Felix Salmon

A great post from Andrew Clavell today, which can be distilled down to one simple piece of advice: Just Say No to Derivatives. If you’re buying derivatives and you’re not a banker, or if you’re buying a derivatives product which was a banker’s idea and not your idea, then, well, you probably shouldn’t be.

Let’s assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.

The more complex the structured product, the more opportunity for agents to extract fees at your expense…

Admitting you don’t know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.

Still, the risk/reward profile of a particular structure might actually be useful to you, provided you are rewarded appropriately for the risk. Let’s use a CPDO as an example. There are always more efficient ways of assuming a similar risk profile than entering into a nicely packaged transaction – simply buying a solid vanilla floater and selling enough iTraxx/CDX OTC protection for your target yield enhancement would get you close enough not to worry much…

If this alternative is unavailable to you, for example, because your trustee documentation forbids trading derivatives, why on earth should it be OK for you to access those derivatives just becuse they were wrapped up in a funded structure with a pretty rating?

Clavell’s a former derivatives whizz: chances are, he knows what he’s talking about. Have you ever wondered how investment bank derivatives desks make so much money in a zero-sum game? It’s because, in Clavell’s words, they’re the Masterminds, and the buy side, in toto, is the Patsy. If you’re buying derivatives to hedge some risk, that’s great. If you’re using them as a profit center, not so much. Holger Härter, pay attention!

The markets don’t always make any sense, and this headline from Bloomberg gives a prime example:

Northern Rock Credit-Default Swaps Rise on Nationalization

Yes, in the wake of the news that the Northern Rock was going to be owned by the UK government with its risk-free credit rating, the price to protect against default on Rock bonds jumped to 295 basis points. To her credit, the reporter, Abigail Moses, didn’t even attempt to come up with some spurious ex-post reason why that should be the case.

Inevitably, the swaps have now tightened, as you’d expect, moving down to 160bp. But let this be a lesson to anybody who likes to look to market reaction to real-world events: sometimes the market is just plain wrong.

Michael Lewis gets his nerd on in the March issue of Portfolio, wading into the Taleb vs Black-Scholes debate. But he actually seems to go even further than Taleb. Think of three levels of skepticism when it comes to the option market:

1. The naive broker-dealer view: Black-Scholes enabled us to price options, and a large and efficient market is built on it.
2. The Taleb view: Bachelier-Thorp (which predates Black-Scholes) enabled us to trade options, and a large and efficient market is built on it, and Black-Scholes is irrelevant.
3. The Lewis view: Black-Scholes enabled us to price options, and a large market is built on it, and Black-Scholes is wrong, and so we’re all doomed.

Lewis blames a lot of things on Black-Scholes, including the housing bubble:

It wasn’t only big Wall Street firms, but a lot of small real estate speculators–otherwise known as homeowners–who, in effect, sold put options too cheaply against the risk of extreme, rare events. That many of these people literally live inside the investment that they’ve speculated on sharpens the pain but fails to drive home the point.

I’m not sure I follow this. In what sense is taking out a mortgage akin to selling a put option too cheaply? If anything, given the non-recourse nature of mortgages, it’s closer to buying a put than it is to selling one. And more generally, Lewis doesn’t persuade me that options prices in reality conform to Black-Scholes theory.

Lewis is right that if options were priced according to Black-Scholes, then we would all be doomed. But are they? Really? Taleb’s paper says that by "fudging and changing the tails and skewness by varying one parameter" in order to get Black-Scholes to accord with market reality, traders essentially render Black-Scholes moot anyway.

And personally I’m not worried about markets "for which there is no completely satisfactory pricing model," be they in options or anything else. After all, there’s no completely satisfactory pricing model for equities, either, and no one seems to be losing sleep over that.

Update: Taleb writes in the comments that "I fully agree with Michael Lewis". The idea I think is that without Black-Scholes we wouldn’t have portfolio theory, CAPM, or any of the other desiderata of financial markets which ultimately enabled the housing bubble to appear.