the results actually contradict one of the major assumptions of the Black-Scholes formula.


pages: 425 words: 122,223

Capital Ideas: The Improbable Origins of Modern Wall Street by Peter L. Bernstein

"Robert Solow", Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bonfire of the Vanities, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, corporate raider, debt deflation, diversified portfolio, Eugene Fama: efficient market hypothesis, financial innovation, financial intermediation, fixed income, full employment, implied volatility, index arbitrage, index fund, interest rate swap, invisible hand, John von Neumann, Joseph Schumpeter, Kenneth Arrow, law of one price, linear programming, Louis Bachelier, mandelbrot fractal, martingale, means of production, money market fund, Myron Scholes, new economy, New Journalism, Paul Samuelson, Performance of Mutual Funds in the Period, profit maximization, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk free rate, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, stochastic process, Thales and the olive presses, the market place, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, Thorstein Veblen, transaction costs, transfer pricing, zero-coupon bond, zero-sum game

A volatility estimate this far above past experience was unusual: most of the time, people expect the near future to look pretty much the way the recent past has looked. The same experiment revealed that the implied volatility of individual stocks reflected the differences in their fundamental characteristics. American Telephone and Telegraph’s implied monthly volatility was only 10.8 percent, compared to 19.3 percent for Chrysler, a company that was in deep trouble at that moment. The implied volatility for UAL was way up at 22.8 percent, reflecting the uncertainty about the airline’s takeover prospects. Note that each of these stocks had an implied volatility above the 7.4 percent of the S&P 500. That should come as no surprise.


pages: 244 words: 79,044

Money Mavericks: Confessions of a Hedge Fund Manager by Lars Kroijer

activist fund / activist shareholder / activist investor, Bear Stearns, Bernie Madoff, capital asset pricing model, corporate raider, diversification, diversified portfolio, family office, fixed income, forensic accounting, Gordon Gekko, hiring and firing, implied volatility, index fund, intangible asset, Jeff Bezos, Just-in-time delivery, Long Term Capital Management, merger arbitrage, NetJets, new economy, Ponzi scheme, post-work, risk free rate, risk-adjusted returns, risk/return, shareholder value, Silicon Valley, six sigma, statistical arbitrage, Vanguard fund, zero-coupon bond

A simple calculation shows that buying rolling three-month put options on the S&P500 at 8 per cent out-of-the-money would only have been profitable over the past 20 years if you had ceased buying options when the implied standard deviation of the option was above 23 per cent – not a great result considering the markets were frequently down a lot during this period. Above that implied volatility threshold the options were simply too expensive for it to be a consistently profitable strategy. There is probably an argument to be made that investors who are comfortable trading options could benefit from buying deep out-of-the-money put options on the market when implied volatilities are low and thus be protected against shock events in their diversified portfolio at a manageable cost, but it is clearly not a strategy for everyone.


pages: 280 words: 79,029

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

Affordable Care Act / Obamacare, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, Black-Scholes formula, bonus culture, break the buck, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, endogenous growth, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, impact investing, implied volatility, income inequality, index fund, information asymmetry, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, margin call, Mark Zuckerberg, McMansion, money market fund, mortgage debt, mortgage tax deduction, Myron Scholes, negative equity, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Savings and loan crisis, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, tail risk, Thales of Miletus, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

One of his experiments, on the employees of a London trading floor, showed that cortisol levels in traders’ saliva jump by as much as 500 percent in a day. Cortisol is a hormone produced in response to stress: Coates found that increases in its levels were directly correlated to a financial-market measure called “implied volatility,” which functions as a gauge of uncertainty. And these, remember, are the professionals.4 All of which suggests that the logical, efficient part of our brain is not always in charge. It is extremely hard to stick to an optimal portfolio allocation when the world is going to hell. When volatility spikes, fear rises.

