Posts tagged with finance quant

Say you find a sucker and you make a bet with him. A bet that is so good for you and so bad for him that you can barely believe he signed on to it. You are smirking inside and when you’re not facing him anymore you break into gleeful, villainous laughter.

A couple months later the contract comes due. You find the sucker and he has made dumb bets all over town. He’s cleaned out and you can’t draw blood from a stone.

That’s counterparty risk.




CAPM assumes a positive correlation between risk and reward. The exact opposite is true with value investing. If you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expectation of reward is greater in the latter case.

One quick example: The Washington Post Company in 1973 was selling for $80 million in the market. At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more. The company owned the Post, Newsweek, plus several television stations in major markets. Those same properties [were] worth $2 billion [in 1984], so the person who would have paid $400 million would not have been crazy.

What’s the social function of Warren Buffett's style of value investing? It saves worthy, established companies from being unfairly shorted below a base sanity valuation.

Consider that large companies have more employees, more customers, and more suppliers. Saving them is like stopping a large swath of forest from burning.

But for my personality type, I’m not as interested in big, publicly held companies. Maybe it’s unreasonable of me. But I am more for shorting the big dogs (the over-valued ones) and for longing the small guys (the ones that just need to be given a chance).

I think that’s more exciting and more interesting. Maybe it’s also more speculative; maybe you have less control over the risk.

(Source: amazon.com)




Antifragility

Nassim Taleb wants us all to go long vol — not just be able to withstand volatility, but to actively seek it out.

He can certainly bet that way (and does — though it’s not paying off), but it’s a bad idea to make society anti-fragile.

Let me define a few words describing potential responses to volatility:

  • fragile — Taleb means systems that break when catastrophic volatility is applied; he’s thinking of people who deep short volatility or at least indirectly bet on stability
  • robust — like a bridge, or an earthquake-resistant building: built to withstand shocks
  • agile — able to adapt to shocks
  • anti-fragile — shock-loving; shock-seeking; volatility-loving; risk-avid

Taleb points out that there is no word for "the opposite of fragile”; only for “not fragile”. True.

But we really shouldn’t try to make the system break in the case of no catastrophes. Imagine a bridge that shattered only-and-always, when no cars drove on it. Or a building that toppled only-and-always, when no earthquakes were shaking it. (Those would be anti-fragile things.)

It would be stupid to build things that way. Same with the financial system — we want to be prepared for bad times but also, ready to capitalise on good times. A mouse who’s so afraid of cats that it never goes to look for food, will die.

What makes anti-fragility an especially bad idea in finance, is that people might try to sabotage, tweak, or influence the system to make their bet pay off. Let’s say some powerful crook is long volatility — that is, s/he will only get paid if some huge catastrophe happens within the next year. Maybe s/he will engineer a catastrophe. That could be truly terrible.

UPDATE: @nntaleb has clarified on twitter that he does intend “antifragility” to mean “long gamma”.

UPDATE 2: Jared (@condoroptions) suggests at minute 30 of this Volatility View podcast that @nntaleb must mean long convexity, not long gamma. I interpret that to mean buying stability, selling normal levels of volatility, and buying extreme levels of volatility. In other words things will usually stay the same, but when they change they’ll change more than people expect.
That answers the finance part. I still don’t see how to practically design real things to be antifragile without giving up normal functionality under typical circumstances.





Volatility

Volatility, in finance, refers to the wiggliness of the time series. You observe the price of a security go up and down over time. If it changes a lot, that’s high vol: unstable, unpredictable. If it changes only a little, that’s low vol: stable, consistent.
There are many ways to define volatility, just as there are different ways to measure distance. Portfolio variation should be measured with a quasimetric (unidirectional metric).
But for all those definitions, it should mean roughly: the magnitude of change in the price, during some time interval.

Volatility

Volatility, in finance, refers to the wiggliness of the time series. You observe the price of a security go up and down over time. If it changes a lot, that’s high vol: unstable, unpredictable. If it changes only a little, that’s low vol: stable, consistent.

There are many ways to define volatility, just as there are different ways to measure distance. Portfolio variation should be measured with a quasimetric (unidirectional metric).

But for all those definitions, it should mean roughly: the magnitude of change in the price, during some time interval.


hi-res




The point of high-frequency trading is to smooth markets over time.

Imagine that you know a big block order is coming in. Some huge pension fund needs to send 70,000 checks out next week so they’re selling some asset.

The asset’s price doesn’t really deserve to go down. The fund just wants to cash out. So you buy the huge block order and dole it out in smaller pieces as regular buy orders ebb in over the next few weeks. Or, you know, minutes.

You just smoothed the asset’s price, as well you should.

That’s not ultra-high-frequency trading — which is more about having the fastest technology — making it possible to liquidate a position RIGHT, RIGHT, RIGHT now.










[A] strong case can be made for the [random walk hypothesis]… This market view is supported by the fact that the vast majority of mutual funds fail to beat the broader market year after year, and history shows us that the ten best-performing funds in any one year will drop to the bottom of the pack in the following two to four years…. Simply put, there is no way to consistently beat the market.

Needless to say, this view of things does not sit well with Wall Street, which preaches that … relying on expertise are the keys to investing (and their business model!)….

[A]lthough the random walk theory paints a strong case against mutual funds, it is not entirely bullet-proof. Investors consistently fall prey to fear, envy, overconfidence, faddism, and other recognizably human imperfections that make markets not only inefficient but predictably inefficient…. If the DOW goes up one week, it is more likely to go up the next week. In the long run all of these moves smooth themselves out, but in the short run, predicting and trading these constant adjustments can actually make for quite a profitable proposition.

Agustin Silvani, Beat the Forex Dealer

What I’m hearing—not for the first time by a trader writing a book—is the implication that the way to consistently make money as a trader is to make the market more efficient, more stable.

If I were running a company based on this asset, I would be thanking the trader who stabilized my business decision. Is that what happens when these guys run longs and shorts all year long?







What’s the point of short-selling? To take money away from those who have too much.

US stock market capitalization is roughly $7 trillion. So all of those trillions of dollars are in public companies and not somewhere else. Maybe that’s not a good idea.

The whole point of finance in general is to make sure society’s money is going to the most worthy projects. In technical terms, to equalize the risk-adjusted marginal return on capital across projects.

(Of course, if “worthy” is measured solely in pecuniary return, then much is missed. That’s why economists want externalities to be priced into the market.)

Shorting a company is a vote against them. The CEO might say it’s mean, but maybe somebody else’s project is more worth funding than theirs. There’s only a finite amount of money after all, so companies have to share.

Imagine you’re building a super-awesome playground. That is definitely more important than having another Arby’s, Hilton, or article in USA Today. Short the hotel and long the playground.