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Caesaria
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 4th, 2011, 5:53 pm

Lets say that I am Goldman Sachs, and you want to buy a variance swap on a November future for Crude. You have a business need for this swap, so how should I price the swap and sell it to you? Should I never sell it to you, since my model for Nov Crude is based on its implied vol curve and is susceptible to black swan events like the Middle East turmoil? Should I charge a really high premium from my fair value, since I am willing to bet that my hedge error would be contained in that range? Or should I worry about a super fat tailed event and just never make a market for it? If I charge a really high price, then someone else (say JP) will sell you this swap for cheaper and will take the risk of a 3 standard deviations event. Damn, so should I be competitive and take the risk and sell it within premium of a 2 STD event? Or should I get the regulator to not allow JP sell that swap to you, since I know that JP's model is undercharging and they are being irresponsible and could potentially screw up their shareholders in case of a rare event? The insurance (I consider derivatives to be insurance products in some sense) industry has been central to the protection of consumers, and for producers locking in profits and corporate management/planning for expansions. If derivatives that have business needs are not sold, then we would have to go back a few decades and since it would slow down the growth of many industries. So what should I do, should I wear my crown of thorns, and bear risks to encourage and promote growth while charging enough premium to know that I would "most likely" make a profit? Or should I say no to selling the derivative, since I want to protect my shareholders from the collapsing bridge? Or should I expand my trading desk to sell exotics for every type of underlying from technology to commodities to forex to other equities and sell exotics on all of them, so that my hedge errors on all those exotics comprise a classically diversified Markowitz portfolio? Or should I worry that in times of a bubble, all of my "diversified" assets will have positive correlation therefore breaking down the "diversification" relationship, and therefore busting up my entire trading desk? And all of the traders having their "call option" type bonuses do not get hurt, and only shareholders get hurt? What the hell do I do to help maintain a 21st century industry? Should I just accept that in our complex dynamic world, I have to come to terms with the fact that we go through boom and bust cycles that promote R&D for both the large customer who requires insurance and the underwriter? We learn from our mistakes don't we? We always recover, to an extent, from a bust right? Doesn't our mind work in a trial and error manner, then why wouldn't society? What should I do, should I sell you that Nov Crude Variance Swap?
Last edited by Caesaria on May 3rd, 2011, 10:00 pm, edited 1 time in total.
 
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Traden4Alpha
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 4th, 2011, 6:25 pm

There's at least two more strategies that let you safely sell the Nov Crude Variance Swap:1. Overhedge: Construct a conservative replication so that you make a profit on all high-N-sigma events (with N>3) and a bounded worst-case loss on the low-sigma events. The point is to hedge in a way that bounds the worst-case loss. You then charge an amount defined by the expected cost of the conservative replication + a share of reserves for the worst case loss + profit margin.2. Make a Market: Find someone who will be the counterparty to the swap and then broker the deal. The only tricky bit is a residual liability for counterparty risks and any interim hedging risks if you sell the swap now, hold the short side in inventory for a bit, and find a counterparty later.One side issue is that "insurance" may be the wrong way to look at these derivatives due to problems with the utility functions of financial derivatives versus traditional insurance contracts. In typical insurance, the covered event still has a strongly negative utility for the participants even if the insurance company provides indemnity. No one generally wants death, accidents, fires, floods, etc. even if they have insurance. Thus the insurance company is relatively safe from exploitation (with some exceptions such as arson and suicide). That residual negative utility condition is less assured in case like variance swaps, especially when one considers the total set of participant who might affect or be affected by crude oil price variance.
 
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crmorcom
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 4th, 2011, 6:26 pm