See Credit-default swap Cecchetti, Stephen, 79 Church-tower principle, 207 Cigarettes, as means of payment, 5 Clark, Geoffrey Wilson, 144 Clearinghouse, 39 ClearStreet, 210 Clinical drug trials, indemnification of, xii–xiii Coates, John, 116 Code, simplification of, 63 Cohen, Ronald, 91–95, 97, 106, 108, 112 Coins, history of, 4 Collateral, xiv, 7, 38, 65, 76, 150, 177, 185, 204–206, 215 Collateralized-debt obligations (CDOs), 43, 234–235 Collective Health, 104 College graduates, earning power of, 170–171 Commenda, 7–8, 19 Commercial paper, 185 Commodity Futures Trading Commission, 54 CommonBond, 182, 184, 197 Confusion de Confusiónes (de la Vega), 24 Congressional Budget Office, 99, 169 Consumer Financial Protection Bureau overdraft fees and prepaid cards, concern about, 203–204 report on reverse mortgages, 141 survey on payday borrowing, 200 CoRI, 132 Corporate debt, in United States, 120 Corporate finance, 237–238 Correlation risk, 165 Cortisol and testosterone, effect of on risk appetite and aversion, 116 Counterparty risk, 22 Credit, industrialization of, 206 Credit Card Accountability, Responsibility, and Disclosure (Credit CARD) Act of 2009, 203 Credit cards, 203 Credit-default swap (CDS), 37, 64–65, 75, 124, 169, 238 Credit ratings, 24, 120–121, 233–236 Credit-reporting firms, 24 Credit risk, 200, 201, 237, 238 Credit scores, 47–49, 201, 216–217 Creditworthiness, xiv, 10, 12, 47, 121, 197, 202, 204, 216 Crowdcube, 152–155, 158–159, 162 Damelin, Errol, 208 Dark Ages, banking in, 11 Dark pools, 60 DCs (defined-contribution schemes), 129, 131 DE Shaw, 163 Debit cards, 204 Debt, 6, 7, 70, 149, 164 Decumulation, 138–139 Defined-benefit schemes, 129, 131 Defined-contribution (DC) schemes, 129, 131 Dependent variable, 201 Deposit insurance, 13, 43–44 Derivatives, 3, 9–10, 29–32, 38, 40 Desai, Samir, 189 Development-impact bonds, 103 Diabetes, cost of in United States, 102 Dimensional Fund Advisors, 129 Direct lending, 184 Discounting, 19 Disposition effect, 25 Diversification, 8, 12, 20, 117–119, 196, 236 Doorways to Dreams (D2D), 213–214 Dot-com boom, 148 Dow Jones Industrial Average, 40 Dow Jones Transportation Average, 40 Drug development, investment in, vii-viii, 114–115 Drug-development megafund adaptive market hypothesis and, 115–117 Alzheimer’s disease, 122 credit rating, importance of, 120–121 diversification and, 117, 119–120, 122 drug research, improvement of economics of, 114–115 financial engineering, need for, 119 guarantors for, 121 orphan diseases and, 118–119, 122 reactions to, 118 securitization and, 117–119, 122 Dumb money, comparison of to smart money, 155–158 Dun and Bradstreet, 24 Durbin Amendment (2010), 204 Dutch East India Company (VOC), 14–15, 38 E-Mini contracts, 54–55 Eaglewood Capital, 183–184 Ebola outbreak (2014), mortality rate of, 230 Ebrahimi, Rod, 210–211 Ecology, finance and, 113 Economist 2013 conference, xv on railways, 25 on worth of residential property, 70 Educational equity adverse selection in, 174, 175, 182 CareerConcept, 166 differences in funding rates, 176 enforceability, 177 in Germany, 166 Gu, Paul, 172, 175–176 income-share legislation, US Senate and, 172 information asymmetry, 174 Lumni, 165, 168, 175 Oregon, interest in income-share agreements, 172, 176 Pave, 166–168, 173, 175, 182 peer-to-peer insurance, 182 problems with, 167–168, 173–174 providers and recipients, contact between, 160, 175 risk-based pricing model, 176 student loans, 169–171 Upstart, 166–168, 173, 175, 182 Yale University and, 165 Efficient-market hypothesis, 115 Endogeneity, 239 Epidemiology, finance and, 113 Eqecat, 222 Equity, 7–8, 149–150, 186–187 Equity-crowdfunding in Britain, 154 Crowdcube, 152–155, 158–159, 162 Friendsurance, 182–183 Equity-crowdfunding in Britain (continued) herding, 159–160 social insurance, 182–183 Equity-derivatives contracts, 29 Equity-sharing, 7–8 Equity-to-assets ratio, 186 Eren, Selcuk, 73 Eroom’s law, 114 Essex County Council, 95 Eurobond market, 32 European Bank for Reconstruction and Development, 169 Exceedance-probability curve, 231–232, 232 figure 3 Exxon, 169 Facebook, 174 Fair, Bill, 47 False substitutes, 44 Fama, Eugene, 115 Fannie Mae, 48, 78, 85, 168 Farmer, Doyne, 60, 63 Farynor, Thomas, 16 FCIC (Financial Crisis Inquiry Commission), 50 Federal Deposit Insurance Corporation (FDIC), 186, 200 Federal Reserve Bank of New York, 170, 204, 205 Feynman, Richard, 115 Fibonacci (Leonardo of Pisa), 19 FICO score, 47–49 Films to rent, study of hyperbolic discounting, 133–134 Finance bailouts, 35–36 banks, purpose of, 11–14 collective-action problem in, 62 computerization of, 31–32 democratization of, 26–28 economic growth and, 33–34 fresh ideas, need for, xviii, 38–39, 80, 85–86 globalization and, 30, 225 heuristics, use of in, 45–50 illiteracy, financial, 134–135 importance of, 10 information, importance of, 10–11 inherent failings in, 241 misconceptions about, xiii–xvi panic, consequences of, 44 regulatory activity, results of, 33 risk assessment, 24, 45, 77–78 risk management, 55, 117–118, 123 as solution to real-world problems, 114 standardization, 39–41, 45, 47, 51 unconfirmed trades, backlog of, 64–65 use of catastrophe risk modeling in, 233–239 See also High-frequency trading (HFT); Internet Finance, history of bank, derivation of word, 12 Book of Calculation (Fibonacci), 19 call options, 10 Code of Hammurabi, 8 coins, 4 commodity forms of exchange, 4–5 credit and debt, 5–7 in Dark Ages, 11 democratization, 26–28 deposits, 6 derivatives, 29–32, 38 Dutch East India Company (VOC), 14–15, 38 early financial contracts, 5 early forms of finance, 3 equity contracts, 7–8 fire insurance, 16–17 first futures market, 29, 39–40 forward contracts, 38 in Greece, 11 industrialization and, 3, 27–28 inflation-protected bonds, 26 insurance, 8–10, 16–17, 20–22 interest, origin of, 5 in Italy, 9, 14 life annuities, 20–22 maritime trade and, 7–8, 14, 17, 23 payment, forms of, 4–5 put options, 9–10 railways, effect of on, 23–25 in Roman Empire, 7, 8, 11, 36 securities markets, 14 stock exchanges, 14, 24–25 Finance, innovation in absence of, xvi–xvii credit and debt, 5–7 derivatives, 9–10, 29–32 diffusion, pattern of, 45 drivers of, 22–26 equity, 7–8 importance of, 66, 242–243 insurance, 8–9, 16–17, 20–22 lessons from, 32–34 mathematical insights, 18–20 payment, forms of, 4–5 risks of, 145 stock exchanges, 14–16 Finance and the Good Society (Shiller), 242 Financial Crisis Inquiry Commission (FCIC), 50 Financial crisis of 2007–2008 causes of, xv, 34, 69 effects of, xx–xi future of finance, effect on, 243 mortgage debt, role of in, 69–70 new regulations since, 185, 187 Financial Times, quote from Chuck Prince in, 62 Fire insurance, early, 16–17 Fitch Ratings, 24 Flash Boys (Lewis), 57 Flash crash, 54–56, 63 Florida, hurricane damage in, 223, 225 Florida, new residents per day in, 225 Foenus nauticum, 8 Forward contracts, 38 Forward transactions, 15 France collapse of Mississippi scheme in, 36 eighteenth century life annuities in, 20–21 government spending in, 99 Freddie Mac, 48, 85 Fresno, California, social-impact bond pilot program in, 103–104 Friedman, Milton, 165 Friendsurance, 182–183 Fundamental sellers, 54–55 Funding Circle, 181–182, 189, 197 Futures, 29, 39–40 Galton Board, 17, 18 figure 1 Gaussian copula, 235 Geithner, Timothy, 64–65 Genentech, xii General Motors, bailout of, xi Geneva, Switzerland, annuity pools in, 21–22 Gennaioli, Nicola, 42, 44 Ginnie Mae, 168 Girouard, Dave, 166 Glaeser, Edward, 74 Globalization, finance and, 30, 225 Goldman Sachs, 61, 98, 156, 235 Google Trends, 218 Gorlin, Marc, 218 Government spending, rise in, 99–100 Governments, support for new financial products by, 168–169 Grameen Bank, 203 Greece, forerunners of banks in, 11 Greenspan, Alan, 236 Greenspan consensus, 236 Grillo, Baliano, 9 Gu, Paul, 162–164, 166, 172, 175–176 Guardian Maritime, 151 Haldane, Andy, 188 Halley, Edmund, 19–20 Hamilton, Alexander, 35–36 Hammurabi, Code of, 5, 8 Health conditions, SIB early detection programs for, 102–104 Health-impact bonds, 103–104 Hedge funds, 123, 158, 183 Hedging, 30–31, 54, 124, 129, 131, 156, 206, 227 Heiland, Frank, 73 Herding, 24, 159–160 Herengracht Canal properties, Amsterdam, real price level for, 74 Heuristics, 45–50 HFRX, 157–158 High-frequency trading (HFT) benefits of, 58 code, simplification of, 63 flash crash, 54–56 latency, attempts to lower, 53 pre-HFT era, 59–61 problems with, 56–58, 62–63 Hinrikus, Taavet, 190–191 HIV infection rates, SIB program for reduction of, 103 Holland, tulipmania in, 33, 36 Home equity, 139–140 Home-ownership rates, in United States, 85, 170 Homeless people, SIB program for, 96–97 Housing boom of mid-2000s, 148–149 Human capital contracts, 165, 167, 173–174, 176, 177 defined, 6 as illiquid asset, 177 Hurricane Andrew, effect of on insurers, 223–224, 225 Hurricane Hugo, 223 Hyperbolic discounting, 133–134, 211 IBM, 169 If You Don’t Let Us Dream, We Won’t Let You Sleep (drama), 111 IMF (International Monetary Fund), 125–126 Impact investing, 92 Implied volatility, 116 Impure altruism, 109–110 Income-share agreements, 167, 172–178 Independent variables, 201 Index funds, 40 India, CDS deals in, 37 India, social-impact bonds (SIBs) in, 103 Industrialization, effect of on finance, 3, 27–28 Inflation-protected Treasury bills, 131 Information asymmetry, 174 Innovator’s dilemma, 189 Instiglio, 103 Insurance, 8–10, 16–17, 142, 223–225 Insurance-linked securities, 222 Interbank markets, x Interest, origin of, 5 Interest-rate swaps, 29 International Maritime Bureau Piracy Reporting Centre, 151 International Monetary Fund (IMF), 125–126 International Swaps and Derivatives Association (ISDA), 40 Internet, role of in finance creditworthiness, determination of, 172–173, 202, 218 direct connection of suppliers and consumers, xviii, 32 equity crowdfunding, 152–155 income-share agreements, 172–173 ROSCAs, 210 small business loans, 216 speed and ease of borrowing, 189 student loans, 166–167 Intertemporal exchange, 6 Intuit, 218 Investment grade securities, 121 Ireland, banking crisis in, xiv–xv, 69 Isaac, Earl, 47 ISDA (International Swaps and Derivatives Association), 40 ISDA master agreement, 40 Israel, SIBs in, 97 Italy discrimination against female borrowers in, 208 financial liberalization and, 34 first securities markets in, 14 maritime trade partnerships in, 7–8 J.


pages: 312 words: 91,538

The Fear Index by Robert Harris

algorithmic trading, backtesting, banking crisis, dark matter, family office, Fellow of the Royal Society, fixed income, Flash crash, God and Mammon, high net worth, implied volatility, mutually assured destruction, Neil Kinnock, Renaissance Technologies, speech recognition, two and twenty

It’s a ticker, for want of a better word, tracking the price of options – calls and puts – on stocks traded in the S and P 500. If you want the math, it’s calculated as the square root of the par variance swap rate for a thirty-day term, quoted as an annualised variance. If you don’t want the math, let’s just say that what it does is show the implied volatility of the market for the coming month. It goes up and down minute by minute. The higher the index, the greater the uncertainty in the market, so traders call it “the fear index”. And it’s liquid itself, of course – there are VIX options and futures available to trade, and we trade them. ‘So the VIX was our starting point.

Ju-Long said, ‘We started accumulating VIX futures back in April, when the index stood at eighteen. If we had sold earlier in the week we would have done very well, and I assumed that’s what would happen. But rather than following the logical course and selling, we are still buying. Another four thousand contracts last night at twenty-five. That is one hell of a level of implied volatility.’ Rajamani said, ‘I’m seriously worried, frankly. Our book has gone all out of shape. We’re long gold. We’re long the dollar. We’re short every equity futures index.’ Hoffmann looked from one to another – from Rajamani to Ju-Long to van der Zyl – and suddenly it was clear to him that they had caucused beforehand.


pages: 1,082 words: 87,792

Python for Algorithmic Trading: From Idea to Cloud Deployment by Yves Hilpisch

algorithmic trading, Amazon Web Services, automated trading system, backtesting, barriers to entry, bitcoin, Brownian motion, cloud computing, coronavirus, cryptocurrency, Edward Thorp, fiat currency, Gordon Gekko, Guido van Rossum, implied volatility, information retrieval, margin call, market microstructure, Myron Scholes, natural language processing, paper trading, passive investing, popular electronics, prediction markets, quantitative trading / quantitative finance, random walk, risk free rate, risk/return, Rubik’s Cube, Sharpe ratio, short selling, sorting algorithm, systematic trading, transaction costs, value at risk

