John Bender on Option Pricing

In the book Stock Market Wizards, author Jack Schwager interviewed a very intelligent options trader John Bender. I highly recommend you read the whole interview because it really explains some options concepts intuitively without the use of any math. Nonetheless, below are some very rich points that Bender makes on option pricing and risk taking. Sorry for the lengthy quotes, but reading them in their entirety paints the best picture (no one could really have explained skew or model fitting better).

On Random Walk Assumption of Black Scholes

Black Scholes assumes stocks follow a random walk, returns are normally distributed, which is not always a good model. John Bender gives an incredibly elegant counter to the random walk assumption by discussing how trading stops could actually accelerate the price movement of stocks and therefore make larger moves more probable than smaller moves. When reading this, I understood for the first time the overall beauty of 1x2 or 2x1 call spreads; you can also guess the reasons for skew in this passage. In the same way, if one were to bet against a cash merger (take the view that the merger would fall apart) via options, one could sell some put options near the current spot / deal price, but buy a higher quantity of downside put options which are more out of the money. News of a break-up of the deal would likely cause the stock to fall violently; hence, large movements are more likely than smaller movements in this case. Also, in the first paragraph, Bender discusses how stops might trigger a "slippery strike" effect; Paul Tudor Jones also spoke about his experience on the floor where he tried to force the price of a commodity through certain levels where there could be a lot of stop-loss orders.

"The best example I can think of involves the gold market rather than stocks. Back in 1993, after a thirteen-year slide, gold rebounded above the psychologically critical $400 level. A lot of the commodity trading advisors [money managers in the futures markets, called CTAs for short], who are mostly trend followers, jumped in on long side of gold, assuming that the long-term downtrend had been reversed. Most of these people use models that will stop out or reverse their long positions if prices go down by a certain amount. Because of the large number of CTAs in this trade and their stop-loss style of trading, I felt that a price decline could trigger a domino-effect selling wave. I knew from following these traders in the past that their stops were largely a function of market volatility. My perception was that if the market went back down to about the $390 level, their stops would start to get triggered, beginning a chain reaction.

I didn't want to sell the market at $405, which is where it was at the time, because there was still support at $400. I did, however, feel reasonably sure that there was almost no chance the market would trade down to $385 without setting off a huge calamity. Why? Because if the market traded to $385, you could be sure that the stops would have started to be triggered. And once the process was under way, it wasn't going to stop at $385. Therefore, you could afford to put on an option position that lost money if gold slowly traded down to $385-$390 and just sat there because it wasn't going to happen. Based on these expectations, I implemented a strategy that would lose if gold declined moderately and stayed there, but would make a lot of money if gold went down huge, and a little bit of money if gold prices held steady or went higher. As it turned out, Russia announced they were going to sell gold, and the market traded down gradually to $390 and then went almost immediately to $350 as each stop order kicked off the next stop order.

The Black-Scholes model doesn't make these types of distinctions. If gold is trading at $405, it assumes that the probability that it will be trading at $360 a month from now is tremendously smaller than the probability that it will be trading at $385. What I'm saying is that under the right circumstances, it might actually be more likely that gold will be trading at $360 than at $385. If my expectations, which assume nonrandom price behavior, are correct, it will imply profit opportunities because the market is pricing options on the assumption that price movements will be random."

On Fitting Prices to the Market

Sell-side bank traders can easily apply Bender's comments to their own lives. Most models will never be perfect, but in order to be prepared for client orders, flow desks and market makers continually "fit" their parameters to the market. Even if the pricing model is wrong/insufficient, one can still get the correct prices if one keeps tweaking inputs enough. As a result, it's important for one to know the short-comings in models and also if one parameter is compensating for another parameter in the pricing.

Schwager: Don't other firms such as Susquehanna [a company whose principal was interviewed in The New Market Wizards] also trade on models based on perceived mispricings implied by the standard Black-Scholes model?

Bender: When I was on the floor... I was typically trading on the other side of firms such as Susquehanna. They thought they had something special because they were using a pricing model that modified the Black-Scholes model. Basically, their modifications were trivial.

