riskless arbitrage

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The Volatility Smile by Emanuel Derman,Michael B.Miller

Albert Einstein, Asian financial crisis, Benoit Mandelbrot, Black Monday: stock market crash in 1987, book value, 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, financial engineering, 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

First, one has to be very careful in modeling the stochastic evolution of implied volatility directly, because changing implied volatility changes all option prices, and it is difficult to avoid violating the constraints imposed by the principle of no riskless arbitrage. Second, one must not forget the awkward fact that implied volatility is a parameter of the BSM model itself, which fails to describe option values correctly, and that we are therefore trying, perhaps illogically, to model the parameter of an inaccurate model. For readers familiar with interest rate modeling, this approach is analogous to the Heath-Jarrow-Morton model in which the entire yield curve is allowed to become stochastic while still respecting the no-riskless-arbitrage constraints on bond prices. It is possible to develop implied volatility models in the same spirit, but they are complicated and computationally difficult.

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We may have to settle for a replicating portfolio that is approximately the same in most scenarios. What both of the aforementioned formulations hint at is the impossibility of arbitrage, the ability to trade in such a way that will guarantee a profit without any risk. Another version of the law of one price is therefore the principle of no riskless arbitrage, which can be stated as follows: It should be impossible to obtain for zero cost a security that has nonnegative payoffs in all future scenarios, with at least one scenario having a positive payoff. This principle states that markets abhor an arbitrage opportunity. It is equivalent to the law of one price in that, if two securities were to have identical future payoffs but different current prices, a suitably weighted long position in the cheaper security and a short position in the more expensive one would create an arbitrage opportunity.

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It is equivalent to the law of one price in that, if two securities were to have identical future payoffs but different current prices, a suitably weighted long position in the cheaper security and a short position in the more expensive one would create an arbitrage opportunity. Given enough time and enough information, market participants will end up enforcing the law of one price and the principle of no riskless arbitrage as they seek to quickly profit by buying securities that are too cheap and selling securities that are too expensive, thereby eliminating arbitrage The Principle of Replication 15 opportunities. In the long run, in liquid markets, the law of one price usually holds. But the law of one price is not a law of nature.

Bernie Madoff, the Wizard of Lies: Inside the Infamous $65 Billion Swindle by Diana B. Henriques

accounting loophole / creative accounting, airport security, Albert Einstein, AOL-Time Warner, banking crisis, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, break the buck, British Empire, buy and hold, centralized clearinghouse, collapse of Lehman Brothers, computerized trading, corporate raider, diversified portfolio, Donald Trump, dumpster diving, Edward Thorp, financial deregulation, financial engineering, financial thriller, fixed income, forensic accounting, Gordon Gekko, index fund, locking in a profit, low interest rates, mail merge, merger arbitrage, messenger bag, money market fund, payment for order flow, plutocrats, Ponzi scheme, Potemkin village, proprietary trading, random walk, Renaissance Technologies, riskless arbitrage, Ronald Reagan, Savings and loan crisis, short selling, short squeeze, Small Order Execution System, source of truth, sovereign wealth fund, too big to fail, transaction costs, traveling salesman

In his prison interviews and in subsequent letters, Madoff claimed that he was generating those solid, consistent profits for his father-in-law’s partnership accounts through an investment strategy that he said was his small firm’s specialty in the 1970s. It was called riskless arbitrage, and it was widely understood and accepted among the professionals on Wall Street in that era. Riskless arbitrage is an age-old strategy for exploiting momentary price differences for the same product in different markets. It could be as simple as ordering cartons of cigarettes by telephone from a vendor in a low-cost state and simultaneously selling them over the phone at a higher price in states where they are more expensive, thereby locking in a profit.

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It was not unusual for a company’s shares to trade at $12 on the Pacific Stock Exchange in San Francisco at the same moment that the same shares were changing hands for $11.25 on, say, the Boston Stock Exchange. By simultaneously buying in Boston and selling in San Francisco, an alert investor could lock in that $0.75 difference as a riskless arbitrage profit. At a more sophisticated level, a level Madoff was known to exploit, riskless arbitrage involved corporate bonds or preferred stock that could be converted into common stock. A bond that could be converted into ten shares of stock should usually trade for at least ten times the price of the stock—but it didn’t always do so. If a bond that could be converted into ten shares of a $15 stock could be bought for less than $150—for $130 per bond, let’s say—that was an opportunity for arbitrage.

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Market makers were traders who consistently and publicly maintained a ready market in specific securities, buying from other traders who wanted to sell and selling to traders who wanted to buy. Continually offering to buy and sell the arcane securities involved in riskless arbitrage strategies—convertible bonds, preferred stock, common stock units with warrants—and trading those securities for his own account and those of his clients became Madoff’s increasingly profitable market niche, he said. According to Madoff, none of the big Wall Street firms were willing to do riskless arbitrage in small pieces for retail investors. But he was, and some of the biggest names on the Street would send him small arbitrage orders to execute for their customers, he said.