QuoteOriginally posted by: CaesariaLets say that I am Goldman Sachs, and you want to buy a variance swap on a November future for Crude. You have a business need for this swap, so how should I price the swap and sell it to you? Should I never sell it to you, since my model for Nov Crude is based on its implied vol curve and is susceptible to black swan events like the Middle East turmoil? Should I charge a really high premium from my fair value, since I am willing to bet that my hedge error would be contained in that range? Or should I worry about a super fat tailed event and just never make a market for it? If I charge a really high price, then someone else (say JP) will sell you this swap for cheaper and will take the risk of a 3 standard deviations event. Damn, so should I be competitive and take the risk and sell it within premium of a 2 STD event? Or should I get the regulator to not allow JP sell that swap to you, since I know that JP's model is undercharging and they are being irresponsible and could potentially screw up their shareholders in case of a rare event? The insurance industry has been central to the protection of consumers, and for producers locking in profits and corporate management/planning for expansions. If derivatives that have business needs are not sold, then we would have to go back a few decades and since it would slow down the growth of many industries. So what should I do, should I wear my crown of thorns, and bear risks to encourage and promote growth while charging enough premium to know that I would "most likely" make a profit? Or should I say no to selling the derivative, since I want to protect my shareholders from the collapsing bridge? Or should I expand my trading desk to sell exotics for every type of underlying from technology to commodities to forex to other equities and sell exotics on all of them, so that my hedge errors on all those exotics comprise a classically diversified Markowitz portfolio? Or should I worry that in times of a bubble, all of my "diversified" assets will have positive correlation therefore breaking down the "diversification" relationship, and therefore busting up my entire trading desk? And all of the traders having their "call option" type bonuses do not get hurt, and only shareholders get hurt? What the hell do I do to help maintain a 21st century industry? Should I just accept that in our complex dynamic world, I have to come to terms with the fact that we go through boom and bust cycles that promote R&D for both the large customer who requires insurance and the underwriter? We learn from our mistakes don't we? We always recover, to an extent, from a bust right? Doesn't our mind work in a trial and error manner, then why wouldn't society? What should I do, should I sell you that Nov Crude Variance Swap?If you use static hedges (vanilla options), you are OK wrt tail-events. Perhaps a variance swap was a bad example?In general, though, the problem is not the "black swan" events, per se, but that many models don't take account of extreme tails because it's mathematically inconvenient. So long as your model is reasonably well-specified, and so long as you are imaginative about how things could go wrong, then your hedges are going to be a) reasonably robust and b) you will have some idea of what your downside is when things blow up. You'll also have carefully thought out risk-limits so, even if you are wrong, you won't go up in flames.In fact, just like Goldman and several other thoughtful players did before the credit crisis, you would keep on selling those derivatives. If you thought the market was mispriced, you'd sell the derivative, pocket the spread, and pass on the risk to the market. You'd do this as much as you possibly could, but you'd make damn sure that you didn't have too much of the muck on your balance sheet. If you thought you understood the mispricing, you'd position yourself the other way; if you suspected you might not, you'd stay as lean as possible and try to make money market-making.That's how derivative markets have always worked and how it will always work - and this is true from before we had Black-Scholes. Black-Scholes just allowed participants to think that they could be more certain of the value of the contracts they were writing, because delta-hedging allows you to reduce the variance of your portfolio PL in theory.And Goldman is most definitely not bearing risks "to encourage and promote growth"! They are doing it to make a buck. GS is not in the business of maintaining an industry. The decision for regulators, from a classical economic perspective is more subtle. If they believe there is an externality - e.g. bail-out moral hazard or systemic counterparty risk - then they should try to fix it; otherwise, they should not. But that's a broader question.
 
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Caesaria
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 4th, 2011, 6:32 pm

fine, I was thinking any favorite exotic of yours, lets say a 6 month lease on a power plant. or a spark spread basis option. or a spark calendar spread locational option. How about we edit that to a Calendar Spread Variance Swap (of Nov-Dec) where the market for a CSO for Nov-Dec is fairly thin. Agreed that a plain Nov variance swap was a bad example. Or how about say a Nov-2*Dec+Jan Crude option... a butterfly option (expiry for Nov ofcourse). The point is not the exotic, but the imperfect hedge-ability of the exotic.
Last edited by Caesaria on May 3rd, 2011, 10:00 pm, edited 1 time in total.
 