I call what they were doing TV set—type adjustments. Let's say I have an old-fashioned TV with an aerial. I turn it on, and the picture is not quite right. I know it's supposed to be Mickey Mouse, but one ear is fuzzy and he is a funny color green. What do I do? Do I sit down and calculate where my aerial should be relative to the location of the broadcast antenna? No, I don't do that. What I do is walk up to the TV, whack it a couple of times, and twist the aerial. What am I doing? I'm operating totally on feedback. I have never thought once about what is really going on. All I do is twist the aerial until the picture looks like what I think it should—until I see Mickey Mouse in all of his glory.

The market-making firms would make minor adjustments to the Black-Scholes model—the same way I twisted the aerial to get Mickey Mouse's skin color to be beige instead of green—until their model showed the same prices that were being traded on the floor. Then they would say, "Wow, we solved it; here is the model!" They would use this model to print out option price sheets and send in a bunch of kids, whom we called "sheet monkeys," to stand on the floor and make markets. But did they ever stop to think about what the right model would be instead of Black-Scholes?" No. They merely twisted the aerial on the TV set until the picture matched the picture on the floor.

This approach may be okay if you are a market maker and all you are trying to do is profit from the price spread between the bid and the offer rather than make statements about which options are fundamentally overpriced or underpriced. As a trader, however, I'm trying to put on positions that identify when the market is mispriced. I can't use a model like that. I need to figure out fundamentally what the real prices should be, not to re-create the prices on the floor.

Again, if you have the time, I would recommend you pick up a copy of the Stock Market Wizards book or try to find a copy of the interview.




Related Posts:
http://relavalue.blogspot.com/2013/12/investing-finance-book-recommendations.html

The "Starbucks Principle" - Size Matters

Once while chatting with a very knowledgeable commodities arbitrage trader (J.K.), I asked why he didn't  build up infrastructure to trade a certain type of arbitrage. He simply replied, "I follow the Starbucks principle; if I can make more money per hour working at Starbucks than implementing a trade, then it is probably not worth my time." Eventually, he pointed out that operationally he could not afford to spend 5 hours to book a trade. I thought it was quite an elegant and ironic thought; the lesson has nothing to do with Starbucks employees (who are overwhelming nice and diligent in brewing good coffee), but rather with balancing investment of time vs. the end return for any opportunity.

Let's apply the Starbucks principle to playing poker for a living. Say you are working as an engineer, but happen to be a decent poker player living close to a small-time casino. This casino runs only 1 game of poker, a $0.50 / $1.00 No Limit Hold'em game (small blind = $0.50, big blind = $1.00). You calculate that because you are relatively better than the other players, on average you can earn 20 times the big blind per hour after accounting for the rake (so your expected hourly profit = $20). Do you quit your high-tech job to go play poker full-time? Probably not, because although victory tastes so sweet, you are not earning enough to justify leaving your job. You could try driving to a bigger casino far away, but you might find yourself outplayed in the higher limit games.

Profitable real estate agents in New York City are experts on the Starbucks Principle. Usually an agent cares most about getting the deal done, and secondarily about finding the best price for the client. By convincing sellers to drop their prices or convincing buyers to give an initial bid at the ask price, they are able to complete a transaction faster with less energy. Then once a apartment is close to contract, the agent takes the unit off the market without shopping for a better price in order to focus on the next deal.

As a corollary to the Starbucks principle, you should seek out markets or opportunities which are deep and offer you the choice to scale up. Although sometimes there might be a simple mispriced trade with very high return / little risk, BUT the time required to negotiate, follow, and close out the transaction might not justify the end return or profit. Moreover, some successful managers run concentrated portfolios because they prefer to invest only in their 10 best ideas instead of suffering "diworsification" (Lynch, One Up on Wall Street). When selling short the Sterling in 1992 Black Wednesday, Soros was quoted as saying something along the lines of "if we are confident in our research, then how big can we get?" For Soros and a slew of other great risk takers, size matters.