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 engineering, 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

We give three definitions. The first two are of a risk-free arbitrage opportunity and the third is of a risky arbitrage. DEFINITION 1 (RISKLESS ARBITRAGE) A risk-free arbitrage opportunity is one with the following properties: 1. It generates a positive profit (inflow) at time T, subsequent to today, represented by time t. 2. The profit generated at time T is riskless. That is, it is certain. 3. The cost today of generating that risk-free, positive profit at time T is zero. DEFINITION 2 (RISKLESS ARBITRAGE) A risk-free arbitrage opportunity is one with the following properties: 1. It generates a positive profit (inflow) today, time t. 2.

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Unfortunately, we know that the payoff can be positive or negative at expiration so there is no guarantee of a positive profit in any state of the world. Therefore, such positions are clearly not riskless arbitrage opportunities (see parts 1. and 2. of Definition 1). Neither are they risky arbitrage opportunities even though they have a chance of a positive profit at expiration (see Definition 3, part 3., section 4.6.1). The reason is that part 2. of Definition 3 is violated, negative profits (costs) could arise at expiration. b. An unexpired lottery ticket that someone lost and that you found is not a riskless arbitrage because winning is not a certainty. However, it is a risky arbitrage because there is a state of the world in which there is a (large) positive payoff, that in which you have the winning number.

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We would be happy too, because we got it cheap relative to B. Our strategy would yield an immediate riskless arbitrage profit of PB,t–PA,t>0, and no subsequent cash flow implications because we have unwound all positions. The short sale of B has been closed out by covering the short sale. The long position we acquired in A has been liquidated by using A to cover the short sale, after which we own no position in A nor in B. Further, if we short sell B and purchase A fast enough, the immediate cash flow will be almost riskless. Now, recall definition 2 of (riskless) arbitrage given in Chapter 4, section 4.6.1. Risk-Free Arbitrage Definition 2 A risk-free arbitrage opportunity is one with the following properties: 1.

Models. Behaving. Badly.: Why Confusing Illusion With Reality Can Lead to Disaster, on Wall Street and in Life by Emanuel Derman

Albert Einstein, Asian financial crisis, Augustin-Louis Cauchy, Black-Scholes formula, British Empire, Brownian motion, capital asset pricing model, Cepheid variable, creative destruction, crony capitalism, currency risk, diversified portfolio, Douglas Hofstadter, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial engineering, Financial Modelers Manifesto, fixed income, Ford Model T, Great Leap Forward, Henri Poincaré, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, Isaac Newton, Johannes Kepler, law of one price, low interest rates, Mikhail Gorbachev, Myron Scholes, quantitative trading / quantitative finance, random walk, Richard Feynman, riskless arbitrage, savings glut, Schrödinger's Cat, Sharpe ratio, stochastic volatility, the scientific method, washing machines reduced drudgery, yield curve

When we compare it with almost everything else in economics, the wonderful thing about this law of valuation by analogy is that it dispenses with utility functions, the undiscoverable hidden variables whose ghostly presence permeates economic theory. Financial economists like to recast the Law of One Price as the more pedantically named Principle of No Riskless Arbitrage: Any two securities with identical future payoffs, no matter how the future turns out, should have identical current prices. This Law of One Price embodies the common sense that the author of “the fundamental theorem of finance” was trying so hard to convey but expressed so unclearly. In the imaginary world of the Efficient Market Model, a stock’s price movements are completely characterized by its expected return μ and its volatility a.