Quandl also provides, for example, diverse data sets for single stocks, like end-of-day stock prices, stock fundamentals, or data sets related to options traded on a certain stock: In [29]: data = q.get('FSE/SAP_X', start_date='2018-1-1', end_date='2020-05-01', api_key=config['quandl']['api_key']) In [30]: data.info() <class 'pandas.core.frame.DataFrame'> DatetimeIndex: 579 entries, 2018-01-02 to 2020-04-30 Data columns (total 10 columns): # Column Non-Null Count Dtype --- ------ -------------- ----- 0 Open 257 non-null float64 1 High 579 non-null float64 2 Low 579 non-null float64 3 Close 579 non-null float64 4 Change 0 non-null object 5 Traded Volume 533 non-null float64 6 Turnover 533 non-null float64 7 Last Price of the Day 0 non-null object 8 Daily Traded Units 0 non-null object 9 Daily Turnover 0 non-null object dtypes: float64(6), object(4) memory usage: 49.8+ KB The API key can also be configured permanently with the Python wrapper via the following: q.ApiConfig.api_key = 'YOUR_API_KEY' The Quandl platform also offers premium data sets for which a subscription or fee is required. Most of these data sets offer free samples. The example retrieves option implied volatilities for the Microsoft Corp. stock. The free sample data set is quite large, with more than 4,100 rows and many columns (only a subset is shown). The last lines of code display the 30, 60, and 90 days implied volatility values for the five most recent days available: In [31]: q.ApiConfig.api_key = config['quandl']['api_key'] In [32]: vol = q.get('VOL/MSFT') In [33]: vol.iloc[:, :10].info() <class 'pandas.core.frame.DataFrame'> DatetimeIndex: 1006 entries, 2015-01-02 to 2018-12-31 Data columns (total 10 columns): # Column Non-Null Count Dtype --- ------ -------------- ----- 0 Hv10 1006 non-null float64 1 Hv20 1006 non-null float64 2 Hv30 1006 non-null float64 3 Hv60 1006 non-null float64 4 Hv90 1006 non-null float64 5 Hv120 1006 non-null float64 6 Hv150 1006 non-null float64 7 Hv180 1006 non-null float64 8 Phv10 1006 non-null float64 9 Phv20 1006 non-null float64 dtypes: float64(10) memory usage: 86.5 KB In [34]: vol[['IvMean30', 'IvMean60', 'IvMean90']].tail() Out[34]: IvMean30 IvMean60 IvMean90 Date 2018-12-24 0.4310 0.4112 0.3829 2018-12-26 0.4059 0.3844 0.3587 2018-12-27 0.3918 0.3879 0.3618 2018-12-28 0.3940 0.3736 0.3482 2018-12-31 0.3760 0.3519 0.3310 This concludes the overview of the Python wrapper package quandl for the Quandl data API.


Systematic Trading: A Unique New Method for Designing Trading and Investing Systems by Robert Carver

asset allocation, automated trading system, backtesting, barriers to entry, Black Swan, buy and hold, cognitive bias, commodity trading advisor, Credit Default Swap, diversification, diversified portfolio, easy for humans, difficult for computers, Edward Thorp, Elliott wave, fixed income, implied volatility, index fund, interest rate swap, Long Term Capital Management, margin call, merger arbitrage, Nick Leeson, paper trading, performance metric, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, survivorship bias, systematic trading, technology bubble, transaction costs, Y Combinator, yield curve

I mentioned a particular spread betting system in the introductory chapter which held positions for around a week. This would have a turnover of 52 round trips per year. The standardised cost I’m using for spread bets is 0.01 SR, so this gives costs of 52 × 0.01 = 0.52 annually. Earlier (page 150) I calculated the implied volatility target of that system at 160%. This implies you’d need to make 0.52 × 160% = 83% a year on your trading capital before costs – just to break even! Table 34 shows that with spread bets you can’t use stops with holding periods of less than about six weeks. Furthermore it’s unlikely that any trader will be happy with a holding period of more than six months.

Euro$ T-note Estxx V2TX MXP Corn Combined forecast (K) 15.8 20 -2.1 -11.7 2 -11.6 Subsystem position, contracts (L) 29.0 21.9 -1.2 -34.3 3.4 -12.3 11.7% 11.7% 20% 10% 23.3% 23.3% K × J ÷ 10 Instrument weight (M) 255 Systematic Trading Instrument Diversification Multiplier (N) 1.89 1.89 1.89 1.89 1.89 1.89 Portfolio instrument position, contracts (O) 6.40 4.83 -0.45 -6.45 1.49 -5.42 6 5 0 -6 1 -5 L×M×N Rounded target position contracts (P = round O) Notable positions are a large long in US treasury notes, which had been rallying strongly for a month giving positive momentum, and also had a carry forecast of over 19. The V2X also had a substantial short carry forecast of -20, and although volatility spiked substantially over the last two weeks, the very slowest EWMAC rules were still short after the steady fall in implied volatility for most of 2014. 1 December 2014 Let’s move forward to 1 December. The system has made cumulative profits of around $10,000 so your trading capital is $260,000 and annualised cash volatility target is $52,000. There has now been a pronounced rally in the equity markets so we’re now modestly long Euro Stoxx, with volatility easing and V2X falling in price.


pages: 289 words: 113,211

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber

"Robert Solow", affirmative action, Albert Einstein, asset allocation, backtesting, beat the dealer, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commoditize, commodity trading advisor, computer age, computerized trading, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, Edward Thorp, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, intangible asset, Jeff Bezos, John Meriwether, London Interbank Offered Rate, Long Term Capital Management, loose coupling, margin call, market bubble, market design, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, oil shock, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, selection bias, shareholder value, short selling, Silicon Valley, statistical arbitrage, tail risk, The Market for Lemons, time value of money, too big to fail, transaction costs, tulip mania, uranium enrichment, William Langewiesche, yield curve, zero-coupon bond, zero-sum game

IGNORING THE CASSANDRAS There were warning signs before any of this happened, of course. By the beginning of October there had been rising concerns that things had gone too far, even though the market had retrenched from its August highs. One indication on the technical side was that the premiums for put options were increasing because of a rise in the implied volatility of these options. On the intellectual side was John Kenneth Galbraith, who wrote an article for the January 1987 Atlantic Monthly entitled “The 1929 Parallel” that stated bluntly: “The market at this stage is inherently unstable.” Galbraith, who had lived through the first Crash, cited the market’s spectacular and constant rise, in part because of “the present commitment to seemingly imaginative, and eventually disastrous, innovation in financial structure.”

Thus the dynamic stop-loss strategy at the core of portfolio insurance was designed to transform a portfolio into one giant call option; it replicated the payoff from a call option that had an exercise price equal to the floor. 262 ccc_demon_261-270_notes.qxd 2/13/07 1:47 PM Page 263 NOTES 3. Another person who detected the emerging problem was Sandy Grossman, a brilliant researcher who was one of the early academics to move into the hedge fund world. In the months before the 1987 crash, Sandy noticed that option implied volatility was expanding relative to the volatility of the underlying stocks and that this differential was trying to tell the markets something: There was a lot of liquidity demand chasing these options, and the actual cost of hedging was probably higher than it appeared. The markets had something to say, but no one was listening.


Stock Market Wizards: Interviews With America's Top Stock Traders by Jack D. Schwager

Asian financial crisis, banking crisis, barriers to entry, Bear Stearns, beat the dealer, Black-Scholes formula, commodity trading advisor, computer vision, East Village, Edward Thorp, financial independence, fixed income, implied volatility, index fund, Jeff Bezos, John Meriwether, John von Neumann, locking in a profit, Long Term Capital Management, margin call, money market fund, Myron Scholes, paper trading, passive investing, pattern recognition, random walk, risk free rate, risk tolerance, risk-adjusted returns, short selling, Silicon Valley, statistical arbitrage, the scientific method, transaction costs, Y2K