Exotic Options & Shortcomings of Black-Scholes

A short introduction into exotic non-vanilla options as well as the weaknesses of Black-Scholes

Besides the plain vanilla options we can trade on E*Trade, there's in fact a whole universe of bespoke and exotic derivatives that are traded Over-The-Counter with sophisticated institutions. Here, we'll go through a few types of exotic options and then speak a little about where Black Scholes is insufficient.

Types of Exotic Options

1. Digital Options - Digital options are also known as “cash-or-nothing” options and pay a fixed amount if an option expires in the money or nothing if the option expires out of the money.
2. Quanto and Compo options - These reference options whose pay-off can be in a currency which is different from the underlying. A client may want exposure to a foreign underlying, but not want the exposure to the foreign exchange rate. In those scenarios, the client can trade an quanto option or swap, where the pay-off is only dependent on the underlying performance and not on the F/X.
3. Auto Callable Note - These structured products are issued to private banking clients and get automatically redeemed (“autocalled”) when the the underlying price crosses a pre-determined barrier. As a result, the maturity of the trade is not known because the product could be canceled at any date up to the maturity of the note.
4. Cliquet - Also known as a rachet option, a cliquet is a series of forward-starting at-the-money options where the strike is reset periodically.
5. Options on a basket - Instead of having a call on just one underlying, a client may have a view on a sector or group of companies and want to trade an option on a basket of stocks. Examples of these types of options would be a best-of call or worst-of put. The correlation between underlyings would impact the pricing; for example, a client can get cheaper bearish exposure by buying a worst-of put and would be long correlation through that structure.
6. Hybrids - These options combine equity and fixed income characteristics. For example, one can trade a hybrid SPX option which knock-outs if oil futures trade below a certain level.
7. And the list goes on...

Weakness of Black Scholes

Black-Scholes option pricing model assumes a few things about financial markets which do not fit reality: no gap risk, deterministic rates, deterministic dividends, deterministic volatility. With respect to gap risk, the model assumes that one can hedge stocks continuously and for any size. In reality, assets can gap or jump instead of trading continuously, thereby preventing a short option holder from effectively hedging with the underlying. Also, the Black-Scholes model assumes that interest rates and dividends are constant over the period of the option, but in reality, these parameters vary over time. The volatility of interest rates and dividends can significantly impact long-term option prices.  (For a discussion on tail volatility of long-term interest rates and its impact on equity options: http://relavalue.blogspot.com/2013/12/hyperinflation-other-tail-in-equity.html). Lastly, asset volatility is not constant as assumed by Black-Scholes. When a position will realize volatility impacts the profit and loss from that position since the gamma of an at-the-money option is greatest at maturity; hence, the specification that vanilla options are "path-dependent."

Option Pricing Models

A few models have attempted to resolve these shortcomings of Black-Scholes. Before the crash of 1987, most market participants assumed that the implied volatility was the same for options across different strikes and moneyness. However, repeated catastrophes verify that market crashes happen more frequently than predicted by a normal distribution of returns. This phenomenon is known as volatility skew or volatility smile. In the local volatility model, volatility is a function of terminal spot and time; therefore, this model tries to address the existence of volatility skew. Nonetheless, local volatility has shortcomings in pricing option payouts with multiple observations, such as cliquets. The Heston model is a stochastic volatility model where the volatility of assets are not deterministic, but rather random. After Heston, there are other models which address short-comings of Black-Scholes, to be followed up in future posts...

Gold - A Greater Fool Asset by Buffett

Warren Buffett gives a great illustration on the relative value of gold vs. real assets like equities and land.

Every year, Buffett publishes an annual report summarizing the performance of Berkshire Hathaway, while also giving some related insight on current investments. In 2011, he wrote an amazing piece on why gold is an overvalued asset, comparing the what you could buy in equities and real estate with the amount you pay for Gold.

http://www.berkshirehathaway.com/letters/2011ltr.pdf

"Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A. 

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?"