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See also Black-Scholes Model metaphor(s): as analogies definition/nature of models and electromagnetic theory as facts confused with feelings as financial models as God and hierarchy of linguistic and irreducible nonmetaphor language as tower of limitations of mysteries of world and physical basis of positron and purposes of of Schopenhauer symbols and theories and method: Goethe’s view about content and mind: body relationship with composition of world and domino computer and idea and invention/ discovery as synthesis of world and laws of materialism and Spinoza’s emotions theory and will and Minsky, Marvin miscegenation mnemonics Modeh (children’s prayer) Model T Modelers’ Hippocratic Oath models: accuracy of analogies and assumptions and benefits of as caricature as collection of parallel thought universes definition of explanations required for as fetish as gedankenexperiments good and bad ideal language and laws and limitations/inadequacies of and making the unconscious conscious as metaphor mysteries of world and nature of purposes of for risk rules for using as saving mental labor as simplifications theorems and theories compared with time and types of unreliability of validity of verification of vulgarity of as way of understanding world See also failed models; specific model or topic money See also currency/cash monocular diplopia Montagu, South Africa: Derman visit to morals: markets and mortgages Moses: burning bush and Mossin, Jan moth in refrigerator example motion, laws of Mottelson, Ben mudita, Nabokov, Vladimir National Union of South African Students (Nusas) Nationalist Party, Afrikaner nature: inner relationships of negative energy Newton, Isaac: as a bird calculus and CAPM and and Derman’s question about laws and explanations discoveries about matter of electromagnetic theory and Keynes’s views about laws of laws of the universe and mechanics theory of and perfection via intuition and right way to use models theories of observation Oersted, Hans Christian “On the Suffering of the World” (Schopenhauer) options: benefits of financial models and Black-Scholes Model and Merton and as objects of interest to financial models Spinoza’s theory of emotions and valuing of vulgarity of financial models and pain: definition of money and Spinoza’s emotions theory and Palestine parity violation passions perfection: definition of electromagnetic theory and God as intuition and knowledge and levels of nonexistence of reality and Spinoza’s definition of Spinoza’s emotions theory and of theories phenomena: electromagnetic theory and importance of physics: abstractions and analytic continuation in birds and frogs in collective model in nuclear Derman’s interest in studying equilibrium in failed models in financial models and function of fundamental theorem of God and good and bad models and theories in laws of and making the unconscious conscious mathematics and Maxwell’s impact on nature of models and negative energy and purpose of models in and right way to use models theory as distinguished from models and uncertainty and values of fundamental constants in world as focus of See also specific scientist, model, or theory “A Piece of Chalk” (Chesterton) The Pirates of Penzance (Gilbert and Sullivan) Planck, Max pleasure: definition of as derivative of love expected financial models and generalized intuition and localized money and perfection and Spinoza’s emotions theory and pleasure premium Poalei Zion (Workers of Zion) Poincaré, Henri points politics: failed models in financial models and human affairs and Population Registration Act (1950) portfolios, investment Portnoy’s Complaint (Roth) positrons postulates Powers, Melvin pragmamorphism “The Precision of Pain and the Blurriness of Joy” (Amichai) preconceptions prediction: financial models and purpose of models in physics and presence: absence as price: definition of drift in financial models and fluctuation in futility of using financial models and history of implied opaque prediction of future purpose of finance models and risk model and value and volatility of See also Law of One Price; specific financial model or theory primes primitives See also specific primitive Principle of No Riskless Arbitrage. See Law of One Price principles: definition of theories and Euclid’s geometry and in finance privatization probability Prohibition of Mixed Marriages Act (1949) proxies: artists’ models as psyche, Freud’s theory of psychoanalysis psychology Pygmalion model Pythagoras’s theorem QED.

Endless Money: The Moral Hazards of Socialism by William Baker, Addison Wiggin

Alan Greenspan, Andy Kessler, asset allocation, backtesting, bank run, banking crisis, Bear Stearns, Berlin Wall, Bernie Madoff, Black Swan, bond market vigilante , book value, Branko Milanovic, bread and circuses, break the buck, Bretton Woods, BRICs, business climate, business cycle, capital asset pricing model, carbon tax, commoditize, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, crony capitalism, cuban missile crisis, currency manipulation / currency intervention, debt deflation, Elliott wave, en.wikipedia.org, Fall of the Berlin Wall, feminist movement, fiat currency, fixed income, floating exchange rates, foreign exchange controls, Fractional reserve banking, full employment, German hyperinflation, Great Leap Forward, housing crisis, income inequality, index fund, inflation targeting, Joseph Schumpeter, Kickstarter, laissez-faire capitalism, land bank, land reform, liquidity trap, Long Term Capital Management, lost cosmonauts, low interest rates, McMansion, mega-rich, military-industrial complex, Money creation, money market fund, moral hazard, mortgage tax deduction, naked short selling, negative equity, offshore financial centre, Ponzi scheme, price stability, proprietary trading, pushing on a string, quantitative easing, RAND corporation, rent control, rent stabilization, reserve currency, risk free rate, riskless arbitrage, Ronald Reagan, Savings and loan crisis, school vouchers, seigniorage, short selling, Silicon Valley, six sigma, statistical arbitrage, statistical model, Steve Jobs, stocks for the long run, Tax Reform Act of 1986, The Great Moderation, the scientific method, time value of money, too big to fail, Two Sigma, upwardly mobile, War on Poverty, Yogi Berra, young professional

One in particular, Harry Marcopolos, took it upon himself to pen a 19-page examination of Madoff complete with a recitation of no less than 29 “red flags,” which he presented seemingly on a silver platter to SEC officials titled, The World’s Largest Hedge Fund is a Fraud.12 Marcopolos is a derivatives expert, having traded portfolios in the billions of dollars in various options strategies for hedge funds and institutional clients. The general thesis Marcopolos advances is that for Madoff to have outdone the returns the market permits for riskless arbitrage, he would have had to deviate from it and consistently made bets that were winners for nearly 200 months, consecutively. (Madoff had seven months in which he claimed losses of less than 1 percent.) Zeroing in on periods of time when the market was pricing options such that riskless arbitrage was essentially inoperable, such as the Asian currency crisis, he concluded the likelihood of Madoff not having suffered more than a few skin lacerations is statistically almost impossible.

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While selection of and access to funds with high returns is a key determinant of the success of funds of funds, an equally large selling point for them is usually their procedures for due diligence (how well they kick the tires). The most amazing part of the Madoff affair is that experienced hands in the industry which practiced the investment strategy Mr. Madoff Wings of Wax 25 professed to employ, an options trading technique long known as “riskless arbitrage,” loudly proclaimed that it was impossible to produce a track record with it akin to what Madoff reported to his investors. When practiced in its purest form, it involves buying and selling calls, puts, and an underlying equity such that risk of price movement is hedged away. Under these circumstances the market has long offered essentially Treasury bill type returns, because arbitrage has narrowed spreads since at least the 1970s.

