Just How Vulnerable Is Asia To The Current US Sub-Prime Crisis?

If you ask Asian banks about their exposure to US Sub-Prime debt, they would probably say that the exposure is pretty small. In fact, Asian central banks also agree with this notion. Unlike some hedge funds with nearly 100% exposure to the sector, the percentage of exposure to US Sub-Prime trough CDO's are not significant enough to dent the bank's earnings and value. Income streams of these banks are diversified enough to absorb the shocks. But that's in the ideal world, where current correlations regimes stay constant.

But we all know that during a crisis situation, correlations can change, and a seemingly isolated case can evolve into a full blown crisis that affects everything. Now we don't know if the banks are thinking about this situation or not. But risk management best practice dictates that they should.

My QA = TA Post Sparked a Debate

I knew this was coming. Posting a link to my previous blog entry in a quants forum sparked a heated debate. See what very intelligent people has to say about the merits of quantitative analysis and technical analysis. Some even pointed out that TA has more realistic models than QA.

Link to the QA vs. TA thread

Tags: quant technical analysis wilmott

Quantitative Analysis = "Highly" Technical Analysis (?)

Branding Quantitative Analysis as "Technical Analysis" will probably bring in some violent reactions from quants. But I just want to point out the similarities that they share. In fact, it can be seen that Quantitative Analysis is a higher form of Technical Analysis.

Technical Analysis is commonly described as Charting. It is the study of charts (graphical representation of past price movements) and finding patterns in them. Investment decisions are then based on these patterns. People say this is superstition as price moves randomly and just forms these patterns by chance. Technical analysis also utilize quantitative techniques via Technical Indicators. Technical Indicators aren't just numbers, they are results of some statistical modelling. Indicators like MACD and Bollinger Bands are actually similar to statistical measures used by quants today (mean and standard deviation respectively). These measures are used for momentum and mean reversion strategies. Technical analysis also looks into other quantifiable variables found in the market like traded volume, open interest, bid ask spreads, etc. Technical analysis gives rise to automatic trading rules which is also done with quantitative analysis.

In the Jan/Feb 2007 Issue of CFA Magazine, there is an article ("Perpetual Motion by Susan Trammell, CFA") about a recent study on trends in quantitative investing. Below are some findings:

Phenomena Being Modeled:

• Fund Capacity: 20%
• Impact of Trades: 24%
• Textual Data: 2%
• Higher Moments: 2%
• Regime Shifts: 10%
• Volatility: 20%
• Extreme Events: 10%
• Momentum / Reversal: 31%
• Trends: 28%

Modeling Methodologies Used:

• Shrinkage / Averaging: 9%
• Regime Shifting: 4%
• Nonlinear: 7%
• Contegration: 7%
• Cash Flow: 17%
• Behavioral: 16%
• Momentum / Reversal: 28%
• Regression: 36%

As seen in the survey results, trends, momentum, and reversal models are quite popular in quantitative analysis. These are also the same phenomena being modeled by technical analysis but at a less "scientific" degree.

The relationship of Technical and Quantitative analysis can be likened to the relationship between Astrology and Astronomy. One is seen as superstition while the other as a science. Astrology came about due to the lack of sophisticated tools and theories. The same with Technical Analysis -- people relied on charts because it was easier to analyze than numbers. But in the advent of faster and more powerful computers, large amounts of numbers can be analyzed with ease.

To see the survey results, please refer to www.theintertekgroup.com.

Tags: financial engineering investments quant technical analysis

Doomsday!?

We've been hearing about several doomsday scenarios. The most relevant one we're hearing nowadays is Climate Change. But there are also people who speak about Financial Disaster and sites like Financial Armageddon is an example. Their concerns are plausible and worth thinking about.

Tags: books capital markets finance risk management

Losing Money When There is No Volatilty

It is common knowledge that there is more risk when there is more volatility. But it is also possible to lose (a lot of) money in the absence of volatility as well. This case was illustrated in a recent article published by Financial Engineering News. It was reported that Credit Suisse recently lost $120 million in Korean Derivatives -- particularly reverse convertible bonds.

A conventional convertible bond offers lower interest rates but gives the investors an option to call a company's stock. The bondholder is effectively the owner of the option and the issuer is the option writer. A reverse convertible bond gives investors higher interest rates but gives the issuer the right to put shares to the investor. In this case, the bondholder is the seller of the option and the issuer is the option buyer. When volatility increases, option prices increase as well. This added value stems from a higher possibility of going in-the-money. Conversely, a decrease in volatility will lower the option value. So if Credit Suisse was the one who "bought" the stock options via the reverse convertible structure, a decrease in volatility will decrease option value and will result into a mark-to-market loss on their end.

Now as market makers (structurers), shouldn't Credit Suisse be hedging their exposure? The problem with this particular structure is that the option is not based on one stock. It issued reverse convertibles on a number of shares. Hedging proved to be quite difficult and luck was not on their side, as stated in the article:

The problem however came in the hedging. Credit Suisse no longer had a single put option, nor did it have a portfolio of put options, since it could exercise its put into only one share. Instead it had an option on an option, a put option under which it could choose the share on which the option would be exercised. This instrument could be reasonably hedged by an appropriate portfolio of the shares provided volatility remained approximately constant, but it was effectively unhedgeable against a sharp change in volatility. If volatility in Korean shares had increased, there would be no problem; Credit Suisse’s multiple put option would be more valuable. There was, however, no effective way to hedge against a decline in volatility, which is what happened.

The lessons that we can learn here are the following:

1) You can lose when there is less volatility -- particularly in options since volatility is explicitly included in valuation.
2) When building a structure, one should know how to hedge it properly.

Tags: derivatives financial engineering investments valuation volatility structured products options

My Tip for CFA Candidates

This may be old but my quote was publised in the November 06 issue of CFA Advantage.
Hope you find it helpful and inspiring.

Tags: CFA