Let's also give some background on the topic. Buffett, is not just a great stock value investor, but also has a great macroeconomic sense (evidenced by past successful trades on the USD F/X). In the past, he has discussed the impact of future inflation, so he's not abhorring gold because he has a deflationary view on the US economy. He simply notes that if the 2011 value of all the gold in the world could buy you all US farmland and 16 Exxon, then it should seem obvious that gold is crazily overvalued. As you can imagine, I agree with Buffett opinion that gold is just a greater fool asset; it is only worth what others are willing to pay for it (think Tulip mania in 1600 Netherlands where one noble sold his mansion for 3 tulip bulbs). Now some will point out that gold has been a storage of value in society throughout the history of man; that it fulfills the rules of a storage of value because it's easily divisible and does not rust or break down. Seashells and rocks throughout mankind have had the same effect. But in terms of a real asset, gold does not produce anything valuable - farmland produces food and Exxon Mobil generates profits, which become dividends.

Before you look into shorting gold, keep in mind Buffett published the letter in 2011, so he basically called the top in Gold; since his annual letter, GLD has sold off roughly 30% or so. Meanwhile, a few notable fund managers have taken it in the chin with the move down in gold (*cough* John Paulson).

" Gold gets dug out of the ground, then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head"

Hyperinflation - The "Other" Tail in Equity Derivatives

Wikipedia defines hyperinflation as a situation "when a country experiences very high and usually accelerating rates of monetary and price inflation, causing the population to minimize their holdings of money." With Zimbabwe as a recent example, the idea of extreme inflation is not anything new. However, a few fund managers have put forth a novel means of expressing a view on long inflation through equity derivative products. In an interview from The Invisible Hands by Drobny, fund manager Jim Leitner describes implementing a view on hyperinflation by buying 10-year S&P500 10'000-Strike Calls. He draws upon Turkey as an example of a country where large rallies in the stock market correlated with periods of high inflation because equities acts like a "real asset" in many cases; to be precise, Leitner hypothesizes that high inflation causes high equity markets. To quote him: "The Turkish stock market (ISE 100) started at one in 1986. Today it is at 55,000. But if you chart that in real terms from 1988 to today, it's basically flat. THe ISE 100 with CPI subtracted out has not gone anywhere." In fact, the same happened in Zimbabwe as well as Israel in the late 1980s.

Comments

When pondering US inflation in the next 10 years [in the shower or while waiting for the subway], there some basic facts to consider:

1. The last few years of QE has given us a unnatural period of 0% US interest rates. We should not expect this type of environment can not continue indefinitely
2. In the late 1970s and early 1980s, the US did undergo a period of high interest rates (home mortgage interest rates in the U.S. reached 16.55% in 1981)

And then some aggressive opinions to consider:

1. The Fed taken very strong measures akin to almost manipulating certain segments of the bond market. These actions may result in extreme reactions.
2. As U.S. increases exponentially the amount it borrows each year, there will come a day when investors start to doubt the credit-worthiness of the US resulting in a sell-off of Treasuries and elevated inflation. 

At the end of the day, price determines if a trade is in fact interesting. Leitner mentioned that one could pay 14 basis points for 10-year 10'000 calls, which sounds like a very fair price to me. What's nice also about buying cheap options is that it doesn't require one to post collateral or use leverage (as opposed to selling options). Nonetheless, long-term options only trade Over-The-Counter, so then again one would have counterparty risk.

Rethinking Equity Volatility Skew

We can also discuss the converse of hyperinflation: is it valid for long-term index options (say 10y S&P500) to be pricing a downside skew (downside volatilities higher than upside volatilities)? One exotic trader (credit to M.C.) suggested that long-term skew existed simply because all traders are used to pricing a short-term skew. Short-term downside skew on indices makes a bit of sense, since in a sell-off, the correlation of the index increases, hence exacerbating the downside move; in general, indices slowly march up but can experience a violent move down. One-sided flow in index option markets also contribute to skew, since Insurance Companies and Pension funds tend to always buy downside puts for annuity programs, causing volatility to be bid up. But logically, you have to ask yourself, 10 years from now is it more likely for the S&P to be up 30% or down 30%? Is there more risk to the downside or to the upside?

The Wisdom (or Danger) of Crowds

As noted, at least 2 sources besides Leitner describe possible hyperinflation and to implement such a view via long-dated out of the money equity index call options. Hence, we could say that the cat is definitely out of the bag. (I will give Leitner credit for the idea because his interview was published first).