Madoff Talks: Uncovering the Untold Story Behind the Most Notorious Ponzi Scheme in History by Jim Campbell

algorithmic trading, Bear Stearns, Bernie Madoff, currency risk, delta neutral, family office, fear of failure, financial thriller, fixed income, forensic accounting, full employment, Gordon Gekko, high net worth, index fund, Jim Simons, margin call, merger arbitrage, money market fund, mutually assured destruction, offshore financial centre, payment for order flow, Ponzi scheme, proprietary trading, Renaissance Technologies, risk free rate, riskless arbitrage, Robinhood: mobile stock trading app, Sharpe ratio, short selling, sovereign wealth fund, time value of money, two and twenty, walking around money

At this time all arbitrage was handled by these people and was performed strictly for their firms’ account, meaning no retail business. These same individuals did not want to be bothered with trading small amounts of bonds, known as odd lots, or orders of less than 100 shares. I said I would take all their referrals.”7 Madoff was engaging in “riskless arbitrage”—buying convertible bonds while simultaneously selling the stocks that the bonds were convertible into, earning a small and generally riskless spread on momentary pricing inefficiencies. His insight: the speed of the conversion was critical. At the time, the settlement process went through a conversion agent, adding a layer of complexity and delay.

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., 12–13, 20, 23, 25, 156, 167 Palm Beach Country Club, xvii, 13, 20, 57 Paris, France, 20 Paulson, Hank, 181–182 Pension plans, 98 Perelman, Ron, 161 Perez, George, 82, 91, 94–96, 95f, 148, 152 Personal expenses, payment of, 245–246, 245f Pettitt, Brian, 22 PharmaSciences, 55 Phelan, John, 33, 37 Picard, Irving, xx, xxvi appointment of, 179 billing rate of, 142 BLM on, 167, 168, 194, 201–202, 236 in BLMIS offices, 152 and BLMIS “piggy bank,” 245–247 and Stanley Chais, 194–196 and Sonja Cohn, 161 fees received by, 47, 180, 184, 284–285 and JPMorgan Chase, 168 Andrew Madoff on, 241 Ruth Madoff sued by, 188, 234–235 and Ezra Merkin, 162 mission of, as Trustee, 179 perception of, as bully, 210 Ponzi scheme victims sued by, 189–190 recovery rate of, 180, 185 resilience of, 286 successes of, 190–193 tax fraud ignored by, 290 team of, 197–200 Picower, Barbara, 55, 56, 98 Picower, Emily, 55 Picower, Jeffry, xxiv, 51, 53–57, 60, 62–64, 85, 97–100, 142, 190–191, 193–196, 200, 201, 260, 269, 273, 274, 289–290 Picower Foundation, 55 Picower Institute for Medical Research, 55 Piedrahita, Andrés, 156 Pink sheets, 32 P&Ls (see Profit and loss reports) Pomerantz, Steven, 163–166, 256 Ponzi schemes, xvii, xxiv, 184 Pottruck, David, 21 Price Waterhouse (PW), 66, 110, 193, 277 Prime brokerages, 122 Pritzker family, 273 Private placement memoranda (PPMs), 157 Profit and loss reports (P&Ls), 44–45, 82, 146–147, 231–232 Promissory notes, 62 “PRT62V” programs, 93 Put options, 72 Putnam, 184 PW (see Price Waterhouse) QUANT hedge fund, 75–76 Quants, 41, 163 Queens College, 238 Rampart Investment Management, xv–xvii, 117–118, 120, 123, 126, 291 Random number generators, 92 RBS (Royal Bank of Scotland), 107 Reagan, Ronald, 274–275 Regulatory reform, need for systemic, 277–278 Regulatory reports, falsified, 150–151 Renaissance Technologies, 75, 115–116 Riopelle, Roland, 86, 88, 99, 262–263, 290 Riordan, Erin, 152 “Riskless arbitrage,” 35–36 Roberts, Paul, xix, 12, 46–47, 67, 87, 88–89, 94, 96, 98, 141–142, 151–153, 171, 172, 230, 269, 293 Robertson, Julian, 42 Robinhood, 39 Rosa Mexicano restaurant, 6 Rothko, Mark, 162–163 Round Hill Club, 156 RP/EQ, 146, 147, 232 “RuAnn Family Plan,” 87 Rule 2860, 109 Russia, 195, 291–292 San Marino, Calif., 156 Sandell, Laurie, xx SAR (Suspicious Activity Report), 172, 174 Schumer, Chuck, 210 Schwab (see Charles Schwab & Company) Securities and Exchange Commission (SEC), xvii, xviii, xxv and arrest of BLM, 8–10 basic questions not asked by, 103–105 BLM and incompetency of, 222, 293 BLM on respect of, for BLMIS, 36 BLMIS IT specialists and false reporting to, 94–95 BLMIS’s dealings with, 37, 42, 83, 90, 91, 157–159, 221 BLM’s claim to be on “short list” for chairman of, 131 BLM’s parents’ registration with, 243 Boston District Office of, 111, 114 broker-dealer vs. investment-advisory arms of, 105–106 and Stanley Chais, 195 dysfunction at, 137–138 earlier investigations of, 96–97, 277–278 exploitation of incompetence of, by BLM, 105–106 failure of, to detect BLM’s Ponzi scheme, 103–117 falsified reports filed with, 150–151 and FBI, 152 and FINRA, 136, 287 Securities and Exchange Commission (SEC) first exoneration of BLM by, 61–67 “job” of, 129 made-up “rule” of, 88 Harry Markopolos’ complaint to, 111, 113–114, 124 New York Regional Office of, 133, 226 Northeast Regional Office of, 113–115 Office of Economic Analysis of, 109 organizational silos at, 154 oversight needed for, 286 Ponzi scheme victims and failure of, 214 and Rampart Investment Management, 118 