(In contrast, the time remaining until expiration and the relationship between the current market price and the strike price can be exactly specified at any juncture.) Thus, volatility must always be estimated on the basis of historical volatility data. The future volatility estimate implied by market prices (i.e., option premiums), which may be higher or lower than the historical volatility, is called the implied volatility. INDEX accounting, 84, 89, 91, 94, 324 Blake, Gil, 189, 197-98 Bloomberg financial services, 57, 59 acquisition finance, 250-52, 253 Advanced Research Projects Agency (ARPA), 262 AIDS drugs, 1 74 Amazon.com, 150-52, 272-73, 323 America Online (AOL), 43-44, 235, 259 Amerigon, 62 arbitrage, 132-33, 255-56, 267, 284 ARPAnet, 262 Asian financial crisis, 18 assets: growth of, 23-24, 207, 312-13 liquidation of, ]65 return of, ], 31 transfer of, 189 value of, 41, 63, 248-49, 253 audits, 84,91 Balance Bars, 66 balance sheets, 42, 51, 85, 268 Bankers Trust, 57, 58 banking, 141, 243-44, 249 Bombay (clothing store), 67-68 bonds: convertible, 257 government, 8, 247-48 illiquid, 7, 8, 25 interest rates and, 9, 24, 67, 105, 133-34, 135, 269, 277 junk, 82 market for, 9-10, 1 10-1 1, 144-45, 285, 309 price of, 7-8, 110-11, 144-45, 285 book value, 44, 149, 150, 165, 167 Brandywine Fund, 58-59 brokerage firms, 55-56, 61-62 Buffett, Warren, 40, 42, 157 business plans, 68-69, 91, 94, 1 18, 122, 316, 324 Business Week, \27n Canada, 1-6, 9-10, 36 capital: bankruptcy, 12-14, 24, 105-6, 122, 139, 145-46, appreciation of, 23 loss of, 68 163 Bannister, Roger, 291 Bear Stearns, 127, 131, 135-36, 138, 142 Beat the Dealer (Thorpe), 266 Beat the Market (Thorpe), 266 Bender, John, 221-38 background of, 221-25 fund managed by, 221, 222 losses of, 225 as novice trader, 225-27 profits of, 221-22, 234 strategy of, 221, 226-38, 303, 304, 306, 312 Bezos, Jeff, 272-73 preservation of, 44, 141, 217 venture, 10, 205, 207, 222, 303 capitalization: large, 34, 43-44, 150, 198-99, 320 medium, 58 revenue vs., 36-37, 45, 52 small, 24, 47, 57, 58, 59, 68, 69, 78, 198-99, 281 for trading, 10, 114-19, 120, 142, 146, 147,205, 207, 222, 303 cash flow, 43, 44, 45, 51, 149, 248 catalysts, 44-46, 52, 60, 61, 62-63, 89, 94, 114, bid/ask differentials, 134-35 215-17,220, 279-81, 307, 325 Black & Decker, 62-63 central processing unit (CPU), 261 blackjack, 266-67 Black-Scholes model, 221, 227-34 certificates, stock, 69-70 chart patterns, 181-84 331 INDEX chief executive officers (CEOs), 49, 91, 241, 244-45, 250 Cook, Marvin, 95, 96, 123-24, 126 Cook, Terri, 97, 99, 106 funds managed by, 128-29, 138, 142-47 Ingram's, 272 as novice trader, 127-38 initial public offerings (IPOs), 24, 25, 250-52, chief financial officers (CFOs), 57, 58, 59, 60, 62, 64, Cramer's commentary, 218 67, 71, 72,94, 142, 324 Church, George J., 320 Cisco, 22 Cray, Seymour, 261-62 profits of, 128-29, 132, 141-42, 147 strategy of, 138-47, 252, 300, 301, 304, 305, 306 279-81 innovation, 147 currency trading, 5, 9, 202-3 Cyrus J.

., 91-92 Gulf War, 81, 113 Einstein, Albert, 236 Elsie the Cow, 98-100 head-and-shoulders pattern, 265 Enamalon, 68 enhanced index funds, 34-36 equity trading, 6, 144-45, 257 hearing aids, 242 hedge funds, 16, 22, 59-60, 61, 80, 81-84, 146-47, 200-202, 207, 295, 306 strategy of, 241-53, 301, 306, 315 historical volatility, 330 Kidder Peabody, 32, 127-28, 135-38 Kiev, Ari, 285, 288-97, 310, 313, 315 "Knowledge Based Retrieval on a Relational Database Machine" (Shaw), 258-59 Korea, Republic of (South Korea), 18 Kovner, Bruce, 191 Lancer Offshore, 31, 50 Lauer, Michael, 30-53 FarSight, 259 Hoik, Tim, 191-92 as financial analyst, 31-32, 48 fund managed by, 30, 31, 33, 36-37, 51 Federal Reserve Bank, 271, 277 fees, 35, 55, 275 Fidelity Magellan, 34-36, 38-39, 43, 67 financial statements, xiii, 57, 185, 255 home-equity loans, 12-14, 20 How to Trade in Stocks {Livermore), 176-77 losses of, 31,42-43, 46 Fletcher, Alphonse "Buddy," Jr., 127-47 background of, 129—31 as black, 127-28, 136-38 IBM, 37, 131-32, 133, 193, 227, 232, 269, 279, 308, 327 implied volatility, 330 index funds, 34-37, 39, 50, 52, 53, 217-18, 285, 321 as novice trader, 31-32, 48-49, 50 profits of, 30-31, 50 strategy of, 37-53, 229, 253, 301, 302, 306-7, 308-9, 31 1, 314, 315, 318, 319, 320, 321, 322, 326 LensCrafters, 242 INDEX Lescarbeau, Steve, 189-206 background of, 190-91 fund managed by, 189, 200-202 as novice trader, 190-94, 202-3 profits of, 189, 198,201 strategy of, 189, 194-206, 300, 302-3, 304, 311, 315,321 leverage, 47-48, 69-70, 117, 174, 204, 222, 314-15 as novice trader, 72, 170, 188 profits of, 170, 175, 188 strategy of, 169, 171-88,299,303,304,305,312, 314, 316,317, 318 Miramar Asset Management, 76, 85-89, 93 Molecular Simulations Inc., 259 money managers, 144-45, 176, 200-202, 205, 214, 226, 234, 235 INDEX primer on, 95re, 150n, 221n, 327-30 probability curve for, 221, 227-34, 236-37 cash flow vs., 44 discrepancies in, 254, 257-58 put, 84, 85, 102, 110, 116, 118, 159-60, 325, 327, earnings vs., 21, 22, 43-44, 52, 58, 59, 60, 62, 65, 328, 329 risk of, 101, 109-10, 112, 138-40,328 strike price for, 151, 159, 160, 167, 327-28, 329, 330 volatility of, 330 66, 72-73, 79, 81, 89, 92, 94, 149, 152, 154-55, 158, 164, 165, 166-67, 172, 216, 306, 320, 321, 325 entry and exit, 157-58, 162-63, 171, 217, 220, 231,232,257,305,308 recovery of, 25-26, 44 relative, 42, 51, 81, 1 72-73, 311 run-ups of, 17, 35-40, 43-44, 229, 277, 325 leveraged buyouts (LBOs), 248-50, 253 Levitt, Jim, 80, 81 Morgan Stanley, 256, 263 multiple regression, 1 30 Lewis, Michael, 246 Liars Poker (Lewis), 246 mutual funds, 34-36, 40, 55, 82, 189-206, 207, 214 Livermore, Jesse, 176-77 Liz Claibornc, 6, 10, 12 Nasdaq, 75, 110, 158 Network Associates, 89-90 Pairs Trading: Performance- of a Relative Value Arbitrage Lloyd's Bank, 4-6 Lo, Andrew, 265 Newman, Bill, 58 New Yorker, 229 Rule (Gatev, Goetzmann, and Rouwenhort), 256n parallel processors, 258-63 lognormal curve, 237n Long-Term Capital Management (LTCM), 19—20, New York Post, 278 Pearle Vision, 242 New York Stock Exchange, 107,312 Nintendo, 276 Novell, 22 Pegasystems, 91 Peil, Tom, 208 OEX, 84 phone cards, 146 pig-at-the-trough approach, 58, 73 locked-in, 255 PIMCO, 144 probable, 255 reinvestment of, 25 risk vs., 70-71, 76, 125, 127, 128-29, 132, 134-35, 166, 207, 222, 237, 249-50, 255, 265, 269, 299, 323, 326 sources of, xiii sales vs., 44 271, 306 Love, Richard, 171 LTXX, 63 Lynch, Peter, 34, 66-67, 157, 161, 316-17 oil prices, 81 Okumus, Ahmet, 148-68 background, 148-49, 160-61 fund managed by, 149, 153, 162-63 McGuinn, Ed, 59 macroeconomics, 15—16, 18, 26, 81 Magic Faith and Healing: Studies in Primitive Psychiatry Today (Kiev), 289 Mammis, Justin, 209 losses of, 149-53, 167 as novice trader, 148-49, 153-57 management, 25-26, 45,91, 141-42, 150, 156-57, 166,250-52 manufacturers, 65—66 Marcus, Michael, 191 margin calls, 103, 105 market makers, 234, 247^18 market timers, 196 Marlin fund, 207 Masters, Michael, 207-20 background of, 209-14 fund managed by, 207 as novice trader, 209 profits of, 207, 209, 218 strategy of, 211-12, 214-20, 301, 302, 304, 307, 308 profits of, 155-56, 162 strategy of, 155-68, 306, 308, 309-10, 318, 319, 325 Okumus Opportunity Fund, 148, 153, 162-63 Olympics, 288, 289-90, 291, 297, 310 Olympic Sports Medicine Committee, U.S., 288, 289-90 One Vf on Wall Street (Lynch), 66-67, 1 57 Oppenheimer & Co., 32 options: bid/ask differentials for, 134-35 box spread for, 134 call, 101-2, 103, 108-9, 113, 124, 150-51, 325, 327, 328, 329 cumulative tick indicator for, 107-11,114 Masters, Suzanne, 214 Masters Capital Management, 207 exercised, 103, 151n, 159, 325, 327, 328 expiration of, 121-22, 151,313, 329-30 M.B.A.s, 4, 5,31,209 Men's Wearhouse, 68 Meriwether, John, 271 index, 140 "in the money" vs.


pages: 199 words: 48,162

Capital Allocators: How the World’s Elite Money Managers Lead and Invest by Ted Seides

Albert Einstein, asset allocation, business cycle, coronavirus, Covid-19, COVID-19, crowdsourcing, deliberate practice, diversification, Everything should be made as simple as possible, family office, fixed income, high net worth, hindsight bias, impact investing, implied volatility, impulse control, index fund, Lean Startup, loss aversion, passive investing, Ralph Waldo Emerson, risk tolerance, Sharpe ratio, sovereign wealth fund, tail risk, The Wisdom of Crowds, Toyota Production System, zero-sum game

It’s all about what value a manager can deliver above and beyond what I can do for myself.” – Dawn Fitzpatrick Risks “The essential skill of a hedge fund manager is continuing to run a hedge fund.” – Matt Levine “All the gigantic multi-strategy absolute return funds are predicated on volatility scaling. When implied volatility comes down, they increase exposure to keep up returns.” – James Aitken “Finding good macro managers is incredibly challenging because it’s often hard to distinguish if someone’s track record is a function of incredible skill and foresight or just dumb luck.” – Adam Blitz “Macro has an emphasis on gurus.