Artemis Capital Management also published in interesting research piece in 2012 detailing the same trade:

http://www.artemiscm.com/wp-content/uploads/2012/04/Artemis-Capital-Q12012_Volatility-at-Worlds-End1.pdf

In their article, Artemis took the extra step of discussing Central Banker's tendencies and hypothesizing that all central banks would do whatever it takes not to have deflation, regardless of the side effects.

Another mention of Leitner's trade came in an interview with Jamie Mai in Hedge Fund Market Wizards by Schwager. Mai's traded involved buying 10-year calls on the Dow Jones Industrial Index, which is not the best representation of the equity market since DJI is price-weighted (as opposed to S&P500 which is market-cap free-float weighted). By the way, Jamie Mai's interview was one of the best interviews in the book, there is some good discussion over the pricing of long-term options as well as a very interesting perspective of worst-of options.

Batali Hitler Quote Revisited

"This above all; to thine own self be true" 

2 years ago, Mario Batali made headlines by comparing bankers to Hitler or Stalin.

http://www.forbes.com/sites/jeffbercovici/2011/11/08/celebrity-chef-mario-batali-says-bankers-as-bad-as-hitler-stalin/

"I would have to say that who has had the largest effect on the whole planet without us really paying attention across the board and everywhere is the entire banking industry and their disregard for the people that they’re supposed to be working for….So the ways the bankers have kind of toppled the way money is distributed and taken most of it into their hands is as good as Stalin or Hitler and the evil guys…They’re not heroes, but they are people that had a really huge effect on the way the world is operating".

That set off a rash of negative reaction across the finance industry. The best I ever saw was a Bloomberg review titled "Et tu Brutu?" For those unfamiliar with Batali, he's an American chef best known for Italian themed restaurants; in New York, a few Batali strongholds include Del Posto, Casa Mono, Lupa, Babbo, and Otto (all located in Manhattan). In my naive opinion, all are simply average except for Babbo. Also, as of late, Batali has diluted his name about as much as Donald Trump when Trump started selling steaks. By dilution, I mean, he's everywhere; in Vegas, there are a few that use his name, which calls into question the quality of the restaurant.

In any case, after I heard the comments, I vowed never to visit a Batali restaurant again out of principle. Why? Because the man simply does not know at all what he's talking about! I tried to analyze his comments like I tried analyzing Captain Ahad in Moby Dick, but came to my null hypothesis that financiers and bankers have very little influence whatsoever. In fact, on could argue Mr. Batali made a Jersey Shore-quality comment (which so happened to offend a significant percentage of the hard-working folk in great city of New York City). 

Then earlier this month, I went to Babbo (after a 5-year hiatus) and found myself in a predicament because the food was actually very good. I tried to find errors with the service, the food, the atmosphere and couldn't really. Hence, it really asks the question on whether or not we should stay true to ourselves when presented with an attractive deal. If a salesperson would offend you, would you still buy a TV from him if only he was carrying a great TV at a reasonable price? I was torn. Then, I decided in the end that by going again, I would concede on the principle of dealing with offensive / clueless people, but be true to my inner value investor; in all, Babbo represents a great trade for me (I pay reasonable amount of money and receive high quality Italian food). In any case, there is no reason to hold my breath as the place is impossible to get a reservation to anyways.

World's most confusing advertisement

High Frequency Primer

For those who have been search far and away for some good introduction to high-frequency trading, here is something that you should read. It covers a wide array of topics and should help get you started in understanding the basics:

High Frequency Primer - Gomber Arndt et all

Hope you enjoy this delectable bed-time reading material. If you find this paper interesting, feel free to comment on any other topics you might want to hear about in the future...

Phil Galfond PLO Seminar

So shifting gears from investing, here's an interesting video about poker, written by none other than Phil Galfond, about an interesting variation of poker called Pot Limit Omaha (PLO). So far, this is head and shoulders above and beyond anything else written on the subject. In PLO, instead of having 2 hole cards like in No Limit, all players start out with 4 hole cards, but must use 2 of the 4 hole cards (so a board with 4 suited hearts would not complete a flush for you if you only held 1 heart in your hand). Among our friends, there's one guy (let's call him "Mr. Celtics") who really plays PLO at casinos, so in our home games, Mr. Celtics is more positive EV than Jaws in the 100 meter Freestyle event.