real trading never verified by, 103–104, 106–109 reforming the, 278–282 and Robinhood, 39 and SIPC, 181, 187, 283 and Sterling Equities, 166 2005 failed examination by, 129–134 utter failure of, as regulator, 294 whistleblower tips/revelations ignored by, 109–117 Securities Industry Automation Corporation (SIAC), 108 Securities Investor Protection Act (SIPA), 184, 186, 284–286 Securities Investor Protection Corporation (SIPC): and fees charged by Trustees, 184, 185, 188 GAO’s warning to, 278 goalposts moved by, 183–184 inadequate customer protection fund of, xxvi mission of, 142, 179 and Net Investment Method, 185–186 Hank Paulson and, 181–182 “protection” of investors offered by, 179–181 recovery rate of, 180 reforming the, 282–286 settlements made by, 196–197 top ten “bad guys” targeted by, 190–193 (See also Picard, Irving) Self-regulatory organizations (SROs), xxviii, 135, 136, 286 Serious Organised Crime Agency (SOCA), 174, 291 Settlements (made by SIPC), 196–197 “703 account,” xix, 10, 13, 15–16, 18, 23, 25, 78, 82–84, 87–88, 90, 97, 104, 109, 144–146, 152 Shapiro, Carl, 22, 23, 53, 56–57, 59, 64, 87, 97, 191, 193–196, 201, 273 Shapiro, Mary, 280–281 Shapiro, Ruth, 56 Sharpe ratio, 204 Sheehan, David, 185, 197 Shtup file, 94, 149 SIAC (Securities Industry Automation Corporation), 108 Sibley, Lee, 15, 153 Simons, Jim, 75–76, 115–116 SIPA (see Securities Investor Protection Act) SIPC (see Securities Investor Protection Corporation) Smith Barney, 45 SOCA (Serious Organised Crime Agency), 174, 291 Sodi, Marco, 156 Soft Screw (Oldenburg sculpture), 269 Solomon, Elaine, 7 Sorkin, Ira “Ike,” xxiii, 14, 16, 18–19, 61, 63, 193, 223–224, 226, 234, 240–241, 269 Soros, George, 42 Southern District of New York (SDNY), 196, 220, 226, 290 S&P 100 Index, 72, 92, 107, 149, 165, 167, 173 S&P 100 OEX, 77 S&P 500 Index, 33, 97, 284 SPCL programs, 92 Spear, Leeds & Kellogg, 45–46 Specialists, trading, 31 Split strike conversion (SSC) investment strategy, 71–77, 86, 92, 97, 100, 103, 108, 111, 116, 118–119, 132, 148, 149, 155, 157, 158, 162–166, 165f, 191, 202, 228, 257–258, 264, 276 Squillari, Eleanor, xviii–xix, 3–9, 11–13, 21, 23–24, 77, 89, 90, 160–161, 203, 220, 223, 225, 228, 229, 246, 255, 258, 259, 290, 293 Squillari, Sabrina, 24 SROs (see Self-regulatory organizations (SROs)) Stampfli, Josh, 37–41, 43–45, 146–147, 221–222 “STDTRADE” file, 92 Sterling Equities, 166–168 “STMTPro” program, 93 Stock options, 72 Strike price, 72 Structured notes, 118 Suh, Simona, 107–109 Suspicious Activity Report (SAR), 172, 174 Swaps, 121 Switzerland, 291 Synthetic structured products, 172–174 TARP bailout, 182 Tax fraud, 82, 88, 90, 266–267, 289–290 Tax shelters, 53, 54 Teicher, Victor, 162 Thema International Funds, 160, 161, 192 Tibbs, Susan, 109 Toub, Philip Jamchid, 156 “TRADE17” program, 92 “TRADE1701” program, 92 Transparency, trading, 32, 46, 76, 174 Treasury bills (T-bills), 64, 73–74, 98, 118, 119, 164, 173, 174, 206, 273 Treasury bonds, 22, 100, 146, 165 Tremont Fund, 173, 192 Trump administration, 282 Trust, 275–276 Tucker, Jeffrey, 22, 156, 168 Tufts University, xvii UBS (Union Bank of Switzerland), 107 Underwriters, IPO, 52 University of Alabama, 30 University of California, Berkeley, 163 US Congress, 184, 207, 210 US Department of Justice (DOJ), 44, 154, 175, 192, 196, 220, 234 US Department of Labor, 98 US Department of the Treasury, 182, 282 Vanderhonval, Bill, 23 Vanguard, 37, 39, 184 Vanity Fair, 156 Vanity Fair Corporation, 56 Victims of the Ponzi scheme, 203–214 Ambrosino family, 207–211 average age of, 185 BLM’s seeming lack of remorse for, 211–213 and Congress’ failure, 207 and the European banks, 201 Willard Foxton Jr., 207–208 hardship cases, 199–200 Norma Hill, 204, 205f, 206–207 and the IRS, 202–203 Jews as, 204 lesson learned by, 214 recoveries of, 213–214, 274 and SEC’s failure, 214 SIPC and, 179–202 Eleanor Squillari on, 203 Vienna, Austria, 161, 208 Vijayvergiya, Amit, 122, 159 Villehuchet, René-Thierry Magon de La, xv–xvii, 21, 119, 125, 155, 270 Volume Weighted Average Price (VWAP), 36, 148 Walker, Genevievette, 115 Walker, Richard, 110 Wall Street Journal, 45, 63 Walmart, 210 Ward, Grant, 113 Waters, Maxine, 210 Weinstein, Sheryl, 255–256 Weiss, Paul, 226 West, Deborah, 196 Wharton School of Business, 81, 221 Whistleblowers and others suspecting misconduct, 109–124 A&B feeder fund tip (1992), 110–111 anonymous informants (Oct. 2005), 116 Frank Casey, 103, 123–129 Neil Chelo, 122 “concerned citizen” (Dec. 2006), 116–117 hedge fund whistleblower (May 2003), 114–115 Harry Markopolos, 111–114, 117–119, 124–126 Ocrant and Arvedlund articles, 120–121 Renaissance Technologies internal emails (Apr. 2004), 115–116 Wilpon, Fred, 163, 166–168, 197 The Wizard of Lies (Henriques), 60 Yang, Chan, 173 Yelsey, Neil, 45, 147, 231 Yeshiva University, 161 Zames, Matt, 172–173 ABOUT THE AUTHOR Jim Campbell is the host of the nationally syndicated radio show Business Talk with Jim Campbell and his crime show: Forensic Talk with Jim Campbell.

