Posts Tagged ‘volatility’
Volatility and Losses: No End in Sight
If you haven’t read it, For the Vix, 40 Looks Like It’s the New 20 in today’s The Wall Street Journal please know that is a decent column.
We particularly like the paragraph:
“Volatility may not return to its highs, but it isn’t clear when it will get back to normal, either. Volatility breeds fear, which breeds more volatility. There is still too much uncertainty about the losses lurking on bank balance sheets and about the depth and breadth of the current recession to inspire much calm.”
Now, the first sentence is true but says absolutely nothing. We’re not trying to ridicule Mark Gongloff the writer of the Ahead of the Tape column; instead, we empathize with the difficulty he faces writing about markets and uncertainty.
The notion of uncertainty about uncertainty–and the inability to measure it in a simple manner – tends to make statements about the topic either sound overly-complex and overly-qualified (by all of the necessary descriptive qualifications to the statement) or makes them sound trite. Sometimes that’s the writer’s fault, but often it is the reader’s fault, too, especially when the reader incorrectly possess no uncertainty about their own “knowledge.”)
Now, we especially like Mr. Gongloff’s following sentences because that’s almost exactly what we’ve written during the past several months – almost three months now.
The mortgage crisis that created the confidence and liquidity crisis and the resulting equity market volatility all continued unabated. Last Wednesday, in The Mortgage Crisis: Why Not Incentivize the Private Sector? we wrote: “By the way, folks who think this Thanksgiving week’s mini-rally signifies that the worst is over are likely to be sadly mistaken. We do hope that we’re wrong, but doubt it.”
While we try not to make much of one-day changes, even when they are as large as today’s drop of 680 points in the DJIA and the nearly 9% decreases in the S&P 500 and NASDAQ indices, we do believe both the continuing volatility and losses provide evidence that the government’s actions to date have not helped instill confidence. In all likelihood have hindered economy and financial activities by not allowing any resolution of the uncertainty of the value and viability of large financial intermediaries.
We wrote about that in Could a “Bailout” Prolong the Financial Crisis? and The Uncertain Value of Mortgage Securities (among other posts) in late September. However, the government’s execution and lack of planning has been even worse than we could have imagined, and we had extremely low expectations to begin with.
As we have been mentioning since that time, we wish federal government would provide tax incentives – say, mortgage investment tax credits – to motivate private purchases of troubled assets.
We also wish the government would expropriate the worst offenders – the most poorly capitalized large banks. We know that the Treasury can’t run banks any better than the existing managements, but that’s not one of our reasons. A main reason is to motivate other healthier institutions to act. Having ready buyers – motivated by such tax credits – would certainly help those banks exchange assets for cash, and that lack of trade keeps the analyses of each bank’s financial conditional needlessly opaque, and that’s (by definition) no way to resolve uncertainty.
We’re not sure when during the day, Mr. Paulson spoke of new programs (Paulson Says Treasury Actively Mulling New Rescue Programs), but we doubt if that stemmed the (ebbing) tide of sharply decreasing equity values. Unfortunately, there is no reason to expect any positive news any time soon.
Speculators, Hedge Funds and Lehman Brothers
We saw a headline yesterday (September 10) about plans in Congress to bail-out of the auto industry. We are formulating a post about it in the context of adult irresponsibility, which seems to be the defining characteristic of many (but not all) baby-boomers. However, we don’t have time for a long post like that one, but we do have a few brief observations about current events. Well, two briefs ones, and one longer one.
Speculators: First, in yesterday’s (September 10) The Wall Street Journal, we saw the title of an article, Report Faults Speculators for Volatility in Oil Prices. Now, we’re sure that in some sense, it is true, especially in the short-term, when there might be more daily fluctuations than without such speculation. We wonder, however, whether it is true in the long-term, i.e., without speculators – whatever they are – providing liquidity, would prices be as stable in the long-term?
However, we’re neither analyzing nor honestly debating the merits of “speculation” today. (As we have mentioned in the past, we like the John Maynard Keynes’ bubbles analogy on our quotes page.) Instead we ask a simple question about the title of the article. Would there ever be a published report that didn’t find fault with speculators, i.e., Report Credits Speculators with Providing Liquidity? No, we don’t think so, either, which give credence to the modern use of the term as a pejorative. In fact, a few months ago, we offered this definition of speculation.
Hedge Funds: Secondly, there is a short article, Hedge Funds Take Lumps Like Us, also in yesterday’s (September 10) The Wall Street Journal. On-line, the article is entitled, Market Perplexes Hedge Funds, Too.
For both versions, the second part of subtitle is …Big Cash Balances Signal Bullish Times Ahead.
We’re not so sure. It seems more likely that many funds are planning for (or have been warned of) massive withdrawals and redemptions in the coming months. We’ll see if our conjecture is correct by January.
We also like the phrase: “…that is hardly the goal of these investment vehicles, which seek positive returns, no matter the environment.” Now, this is a very small point, but how does that make them special or different than most anyone else?
Lehman: Finally, we’ll probably have more to say about this in the future, but should anyone but the most obtuse ‘quant’ be surprised that Lehman is having huge problems? We’re not, and we’re constructing our own Narrative Fallacy by the way. We recall having similar thoughts quite awhile back when we spoke with a Lehman ‘quant.’ After our conversation – being a country bumpkin in the wilds of Western Pennsylvania– we wondered whether three-card Monte dealers were still permitted on the streets of NYC. If so, we guessed that many such dealers took substantial sums off of at least a few of these quants. (We also sure that Lehman’s problems go far beyond obtuse quants.)
