November 2008


TGM

In my last post on this wonderful book , I will try to summarize the Credit products highlighted in the book.

Credit Risk is managed by Commercial Banks and Market Risk is managed by Ibanks. Ibanks are not comfortable holding stuff for a long time. However with the onset of credit wars, Ibanks Vs Commercial banks, it started the biggest party of the decade, the credit derivatives party.

What’s the real use of credit derivatives ? It is not to transfer risk , it is an instrument to free up capital. Total return swap by Bankers trust was the first taste of slew of derivative products to hit the market. First to default basked was picked up eagerly by all the investors. Slowly CDS market started to bloom. Initially there were a ton of difficulties in kickstarting CDS market. The problems were , firstly, CDS is like an insurance on the credit characteristics of the loan. There was a quite a lot of time spent on details such as whether making this asset a legal asset in the first place. The other problems associated with CDS was WHO and HOW ? Who was the reference entity in a CDS and How much would the payment be ? As products become exotic WHO and HOW questions became very very complicated to answer.

Securitization and Synthetic Securitization further complicated the situations. SPV, basically unregulated banks started mushrooming everywhere. BISTRO deal created by JPMorgan started the synthetic securitization game and a game that created the biggest mess of all times. Terms such as mezzanine investor, monoline insurers, rating agencies , SPVs , Credit correlations all started becoming a common vocabulary of everyday people. and then the party stopped and we are in 2008 ..

🙂 Today Wachovia declared a loss of 27 Billion dollars for a quarter!!!! .Wow!! that’s the magnitude of mess we are in!!

Anyways , this book has no doubt been one of the best books on Derivatives that I have read till date. The very fact that I have written 3 posts on the book means a lot to me!! I would treasure this book forever and read it once a while , not for anything else, but to laugh at the world of derivatives trading. Now, I need to get back to calibrate Heston stochastic volatility model !! After all I want to be a part of this entire troupe called quants…Will try to sit and calibrate stochastic vol model for now, but once in a while , will read this wonderful book to remind myself to take it easy and chill..After all its a drama out there!!

Link to my first 2 posts relating to this book :
Traders Guns & Money – Summary Part I
Traders Guns & Money – Summary Part II

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Continuing from the previous post on Traders Guns and Money, here is second part of the book summary!.

tgm1

 

Show me the Money :

MONEY

What’s this chapter about ?It is about profit and loss and how dicey things can get.

Profits in derivatives can be compared to Heisenberg uncertainty principle where basic matter behaves as a form of particle and wave, the experiment result depends on what is your initial assumption. Profits in derivatives behave in a similar way. There is accounting profit, there is trading profit and then there is THE PROFIT, which is the bonus that the trader gets at the end of the year. There can be three different numbers for the same time period for a trader. Profit process is a stochastic process I guess 🙂

Losses too behave in the same way. You can pretty much write down any asset at any value, this is especially true for exotic products!!

Overall the P&L of derivative trades can be made to appear in whatever way one wants it to be.

Risk Management : Voodoo:

rm

This is a topic which author freaks out as this area has been in the recent times come under tremendous criticism , be it from taleb, or other VAR critics…One can find a new meaning for VAR in this chapter..
Variable and wRong Yes , if one looks at the crisis that have hit in the past, one can say that the acronym is a very apt description . The following are the list of events which are supposed to happen once in 100 years…But they have happened in much lesser frequency :

  • 1987 Stock market crash
  • 1990 Junk bond crisis
  • 1991 Gulf war
  • 1994 Mexican crisis
  • 1997 Asian crisis
  • 1998 Russian Default
  • 1998 LTCM Default
  • 1999 Gold market
  • 2000 TMT stocks
  • 2001 Argentina default on debt
  • 2001 US Corp bond crisis
  • 2003/2004 Oil price increase
  • 2005 – GM Ford downgraded to Junk
  • 2007-2008 Credit crisis like never seen before!!

    Should one really believe in risk management !! after all this??

Super Models – Derivative Algorithms:

models

Like Super Models, Financial Models are idealized representations.
They are not real. They don’t quite work the way real world works

loss

Black Scholes Merton brought the glamor to the random world of trading. Introducing PDEs , GBMs , replicating arguments, diffusion principles, they glamorized finance. Even though BS never wanted to price an option in the first place, they were interested in pricing shares as a call option on asset value of the firm. However they ended up with a formula for a call option premium. However the biggest contribution from them is the replication argument. Greeks became the normal vocabulary of the traders. Models churn out greeks and traders hedge using the greeks and make money by either going short vol or long vol.

Math finance either in fixed income world or equities world has always found it difficult to prove its utility . Even though there were a lot of conveyor belts( MFE programs) , the supply far exceeded the real demand. The real demand is in valuing instruments fair value , but it is notoriously difficult. Learning GBM. PDEs , Finite difference does not mean that it would be useful in finance. All it says that if a model does not perform , one can speak in some math jargon what went wrong. There is reams of academic literature on option pricing, vol surface determination, American option pricing, etc etc…Think of it..with all these sophisticated techniques, we are in the worst of times … Recession, stock markets are screwed beyond shape, Large write downs, Defaults….Steven Shreve says, we need better financial engineering..Is it ? I don’t know…May be ..May be not…
Why have banks, hedge funds, prime brokers all become POW – Prisoners of Wall Street ? Why cant we just connect interest rate points with French curves rather than cubic spline, quartic spline all that math jazz ?

With all this math jazz, hedging is still extremely difficult. What happens to the underlying on the day of expiry ? Should you hedge or leave it ? Would you get gamma-ed ? No trader can provide consistent answers to this ? After spending one year in math fin , i feel there is more jazz than required to extract alpha..Or may be I am too naive to understand math fin contribution..

One thing is for sure, this book has made me more skeptical about modeling applied to finance!!

Inverse World of Structured Products:

str prod

This chapter talks about the big bad world of structured products, structured vehicles. It grew in to prominence as investors wanted better yield , dealers wanted better hedges, etc. However soon it became very commoditized when Triple Currency Bonds became the pool of assets in the structured vehicles. There have been umpteen blowups in the structured products business..Game continued till 2007-2008 when major blowups happened. and not Structured Product Vehicle is synonymous with bullshit , post credit crisis.

The last sections on the book talks about equity and credit derivatives. I have never written a three post summary for any book till date. This book deserves it as there are so many funny things mentioned in the book. For any financial engineer, this book is a reminder to take life easy 🙂 ..Afterall , it is an opera out there and you can act out your role and chill in life 🙂 Not to take one’s work seriously is perhaps the single most learning from this book , atleast if you are working in the financial services business!!

Would try to summarize the last portion of the book in my next post.

Link to : Traders Guns & Money – Summary Part I