Mathematics for Economics and Finance by Michael Harrison, Patrick Waldron

Brownian motion, buy low sell high, capital asset pricing model, compound rate of return, discrete time, incomplete markets, law of one price, market clearing, Myron Scholes, Pareto efficiency, risk tolerance, riskless arbitrage, short selling, stochastic process

We already know from (1.12.4) that V must be positive semi-definite, but we require this slightly stronger condition. To see why, suppose ∃w 6= 0N s.t. w> Vw = 0 (6.4.6) Then ∃ a portfolio whose return w> r̃ = r̃w has zero variance. This implies that r̃w = r0 (say) w.p.1 or, essentially, that this portfolio is riskless. Arbitrage will force the returns on all riskless assets to be equal in equilibrium, so this situation is equivalent economically to the introduction of a riskless asset later. In the portfolio problem, the place of the matrix A in the canonical quadratic programming problem is taken by the (symmetric) negative definite matrix, −V, which is just the negative of the variance-covariance matrix of asset returns; g1 = 1> and α1 = W0 ; and g2 = e> and α2 = W1 . (6.4.5) guarantees that the 2 × N matrix G is of full rank 2.

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

Alan Greenspan, Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, behavioural economics, Bernie Madoff, Black Swan, Bob Litterman, bond market vigilante , book value, Bretton Woods, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, carbon credits, Carmen Reinhart, central bank independence, classic study, collateralized debt obligation, commoditize, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, deal flow, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, equity risk 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 macro, 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, inverted yield curve, invisible hand, John Bogle, junk bonds, Kenneth Rogoff, laissez-faire capitalism, law of one price, London Interbank Offered Rate, Long Term Capital Management, loss aversion, low interest rates, managed futures, 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, pension time bomb, performance metric, Phillips curve, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, proprietary trading, 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, savings glut, search costs, selection bias, seminal paper, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, stock buybacks, 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

Arbitrage is possible because assets are “not unique works of art” but have close counterparts in other assets or mixes of other assets (Scholes, 1972). If there are perfect substitutes and frictionless markets, buying a highexpected-return asset while selling a substitute with a lower expected return constitutes a riskless arbitrage. Subsequent empirical studies disputed the notion that perfect substitutes exist. Demand effects may play a key role in explaining time-varying risk premia, given the lack of substitutes for market risk exposures. Even the substitutability of single stocks can be challenged. A key example is the S&P 500 inclusion effect—the finding that new entries to the S&P 500 index experience a sudden and persistent price jump, presumably due to new buying pressure from index funds.