In one of his books, Taleb makes a nice point about two different guys observing an experiment. His story went something like this: what would each infer about a sequence of 100 flips of a “fair” coin if, say, 95 tosses came up heads. The first, who Taleb clearly does not like, takes the claim of “fair” at face value and remarks that such an outcome is highly improbable – calculating the probability to any desired degree of precision. The other, with whom Taleb sympathizes and who has with little or no statistical training, concludes that the coin isn’t fair (and only a sucker would assume that it is and carry on any type of analysis).
In that spirit, we offer another analogy of cluelessness. She doesn’t seem extremely quantitative, but she does teach high school calculus – maybe even an AP course. She is also the principal of a relatively expensive private school. She commented that her team’s tennis coach must be good because the team has been very successful. The school competes in the typical regional and state public school leagues (for small schools), and it faces few other privileged, private schools.
Now, here are two hypotheses that aren’t quite mutually exclusive but are close: (1) the team is successful because the coach is very talented, or (2) her team is comprised of middle-class, upper-middle-class, and wealthy girls, and many of those girls have been taking lessons for ten years or more, which provides a huge advantage over the team’s public school competition. To any reasonable person who ever played sports, especially something like tennis that requires extensive practice, which hypothesis seems more likely? An excellent coach, who uses the two-week preseason to turn the inexperienced into winners, or a coach who could be replaced by a mop given that the top girls have played their entire walking, lives.
Now, if the reader hasn’t played tennis and has no experience or frame of reference to evaluate the validity of the two (mostly competing) hypotheses, well, that’s kind of our point, too.
We don’t have a formal model, but it seems that Lehman’s attempts at vertical integration went the wrong way: not towards the markets (and towards liquidity), but away from the market towards illiquidity (and, in some ways, more intense – or at least less-diversified – speculation). From securitizing mortgages to originating mortgages to the speculating on pre-subdivision land development. (In other words from the 21st century back to at least the 17th century; we recall reading about a mad land rush in New England at some point in our colonial past.)
We’re not sure that we can formalize our argument, but we think it depends upon on learning specific things in specific environments that often require the actual first-hand experience or observations to mitigate risk (and reduce the probability of getting screwed). (And working as a trainee for two years before acquiring an MBA doesn’t qualify as “expertise.”)
Yeah, acquiring or possessing meta-knowledge isn’t as easy as the hubristic may believe. That is why there are often substantial benefits of decentralization – both within the economy and within firms, too.
So, while our argument is not complete it seems compelling.
Caveat Emptor
We recently met an individual who is working towards a PhD in mathematical finance. He had a masters degree in something technical, too, and if we recall correctly, has been in the PhD program for four years.
He wanted us to read his paper regarding the volatility of volatility. We didn’t have the time, but a quick skim revealed that it was suitably loaded with math and graphs — quite technical. 1
When individuals discuss volatility, they usually speak of one of two kinds: (1) historical or realized vol or (2) implied vol. Historical or realized vol is the measured randomness in a past sequence of observations of a particular variable.
Implied vol is an estimate of future randomness, and it is called “implied” because it is found by solving a model, which will have any number of assumptions and restrictions. For example, imagine a pricing model (a function) of, say, input five variables. 2 Now, imagine that one can observe the actual price and four of the five input variables. Then, under suitable conditions, one can solve for the fifth, possibly unknown, variable that is implied by the function or model.
If one is using the Black-Scholes option pricing model or one of its variants, then (usually) the price of the option is known, and four of the five input variables are known or can be independently estimated: (1) the exercise value of the underlying variable, (2) the current value of the underlying variable, (3) the time until expiration, and (4) the risk-free rate. Using the appropriate algorithm, one can then find the implied vol that sets the function equal to the observed option price.
All of that just to say that when folks are concerned about the vol-of-vol, it almost always involves options, and when people are concerned about options or instruments with embedded options, they almost always use Black-Scholes or some variant. So, Black-Scholes and vol-of-vol are kind of like bread and peanut butter. A lot things can be eaten with bread (Black-Scholes), but peanut butter (vol-of-vol) is used almost exclusively with bread (B-S). Of course, we know about peanut butter pie and crackers and celery, but it is a decent analogy, and we are always willing to hear of better ones.
So, what does all of this have to do with our new acquaintance? We asked him to describe the Black-Scholes model, which is like the bread of any vol sandwich. His reply: when he had left his country of birth — about six years ago — they did not have equity options; so, he didn’t really know it well enough to explain it to others. Not the answer that we sought. Morals: (1) make certain that you have the right person asking the right questions, and (2) thought before calculation is the preferred order for the two.
Footnotes:
- Now for those of you who are unaware or unconcerned about the volatility of volatility, it basically involves the randomness of the randomness of an underlying (random) variable. For some market variables, we may have periods of great variability interspersed with other periods of near certainty — little change from day-to-day. Our short-term measures of uncertainty — like, say, the standard deviation over thirty days — would then vary, too. ↩
- These five variables will determine the price or value. ↩