I don't know Phil personally or have ever played against him, but think he has always helpful insight on poker. In his ability to articulate clearly with a strong chain of logic, Galfond is similar to Warren Buffett or Peter Lynch; anyone can really follow why he advises a certain action in a certain situation. If you search his other videos on YouTube, you'll see in many situations he makes incredible calls because he's able to think through why his opponent would make a specific bet. He's also a pretty straight up guy, many times being open about trust in gambling. In one post, he alluded to the fact that most pro poker players you see on TV have less wealth than what you would think (which is confirmed by friends who have played professionally).

Onto the juicy analysis, throughout the video, Phil advocates "balance", a very elegant and rich word when it comes to poker. As a player, you want your opponents to be afraid that you are capable of making a wide range of plays and bluffs. Also, there is a good discussion on dangerous boards and hands which are can be dominated, hence resulting in winning small pots and losing huge ones (in trading lingo, "short tail" trades). Personally, I found it helped for my No Limit game.

Life Settlements Primer

Post-2008, there was in fact, a growing market for life settlement contracts. I met a guy (friend of a classmate) recently over dinner who worked in this field in the past. Here's a summary of what we chatted, a short primer on life settlements.

Life Settlement Instrument
An insurance policy, besides having the benefit of protecting loved ones from, is actual a tax-free means of transferring wealth from the insured to the beneficiaries. At the inception of the deal, an insurance company and the insured agree on a payment schedule of future insurance premiums as well as the death benefit paid out to beneficiaries. As long as the insured lives, he or she pays the death benefits, which actually will increase each year. Therefore, the contract is generally not so attractive to the insured.


Actuarial Science and Modeling Insurance Policies
Valuation can be based on an actuarial table, where the rows are patient ages, and the columns provide the probability of death within the next year. One other point is the use of a mortality multiplier. One could first model the relative mortality of an individual m(t) = a * m’(t), where m’(t) is the standard mortality function and a is the mortality multiplier. The lower the a, the healthier the person. Generally, a ranges from 60% to 250%.


Investment Strategies
There are many ways of strategies when investing in life settlements. Viatical Settlement refers to investing in very short-term policies. The return of these short-term policies are less, but the instruments are more liquid. On the other hand, one could extend the maturities of life settlement instruments, thus creating “longevity funds”; these funds are more volatile but have the largest potential for return. Afterwards, there are some strategies which straddle grey areas. For example, it is illegal to buy insurance on someone whom the investor does not have an interest in keeping alive; one can buy insurance on their parents, because generally people want their parents to be alive, but one cannot buy insurance on another person. Another strategy life settlement funds might pursue is to pay people to open life settlement policies with the aim of buying these policies.

To structure such a fund, all the money must be collected in the beginning. Part of the cash will be used to invest in policies, but part of the cash will be used to pay investors a steady dividend as well as paying the premiums.

Most arbitrages or market opportunities exist due to a forced seller. Here the forced seller is the insured; the rationale for the trade is that if the insured wants to cancel his policy, he or she could try to cancel with the original insurance company who underwrote the policy. However, the insurance companies would pay very little or give a very poor price to buy back the policy. As a result, the market developed as there was a need for liquidity and efficient pricing in a “secondary market” for insurance policies. The analogous illustration would be plane tickets: if people try to cancel their plane tickets, the airlines themselves would give very little refund. However, investors might want to buy plane tickets from people who would otherwise receive very little from the airlines if the investors felt there was a pay-off that provided a good return on the plane tickets.

Historically, investors and insurance companies had mispriced due to the fact that most people who take out huge insurance policies are wealthy and that wealthy people are in better health than normal people. Another example of a mispricing is when investors purchased insurance policies on AIDs victims. At inception of the trades, investors estimated that AIDs victims only had very little time to live and thus purchased policies on these patients. However, over time, new drugs were developed which prolonged the life of these AIDs victims, thus hurting the returns of investors.