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crmorcom
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 4th, 2011, 6:55 pm

QuoteOriginally posted by: Caesariafine, I was thinking any favorite exotic of yours, lets say a 6 month lease on a power plant. or a spark spread basis option. or a spark calendar spread locational option. How about we edit that to a Calendar Spread Variance Swap (of Nov-Dec) where the market for a CSO for Nov-Dec is fairly thin. Agreed that a plain Nov variance swap was a bad example. Or how about say a Nov-2*Dec+Jan Crude option... a butterfly option (expiry for Nov ofcourse). The point is not the exotic, but the imperfect hedge-ability of the exotic.Oh, no need to edit: the power options are quite difficult enough to hedge, already
 
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Caesaria
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 4th, 2011, 8:16 pm

QuoteOriginally posted by: crmorcomQuoteOriginally posted by: CaesariaAnd Goldman is most definitely not bearing risks "to encourage and promote growth"! They are doing it to make a buck. GS is not in the business of maintaining an industry. The decision for regulators, from a classical economic perspective is more subtle. I know, the post had many elements of sarcasm in it. Irrespective of whether it is greed that is in their best interest, we cannot deny that selling such power options are important for capital budgeting as well as increasing the number of players in such markets that results from budgeting, thereby increasing competition.
 
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Paul
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 4th, 2011, 8:30 pm

QuoteOriginally posted by: Caesaria Lets say that I am Goldman Sachs, and you want to buy a variance swap on a November future for Crude. You have a business need for this swap, ...What should I do, should I sell you that Nov Crude Variance Swap?Fantastic questions! The answer could consist of any or all of: Reduce volume, perhaps to zero; Statically hedge; Charge highest price you can get away with; Diversify; Make market in something as similar as possible; Play the odds, estimate standard deviations; Hope; Pray; Make sure your boss knows your concerns and ok's whatever you do. And probably many more. This is close to being the exact opposite of: Calibrate; Thereby prove mathematically there is zero risk; Trade as much as you can; Tell your boss how brilliant the model is.The former is safer. Far less likely to result in blow ups.The latter is likely to result in big bonuses for a while until blow up and bail out.One of my favourite quotations of Keynes is "It is better to fail conventially than to succeed unconventionally."P
 
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Caesaria
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 5th, 2011, 12:19 am

QuoteOriginally posted by: PaulQuoteOriginally posted by: Caesaria Lets say that I am Goldman Sachs, and you want to buy a variance swap on a November future for Crude. You have a business need for this swap, ...What should I do, should I sell you that Nov Crude Variance Swap?Fantastic questions! The answer could consist of any or all of: Reduce volume, perhaps to zero; Statically hedge; Charge highest price you can get away with; Diversify; Make market in something as similar as possible; Play the odds, estimate standard deviations; Hope; Pray; Make sure your boss knows your concerns and ok's whatever you do. And probably many more. ....One of my favourite quotations of Keynes is "It is better to fail conventially than to succeed unconventionally."PMy client needs 3000 lots of a Crack Spread Option (or as I mentioned below, you can make it as exotic as you want), I can't reduce the volume since thats what he wants! How do I statically hedge this option, I have no idea, do tell me! Charge the highest price I can get away with". Then there would be an offer war between me and JP! I'll keep offering it 1 cent lower than JP until I think that the risk is too much to handle, if JP gives up at a point where my premium for hedge error is a 1.5 STD (rather than a 2 STD), should I bail and let JP handle the risk for a 1.6 STD hedge error? Or should I still go the Commodity Regulators and complain about JP charging an unusually low price for the Derivative, how low is too low? I like the quotation of Keynes, so what he basically says is that "The brilliant guy sitting in his lab, waiting to overcharge for his derivatives and never getting any business is better off than a large investment bank who charges 'competitive' rates and makes money until a bust? Since in the end, both their total profits 'at some point' will a.s. hit 0. Only that the unconventional guy was paid by his shareholders and finally lost all their money. And the conventional guy never made any money in the first place? Really now, if we do not believe in calibration, how can there be a derivatives market? You can't even arrive at a fair value, unless you have a structural model for the underlying! Should there be a crackdown? Or any other viable ideas for making markets on exotics?
 
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Paul
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 5th, 2011, 6:19 am

