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

Model Validation - Not Just for Quants

In an article recently published in the ERisk Monthly Newsletter, it is stated that model validation is not a purely quantitative endeavor. Below is a quote from the article.

Model validation is often thought of as a rather technical and mathematical exercise. However, bank losses from model risk are often caused by poor governance of the wider modeling process, or by a poor understanding of the assumptions and limitations surrounding the model results, rather than by errors in equations.

The growing importance of models in helping executives answer some of banking’s most critical questions – from compliance and capital adequacy to business performance and risk-adjusted compensation – suggests that model validation is too important to be narrowly defined or left to the “quants”.

For both best practice and regulatory compliance reasons, senior bank executives must begin to take a more commanding role in ensuring that model validation is aligned with the overall interests of the bank – and that the bank’s investment in sound risk modeling can be easily communicated and proved to third parties.

Tags: financial engineering derivatives model validation governance audit

Quant Cartoons

This cartoon was sent to me by Financial Engineering News. Enjoy!

FENtoon

Tags: financial engineering derivatives algorithms

Hedge Funds Semantics

Hedge funds are very risky investments. They invest in derivatives, employ unconventional trading strategies, and are usually greatly leveraged... All for the pursuit of extraordinary profits. A lot of hedge funds have come and gone and the survival rate is not encouraging. So why are they called "hedge" funds in the first place?

When we hear the word "hedge" we usually think of protection and safety. In finance, a hedge, usually in the form of derivatives, is used to protect an investment from loss. But it also limits the gains of the position as well. This makes potential earnings predictable and constant. Risk is eliminated since risk is defined as "uncertainty".

But looking at the hedging instrument individually, it is just as exposed to losses as other instruments. Moreover, derivatives are leveraged and losses are potentially greater than conventional assets. The hedge only takes shape if the hedging instrument is taken together with another position, and their reaction to changes in market factors should cancel each other out.

Hedge funds act in the same way. Taken alone, hedge funds are risky investments. But when combined with conventional funds, they can provide diversification benefits and even enhanced returns due unconventional strategies and assets employed. These unconventional strategies and assets result into low correlations with conventional funds.

I guess a lot of people assume that hedge funds are supposed to be safe investments because of the word "hedge". But if these funds are meant to safe in the first place, they should be called "hedged" funds instead.

Tags: finance derivatives hedge funds investments

An Option with a Negative Implied Volatility?

Previously, we talked about cases when an option will have a negative value. This time, it was asked in Wilmott if there are real-life cases where options have negative implied vols.

Here's my take on the subject matter:

Since implied volatilities are derived values, based on observed market parameters and a model or formula, it is indeed possible to have negative results. But does it make sense? Intuitively, we would think that the volatility measure should only be positive and it does not make sense if negative. I think negative implied vols are a result of either a misspecification in the model, or mispricing by the market (an arbitrage opportunity, as mutley pointed out).

Tags: finance derivatives options valuation volatility

Running Government Finances Like a Bank

Many investors are concerned about the increase in public debt of Asian countries since the Asian Financial Crisis. As justification, governments need to issue debt to support the financial markets, jump start the economy, and develop infrastructure, etc. Sovereigns with large outstanding debt are seen to be more credit risky and more more susceptible to something going wrong. Thus, the IMF issued guidelines on Public Debt Management (PDM).

In a nutshell PDM takes Asset-Liability Management best practice from banks and insurance companies and applies them in managing government debt. This makes sense since the biggest financial portfolio in a country is the government's finances anyway.

Governments should focus on ALM issues like liquidity and interest rate risk management. It should analyze the cost-benefit trade off of borrowing in the short term - which is cheap but risky and volatile, as opposed to borrowing long term - which is expensive but predictable. They should also focus on minimizing unhedged foreign exchange exposures, debt with embedded put options (unpredictable maturities), and implicit contingent liabilities.

Governments should also push for the development of their domestic currency capital markets. A developed capital market would mean that there are a lot of investors and variety of issued securities. Development of derivatives markets will also be beneficial as investors are more willing to take and hedge risks. A developed capital market will also allow the government to issue longer-dated debt since there are willing investors.

Having a large public debt portfolio is not such as bad thing as it can be a catalyst for economic growth. The key here is proper risk management. All they (governments) have to do is to look at what the banks and other financial institutions are doing.

Sources:

International Monetary Fund
Financial Engineering News

Tags: finance derivatives risk management alm government debt bonds capital markets

Do you use Bloomberg for Risk Measurement?

Bloomberg is holding a Market Risk Seminar this month. But before the details, here are my comments.

