Fooled by Randomness

[syswizard]

he does point out that option sellers, like Neiderhoffer (who blew up in '97 because of the Asian financial crisis, and again in '07 because of this one), repeatedly blow up because they don't expect the unexpected, and trade that way, and that this is empirical proof that out of the money options are mispriced.

Options are never mispriced if there is a lot of liquidity (example: QQQQ) and let's not forget that old Vic had some tremendously profitable YEARS. In fact he was one of the top money managers around.
His undoing was his attitude: Instead of credit spreads, he insisted on going naked....and that killed him...twice. He was one cocky SOB...

 

[panzerman]

Quote from Martinghoul:

Let me give you a specific example: the Black Swan fund, named after Taleb's concept, made a lot of money last year by buying outstrike options. However, what do they say now? "36 South plans to close its Black Swan Fund within the next two months and return the money to investors as options are now “very expensive” and are unlikely to produce “significant returns,” Haworth said." So clearly any realistic investor or manager cannot just say "OTM options always cheap". They have to have a measure that can be used to determine what's cheap, what's expensive. Does NNT offer insight into how to formulate this measure? No... That's my problem with him. [/B]

But cheap and expensive are relative terms, not absolute. What's expensive can become more expensive, and what's cheap can become cheaper (bounded by zero of course.) So yes, using Black Swan, you always have to buy no matter the price, because you don't know when they may become more expensive. Trying to time volatility swings is just as difficult as timing swings in the underlying price.

 

[intradaybill]

Quote from syswizard:

Options are never mispriced if there is a lot of liquidity (example: QQQQ) and let's not forget that old Vic had some tremendously profitable YEARS. In fact he was one of the top money managers around.
His undoing was his attitude: Instead of credit spreads, he insisted on going naked....and that killed him...twice. He was one cocky SOB...

Well, there is a twist to this story that some market maker conspired to liquidate him by not pricing options fairly. I think he took them to court AFAIK and there may be a secret settlement we cannot know about. But this is speculation.

 

[Martinghoul]

Quote from panzerman:

But cheap and expensive are relative terms, not absolute. What's expensive can become more expensive, and what's cheap can become cheaper (bounded by zero of course.) So yes, using Black Swan, you always have to buy no matter the price, because you don't know when they may become more expensive. Trying to time volatility swings is just as difficult as timing swings in the underlying price.

Right... And have you actually considered what the performance of this strategy might look like?

 

[nelsanity]

Quote from Martinghoul:


Again, this to me is not necessarily a demonstration of the flaws in the model, but rather of how people misuse it. The basic idea of collateral, ISDA CSA etc is sound, at least just as sound as an idea of a central clearing cpty (e.g. an exchange). Problems start when people start abusing the idea. In the case of CDS and AIG, it's clear, for example, that tying collateral requirements to the counterparty's credit ratings can beget a negative feedback loop.

Yep I agree. In the case of AIG, both the company's own executive management, and the banks should have noticed and thought a couple things:
1) This is a giant insurance company which is & has to hold a massive bond portfolio. When credit ratings decline at least the company doesnt have to post cash because these are funded assets. Now they are further exposing themselves to credit risk by selling a ton of CDS, although these contracts are unfunded what happens if credit declines...Oh @#$$ ! Will we have the cash to post? hmmm..... Also, it's always a risk management decision to decide whether you think your counterparty will be able to post collateral if they end up on the losing end. Bank management had to assume government would step in on AIGs behalf, but that is an awefully big gamble because that decision may not be repeated next time. Once the US saddles itself down with as much debt as Japan has, maybe they won't be able to afford big bailouts again.

intradaybill - you are right, there is exchange risk if it cannot deliver the commodities promised. Exchanges can usually cover defaults by small brokers but when a bunch of big fish go down, it is very plausible that the exchange can fail. You see we actually agree

 

[Swan Noir]

Quote from dtrader98:



This is why, IMO, the famous quote, "markets can remain irrational longer than you can remain solvent," is so timeless and enduring.
Respectfully, dt

dt ... I would never disagree with the above axiom. It has survived the ages because it is rooted in reality.