Stocks for the Long Run, 4th Edition: The Definitive Guide to Financial Market Returns & Long Term Investment Strategies by Jeremy J. Siegel

addicted to oil, asset allocation, backtesting, Black-Scholes formula, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, capital asset pricing model, cognitive dissonance, compound rate of return, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, Eugene Fama: efficient market hypothesis, Everybody Ought to Be Rich, fixed income, German hyperinflation, implied volatility, index arbitrage, index fund, Isaac Newton, joint-stock company, Long Term Capital Management, loss aversion, market bubble, mental accounting, Money creation, Myron Scholes, new economy, oil shock, passive investing, Paul Samuelson, popular capitalism, prediction markets, price anchoring, price stability, purchasing power parity, random walk, Richard Thaler, risk free rate, risk tolerance, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, stocks for the long run, survivorship bias, technology bubble, The Great Moderation, The Wisdom of Crowds, transaction costs, tulip mania, Vanguard fund

This is because expected volatility is a signal of the level of anxiety in the market, and periods of high anxiety have often marked turning points for stocks. By examining the prices of put and call options on the major stock market indexes, one can determine the volatility that is built into the market, which is called the implied volatility.11 In 1993, the Chicago Board Options Exchange (CBOE) introduced the CBOE Volatility Index, also called the VIX Index or the VIX, based on actual index options prices on the S&P 500 Index, and it calculated this index back to the mid-1980s.12 A weekly plot of the VIX Index from 1986 appears in Figure 16-4.

., 59i, 61 Hertzberg, Daniel, 273n High-growth country stocks, 362 Hilscher, Jens, 158n Hirshleifer, David, 325n, 326n Historical prices, 117 Hitler, Adolph, 78 Holding period, risk and, 24–27, 25i, 26i Home Depot, 155, 156, 176 Honda Motor, 176 Hong Kong and Shanghai Bank, 184 Hoover, Herbert, 227 Houdaille, Maurice, 63 Houdaille Industries, 60i, 63 Household survey, 241 HSBC Holdings, 175, 184 Hsu, Jason, 159n, 355n, 356 Hu, Jian, 241n Humphrey-Hawkins Act of 1978, 194, 195n Hussein, Saddam, 85 Hwng, Chuan-Yang, 302n Ibbotson, Roger, 84 IBM, 56i, 57, 176i IDEX, 63n Imasco, 63 Implied volatility, 281 “In the Market We Trust” (Kaufman), 86–87 In-the-money puts, 266 Income: median, in United States, 189 national, ratio of corporate profits to, market valuation and, 115–116, 116i net, 102–104 (See also Earnings) Income taxes: on corporate earnings, failure of stocks as longterm inflation hedge and, 202–203 historical, 66, 67i total after-tax returns index and, 66, 68–69, 68i, 69i Index arbitrage, 257–258 Index futures (see Stock index futures) Index mutual funds, 342 choosing, 262–264, 263i no-load, 263 Index options, 264–268 buying, 266–267 importance of, 267–268 Index Index options (Cont.): selling, 267 Indexation: capitalization-weighted, 351–352, 352i, 353–355 fundamentally weighted, capitalization-weighted indexing versus, 353–355 India: global market share of, 179i, 180, 180i growing market share of, 178 Industrial and Commercial Bank of China (ICBC), 175, 184 Industrial sector: in GICS, 53 global shares in, 175i, 177 Inflation: after World War II, 9, 10i capital gains tax and, 70–72, 71i core, 245–246 economic downturns and, 30–31 impact on financial markets, 246 money supply and, 189–190, 191i during 1970s, 9 stocks as hedges against, 199, 200i, 201–204 Inflation hedges, 199, 200i, 201–204 long-term, failure of stocks as, 201–204 Inflation-indexed bonds, 35 Inflation reports, 244–246 Information cascade, 325 Information technology sector: in GICS, 53 global shares in, 175i, 177 Informed trading, 349–350 Initial public offerings (IPOs), 154–157 Insider holdings, in capitalization-weighted indexing, 353 Institute for Supply Management (ISM), 243 373 Integrys Energy Group, 48 Intel, 38, 155, 156, 158, 176i on Nasdaq, 44 Interest costs, inflationary biases in, failure of stocks as long-term inflation hedge and, 203–204 Interest rates: on bonds, 7–9, 9i failure of stocks as long-term inflation hedge and, 201–202 Fed actions and, 196, 197i, 198–199 federal funds rate, 196 on government bonds, above dividend yield on common stocks, 95–97 during Great Depression, 8 International Accounting Standards Board (IASB), 105, 174 International incorporations, 174 International stocks, 362 Inventory accounting methods, failure of stocks as long-term inflation hedge and, 203 Investing: bear market and its aftermath and, 89–91 beginning of great bull market and, 85–86 common stock theory of, 82 early views of, 79–82 postcrash view of returns and, 83–85 practical aspects of, 360 radical shift in sentiment and, 82–83 successful, guides to, 360–363 top of bubble and, 88–89 warnings of overspeculation and, 86–88 Investment advisors, 364 Investment strategy, 363–364 Investor sentiment, 333–334, 335i Iraq, defeat in Gulf War, 85 “It Pays to Be Contrary” (Neill), 333 Jagannathan, Ravi, 241n January effect, 306–311, 307i causes of, 309–310 weakening of, 310–311 Japan: global market share of, 179, 179i, 180i market bubble in, 165 sector allocation and, 175i, 176, 177 JCPenney, 64 JDS Uniphase, 89 Jegadeesh, Narasimhan, 302 Jensen, Michael, 99n, 345 Jobs and Growth Reconciliation Act of 2003, 69–70 Johnson, Lyndon B., 193, 226 Johnson & Johnson, 144, 176i, 177 Jones, Robert, 356 Jorion, Phillipe, 12n Journal of the American Statistical Association, 81 JPMorgan Chase, 176i Kahneman, Daniel, 322–323, 328, 330 Kansas City Board of Trade, 256 Kaufman, Henry, 86, 87n Keim, Donald, 306, 309n, 316–317 Kennedy, John F., 226 Keta Oil & Gas, in DJIA, 38–39 Keynes, John Maynard, 81, 278, 285, 287, 359q, 364 Knowles, Harvey, 147 Kohlberg Kravis Roberts & Co.


pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, Bear Stearns, beat the dealer, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy and hold, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, commoditize, complexity theory, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disinformation, disintermediation, diversification, diversified portfolio, Edward Thorp, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, John Meriwether, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, mega-rich, merger arbitrage, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mutually assured destruction, Myron Scholes, new economy, New Journalism, Nick Leeson, Nixon triggered the end of the Bretton Woods system, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, Right to Buy, risk free rate, risk-adjusted returns, risk/return, Satyajit Das, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, the new new thing, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

A key input in valuing options is volatility, which refers to how much interest rates might be expected to move around in the future. The problem was that it was da future. Traders use implied volatility to mark-to-market 05_CH04.QXD 17/2/06 4:22 pm Page 145 4 S h o w m e t h e m o n e y – g re e d l o s t a n d re g a i n e d 145 positions, which is the level quoted by other traders as reflected in the prices of options being traded. The problem for NatWest was that implied volatility for interest rate options, especially long-dated ones, is not readily available. Few people trade these products and quote prices. NatWest was one of the few traders.


pages: 517 words: 139,477

Stocks for the Long Run 5/E: the Definitive Guide to Financial Market Returns & Long-Term Investment Strategies by Jeremy Siegel

Asian financial crisis, asset allocation, backtesting, banking crisis, Bear Stearns, Black-Scholes formula, break the buck, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, capital asset pricing model, carried interest, central bank independence, cognitive dissonance, compound rate of return, computer age, computerized trading, corporate governance, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Deng Xiaoping, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Financial Instability Hypothesis, fixed income, Flash crash, forward guidance, fundamental attribution error, housing crisis, Hyman Minsky, implied volatility, income inequality, index arbitrage, index fund, indoor plumbing, inflation targeting, invention of the printing press, Isaac Newton, joint-stock company, London Interbank Offered Rate, Long Term Capital Management, loss aversion, market bubble, mental accounting, Money creation, money market fund, mortgage debt, Myron Scholes, new economy, Northern Rock, oil shock, passive investing, Paul Samuelson, Peter Thiel, Ponzi scheme, prediction markets, price anchoring, price stability, purchasing power parity, quantitative easing, random walk, Richard Thaler, risk free rate, risk tolerance, risk/return, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, selling pickaxes during a gold rush, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, stocks for the long run, survivorship bias, technology bubble, The Great Moderation, the payments system, The Wisdom of Crowds, transaction costs, tulip mania, Tyler Cowen: Great Stagnation, Vanguard fund

This is because expected volatility is a signal of the level of anxiety in the market, and periods of high anxiety have often marked turning points for stocks. By examining the prices of put and call options on the major stock market indexes, one can determine the volatility that is built into the market, which is called the implied volatility.13 In 1993, the Chicago Board Options Exchange introduced the CBOE Volatility Index, also called the VIX Index or the VIX (first mentioned in Chapter 3), based on actual index options prices on the S&P 500 Index, and it calculated this index back to the mid-1980s.14 A weekly plot of the VIX from 1986 appears in Figure 19-5.