I think you've got the conventional guy and the unconventional guy the wrong way around! The unconventional guy is the one not selling any derivatives! (At least that seems like an unconventional way to run a business to me!) And 'better' here can mean 'in the eyes of the world.' In other words the guy who does the conventional thing, i.e. sells whatever he can without worrying too much about value and consequences, will be perceived well by his colleagues. Whereas the person who advocates caution will be a pariah. I like your summary for a couple of reasons. One is that it is a very sophisticated list of problems, together with solutions, that reflect the real business of exotics. It's not a nerdy mathematical exposition. It's got to the heart of the matter succinctly.The other reason is very simply that absolutely nothing in what you say has anything to do with calibration! At the end of your latest post you pluck this out of thin air: "Really now, if we do not believe in calibration, how can there be a derivatives market?" It's a non sequitur. There's no business in the world in which calibration happens the way it does in finance. When a publisher sells a new book they certainly get some information about the market, but they don't curve fit according to the words used in the new book versus all the words used in other traded books and the prices of those books. The publisher does all the things you mention in your first post.You also say "You can't even arrive at a fair value, unless you have a structural model for the underlying!" I agree. I'm not at all advocating throwing away models, it's one of the things I do for a living! (Although I wouldn't use 'fair value' just 'value' maybe. Fair value has too much baggage.) Goal number one is that I just want people to understand what calibration means. P
 
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katastrofa
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 5th, 2011, 10:17 am

QuoteThere's no business in the world in which calibration happens the way it does in finance.Actually, the most popular band structure models in solid state physics (k.p, empirical tight-binding) are calibrated by, well, more or less sophisticated curve fitting.
 
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Caesaria
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 5th, 2011, 1:02 pm

QuoteOriginally posted by: PaulI like your summary for a couple of reasons. One is that it is a very sophisticated list of problems, together with solutions, that reflect the real business of exotics. It's not a nerdy mathematical exposition. It's got to the heart of the matter succinctly.The other reason is very simply that absolutely nothing in what you say has anything to do with calibration! At the end of your latest post you pluck this out of thin air: "Really now, if we do not believe in calibration, how can there be a derivatives market?" It's a non sequitur. PThanks, and I didn't pluck the calibration out of thin air. The fact that I claim that my premium for selling the exotic is based on a "1.5 STD Hedge Error", is arrived by calibrating some model for my underlying and then valuing the exotic and then seeing my hedge error STD. Infact I couldn't even arrive at this "premium" from a "value" for the exotic if I did not have a "model" for my underlying whose dynamics are implied from vanilla options (and/or historical data). To even arrive at this so called "highest price I can get away with", .i.e. "most competitive price I can get away with" for such exotic instruments you just need to have a calibrated model for your underlying. I think my answer to the exotics industry is the last paragraph of my first post. We can't stop the natural progression of group dynamics, we might just have to accept the reality of these cycles.Unless there is another answer.
Last edited by Caesaria on May 4th, 2011, 10:00 pm, edited 1 time in total.
 
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Traden4Alpha
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 5th, 2011, 1:44 pm

Two other solutions to the systemic risks:1. Limited Liability Instruments: Most traditional insurance companies have a maximum pay-out or level of coverage on their policies. The same could be applied to exotics contracts. Even if the variance of the underlying grows without bounds, the payment of the contract should (and does) have a maximum. This protects the instrument buyer to some level, but it's never unbounded. One might argue that we've always had limited liability in the modern era due to bankruptcy laws and other legal mechanisms. But these limits were always associated with catastrophic failure. Perhaps the solution is to make these liability limits explicit so they can be managed.2. Capital Structure Requirements: If GS or JP wish to hold risky exotics, perhaps they should do so only with equity backing and not with depositor's or bondholder's money. The key to avoiding dangerous cycles is in managing some separation between risk-tolerant and risk-intolerant portions of the financial system. If a risky start-up fails, as 90% of them do, the economy doesn't falter. How does one make it so that GS can fail and the economy doesn't falter. If one company takes on exposure to some level of loss, the backers of that company need to be able tolerate their share of that level of loss. GS et al could still use leverage, but only in the context of limited liability exotics.
 
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crmorcom
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 5th, 2011, 2:07 pm