Here's my contention: The markets had stopped being irrational by the summer of '08. Bear Sterns was toast. The credit crunch was upon us and Lehman was under pressure. Real Estate markets were not only collapsing in most of the country we were clearly in the first nationwide decline in 75+ years. In a handful of states the collapsing markets were in free fall and in some the percentage of closed housing deals that were foreclosures was exploding.

The markets had stopped holding up. The were all in downtrends that were obvious and quantifiable. It was not a situation where the markets were irrational in the face of facts. They had begun responding to general conditions months earlier and by the summer were in fact feeding upon themselves in ways that were easily observed.

I'm not suggesting that in the summer of '07 your comment about how long markets can remain irrational would not have rightly cautioned us to wait and see. Yet by August of '08 using that as a guiding principle was to ignore that those markets were acting perfectly rationally -- they were in strong trends to the downside and the reactions were no longer vibrant enough to discourage an astute observer from being more bearish than at any other time in the post WWII era.

 

[intradaybill]

Quote from nelsanity:

intradaybill - you are right, there is exchange risk if it cannot deliver the commodities promised. Exchanges can usually cover defaults by small brokers but when a bunch of big fish go down, it is very plausible that the exchange can fail. You see we actually agree

Yes, we agree, with one exemption: this has never happened in the past. I think exchange default is an extreme black swan nobody has made money from betting on it.

I repeat that I think the crisis had little to do with pricing. Pricing can be right or wrong and market forces correct it fast, very fact. It had to do with counterparty default, something that cannot be included in pricing. Thus, Taleb is barking up the wrong tree.

 

[Martinghoul]

Quote from Swan Noir:

dt ... I would never disagree with the above axiom. It has survived the ages because it is rooted in reality.

Here's my contention: The markets had stopped being irrational by the summer of '08. Bear Sterns was toast. The credit crunch was upon us and Lehman was under pressure. Real Estate markets were not only collapsing in most of the country we were clearly in the first nationwide decline in 75+ years. In a handful of states the collapsing markets were in free fall and in some the percentage of closed housing deals that were foreclosures was exploding.

The markets had stopped holding up. The were all in downtrends that were obvious and quantifiable. It was not a situation where the markets were irrational in the face of facts. They had begun responding to general conditions months earlier and by the summer were in fact feeding upon themselves in ways that were easily observed.

I'm not suggesting that in the summer of '07 your comment about how long markets can remain irrational would not have rightly cautioned us to wait and see. Yet by August of '08 using that as a guiding principle was to ignore that those markets were acting perfectly rationally -- they were in strong trends to the downside and the reactions were no longer vibrant enough to discourage an astute observer from being more bearish than at any other time in the post WWII era.

I agree with the axiom, but I disagree with you, Mr Black Swan...

Two points:
1) Everything seems more rational in hindsight than it appears contemporaneously.
2) Maybe stock mkts behaved rationally. However, other asset classes experienced all sorts of irrational behavior. Moreover, cross-asset correlations broke down completely.

 

[Martinghoul]

Quote from intradaybill:

Yes, we agree, with one exemption: this has never happened in the past. I think exchange default is an extreme black swan nobody has made money from betting on it.

I repeat that I think the crisis had little to do with pricing. Pricing can be right or wrong and market forces correct it fast, very fact. It had to do with counterparty default, something that cannot be included in pricing. Thus, Taleb is barking up the wrong tree.

Why can't counterparty default be incorporated in the pricing? Isn't that the whole purpose of pricing corp bonds?

 

[nutmeg]

Quote from Martinghoul:

Why can't counterparty default be incorporated in the pricing? Isn't that the whole purpose of pricing corp bonds?

I thought that is the way it was BUT the way I understand it, A contracts with B and prices accordingly BUT A then sells to C with B being unaware of the new sale.

A does not tell B it's obligation has been sold to C and C is not aware that the original counterparty is B.

From this point on B and C has been reduced to math and numbers, this is where the rating agencies came in.

comments?