See also Calendar anomalies, 334–335, 337 Home Depot, 188–189, 205 Hoover, President Herbert, 247–248 Horizons, 94–97 Hot hands, 364–365 How to Beat the Market , 365 HSBC, 44, 205 Hsu, Jason, 371 Humphrey-Hawkins Act, 216 Hussein, Saddam, 13 Ibbotson, Roger, 12, 76, 192 IBM internationally, 205 market price of, 108 performance of, 173–176, 193 in S&P 500 Index, 124 in technology sector, 122 ICE (Intercontinental Exchange), 112–113 Implied volatility, 303 In-the-money puts, 286 Income tax, 141–142 Index mutual funds, 282–284 Index options buying, 286 importance of, 287–288 introduction to, 267, 284–286 selling, 286–287 Indexing capitalization-weighted, 368–371 fund performance and. See Fund performance fundamentally weighted, 369–372, 376 introduction to, 347–349 India, 58, 64–66 Individual retirement accounts (IRAs), 284 Industrials.


pages: 332 words: 81,289

Smarter Investing by Tim Hale

Albert Einstein, asset allocation, buy and hold, buy low sell high, capital asset pricing model, collapse of Lehman Brothers, corporate governance, credit crunch, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, eurozone crisis, fiat currency, financial independence, financial innovation, fixed income, full employment, implied volatility, index fund, information asymmetry, Isaac Newton, John Meriwether, Long Term Capital Management, Northern Rock, passive investing, Ponzi scheme, purchasing power parity, quantitative easing, random walk, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, technology bubble, the rule of 72, time value of money, transaction costs, Vanguard fund, women in the workforce, zero-sum game

It gets more tricky though The upside return is delivered via the purchase of a derivative contract linked to an asset class index, often an equity index, such as the FTSE 100 index which tracks the price level of the 100 largest UK listed companies (getting a bit more complex), usually in the form of a call option, although this could be a SWAP or a futures contract (oh dear), priced using an option pricing model such as Black-Scholes that takes into account factors such as the strike price of the option, the price today, the implied volatility of the index and the time to expiry (help!). Hopefully you get the point – the mechanics of this ‘simple’ product are actually quite sophisticated and complex. Investment banks employ bright, ambitious people on big packages to structure these products. Scope exists for some tricky pricing too, given that the average adviser, let alone retail investor, will have little chance of truly understanding the underlying costs involved.


Monte Carlo Simulation and Finance by Don L. McLeish

algorithmic bias, Black-Scholes formula, Brownian motion, capital asset pricing model, compound rate of return, discrete time, distributed generation, finite state, frictionless, frictionless market, implied volatility, incomplete markets, invention of the printing press, martingale, p-value, random walk, risk free rate, Sharpe ratio, short selling, stochastic process, stochastic volatility, survivorship bias, the market place, transaction costs, value at risk, Wiener process, zero-coupon bond, zero-sum game

Although the graph can be shifted and tilted somewhat by choosing different variance parameters, the shape appears to be a consequence of assuming a symmetric normal distribution for returns when the actual risk-neutral distribution is skewed. It should be noted that the practice of obtaining implied volatility parameters from options with similar strike prices and maturities is a partial, though not a compete, remedy to the substantial pricing errors caused by using a formula derived from a frequently ill-fitting GENERATING RANDOM NUMBERS FROM NON-UNIFORM CONTINUOUS DISTRIBUTIONS155 Figure 3.17: Relative Error in Black-Scholes formula when Asset returns follow extreme value Black_Scholes model.


pages: 345 words: 87,745

The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri

asset allocation, backtesting, Bernie Madoff, buy and hold, capital asset pricing model, cognitive dissonance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, intangible asset, Long Term Capital Management, money market fund, passive investing, Paul Samuelson, Performance of Mutual Funds in the Period, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, survivorship bias, Tax Reform Act of 1986, too big to fail, transaction costs, Vanguard fund, yield curve, zero-sum game

When the perceived risk of an asset class is low, the expected return is also low relative to more risky asset classes. Table 10.1 is a sample of long-term expected returns for various asset classes. Each year, I analyzed the primary drivers of asset class long-term returns, including risk as measured by implied volatility, expected earnings growth based on expected long-term GDP and foreign sales growth, an implied 3 percent inflation rate, and current cash payouts from interest and dividends on bond and stock indexes. These factors plus others are used in a valuation model to create an estimate for risk premiums over the next 30 years.


All About Asset Allocation, Second Edition by Richard Ferri

activist fund / activist shareholder / activist investor, asset allocation, asset-backed security, barriers to entry, Bear Stearns, Bernie Madoff, buy and hold, capital controls, commoditize, commodity trading advisor, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, equity premium, estate planning, financial independence, fixed income, full employment, high net worth, Home mortgage interest deduction, implied volatility, index fund, intangible asset, Long Term Capital Management, Mason jar, money market fund, mortgage tax deduction, passive income, pattern recognition, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, Sharpe ratio, stocks for the long run, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve

We can see this movement in measures of daily and intraday price volatility. Figure 14-2 illustrates the CBOE Volatility Index (VIX) level from 2007 through 2009 to provide a picture of this emotion-creating phenomenon. When to Change Your Asset Allocation FIGURE 297 14-2 High Market Volatility Signals Terrifying Moments in Investors’ Lives 100 90 80 Implied volatility 70 60 50 40 30 20 10 Jan-10 Oct-09 Jul-09 Apr-09 Jan-09 Oct-08 Jul-08 Apr-08 Jan-08 Oct-07 Jul-07 Apr-07 Jan-07 0 Spikes in price volatility create fear and uncertainty in the financial markets. Typically, a VIX reading above 30 means that investors are fearful. During late 2008 and early 2009, the VIX was consistently over 50 and hit 80 on more than one day.


pages: 358 words: 106,729

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan

accounting loophole / creative accounting, Andrei Shleifer, Asian financial crisis, asset-backed security, assortative mating, bank run, barriers to entry, Bear Stearns, Bernie Madoff, Bretton Woods, business climate, business cycle, Clayton Christensen, clean water, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, diversification, Edward Glaeser, financial innovation, fixed income, floating exchange rates, full employment, global supply chain, Goldman Sachs: Vampire Squid, illegal immigration, implied volatility, income inequality, index fund, interest rate swap, Joseph Schumpeter, Kenneth Rogoff, knowledge worker, labor-force participation, Long Term Capital Management, longitudinal study, market bubble, Martin Wolf, medical malpractice, microcredit, money market fund, moral hazard, new economy, Northern Rock, offshore financial centre, open economy, price stability, profit motive, Real Time Gross Settlement, Richard Florida, Richard Thaler, risk tolerance, Robert Shiller, Robert Shiller, Ronald Reagan, Savings and loan crisis, school vouchers, short selling, sovereign wealth fund, tail risk, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, Vanguard fund, women in the workforce, World Values Survey

There is evidence that this board pushed Citigroup into taking more of the risk that brought it to its knees.22 Although we cannot tell whether the board was independent or in management’s pocket, it apparently did not restrain the bank’s risk taking. Finally, equity markets were not entirely unaware of the risks. From the second quarter of 2005 to the second quarter of 2007, the two-year implied volatility of S&P 500 options prices—the market’s expectations of the volatility of share prices two years ahead—was 30 to 40 percent higher than the short-term one-month volatility.23 This figure suggests that the market expected the seeming calm would end, even though the high level of the market indicated it did not place a high probability on events turning out badly for shareholders.


pages: 402 words: 110,972

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Bear Stearns, Big bang: deregulation of the City of London, business cycle, butter production in bangladesh, butterfly effect, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, fixed income, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, intangible asset, Internet Archive, John Nash: game theory, Kenneth Arrow, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, Metcalfe’s law, moral hazard, mutually assured destruction, Myron Scholes, natural language processing, negative equity, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Metcalfe, Ronald Reagan, Rubik’s Cube, Savings and loan crisis, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, two and twenty, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra, your tax dollars at work

