Published March 1st, 2008
in Finance.
Unless you have been in a different planet, you know that the Dollar has declined in value against all major currencies in the world, even against the Israeli currency known as NIS (New Israeli Shekel). In January alone, the Dollar has declined about 7% in value against the Shekel. What followed after such a dramatic was the constant whining of money managers of how speculators have taken over the Israeli market and are doing as they wish. I would dare to speculate that the whiners have been on the loser side and have not hedged themselves against the rally down. It is always easier to blame some unknown cause at your loses than to admit that the only reason you did not hedge against such a decline was because you thought “Hey, it is so low now it certainly can’t get any lower!!”
Having examined the volume traded in the option market on the dollar/shekel, it was evident that the volume has more than doubled. What was more interesting is that more out of the money calls were been bought than out of the money puts. The distribution in normal times is usually 70% for out of the money calls and 30% for out of the money puts. In January it was about 85/15. One of the reasons in my opinion to such a result is due to the fact the as the Dollar started to decline, money managers (such as those who blame speculators) started buying out of the money calls thinking the Dollar would surely soon rally up. This has not happened though.
Conclusions
What can we conclude from this? Firstly, we can conclude that most experts don’t know what they are doing that’s for sure. The 7% fall in one month was not expected. A better way to react was to be more adaptive and not assume because you have not seen such low levels of the Dollar in 10 years that it can’t be happening and it should rise in value! That argument never works.
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Published September 15th, 2007
in Finance.
Happy new Jewish year!
I have come across a news article in Hebrew on some predictions of analysts to the upcoming year. As always it serves for good laughs and fun. As you already know, I consider those prediction to equivalent of witchcraft.
One Economist says that 2008 would be a very tough year because of the slow growth in the US economy and the sub-prime crisis. Classic after the fact analysis. Who ever heard about the sub-prime crisis before it happened?
Another Economist, called the “optimistic” one by the reporter, predicts that the local stock market would rise between 12%-17%. I have really no idea where these people get those numbers. It is pretty pretentious if you ask me.
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Published July 3rd, 2007
in Finance.
Is it possible to “capture” the expectations of investors? How is it even possible if each investor has his own expectation of where the price should be?
Some Background
Determining expectations when investing is important in order to price financial instruments. Take for example pricing an option with a strike of 100. If I expect that the stock would be at 110 in 1 month with 50% chance and 90 with 50% chance, how would I price the stock? We have a 50% chance of earning 10 and 50% of not earning nothing. This means that on average we would earn 5 and that should be a fair price of the option.
No arbitrage Principle
Each investor in the market has his own expectations like the one above. So how can we capture all of these? it turns out, quite remarkably, that in a complete market, there is one expectation that is true for all investors. That is quite a statement and it is difficult to explain without getting into more technical details. You could read about pricing an option to get an idea about it. The point here to remember is that we assume the market is complete. In a complete market, options can be perfectly replicated by a combination of stocks and bonds.
Risk Neutral Density
These probabilities as in the simple example of the 50-50 chance, are known as the Risk Neutral Density function. In the Black and Scholes world, the density is bell-shaped with known average and variance. The problem is that the Black and Scholes world is very simplified and does not fit empirical evidence. This leads us to try to find the “real” density function, assuming it exists and it is unique.
Implied Density Function
One way to find out the implied density function is to derive it from current option prices. That is why it is called implied. There have several methods proposed to find the implied density function. The big question is if it adds any new information we can’t derive from other methods? This question is complex and there has been a lot of research on the topic. If you believe that market is incomplete than finding the implied density function in theory does not tell you anything.
I’m currently working on this topic myself so I’ll write more about this in the next post. Don’t worry if you did not understand everything above. It takes time to assimilate.
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