QuoteOriginally posted by: Traden4AlphaTwo other solutions to the systemic risks:1. Limited Liability Instruments: Most traditional insurance companies have a maximum pay-out or level of coverage on their policies. The same could be applied to exotics contracts. Even if the variance of the underlying grows without bounds, the payment of the contract should (and does) have a maximum. This protects the instrument buyer to some level, but it's never unbounded. One might argue that we've always had limited liability in the modern era due to bankruptcy laws and other legal mechanisms. But these limits were always associated with catastrophic failure. Perhaps the solution is to make these liability limits explicit so they can be managed.As a pair of individual counterparties, this is quite easy to do. If you are an external body (a.k.a. regulator) which doesn't examine and OK every single contract, this is very hard. You can easily rewrite contracts to increase the leverage changing the relationship between the notional and the payout variation. This way you can make some contracts which appear to be quite innocuous from a regulator standpoint suddenly become really quite toxic. An example of this would be Robert Citron's (Orange County) inverse turbo floaters. They looked like AA-rated floating rate bonds but, boy, were they not. If you have exchange-traded instruments that the regulator (or CCP) can understand, then your margin requirements have the same effect.Quote2. Capital Structure Requirements: If GS or JP wish to hold risky exotics, perhaps they should do so only with equity backing and not with depositor's or bondholder's money. The key to avoiding dangerous cycles is in managing some separation between risk-tolerant and risk-intolerant portions of the financial system. If a risky start-up fails, as 90% of them do, the economy doesn't falter. How does one make it so that GS can fail and the economy doesn't falter. If one company takes on exposure to some level of loss, the backers of that company need to be able tolerate their share of that level of loss. GS et al could still use leverage, but only in the context of limited liability exotics.Just requiring different capital structure still doesn't really get rid of the bail-out moral hazard, though requiring more equity does help. It only works if the regulator's threat to allow a company to fold and wipe-out equity holders and junior creditors is credible. If you are, say, JPM, I don't think this is the case: your balance sheet matters too much to the economy. Even equity holders are likely to take too much risk. The reason why risky start-ups failing is OK is not because they are financed with equity, but because they aren't systemically important.That being said, capital structure restrictions (equity, co-cos, etc.) is still an important part of a calorie-controlled diet; it's just not an answer on its own.
 
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katastrofa
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 5th, 2011, 2:11 pm

QuoteOriginally posted by: Traden4AlphaTwo other solutions to the systemic risks:1. Limited Liability Instruments: Most traditional insurance companies have a maximum pay-out or level of coverage on their policies. The same could be applied to exotics contracts. Even if the variance of the underlying grows without bounds, the payment of the contract should (and does) have a maximum. This protects the instrument buyer to some level, but it's never unbounded. One might argue that we've always had limited liability in the modern era due to bankruptcy laws and other legal mechanisms. But these limits were always associated with catastrophic failure. Perhaps the solution is to make these liability limits explicit so they can be managed.But the instruments on which banks lost so much money during the credit crunch (CDOs) were limited liability -- the most you could lose was the tranche notional. This didn't stop them from losing billions, because they were leveraged. The insurance industry not only caps the liability per notional, but also prevents leverage -- if I own a £200,000 house, I can't insure it for £1,000,000. In derivatives, I could insure a £50,000 maisonette for £500,000, no questions asked.Quote2. Capital Structure Requirements: If GS or JP wish to hold risky exotics, perhaps they should do so only with equity backing and not with depositor's or bondholder's money. The key to avoiding dangerous cycles is in managing some separation between risk-tolerant and risk-intolerant portions of the financial system. If a risky start-up fails, as 90% of them do, the economy doesn't falter. How does one make it so that GS can fail and the economy doesn't falter. If one company takes on exposure to some level of loss, the backers of that company need to be able tolerate their share of that level of loss. GS et al could still use leverage, but only in the context of limited liability exotics.http://www.gsb.stanford.edu/news/resear ... quity.html
 
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Traden4Alpha
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Given that calibration is nonsense, what is the solution to making markets on Exotics

May 5th, 2011, 2:42 pm

Good points, katastrofa.There's nothing wrong with banks losing billions as long as it's shareholders' money, not bond holders' or depositors' money. And the leverage problems weren't just at the banks. Home buyers over-leveraged, too. What's a mortgage with the <3% downpayment except a >33:1 leveraged purchase. Leveraged lender + leveraged borrower = disaster. The rule should be that if a bank wants to lend to a high-leverage home buyer, then the bank needs low leverage. And if a bank wants to be high-leverage, then it can only lend to low-leverage borrowers. Someone must hold enough equity in reserve to buffer the volatility. In the recent crisis, we had no one holding sufficient reserves.One sticky challenge is making sure that financial firms' assets and liabilities have the right correlation. With CDOs, banks owned covered calls in real estate. These positions lose value in times of volatility. If a bank sells variance swaps, it's liabilities increase in times of volatility. Not good!
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