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Bearish expectations, elevated risk, and risk aversion do not alone explain the distressed price levels of securitized bonds and other assets. Many financial intermediaries and investors became forced sellers as market frictions prevented them and other investors from taking advantage of good deals or nearly riskless arbitrage opportunities. Opportunities that appeared compelling over the long horizon could not be taken due to the possibility that further de-levering and related mark-to-market volatility would make the investment positions unsustainable over the short run. A diverse literature on market frictions explains why asset prices might deviate from fair values or respond sluggishly to new information.

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Cross-sectional trading strategies may be relatively value-oriented (buy low, sell high) or momentum-oriented (buy rising stocks, sell falling ones; essentially buy high, sell low)—and they may be applied within one market (say, equities) or across many asset markets. Micro-inefficiency refers to either the rare extreme case of riskless arbitrage opportunities or the more plausible case of risky trades and strategies with attractive reward-to-risk ratios. Cross-sectional opportunities are safer to exploit than market-directional opportunities—one can hedge away directional risk and diversify specific risk much more effectively. The value effect refers to the pattern that “value stocks”, those with low valuation ratios (low price/earnings, price/cash flow, price/sales, price/dividend, and price/book value ratios) tend to offer higher long-run average returns than “growth stocks” or “glamour stocks” with high valuation ratios.

Deep Value by Tobias E. Carlisle

activist fund / activist shareholder / activist investor, Andrei Shleifer, availability heuristic, backtesting, behavioural economics, book value, business cycle, buy and hold, Carl Icahn, corporate governance, corporate raider, creative destruction, Daniel Kahneman / Amos Tversky, discounted cash flows, financial engineering, fixed income, Henry Singleton, intangible asset, John Bogle, joint-stock company, low interest rates, margin call, passive investing, principal–agent problem, Richard Thaler, risk free rate, riskless arbitrage, Robert Shiller, Rory Sutherland, shareholder value, Sharpe ratio, South Sea Bubble, statistical model, Teledyne, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, Tim Cook: Apple

Icahn and Kingsley bought the units of the closed-end funds trading at the widest discount from their underlying asset value, and then hedged out the market risk by shorting the securities that made up the mutual fund’s portfolio. Like the convertible arbitrage strategy, the closed-end fund arbitrage was indifferent to the direction of the market, generating profits as the gap between the unit price and the underlying value narrowed. It was not, however, classic riskless arbitrage. As it was possible for a gap to open up between the price of the mutual fund unit and the underlying value of the portfolio, it was also possible for that gap to widen. When it did so, an investor who had bought the units of the fund and sold short the underlying portfolio endured short-term, unrealized losses until the market closed the gap.

Manias, Panics and Crashes: A History of Financial Crises, Sixth Edition by Kindleberger, Charles P., Robert Z., Aliber

active measures, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, Boeing 747, Bonfire of the Vanities, break the buck, Bretton Woods, British Empire, business cycle, buy and hold, Carmen Reinhart, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, Corn Laws, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, cross-border payments, currency peg, currency risk, death of newspapers, debt deflation, Deng Xiaoping, disintermediation, diversification, diversified portfolio, edge city, financial deregulation, financial innovation, Financial Instability Hypothesis, financial repression, fixed income, floating exchange rates, George Akerlof, German hyperinflation, Glass-Steagall Act, Herman Kahn, Honoré de Balzac, Hyman Minsky, index fund, inflation targeting, information asymmetry, invisible hand, Isaac Newton, Japanese asset price bubble, joint-stock company, junk bonds, large denomination, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Mary Meeker, Michael Milken, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, new economy, Nick Leeson, Northern Rock, offshore financial centre, Ponzi scheme, price stability, railway mania, Richard Thaler, riskless arbitrage, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, special drawing rights, Suez canal 1869, telemarketer, The Chicago School, the market place, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, tulip mania, very high income, Washington Consensus, Y2K, Yogi Berra, Yom Kippur War

Hence it is useful to assume that investors are rational in the long run and to analyze economic issues on the basis of this assumption. One interpretation of the rationality assumption is that prices in a particular market today must be consistent with the prices one and two months from now and one and two years from now adjusted for the ‘costs of storage’; otherwise there would be a profitable and relatively riskless arbitrage opportunity. Ragnar Nurkse summarized his survey of changes in the values of the French franc and the German mark in the 1920s with the statement that speculation in the currency market had been destabilizing. Milton Friedman asserted that destabilizing speculation cannot occur – or at least is unlikely to persist – because investors that bought as prices were increasing and sold as prices were declining ‘would be buying high and selling low’; because of these losses, they would either go out of business or change their strategy.

