trinityw82y: Making Money Working

One of the most misleading myths about traders was repeated in this Atlantic article:

Now think of what a trader does. A trader's job is to be smarter than the market. He converts a mess of analysis and intuition into simple bets. He makes moves. If his predictions are better than everyone else's, he wins money; if not, he loses it.

The article is a hagiographic view of traders, like writing that politicians are the best-of-the-best, constantly working on how they can best advance social welfare by seeing win-win exchanges mere mortals cannot. If you are a trader, you might want to send it to your mom or girlfriend.

Traders supposedly described in the article are not like day traders, more like bookies who make money off the vig, and have little insight about 'true value' but usually a lot of franchise value in their brand or network of contacts, which is why they aren't as smart as they would be if they were simply price-taking market wizards Indeed, most of the first Market Wizards book naively conflated market making and speculating, but when the legend becomes folk wisdom, print the legend, because people obviously like comforting myths.

When traders buy and sell the same stuff right away, it's perfect, they make money without risk. When they have to inventory it, they need it hedged and they have to hope it was priced well, which shows up statistically in the inventory depreciation. Hedging is not insanely complicated for the risk factors you can hedge, and for those you can't you have understood limits (the Serenity Prayer is especially important).

Now for 'equity derivatives people', you have to take a collection of non-standard derivatives, price them, and add some profit to anticipate adverse selection and cover your fixed costs plus any transaction costs (eg, the cost of implementing necessary hedges). Consider the following equity derivative transaction described in the article:

"We want a monthly stream of 12% returns as long as price X stays above 95, a downside no greater than Y, and a coupon of 120% of the principal in the event that A, B, and C all happen on or before the close of trading on April 11th."

If you want a 12% return in this market, that's about 11% more than Libor. An 11% yield necessarily has about an 18% default rate in a risk neutral world assuming a 50% loss-in-event-of-default, higher if you believe in a risk premium. The structure he describes is like asking Match.com:

I want an easygoing hetero Jewish blonde, 36-26-36 (or better), 700+ Quantitative GRE, hilarious, symmetric face, caramel complexion, small nose who loves sex, second-hand cigar smoke, and homebrewing.

Equity derivative traders are constrained by simple present values, the expected value discounted by libor, applying probabilities from market prices for options and underlyings. This will be the lower bound to any price quoted to the buyer; they can't create 12% yields without massive downside any more than a pool of subprime loans can create a AAA security without massive subordinate tranches.

This post was published at the author's blog.

After weeks of fruitless negotiations on Republican ideas to cut federal spending and raise the legal debt ceiling, House Speaker John A. Boehner tonight called on President Obama to offer his plan.

Boehner told Bret Baier on Fox News Channel:

I think it is time for the president to put his plan on the table. Let the American people see just what the president is proposing. You can’t go out there and talk about some $4-trillion agreement to substantially change the fiscal situation here in Washington without any facts.

As both sides sought to insulate themselves politically by posturing through the media, the president appeared to raise the stakes of the debt deal talks by telling CBS News that he really couldn't guarantee that those important Social Security, veterans and other entitlement checks would go out after Aug. 2 if there's no agreement with those stubborn Republicans, who won't give ground on no tax increases.

Obama said: "I cannot guarantee that those checks go out on Aug. 3 if we haven’t resolved this issue because there may simply not be the money in the coffers to do it." (Note the wiggle word "may.")

Asked if he believed the president's check-withholding threat, Boehner said:

I don’t know what to believe. The Treasury secretary is going to have options in terms of who should be paid and who shouldn’t. Yes, there are some debts that have to be rolled over, but there is going to be money available on Aug. 3.

Boehner gave no indication of progress in today's round of talks with the White House. He added:

The big issue for today was Mr. Cantor and I, the majority leader of the House, really pressed the president for ‘Where is his plan?’ We have talked about a lot of possibilities. He and I had conversations for a couple weeks, but we have never really seen the whole plan and what they are really willing to do.
One of the problems we got into late last week, and it culminated on Saturday when I finally decided that working with them privately wasn’t working, is that they had some ideas but they never quite put them on paper.

They talk about making substantive reforms in the entitlement programs but never could quite get there. That and they were continuing to insist on us raising taxes.

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-- Andrew Malcolm

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Photo: Screen grab from Fox News, July 12.

trinityw82y

Monday, August 1, 2011

Making Money Working

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