Many options traders and market makers track the message activity as a textual indicator of risk, opportunity, and volatility. A recent survey of volatility prediction, by the distinguished econometricians Clive Granger and Ser-Huang Poon, concluded that the best and most elaborate quantitative models did not rival predictions based on implied volatilities. In their conclusion, they write: “A potentially useful area for future research is whether forecasting can be enhanced by using exogenous variables.”18 The line between manipulation and volatility-inducing events is gray. It is not unreasonable for us to expect to see textually based exogenous variables for volatility prediction in the future.


pages: 550 words: 124,073

Democracy and Prosperity: Reinventing Capitalism Through a Turbulent Century by Torben Iversen, David Soskice

Andrei Shleifer, assortative mating, augmented reality, barriers to entry, Bretton Woods, business cycle, capital controls, Capital in the Twenty-First Century by Thomas Piketty, central bank independence, centre right, cleantech, cloud computing, collateralized debt obligation, collective bargaining, colonial rule, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, deindustrialization, deskilling, Donald Trump, first-past-the-post, full employment, Gini coefficient, hiring and firing, implied volatility, income inequality, industrial cluster, inflation targeting, invisible hand, knowledge economy, labor-force participation, liberal capitalism, low skilled workers, low-wage service sector, means of production, mittelstand, Network effects, New Economic Geography, new economy, New Urbanism, non-tariff barriers, Occupy movement, offshore financial centre, open borders, open economy, passive investing, precariat, race to the bottom, rent-seeking, RFID, road to serfdom, Robert Bork, Robert Gordon, Silicon Valley, smart cities, speech recognition, The Future of Employment, The Great Moderation, The Rise and Fall of American Growth, the strength of weak ties, too big to fail, trade liberalization, union organizing, urban decay, Washington Consensus, winner-take-all economy, working-age population, World Values Survey, young professional, zero-sum game

This is not simply a matter of demand for more complex financial products by firms to hedge against uncertainty in an economy that is simultaneously more decentralized and globalized; it is also a matter of educated workers demanding easier access to credit as they pursue increasingly “nonlinear” careers with more frequent changes in jobs, house purchases, flexible mortgages and savings, time off for retraining and additional schooling, and moves back and forth between work and family (especially as child birth is delayed among high-educated women), as well as complex retirement and partial retirement choices. Because of the implied volatility in income, access to credit markets serves an increasingly important income-smoothing function that is not adequately addressed by the social protection system. (5) Macroeconomic management: as discussed in chapter 3, there has been a widespread move to central bank independence combined with inflation targeting or membership of the Eurozone.


pages: 461 words: 128,421

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox

activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, bank run, beat the dealer, Benoit Mandelbrot, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, buy and hold, capital asset pricing model, card file, Cass Sunstein, collateralized debt obligation, compensation consultant, complexity theory, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, discovery of the americas, diversification, diversified portfolio, Edward Glaeser, Edward Thorp, endowment effect, Eugene Fama: efficient market hypothesis, experimental economics, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, George Akerlof, Henri Poincaré, Hyman Minsky, implied volatility, impulse control, index arbitrage, index card, index fund, information asymmetry, invisible hand, Isaac Newton, John Meriwether, John Nash: game theory, John von Neumann, joint-stock company, Joseph Schumpeter, Kenneth Arrow, libertarian paternalism, linear programming, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market design, Myron Scholes, New Journalism, Nikolai Kondratiev, Paul Lévy, Paul Samuelson, pension reform, performance metric, Ponzi scheme, prediction markets, pushing on a string, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, road to serfdom, Robert Bork, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, selling pickaxes during a gold rush, shareholder value, Sharpe ratio, short selling, side project, Silicon Valley, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, statistical model, stocks for the long run, The Chicago School, The Myth of the Rational Market, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, Thorstein Veblen, Tobin tax, transaction costs, tulip mania, value at risk, Vanguard fund, Vilfredo Pareto, volatility smile, Yogi Berra

The universe has only existed an estimated 12 billion years; the New York Stock Exchange was, as of October 1987, 170 years old.13 Either stock market investors were desperately, spectacularly, unimaginably unlucky that October day, or the bell curve did not come remotely close to representing the true nature of financial market risk. This realization came quickly to some options traders. After October 19, options prices displayed what came to be called a “volatility smile.” By turning the Black-Scholes equation around, one can calculate the implied volatility of any stock from the price of its options. Put options allow one to sell a share of stock at a preset price. After the 1987 crash, put options that were well out of the money (the stock was at $40, say, and the put allowed one to sell it for $10) traded at prices that, according to Black-Scholes, implied a similar crash every few years.


Commodity Trading Advisors: Risk, Performance Analysis, and Selection by Greg N. Gregoriou, Vassilios Karavas, François-Serge Lhabitant, Fabrice Douglas Rouah

Asian financial crisis, asset allocation, backtesting, buy and hold, capital asset pricing model, collateralized debt obligation, commodity trading advisor, compound rate of return, constrained optimization, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, discrete time, distributed generation, diversification, diversified portfolio, dividend-yielding stocks, fixed income, high net worth, implied volatility, index arbitrage, index fund, interest rate swap, iterative process, linear programming, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, p-value, Pareto efficiency, Performance of Mutual Funds in the Period, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk free rate, risk-adjusted returns, risk/return, selection bias, Sharpe ratio, short selling, stochastic process, survivorship bias, systematic trading, tail risk, technology bubble, transaction costs, value at risk, zero-sum game

Treasury while the beta is 0.67 for the Barclay index. In the same vein, the CSFB index has a −0.69 beta with the USD versus major currency while the beta is 0.18 for the Barclay index. Only two indices (CSFB and HF Net) appear to exhibit significant exposure to the S&P 500 and only one (HF Net) to the evolution of the VIX (implied volatility on the S&P 500). Since the choice of index may have a significant impact on the whole investment process (from strategic allocation through performance evalua- Benchmarking the Performance of CTAs 21 tion and attribution), investors should be aware of and tackle those differences in factor exposures.


pages: 611 words: 130,419

Narrative Economics: How Stories Go Viral and Drive Major Economic Events by Robert J. Shiller

agricultural Revolution, Albert Einstein, algorithmic trading, Andrei Shleifer, autonomous vehicles, bank run, banking crisis, basic income, bitcoin, blockchain, business cycle, butterfly effect, buy and hold, Capital in the Twenty-First Century by Thomas Piketty, Cass Sunstein, central bank independence, collective bargaining, computerized trading, corporate raider, correlation does not imply causation, cryptocurrency, Daniel Kahneman / Amos Tversky, debt deflation, disintermediation, Donald Trump, Edmond Halley, Elon Musk, en.wikipedia.org, Ethereum, ethereum blockchain, full employment, George Akerlof, germ theory of disease, German hyperinflation, Gunnar Myrdal, Gödel, Escher, Bach, Hacker Ethic, implied volatility, income inequality, inflation targeting, invention of radio, invention of the telegraph, Jean Tirole, job automation, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Maynard Keynes: technological unemployment, litecoin, market bubble, Modern Monetary Theory, money market fund, moral hazard, Northern Rock, nudge unit, Own Your Own Home, Paul Samuelson, Philip Mirowski, Plutocrats, plutocrats, Ponzi scheme, publish or perish, random walk, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, Rubik’s Cube, Satoshi Nakamoto, secular stagnation, shareholder value, Silicon Valley, speech recognition, Steve Jobs, Steven Pinker, stochastic process, stocks for the long run, superstar cities, The Rise and Fall of American Growth, The Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, theory of mind, Thorstein Veblen, traveling salesman, trickle-down economics, tulip mania, universal basic income, Watson beat the top human players on Jeopardy!, We are the 99%, yellow journalism, yield curve, Yom Kippur War

In a succession of utterances by individual financers [sic] and at bankers’ conferences, the prediction has been publicly made that the end of the speculative infatuation cannot be far off and that an inflated market is riding for a fall.4 Clearly, evidence of speculation was available to the public, which read about it in the news and talked about it on train cars. For example, in the year before its 1929 peak, the US stock market’s actual volatility was relatively low. But the implied volatility, reflecting interest rates and initial margin demanded by brokers on stock market margin loans, was exceptionally high, suggesting that the brokers who offered margin loans were worried about a big decline in the stock market.5 So the evidence of danger was there in 1929 before the market peak, but it was controversial and inconclusive.