Evidence-Based Technical Analysis: Applying the Scientific Method and Statistical Inference to Trading Signals by David Aronson

Albert Einstein, Andrew Wiles, asset allocation, availability heuristic, backtesting, Black Swan, book value, butter production in bangladesh, buy and hold, capital asset pricing model, cognitive dissonance, compound rate of return, computerized trading, Daniel Kahneman / Amos Tversky, distributed generation, Elliott wave, en.wikipedia.org, equity risk premium, feminist movement, Great Leap Forward, hindsight bias, index fund, invention of the telescope, invisible hand, Long Term Capital Management, managed futures, mental accounting, meta-analysis, p-value, pattern recognition, Paul Samuelson, Ponzi scheme, price anchoring, price stability, quantitative trading / quantitative finance, Ralph Nelson Elliott, random walk, retrograde motion, revision control, risk free rate, risk tolerance, risk-adjusted returns, riskless arbitrage, Robert Shiller, Sharpe ratio, short selling, source of truth, statistical model, stocks for the long run, sugar pill, systematic trading, the scientific method, transfer pricing, unbiased observer, yield curve, Yogi Berra

If one were to employ a bet fraction of 0.58 it is likely all funds would be lost, despite the favorable expectation. This is what happens to an arbitrageur with good information who uses too much leverage. Another constraint on an arbitrage’s ability to enforce efficient pricing is the lack of perfect substitute securities. An ideal (riskless) arbitrage transaction involves the simultaneous purchase and sale of a pair of securities with identical future cash flows and identical risk characteristics. An arbitrage transaction based on securities that do not conform to this ideal necessarily involves risk. And it is risk that limits the degree to which arbitrage activity can force prices to efficient levels.

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, book value, British Empire, business cycle, buy and hold, buy the rumour, sell the news, Claude Shannon: information theory, clean tech, 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, do what you love, Edward Thorp, family office, financial independence, fixed income, Flash crash, global macro, hindsight bias, implied volatility, index fund, intangible asset, James Dyson, Jones Act, legacy carrier, Long Term Capital Management, managed futures, margin call, market bubble, market fundamentalism, Market Wizards by Jack D. Schwager, merger arbitrage, Michael Milken, money market fund, oil shock, pattern recognition, pets.com, Ponzi scheme, private sector deleveraging, proprietary trading, quantitative easing, quantitative trading / quantitative finance, Reminiscences of a Stock Operator, 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

It was a good experience managing other people’s money and knowing what that felt like. What was your first investment based job? After my first and only year at law school, I took a summer job trading options at Bear Stearns. Did you know anything about options at that point? No, I ended up doing forward conversions, which are a riskless arbitrage.2 The idea was to put on these arbitrage trades and earn 18 to 19 percent annualized. The option market was that inefficient at the time? No, interest rates were that high at the time. I think the arbitrage added about 5 percent to 6 percent to the risk-free rate. Frankly, the trading was kind of mechanical.

MONEY Master the Game: 7 Simple Steps to Financial Freedom by Tony Robbins

"World Economic Forum" Davos, 3D printing, active measures, activist fund / activist shareholder / activist investor, addicted to oil, affirmative action, Affordable Care Act / Obamacare, Albert Einstein, asset allocation, backtesting, Bear Stearns, behavioural economics, bitcoin, Black Monday: stock market crash in 1987, buy and hold, Carl Icahn, clean water, cloud computing, corporate governance, corporate raider, correlation does not imply causation, Credit Default Swap, currency risk, Dean Kamen, declining real wages, diversification, diversified portfolio, Donald Trump, estate planning, fear of failure, fiat currency, financial independence, fixed income, forensic accounting, high net worth, index fund, Internet of things, invention of the wheel, it is difficult to get a man to understand something, when his salary depends on his not understanding it, Jeff Bezos, John Bogle, junk bonds, Kenneth Rogoff, lake wobegon effect, Lao Tzu, London Interbank Offered Rate, low interest rates, Marc Benioff, market bubble, Michael Milken, money market fund, mortgage debt, Neil Armstrong, new economy, obamacare, offshore financial centre, oil shock, optical character recognition, Own Your Own Home, passive investing, profit motive, Ralph Waldo Emerson, random walk, Ray Kurzweil, Richard Thaler, risk free rate, risk tolerance, riskless arbitrage, Robert Shiller, Salesforce, San Francisco homelessness, self-driving car, shareholder value, Silicon Valley, Skype, Snapchat, sovereign wealth fund, stem cell, Steve Jobs, subscription business, survivorship bias, tail risk, TED Talk, telerobotics, The 4% rule, The future is already here, the rule of 72, thinkpad, tontine, transaction costs, Upton Sinclair, Vanguard fund, World Values Survey, X Prize, Yogi Berra, young professional, zero-sum game

CI: I borrowed money to buy a seat on the New York Stock Exchange. I was a hotshot guy. My experience taught me that trading the market is dangerous, and it was far better to use my mathematical ability to become an expert in certain areas. Banks would loan me 90% of the money I needed for arbitrage, because back then, in riskless arbitrage, if you were good, you literally couldn’t lose. And I was starting to make big money, $1.5 to $2 million a year. TR: I’d love to talk to you about asymmetric returns. Were you also looking for those when you began taking over undervalued companies? CI: I started looking at these companies and really analyzing them.