I've attended Bloomberg seminars before and there is usually a sales pitch somewhere. Looking at the event's lineup of speakers, 4 out of 5 speakers are from Bloomberg (an Algo risk solution is embedded in Bloomberg). Although the topics may sound relevant, they're just intro material to Bloomberg functionalities and add-on services. For those looking for risk management solutions for their organization and looking to comply with Basel II, Bloomberg will present itself as a viable option in this seminar. Bloomberg would more likely say: "Since you are already Bloomberg users, why not leverage on your subscription and use our built-in risk solutions (at an added cost of course)?"

Generally, practitioners I know would trust Bloomberg in a majority of the raw figures that they give out. But when it comes to calculations, some would take them with a grain of salt. Personally, I find the risk solutions of Bloomberg to be less than adequate for the following reasons:

• Limited instrument coverage
• Not flexible
• Lack of transparency (Black Box)

But of course, it would never hurt to sit in a Bloomberg seminar and learn best practice (if ever they are presented) and to discover some new things that our beloved system has to offer.

And now for the seminar details.

Topics:

• Importance of Market Risk Management
• Risk measures for fixed income securities and derivatives
• Reliable data for your risk management systems
• Market risk management in alignment with Basel Accord
• Algo Risk on Bloomberg - a pre-integrated, real time market risk solution

Speakers:

• Nestor A. Espenilla, Jr. - Deputy Governor, Bangko Sentral ng Pilipinas
• Seet Kok Leong - Head of Algo Risk (Asia Pacific), Algorithmics
• Jiten Bhanap - Product Specialist, Bloomberg L.P.
• Ivan Koh - Regional Data Solutions Manager, Bloomberg L.P.
• Neo Siang Noi - Trading Systems Sales Specialist, Bloomberg L.P.

Date:

15 August 2006

Venue:

Makati Shangri-la Manila, Ayala Avenue corner Makati Avenue, Makati City 1200, Philippines

Time:

9:30am - 2:00 pm

Registration:

BU on Bloomberg

email: awang@bloomberg.net

tel: +63 2 849 7100 loc. 4794

*Lunch will be served

Tags: finance derivatives market risk risk management bloomberg seminars courses

An Option with a Negative Value?

A recent post in the Wilmott forums asked "Can an option have a negative value?"

Conceptually, an option with a negative value does not make sense. A negative value means that the option seller (writer) pays the option buyer. This results into a "free lunch" as described by one of the posters (waiter222). The option buyer will always win out in this case. He can exercise and make money when "in-the-money". He also has an instant gain even when the option expires worthless due to the initial cash flow. Indeed it is unfair.

Mathematically, an option value cannot be less than zero as well. (Please correct me if I'm wrong). I've played with several scenarios using the Black-Scholes and Binomial methods and the least value of an option is zero ("worthless").

But it is possible for an option position (note that I'm talking about an option position) to have a negative value when doing mark-to-market valuation. Marking-to-market is getting the close out (unwind) value of the position. And it can result into a loss (negative value). Here's an example, an option writer sells an option for $5. After some time, the value of an option at the same strike and expiration date rises to $6. This could mean that the option is getting more "in-the-money" and the possibility of an exercise increases. This is bad news for the option seller. The value of his position is obtained by assuming an offsetting transaction (he buys an option at $6) . The net result is -$1.

The point that I'm getting at here is that is quite unthinkable to have negative option value. So far no one has disputed that fact. But depending on one's position (P&L standpoint), the treatment of that option can be negative or positive depending on whether you treat is as an asset or liability. Does this make sense?

Tags: finance derivatives options valuation

Brushing up on my math skills...

I'm somewhat amazed on how I got myself into the world of Financial Derivatives. I do not have a quantitative degree (I majored in Management Economics) and didn't pay much attention to my math and statistics classes in college. Yet I find financial markets (derivatives in particular) fascinating. And becoming knowledgeable in them actually gave me an edge in the industry.

Looking back, it seems that I chose the wrong college course. But my interest in the subject matter and the willingness to learn did not stop me from attaining my goal. Although not for quants, the CFA program gave me a good background on the financial markets in general; as well as valuation methods for plain vanilla derivatives.

I searched the net for papers. Marketing and research papers published by the big banks are of great help. Sites like DefaultRisk has loads of papers on Risk Management and Derivatives. But reading them is no simple feat as most of them are written by PhDs or PhD students. My lack of academic foundation in mathematics do get in the way, especially when I encounter a lot of greek symbols.

Finding like-minded individuals to discuss topics of interests and ask for advice also did a lot of good. I am an active member of Wilmott -- an online community of quants (Username: Jomni). At first, I was the one asking questions, and now I give answers and advice myself (on topics that are not mathematically deep).

I never stop reading. Part II of the PRMIA Professional Risk Managers' Handbook is a good refresher on quantitative finance topics. It covers Matrix Algebra, Differential and Integral Calculus, Probability, and Statistics. Other good books would be Hull's Options, Futures and Other Derivatives and Paul Wilmott on Quantitative Finance.

Tags: derivatives finance math quant books cfa