Eric Falkenstein
Dec 23, 2015
Eric Falkenstein
Best way to find alpha currently, is to see what alpha was like in the past
Current alpha, as obvious as shown here, I, nor anyone else, would show you
Outsiders could not arbitrageBid-ask too largeNo way to see real-time prices
Barriers to entryEphemeralIn the early 80’s, pit traders could make
$100k+ arbitraging put-call parity
Call(strike=k) + K = Put(strike=k) + Stock
Since the payoffs are the same, the price must be the same. Thus, in terms of prices,
Call(strike=k) + K = Put(strike=k) + Stock
If C<P+S-K, buy C, sell restIf P<C+K-S: buy P, sell rest
Arbitrage: certain profit if held to maturity of call and put
Convexity adjustment to forwardsForward=e-rt(f-k)Futures=a*(f-k)f (forward) correlated with r (discount rate)Ho-Lee adjustment
2
1 1 90
2
2
0.009.0441 .0421 7 7.25
2
fwddaysfut fwd t t
5/1/2009 Futures Forward ConvBias6/17/2009 0.95 0.94 0.009/17/2009 1.01 1.01 0.00
12/17/2009 1.23 1.22 0.003/17/2010 1.34 1.34 0.006/17/2010 1.58 1.58 0.009/17/2010 1.84 1.83 0.01
12/17/2010 2.15 2.14 0.013/17/2011 2.40 2.38 0.026/17/2011 2.67 2.65 0.029/17/2011 2.91 2.88 0.03
12/17/2011 3.14 3.11 0.033/17/2012 3.30 3.25 0.046/17/2012 3.44 3.39 0.059/17/2012 3.56 3.50 0.06
12/17/2012 3.69 3.62 0.063/17/2013 3.74 3.67 0.076/17/2013 3.82 3.74 0.089/17/2013 3.90 3.81 0.09
12/17/2013 4.00 3.91 0.093/17/2014 4.04 3.94 0.106/17/2014 4.10 3.99 0.119/17/2014 4.18 4.05 0.13
12/17/2014 4.23 4.10 0.133/17/2015 4.25 4.11 0.146/17/2015 4.28 4.13 0.159/17/2015 4.32 4.16 0.16
12/17/2015 4.38 4.21 0.173/17/2016 4.39 4.21 0.186/17/2016 4.41 4.21 0.20
CB=Bond+option at stock price K-call by issuer at interest rate I
CB=Bond+Option100=8% Bond + 38% Vol Option=7%Bond +
45% vol OptionVolatility in option about 8% below ‘actual’
volatilitySpread about 50% above actual volatility
CFOs don’t mind selling options cheap
1994-03
AnnRet 10.3%
AnnStdev 4.5%
Sharpe 1.26
2003-08
AnnRet -7.8%
AnnStdev 12.6%
Sharpe -0.81
Good times, good times…Party over
Pair: Coke and PepsiGo long Coke if Pepsi goes up, but not CokePeople made millions, simple strategy ex post
Remove 1% in annual expenseDon’t alter gross expected returnLower volatilityGrowth to 20% of market: Index Mutual
Funds, ETFs, aboutLots of Alpha hereTough sell, though. Bogle had a tough time.
Generally, anything where you can measure inputs and define outputs, with enough data is done better by computersMarket makingUnderwriting credit
Example. FICO scoresDelinquencies, Past defaultsLength of credit historyAmounts owedLines outstanding
Take a half day to analyze
Create a database, create modelEasy to screw up
Ed Altman, Loan Pricing Corp, S&P not able to make a model though they had opportunity
Moody’s RiskCalc works, is profitable
Finance is about intermediation, savings to investors
Directing a set of savers, or investors, gives you power, responsibility, and thus value
Regular Business wilesHelpful, discrete, coalitions, competent,
energy, etc.Helps to know alpha, which is the final product
Value comes from Brand, reputation, connections, regulations,
scale efficiencies, scope efficiencies, an incurious or limited competence from customers, a secret process, inimitable excellence
Don’t ask someone you don’t know very well what their value-add is an expect an honest answer
In the standard model, risk taking in admired ex ante, not rationally regretted ex postExample: 50-50 chance to win $2 or lose $1When you lose, it is unfortunate, not stupid
In reality, risk taking is derided ex ante, embarrassing when it failsGo long banks in winter 2009Going long banks in summer 2008A ‘bad’ risk is merely considered foolish, not
‘risk’Ask a businessman their biggest risk: a
successful contrary bet
Market makers (traders)Provide liquidity, manage riskPrivileged access to stale retail trades
Long Term Capital ManagementTrading WizardsDumb relative value trades
Short US vol vs European volLong US Swap spreadsLong RussiaPairs (Shell vs Royal Dutch, VW)
James Cramer’s 90s hedge fundDeft trades based on fundamentalsTrading shenanigans
Asset Liability CommitteesManage yield curve exposureSmooth earnings
Bank Economists, Stock AnalystsProvide insight on future pricesGenerate trade ideas
KMV Default ModelPredict default with special sauceSpecial sauce: ketchup and mayonnaise
Easy to say you have alpha, because it presumes a risk adjustment no one agrees uponRisk is essential for defining alphaRisk is indefinableSay ‘you manage risk’ is like saying ‘I have
alpha’
Alpha often easy once you see itDon’t think an idea is too simple to be good
You can still screw it up when its thereWithin organizations
Need low-cost accessSome ideas only work at scale, or in
complementMost ephemeralBig Alpha hard to sell
Then: index fundsNow: beta arbitrage, MVPs
0IQ
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