pages: 586 words: 159,901

Wall Street: How It Works And for Whom by Doug Henwood

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, affirmative action, Andrei Shleifer, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, bond market vigilante , borderless world, Bretton Woods, British Empire, business cycle, buy the rumour, sell the news, capital asset pricing model, capital controls, central bank independence, computerized trading, corporate governance, corporate raider, correlation coefficient, correlation does not imply causation, credit crunch, currency manipulation / currency intervention, David Ricardo: comparative advantage, debt deflation, declining real wages, deindustrialization, dematerialisation, disinformation, diversification, diversified portfolio, Donald Trump, equity premium, Eugene Fama: efficient market hypothesis, experimental subject, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, George Akerlof, George Gilder, hiring and firing, Hyman Minsky, implied volatility, index arbitrage, index fund, information asymmetry, interest rate swap, Internet Archive, invisible hand, Irwin Jacobs, Isaac Newton, joint-stock company, Joseph Schumpeter, kremlinology, labor-force participation, late capitalism, law of one price, liberal capitalism, liquidationism / Banker’s doctrine / the Treasury view, London Interbank Offered Rate, Louis Bachelier, market bubble, Mexican peso crisis / tequila crisis, microcredit, minimum wage unemployment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, oil shock, Paul Samuelson, payday loans, pension reform, Plutocrats, plutocrats, Post-Keynesian economics, price mechanism, price stability, prisoner's dilemma, profit maximization, publication bias, Ralph Nader, random walk, reserve currency, Richard Thaler, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, Savings and loan crisis, selection bias, shareholder value, short selling, Slavoj Žižek, South Sea Bubble, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Market for Lemons, The Nature of the Firm, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, transcontinental railway, women in the workforce, yield curve, zero-coupon bond

"Financial Investment Opportunities and the Macroeconomy,"/our- nal of Finance 46. pp. 529-554. Chen, Nai-Fu, Richard Roll, and Stephen A. Ross (1986). "Economic Forces and the Stock Market," fournal of Business 59, pp. 383-403-Cherian, Joseph A., and Robert A. Jarrow (1994). "Options Markets, Self-Fulfilling Prophecies, and Implied Volatilities," mimeo, Boston University School of Management (October). BIBLIOGRAPHY Chick, Victoria (1976). Transnational Enterprises and the Evolution of the International Monetary System, University of Sydney, Transnational Corporations Research Project, Research Monograph No. 5. — (1983). Macroeconomics After Keynes: A Reconsideration of the General Theory (Deddington, U.K.: Philip Allan Publishers).


pages: 542 words: 145,022

In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest by Andrew W. Lo, Stephen R. Foerster

"Robert Solow", Albert Einstein, asset allocation, backtesting, Benoit Mandelbrot, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, buy and hold, capital asset pricing model, Charles Lindbergh, compound rate of return, corporate governance, Covid-19, COVID-19, credit crunch, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, Edward Glaeser, equity premium, estate planning, Eugene Fama: efficient market hypothesis, family office, fiat currency, financial innovation, financial intermediation, fixed income, hiring and firing, Hyman Minsky, implied volatility, index fund, interest rate swap, Internet Archive, invention of the wheel, Isaac Newton, John Meriwether, John von Neumann, joint-stock company, Kenneth Arrow, linear programming, Long Term Capital Management, loss aversion, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, money market fund, money: store of value / unit of account / medium of exchange, Myron Scholes, new economy, New Journalism, Own Your Own Home, passive investing, Paul Samuelson, Performance of Mutual Funds in the Period, prediction markets, price stability, profit maximization, quantitative trading / quantitative finance, RAND corporation, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, Savings and loan crisis, selection bias, shareholder value, Sharpe ratio, short selling, South Sea Bubble, stochastic process, stocks for the long run, survivorship bias, tail risk, Thales and the olive presses, Thales of Miletus, The Myth of the Rational Market, The Wisdom of Crowds, Thomas Bayes, time value of money, transaction costs, transfer pricing, tulip mania, Vanguard fund, yield curve, zero-coupon bond, zero-sum game

FIGURE 6.1: The CBOE Volatility Index, or VIX, January 1986 to July 2020 (back-tested prior to 2004). Source: “VIX Index Historical Data,” CBOE, http://www.cboe.com/products/vix-index-volatility/vix-options-and-futures/vix-index/vix-historical-data. Let’s assume that traders have properly priced this particular option. If that’s the case, then we can back out the implied volatility of the market, since we know the other four factors and the price. In other words, we can back-calculate how risky investors think the stock market will be over the next three months. In fact, the CBOE has created an index based on this process: the Volatility Index (VIX), usually expressed in percentage of the standard deviation of returns.


Alpha Trader by Brent Donnelly

algorithmic trading, Asian financial crisis, Atul Gawande, autonomous vehicles, backtesting, barriers to entry, beat the dealer, bitcoin, buy low sell high, Checklist Manifesto, commodity trading advisor, coronavirus, correlation does not imply causation, Covid-19, COVID-19, crowdsourcing, cryptocurrency, currency manipulation / currency intervention, diversification, Edward Thorp, Elliott wave, Elon Musk, endowment effect, eurozone crisis, fixed income, Flash crash, full employment, global pandemic, Gordon Gekko, hedonic treadmill, helicopter parent, high net worth, hindsight bias, implied volatility, impulse control, Inbox Zero, index fund, inflation targeting, information asymmetry, invisible hand, iterative process, law of one price, loss aversion, margin call, market bubble, market microstructure, McMansion, Monty Hall problem, Network effects, paper trading, pattern recognition, Peter Thiel, prediction markets, price anchoring, price discovery process, price stability, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, risk tolerance, Robert Shiller, Robert Shiller, secular stagnation, Sharpe ratio, short selling, side project, Stanford marshmallow experiment, Stanford prison experiment, survivorship bias, tail risk, the scientific method, The Wisdom of Crowds, theory of mind, too big to fail, transaction costs, value at risk, very high income, yield curve, you are the product, zero-sum game

You can measure it different ways but unless you are an options trader, I wouldn’t worry about where the number comes from. Just know that when people say “volatility” they are mostly referring to daily historical or realized volatility. The amount the security has moved around in the past, based on daily data. Implied volatility. This is the market price for volatility going forward. This measure is used in option pricing, and is a better proxy for future volatility than historical volatility. The distinction is not important here and for the purposes of an exercise like vol-adjusted position sizing, it rarely matters which data you use.


pages: 782 words: 187,875

Big Debt Crises by Ray Dalio

Asian financial crisis, asset-backed security, bank run, banking crisis, basic income, Bear Stearns, Ben Bernanke: helicopter money, break the buck, Bretton Woods, British Empire, business cycle, buy the rumour, sell the news, capital controls, central bank independence, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, declining real wages, European colonialism, fiat currency, financial innovation, foreign exchange controls, German hyperinflation, housing crisis, implied volatility, intangible asset, Kickstarter, large denomination, manufacturing employment, margin call, market bubble, market fundamentalism, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, Northern Rock, Ponzi scheme, price stability, private sector deleveraging, purchasing power parity, pushing on a string, quantitative easing, refrigerator car, reserve currency, risk free rate, Savings and loan crisis, short selling, sovereign wealth fund, too big to fail, transaction costs, universal basic income, value at risk, yield curve

The report, published by the Mortgage Bankers Association, came as the Federal Reserve held a hearing on what regulators could do to address aggressive abusive lending practices.” –New York Times June 21, 2007 Bear Stearns Staves Off Collapse of 2 Hedge Funds -New York Times June 23, 2007 Bear Stearns to Bail Out Troubled Fund -New York Times July 3, 2007 Glancing at Implied Vols “Recent market action has begun to show a slight pickup in implied volatility across all markets, but these increases have come from levels that were as low as they have been in more than 10 years. Looking broadly across markets, we continue to see very low expected future currency, bond, and commodity volatility, while future expected volatility in the equities is low but closer to normal relative to history.”


pages: 593 words: 189,857

Stress Test: Reflections on Financial Crises by Timothy F. Geithner

Affordable Care Act / Obamacare, asset-backed security, Atul Gawande, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Bernie Sanders, break the buck, Buckminster Fuller, Carmen Reinhart, central bank independence, collateralized debt obligation, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, David Brooks, Doomsday Book, eurozone crisis, financial innovation, Flash crash, Goldman Sachs: Vampire Squid, housing crisis, Hyman Minsky, illegal immigration, implied volatility, Kickstarter, London Interbank Offered Rate, Long Term Capital Management, margin call, market fundamentalism, Martin Wolf, McMansion, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mortgage debt, Nate Silver, negative equity, Northern Rock, obamacare, paradox of thrift, pets.com, price stability, profit maximization, pushing on a string, quantitative easing, race to the bottom, RAND corporation, regulatory arbitrage, reserve currency, Saturday Night Live, Savings and loan crisis, savings glut, selection bias, short selling, sovereign wealth fund, tail risk, The Great Moderation, The Signal and the Noise by Nate Silver, Tobin tax, too big to fail, working poor

But either by netting out cash, a risk-free asset, or paying down $500 billion in liabilities, the bank’s leverage ratio would be reduced to 20:1. 2 capital alone wouldn’t stop a run already in progress: We had no way of determining then how much capital would be enough, but we knew we wouldn’t have unlimited amounts of capital to deploy. That meant that guarantees were needed alongside capital to credibly backstop the system. 3 “fear index”: The Chicago Board Options Exchange Market Volatility Index, or VIX, is a measure of market volatility popularly referred to as the “fear index.” The measure is based on the implied volatility of options on the S&P 500 index of stocks. The VIX captures investor expectations of near-term stock market volatility—how uncertain investors are about whether and how far the S&P will rise or fall. 4 two complex new Maiden Lane vehicles: Among AIG’s major liquidity needs were their securities lending operations and the credit default swaps written by AIG Financial Products on collateralized debt obligations.