Just as with other types of fund management, life settlement fund management requires ability to be liquid. One problem with life settlements is that the maturity is unknown, no one knows when the insured will pass away. Some funds actually suffered because they were short on cash, but still had to pay premiums; in that case, the investors might need to sell some of their investments. As with a lot of other derivative instruments, the short end (shorter maturities) is more liquid than the long end; we see this in equity option markets or in interest rate swap markets. Therefore, investors must balance return with liquidity constraints. It would be attractive to buy only long-term policies because they would provide the most potential, but if the investor needs cash, he or she will not be able to sell the long term life settlement instruments at a reasonable price if at all.

One nuance that some life settlement Portfolio Managers allude to is the existence of an implied government support of insurance underwriters and companies, a la “have you ever seen a government let an insurance company go bankrupt?” Market participants closely evaluate counterparty risk, and insurance companies are not considered risk-free counterparties, especially since the insurance company owes a large death benefit payment to insured people. So people should also take the potentially small probability of default by insurance underwriters into consideration. However, since insurance companies serve a purpose to society, governments may do their best to save failing insurance companies so that insured people still are able to get their death benefit. We saw this case with AIG especially: AIG Financial products was a division of AIG which underwrote insurance on risky mortgage securities and derivatives. When the 2008 financial crisis occurred, AIG Financial products suffered heavy losses and almost caused the parent company to go into bankruptcy, but the U.S. government bought a large stake in the company. This year, the government has exited completely out of its stake in AIG at a profit, allowing the company to increase its weight in equity indices like S&P500 and opening the path to a re-initiation of the dividend (famous hedge fund managers like Dan Loeb and Bruce Berkowitz predicted these developments). However, we should still assume that the government will classify AIG as “systemically important” (similar to banks which are too large to fail), and that insurance companies such as AIG, Prudential, and Metlife might be subject to increased regulation. With further regulation, we might even conclude that the business will become boring, rates of return and net income will become stable but lack growth, and equity volatility on these companies might be dampened.


Helpful Links (More Bedtime Reading)
http://insurancestudies.org/wp-content/uploads/2008/05/Brad.pdf
http://en.wikipedia.org/wiki/Life_settlement
http://www.quatloos.com/uconn_deloitte_life_settlements.pdf

Investing & Finance Book Recommendations (Episode 1)

Part of growing as an investor is learning, speaking to others, and reading on your own. With the internet being a sea of information, I've tried to put a definite list of good reading material and certainly welcome your feedback. More updates on this list (hence the Episode 1).

Derivatives

If you still have your TI-83+ and can still integrate trigonometric functions, you might enjoy these reads.

• Option Volatility & Pricing by Sheldon Natenberg
• This is the gold standard of all finance text because Natenberg details options trading from the view of a practitioner, which is much more important than being able to memorize stochastic formulas. There no book that is equal in richness of practical information; besides, you little math to follow most of it. For example, there is a good illustration of dynamically delta-hedging an option to capture realized vol. Other topics include: option greeks, option spreads, path dependency, etc. Please note this book is already required reading for trader assistants during training at option market-making firms.

• Dynamic Hedging by Nassim Taleb
• Taleb is one arrogant dude who loves flooding his books with archaic words which were last employed in the English Language by Geoffrey Chauncer. But alas, Dynamic Hedging is a strong advanced text which goes through many nuanced topics. For example, he makes some good points on managing option greeks. Some chapters I really enjoyed: soft American options, discrete delta vs continuous delta, fungibility. Just a warning that you might have to read over sections multiple times before you digest ideas.

• The Eurodollar Futures and Options Handbook by Galen Burghardt
• The honorable mention and recommendation for aspiring rates traders. There is a good discussion on convexity adjustment of futures vs. interest rate swaps

Value Investing

Many people claim to be "value investors", but some of these pretenders are simply buying a broken company for cheaper than what the business was historically trading for. Imagine someone trying to sell you Detroit bonds, "If before you liked it up there, now you've love it down here!" (Citation: Y.W.). The books below are for the guys who want to avoid Detroit.

• The Essays of Warren Buffett by Laurence Cunningham

• Basically a collection of letters by Buffett where he shares his perspectives. He's very easy to understand and follow. His discussion on dividend policy and share buy-backs really left an impression for me, but there's a load of other subjects: conflicts of interests with management, acquisitions, etc. Also, let's not under-estimate that Buffett is an extremely talented manager (Berkshire Hathaway is basically the world's largest conglomerate), and we can all take a lesson from him on how he encourages his employees; you'll see a lot of "honest compliments" that Warren hand's out, similar to what is preached by Dale Carnegie.

• One Up on Wall Street by Peter Lynch
• This was the first book I read in college and luckily, it was also one of the best. Like Buffet, Peter Lynch is humble and a huge proponent of investing in what you know (i.e. "circle of competence"). There is a great section on financial statement analysis, what to look for on the balance sheet or income statements (I mean real financial statement analysis for evaluating companies, not what you are taught by college accounting professors). If you enjoy this one, there's a sequel Beating the Street, which is written in more of a journal format (the precursor to the modern day blog)

• Margin of Safety by Seth Klarman
• Klarman is probably the best fund manager that normal people have not heard of. Many of his themes are similar to Buffett (market is a voting machine in the short term, but a weighing machine in the long-term). One part of the book did a terrific job detailing the short-comings of EBITDA. While the book is out of print, you might be able to find .pdf versions.

Global Macro: 

• Inside the House of Money by Steven Drobny
• Great collection of interviews with many fund managers on various topics. I remember how most portfolio managers saw convergence trading / fixed income relative value as being short gamma. I sometimes re-read this book on a long plane ride and still learn something new every time. Drobny followed this one up with a sequel, The Invisible Hands, which is not as strong, but still somewhat intriguing.

General Trading

Throw-out your day-trading books please, usually, you should be reading or taking advice people who actually make money.

• Market Wizards Series by Jack Schwager
• Like Inside the House of Money, every time I read these books, I learn something new. There is a good balance between some technical topics (options) and risk management.

The Sam Bowie List

Allow me to humor you with some history: the 1984 NBA Draft turned out later to be one of the most prolific rookie classes (multiple Hall of Famers and future 1992 Dream Team members). 1st Overall was Akeem Olajuwon. The Portland Trail Blazers, in need of a rookie, used the second overall pick to draft Sam Bowie from University of Kentucky. Then, the Chicago Bulls used the 3rd overall pick to take a guard out of UNC by the name of Michael Jordan. 30 years later, ESPN is still laughing at the Trail Blazers for their decision (In Portland's defense, they drafted for need since they already had a young point guard Clyde Drexler).

So below are a few of the worst finance books ever published, analogous to draft busts:

• Options, Futures, and other Derivatives by John Hull
• You might as well be taking a calculus class if you use this text book. There are no good practical explanation or intuitions on certain formulas (not to mention that most of the models in that book are out-dated). Where's the juicy stuff? Where's the graphs which is worth more than 1000 words when discussing gamma? Really a very over-rated book.

• The Alpha Masters by Maneet Ahuja
• A generous 4-Stars on Amazon, so I have to give my perspective. The feel of the book is written by a first grader with almost no knowledge of finance or logic. Here's an example, author will state "Paulson entered in into X trade, because he thought that these securities are cheap". Then the next part will describe how much money Paulson makes on trade. Well, why is X cheap, was there some forced seller, what is Paulson's logic, what are the downsides, what are the upsides, did Paulson look at any alternative way to implement his views, what was the current environment? That is the tasty stuff, and it is nowhere in the book. Hence, the book does not serve the purpose of its title, which should be instead "Biography of Fund Managers for Kindergarten Reading." 

Any book about Warren Buffet which is not the one mentioned above is basically a waste of paper. I am ashamed to say I have already been arbitraged many times when purchasing a Warren Buffett book at the airport right before a flight, so do not make the same mistake as me. Buffett himself is so skilled at presenting advanced topics so that even a child could understand, yet no other author possesses a great understanding of Buffett's though process (except for Cunningham who simply compiled Warren Buffett's own words).

Hope you enjoyed, more to come soon...