Spero Consulting

Posts Tagged ‘volatility’

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.

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 21^st cen­tury back to at least the 17^th 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.

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: