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trading

I have the hammer

February 26, 2010 in Finance, Sports

Apologies for the slow posts… but the NYT explains:

Wall Street trading is often described as a blood sport. But inside the great investment houses, the sport of the moment is, of all things, curling — that oddball of the Olympics that is sort of like shuffleboard on ice.

This slow-poke game, which originated in 16th-century Scotland, has captivated the Type-A world of Wall Street almost by accident. CNBC, whose market chatter is the background music on trading floors, switches to curling from Vancouver shortly after the closing bell.

I thought I was the only one going curling-crazy, but it turns out all of Wall Street has spent the last couple weeks learning a new vocabulary (just call me “Skip”) and shouting at the TV. Whether or not everyone else has been honing their skills by playing shuffleboard, I don’t know… but my plan to open an NYC curling house/alley/place (?) just got a major boost.

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Another day, another article demonizing CDS

November 28, 2009 in Finance

Bloomberg has a new article up about how the CDS market is starting to crumble – the sort of piece that looks like it’s been sitting on a back burner waiting for an excuse to stoke the flames of derivative fear (thanks, Dubai!).

One of the article’s chief arguments is that “credit-default swaps tied to Thomson SA, the Paris-based owner of film processor Technicolor Inc., paid some holders 30 percent less than those with contracts expiring a day later.” First, however, a technicality – CDS can only expire on four days of the year: the 20th of March, June, September and December (the so-called “roll dates”). Thus, the description of contracts that expire “a day later” is inaccurate. This brings me to a key point: one of the nice things about (most) fixed income is that the terms are… well, fixed. Traders know in advance when a contract will terminate, as well as the quantity (or at least the terms) and timing of any future cashflows. Those definitions extend to procedures in the event of default.

The credit event in Thomson’s case was one of restructuring, the procedures for which were recently updated as part of ISDA’s new “small bang” European protocol. Naturally, in a restructuring event – the debate over whether it should even constitute an event will be left for another post – it may be tough to claim that insurance should pay out. On the one hand, the fixed income product that was being insured just had its terms adjusted (no longer fixed, no longer the same!). On the other hand, the present value of the cashflows should be unchanged which in theory would make investors indifferent (obviously, that’s not the case). Without a cessation of payments, it’s hard to claim that insurance should pay the balance. Therefore, rather than have all insurance contracts pay out uniformly for all referenced bonds, which would fail to capture the odd nature of the restructuring event, traders agreed to set up “buckets” which will each pay out a value deemed fair by market action. The buckets are divided by time to maturity; in Thomson’s case, there were multiple buckets including a 2.5 year bucket, a 5 year bucket, and a 7.5 year bucket. This way, debtholders could more accurately match their insurance claim to the affected bonds.

The crux of Bloomberg’s argument seems to be that a swap maturing on the last roll date of one bucket would pay differently than one maturing on the first roll date of the next bucket (note the semantics – none of this “maturing one day later” language). But under the terms of the protocol, which market participants ratified, that seems appropriate to me. Remember, fixed income means terms are defined in advance. If Thomson had bonds that matured one day before the restructuring was announced, then those bonds would pay out par while bonds maturing the next day would presumably have crashed on the revelation that there isn’t cash to pay them in full (remember, unlike CDS, bonds can and do mature on any day of the year). That actually just happened with the Nakheel December 2009 bonds, which were trading well above par before Dubai’s surprise announcement brought them back to the 70’s overnight. In sum, the fact that some fixed income instruments are treated differently than other is not alarming – maturity and seniority are prime components of the fixed income market and naturally force bonds into differently performing buckets on a daily basis.

So if we can’t fault CDS for the fact that one contract pays out differently than another, maybe we can find something to be upset about because the 2.5 year bucket recovered 30% more than the 5 year bucket (in CDS terms, recall that recovering more means the contract pays less: if a bond recovers its full value, the insurance would pay out nothing at all). But here’s a secret: the disparity arose because of problems in the underlying cash market, not the derivatives market! Okay, it’s not really a secret. Euroweek figured it out well before the auction even took place:

Most of Thomson’s deliverable obligations are thought to be complex private placements and little is known about their documentation. It is possible that none will be deemed eligible for delivery.

CDS payouts aren’t determined by a bunch of traders standing in a room shouting – they are set by the market-clearing price on bonds (“deliverable obligations”) that are submitted by CDS holders in return for insurance payouts. It’s a straightforward system: CDS buyers purchase bonds in the market, then give them to the CDS sellers in return for their par value. The net payment is therefore par less the bonds traded price, or recovery. If there are few bonds available, or little transparency or liquidity about those bonds, then their market price will fluctuate for technical reasons rather than fundamentals. This phenomenon can occur with any traded security: short squeezes are perhaps the most familiar example. That’s exactly what happened with Thomson – so few of the short-dated deliverables were available for public trading that the market clearing price was bid up extremely high. In the next bucket, bonds were more liquid and so reflected recovery more accurately.

Euroweek described it nicely (again, well before the auction even took place):

…it is very likely that there will be a shortage of deliverable obligations and a scramble to get hold of what is available. The consequent short squeeze will drive up prices and the recovery rate much higher than it would otherwise be — good news for protection sellers but bad news for the buyers. For example, the most likely and liquid deliverable obligation, according to Citigroup analysts, is the June 2012 revolver, which would fall in the 2-1/2 to five year maturity bucket. It has been pushed from a 40% price to 70% in recent days.

But the real difficulties lie in the 0 to 2-1/2 year bucket. Thomson, a French media firm, was a regular member of the main iTraxx Europe Index from series 1 to series 7 and was thus much referenced in index CDOs. There are a lot of single name hedges against the name with maturities between now and 2012, putting particular pressure on the 0 to 2-1/2 year bucket.

I’m still waiting for the article titled “CDS auction goes smoothly despite problems in bond market.”

To Bloomberg’s credit, there is a deserved debate over restructuring events and CDS more generally outside the Bang protocols (and even within them). Moreover, the Thomson example – though I disagree with the author’s specific points – is a good one for demonstrating how settling CDS remains a mystifying and seemingly arbitrary process. There is no doubt that further clarity is needed, for the benefit of all market participants. The rest of the article deals with the lack of transparency into what qualifies as a credit event and murkiness following that declaration. I have to point out that though the arguments there have merit, their very existence demonstrates that CDS by nature doesn’t force companies into default or anything along those lines – otherwise these arguments would be settled by a simple imperative to bankrupt the firm.

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Stock is more efficient than options are more efficient than stock

November 18, 2009 in Finance, Risk

There is a very interesting debate taking place on the profitability of options as opposed to the underlying stock. It originates in this post from Ultimi Barbarorum on options volume following the Palm/3Com announcement, and continues in the comments on Felix Salmon’s coverage of that post.

The crux of the argument is the spike in options volatility immediately preceding the merger announcement, which many took as a clear sign of insider trading. Baruch argues that options are notoriously volatile, so one spike is hardly a smoking gun, and I agree (see also: superstitions regarding trading on option expiration days). However, I echo Felix in noting that it’s very hard, therefore, to draw any conclusion about insider trading whatsoever. Baruch’s second point is that if it were insider trading, it was misguided – the insiders could have made more money and attracted far less attention by trading the underlying stock rather than the options. This is where the debate lies – and I confess up front that my immediate impulse was to say “that can’t be right.” In fact, it could be right, depending on your point of view.

(p.s. hats off to Baruch for introducing his post with “Before the Zero Hedge folks get the pitchforks out, let’s stop and think a bit.”)

Baruch writes:

Had someone concrete knowledge of the 3Com deal, it would be far more efficient to buy the stock. The most important of the “Greeks”, as options dudes call the panoply of statistics surrounding options, is “delta”, the rate of change in the value of the option relative to the value of the shares (it’s a function of volatility, time to expiry, a whole lot of stuff, don’t trouble your head), and this is always less than one. 3Com options buyers made far less money on the takeover by buying options than they would if they had bought the stock.

It will be instructive here to discuss delta – I know some of TGR’s readers are already familiar with concept, and I hope you will excuse this detour.

“Delta” is a mathematical (as opposed to financial!) derivative of the option formula, as described by Baruch – but it is easier to understand as a “hedge ratio.” It tells you how many shares of stock you need to hedge your exposure to an option (I’m going to assume from here on that we are discussing calls). To see why, run back to the math for one second and consider that delta is the amount that the price of the option will rise if the stock price goes up by $1 – ok, now ignore the math. If the option is way in the money and trades at its intrinsic value, then it will gain $1 for every $1 the stock rises – a delta of 1. It the option is at the money, then its as likely about whether it will ultimately pay off at all, and so it only gains $0.50 for every $1 the stock rises – a delta of .5. Thus, if you want to hedge your option exposure, you would short [delta] shares for every option you hold. Delta is always less than 1; no option will gain more than $1 for every $1 the stock price rises.

The key to this delta business is that as long as delta is less than 1, you need to short fewer shares than the amount you control via options in order to hedge your option exposure. Put another way, it takes more options than shares to create the same exposure (on a per-share basis) to the underlying stock. If the stock price moves up, the dollar gain from holding that stock will be greater than the dollar gain from the options, hence the argument that stocks are “far more efficient” than options.

The closing price for COMS on November 10th, the day before the option purchasing frenzy, was 5.41. The $5 November calls cost slightly more than their intrinsic value at $0.55, trading with a delta of 0.72. On November 12th, the stock closed at $7.46, representing a gain of $2.05, whereas the options finished at $2.50, gaining just $1.95. Share for share, the stock outperformed.

However, shares controlled is an poor metric for comparing investments. This is particularly true for options, where you may not know until the day they expire if you actually control those shares or not! Instead, for risk management purposes we think of the number of shares the position is likely to control, given the current state of the world: the probability-weighted number of shares. Unsurprisingly, it’s the same as the number of shares it takes to delta-hedge the position. From this observation, a nice property of delta is revealed: it may be roughly interpreted as the probability of an option finishing in the money.

The important philosophical point here is not to make the mistake of thinking that the number of options you buy is equal to the number of shares you own – that’s only true the day they mature in the money. To set up the same exposure in options as we have with shares, at the time of purchase, we need to buy a few extra options. Specifically, for the November calls with a delta of .72, we need 1/.72 or 1.39 options for every share. Run the numbers and you’ll see that this results in a final profit of $2.71 on the option side, vs $2.05 for the shares. If an insider bought options on a delta-adjusted share basis, he’d find the options more profitable than the stock.

(If you constantly adjust the number of options to correspond to the prevailing delta, you’ll wind up making $2.05 on your options – this process is called dynamic delta-hedging [that's a real aside for this post, because the discontinuity in COMS stock price would make the rebalancing futile].)

So, on the basis of shares-at-maturity, stock yielded a better dollar profit. On the basis of shares-at-trade, options would have been preferable. There’s an argument to be made that, as an insider, you know the options will finish in the money, so shares-at-maturity is the right way to consider it. But there’s a third exposure metric: capital at risk.

You can look at capital at risk as either 1) the maximum loss you could experience OR (if you’re an insider who knows the trade will be profitable) as the opportunity cost of capital. This is very straightforward to explain: those options only cost $0.55; the stock cost $5.41. The percentage gain on the options is 355%; for the stock it’s just 38%. If you consider your exposure in terms of dollars invested, rather than shares controlled, you’d find the options a far better bet: they cost almost 90% less than the stock but return nearly as much per contract! So for every dollar you could put into the stock, you could instead put into options and return 10x as much. Options, from this perspective, are far more effective.

So this all depends on how you look at your risk and exposure. Baruch assumes that his insiders want to control a certain number of shares, and from that perspective they should absolutely have transacted stock instead of options (assuming that, with their perfect knowledge, they skip over the delta-adjust share argument). Personally, I would look at it from a capital at risk perspective – if I’m willing to spend $5.41/share to make $2.05, why not put that to work in options and make $19.18?

It all depends on your perspective – both answers could be correct, given some set of portfolio constraints and different definitions of risk/exposure.

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More derivative witch hunts

November 17, 2009 in Finance

Going through the FT’s original post on exchange traded currency notes, I saw a couple of sentences that really bothered me. One thing we do not need right now are witch hunt statements without basis (a point especially compounded by the fact that the FT completely misunderstood how these products worked, even as they wrote a piece describing them):

First:

In quick conclusion, the ETCs appear to be another fine example of how exchange-traded products are mutating from their transparent replication-based beginnings into ever more complex instruments.

Granted, an ETC isn’t going to be as easy to understand as SPY. But that doesn’t mean it’s “out to get” investors. Remember when Seeking Alpha tried to help people lose money even faster with FAZ and FAS? Now those were truly frightening derivatives – leveraged, options and/or swaps based plays with complex end of day delta-balancing schemes. These ETC’s are nothing compared to that. In fact, they’re no more terrifyingly complex – and much less manipulable – than the commodity ETFs Alphaville covers so frequently. Yes, they’re the first currency ETFs (sorry, FT insists that it’s wrong to confuse these for ETFs, even though they don’t say why). Get over it.

Second:

The type of financial whizz-kidery that brought us CDOs, meanwhile, appears to be thriving well in ETFs.

I don’t even know where to start with this one. Maybe the author wrote this because the word “collateral” appears frequently in the prospectus. I wonder if it’s the same financial whizz-kidery that brought us secured loans and mortgages, too? What is this sentence doing here, besides making people associate these products with those that ruined the financial system? We’re talking about total return indices on the deepest, most liquid market in the world – not distressed CDO tranches.

Third (regarding Morgan Stanley, the derivative counterparty):

Morgan uses the proceeds it receives to hedge its total-return-swap exposure — but essentially can do whatever it pleases with the money.

What does this really mean? Morgan Stanley might be fooling investors, opting to take their cash elsewhere rather than hedging their exposures? Well in that case, Morgan Stanley is taking on currency risk equal and opposite to those investors; so it’s not exactly a free trade. One of two things must be true:

MS doesn’t want currency exposure. In this case, they have two options: they use the ETC proceeds to hedge their currency risk OR they “steal” the ETC proceeds and use cash from elsewhere to hedge the exposure. The economic outcome is identical.
MS wants currency exposure. Again, two options: they use the ETC proceeds to hedge their currency risk, after which they put on the desired currency exposure OR they “steal” the ETC proceeds and pray that the ETC investors in aggregate have taken the exact opposite viewpoint from the one MS wants to take. Since option two is extraordinarily unreasonable and volatile, there’s really only one option here: hedge the currency risk with the ETC proceeds.

Fourth:

Bank of New York Mellon has the responsibility of monitoring the eligibility of the collateral, but to all extents and purposes, from what we can make out, Morgan Stanley determines the valuation on a daily mark-to-market basis.

Another piece of conspiracy-bait. Fortunately, FT lays out what that collateral can consist of: “AA-rated G20 government bond, AAA-rated shares of government or treasury money market funds, AAA-rated supranational bonds, unsubordinated bonds issued by Ginnie Mae and any equity listed on ’specified indices’ anywhere in the world” (and I’m going to hazard that adding “anywhere in the world” is yet more bait, since the “specified indices” are major ones in developed economies). Let’s call it like it is: Morgan Stanley is not going to be able to make up their own arbitrary marks, thereby cheating the investor out of their collateral backing, on these deep and liquid securities. In any case, they are disincentivized to do so (as FT reveals in the next paragraph) by a set of over-collateralization rules.

Fifth:

As for the investor — remembering the products were launched as a response to investor demand for “secure, transparent and liquid currency package”– it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then) and downside scenarios that include credit-exposure to Morgan Stanley, covered by a claim on potentially illiquid securities, as valued by Morgan Stanley. Compulsory redemptions at inopportune moments due to a myriad of different triggers. And in the event of counterparty default, a position third-in-line for repayment.

Right off, the carry trade claim is simply wrong. Moreover, these are total return indices, so there ARE all the benefits of interest and dividends – they are just reinvested rather than distributed. The downside scenario is correct that this gives some credit exposure to MS, but the “potentially illiquid” line goes a little too far. I know that the prospectus says that these securities might not have a deep secondary market, because it has to, but in default they are extraordinarily liquid – they represent claims on FX derivatives! There’s no uncertainty about what they are worth in default.

Sixth:

ETF Securities’ ETCs are based on Morgan Stanley’s MSFX Total-Return Currency Indices. The way they achieve that performance, however, is not by replicating the components of those indices, but by taking out a total return swap with a counterparty that assures the performance of that index.

In ETF Securities’ case that counterparty happens to be Morgan Stanley (and only Morgan Stanley for the time being).

Again, misplaced suspicion. Here’s a scenario: to get exposure to the S&P 500 I can either 1) use cash to buy all 500 stocks and actively manage their exposure every day, making sure to reinvest dividends or 2) enter a total return swap which tracks the level of the actual S&P 500, plus dividends, perfectly. (There’s a third option, which is to buy SPY – effectively paying someone to do option one on my behalf.) Which one has a lesser chance of error? (Hint: it’s the swap.) Yes, a TRS is a derivative – but it’s not evil by that virtue. It’s exactly the same as a vanilla interest rate swap, the most liquid derivative in the world, only it reference the level of the S&P 500 instead of Libor. So let’s not get all suspicious of these crazy methods for replicating payoffs.

I’m not going to pretend that these ETCs are vanilla securities. They carry risks – perhaps large ones – and will likely experience liquidity difficulties until (and if) their market attracts traders, just like any security. No, I haven’t read the prospectus, and my comments are based purely on the FT post; moreover, my concern regards the FT’s attitude rather than the securities themselves. I can’t endorse any sort of derivative witch hunt of this sort – its unfounded, based if anything in popular fears that themselves were borne out of ignorance (on the part of both retail investors and institutions). It may be in journalistic vogue, but it’s hardly appropriate here.

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Because no one knows commodities like we do

September 22, 2009 in Finance, Internet

Why did a post up titled “How To Play Natural Gas With Small Cap Stocks” pop up in Silicon Alley Insider’s RSS feed? A little investigating (elementary, my dear Watson) shows that it’s actually from The Money Game – another blog under the Business Insider umbrella. The blogs themselves and current RSS feeds show no cross-posting; the only evidence remains in my Google Reader (which notoriously caches every post).

So what’s the deal – does SAI feel a need to comment on every hey-you-gotta-get-in-on-this bubble out there? Isn’t one enough?

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CDS Markets, briefly (or not so briefly)

July 15, 2009 in Finance

In response to Daniel Indiviglio’s call for “someone who understands the derivatives market,” I posted the following comment on the Atlantic Business blog – and I reprint it here not just because it turned out a surprisingly complete thought, but because I’m a glutton for blogging laziness:

The CDS market works similarly to any other market: traders announce prices (privately or otherwise) at which they are willing to trade, and if two traders’ levels agree, a trade may be executed. These levels may be informed by quantitative models, gut feelings, even sheer necessity – but the mechanism by which trades are conducted is quite straightforward: two CDS traders agree to a trade, at which time their respective firms enter a legally binding contract to exchange the necessary cashflows. That part takes place off the desk, however.

There are two predominant forces in the CDS markets – again, as with most markets – the “buy side” and the “sell side”. The buy side refers to those traders looking to place directional bets; they look to trade securities as advantageous prices, hold them for some time, and then sell them at a profit. The sell side, by contrast, is not interested in taking risk; it merely wants to service the buy side and be compensated for doing so. To accomplish this, sell side traders seek to simultaneously buy and sell the same security, capturing the difference in price for themselves and taking no exposure to the security in the process. The market dynamics arise out of this tension – buy side traders looking for “good” prices, and sell side traders seeking to capture a “bid ask” spread. Increasingly, however, sell side traders are starting to resemble the buy side as banks take on proprietary risk (evidenced most recently by Goldman Sachs).

It would appear that most of the regulatory concern with the CDS market is not about *how* contracts are traded, but rather the management of those contracts themselves. The CDS market is an “over the counter” (OTC) market, meaning transactions are executed between two consenting parties rather than via an anonymous exchange. In any OTC market, there is an advantage in being “the counter” – or the sell side. This is because the sell side 1) has an information asymmetry in that they see much more of the market than any individual buy side trader and 2) can adjust their price – even away from the “fundamentally correct” price – to take advantage of the supply or demand they perceive in the wider market. Thus, one of the first regulatory aims is increased price transparency.

A second concern is how each trader’s firm treats the contract after it has been traded. AIG was not required to post collateral on their sold CDS, and consequently was ruined when they discovered they had sold more contracts than they had collateral to back them. Lehman’s bankruptcy locked away funds owed to other firms, because they did not only have exposure to the firm they traded CDS *on*; they had exposure to the firm they traded *with* as well. The regulatory solution to the issue of counterparty risk is to create a CDS clearinghouse, which will standardize all collateral disputes and decrease counterparty risk throughout the market.

Finally, people are afraid that CDS are mathematically complex, difficult to price products – and to an extent they can be. Nonetheless, this fear arises with many derivatives, because they do not trade on an open market and do not represent “pure” parts of the capital structure (as if companies only issued simple stock and bonds in the first place). A response would be that having a mathematical grounding should actually increase people’s faith in receiving an honest price, for in the absence of a highly liquid market, how else can you determine whether a price is fair? Thinly traded stocks may jump tens of percents each day, because there is no price discovery mechanism – and without a grounding in transparent math, who can say what the proper level is? Unfortunately, many attempts to explain CDS veer into complex math simply because they can, not because they need to. CDOs, while more complex, have a similar problem (though I recently tried my hand here).

I believe that these three items: OTC, counterparties, and scary math have greatly contributed to the demonization of CDS contracts. As Petrobull stated, the incestuous nature of many trading desks and sometimes-difficult trading vocabulary only add to the confusion. Moreover, we have seen the concrete and disastrous toll that derivatives can have in AIG and Lehman, among others, cementing (or necessitating the invention of) the error of these market’s ways in our collective psychology.

Indiviglio was last seen on TGR here.

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Trading Twitter

June 24, 2009 in Finance

Bubble 2.0 datapoint of the day: StreamBase has announced that their CEP (complex event processing) software for algorithmic trading now supports Twitter.

One CIO admits in an otherwise Hallelujah-esque article that “traders he has spoken to haven’t yet jumped onto the Twitter bandwagon.” But here’s the clincher (emphasis mine):

A key benefit of Twitter is that it forces everyone to a 140-character limit for single tweets, therefore providing traders with a fast snippet of information rather than them having to sift through pages and pages of research, he points out.

“There’s a thousand web sites out there driving you to research,” [the CIO] says. “We’re not going to spend thousands looking at that information. Blogs might not have enough credibility to put dollars behind them. But a tweet is different. The value of Twitter is that if we can accept it’s a rumor mill, that will tell us where the fear driving the herd is going.”

Investment professionals don’t have time to spend on “research reports” and “data”, and bloggers can’t be trusted. But 10-word anonymous outbursts from across the globe — how could that go wrong?

On top of all this, I’m left wondering what information could possible come from Twitter that needs to be analyzed in real time. I will buy that real sentiment can be extracted from the service -but over a period measured in hours and days, not nanoseconds. The example actually being used is that when a bomb goes off, Twitter reports it first because “no one cares about the spelling.” But financial news typically isn’t like a bomb, unexpected but tangibly observable; instead, it’s disseminated via press release or announcement, and covered by (embargoed) streaming news services well before Twitter picks it up.

But I’m getting way ahead of myself, since all StreamBase’s software does is scan Twitter – it doesn’t perform any sort of semantic analysis at all.

Thus far, Twitter’s biggest contribution to the financial world (other than Libor tweets) is StockTwits, a site which has succeeded in moving the mindless drivel of the Google Finance boards into Real Time. Is StreamBase’s development going to be the straw that forces every desk to mandate twitter clients for traders?

I’m not holding my breath.

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Yet more reverse convertibles: positive sum games?

June 19, 2009 in Finance

Did Felix Salmon really just write this in defense of his reverse convertibles stance??

For one thing, stocks generally go up over time: they’re a positive-sum game.

…

Retail investors, as a rule, have no business buying instruments with limited upside but 100% downside — I’d even include individual bonds in that, despite the fact that they, like stocks, are a positive-sum game.

I am Jack’s stunned silence.

Felix’s post is an excellent overview of why reverse convertibles are a terrible investment. However it gives no backing to the argument they should be banned rather than avoided. In particular, I don’t follow this logic:

The problem with reverse converts isn’t that they’re too risky, it’s that they’re a transfer of wealth from the client to the broker. This is true in general whenever a stockbroker puts a client into an options trade: options, being derivatives, are a zero-sum game, and the options game is very profitable for the sell side. It’s simply a truism, then, to say that the buy side, in aggregate, loses money whenever it dips into the options market.

Why is it a problem if the transfer of wealth is from client to broker? Since when do people care (or, indeed, even know) whom they face on a trade? Moreover, options are more profitable for brokers simply because they are less liquid; they charge higher commissions, not because of any inherent security characteristic. Indeed, commissions are likely what the last “truism” is premised on, but that seems a stretch to me – like saying on aggregate, baseball fans lose because they buy tickets to watch their team play.

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Explaining MTM

April 17, 2009 in Finance

I really enjoyed a new post from Rortybomb that includes a great distillation of the mark to market debate:

So in the early 1990s, when I was in Junior High, there was a craze about collecting and trading baseball cards. Our classroom would have a corner during lunch where we’d all compare, with our binders and those 3×3 plastic containers for cards, who had what, and we’d trade back and forth accordingly. And of course we had our model, The Model, in fact, the Black-Scholes of our trading.

So while other kids were mowing lawns or delivering newspapers, I decided I was going to make my profit by arbitraging the volatile Frank Thomas rookie card market. I took a highly leveraged position in the Upper Deck Frank Thomas rookie card – I borrowed against future allowances, and bought several cards for $7 each from a kid who wanted to get out of collecting baseball cards in order to try hanging out with girls (loser!). Upper Deck is like the AAA of baseball cards. The guide said that these cards were worth $9. Buy at $7, sell at $9, instant money. My dad took me to the convention center, and I was all ready to make some cash money, when I found out that all the tables were only buying them for $5. Sensing my frustration (and also perhaps worried, since, like the FDIC or those with a savings account, he was providing all the leverage for me), he asked me, “wait, what are those cards worth again?”

I answered that they are worth $9. That’s what the guide, my model, says they are worth. No doubt those guide values are created by the most brilliant minds available. My dad, not in business or finance, was very clear in trying to explain to me “no son, they are only worth what someone is willing to pay you for them.” I responded that this card convention center was completely wrong in how they were valuing my baseball cards. I was but a little financial engineer back then; now I would have know to say “Dad, clearly the Soxs are having a bad season, and/or this isn’t the time in the year-long sporting cycle when demand is reasonable for baseball cards. I don’t feel I should get punished for the normal ups-and-downs of the baseball cycle.” I may have also noted that the flood of crap Fleer-brand baseball cards, the Mortgage Backed Security of its day, was destroying liquidity in the market, but that I had the trust of then Treasury Secretary Brady to start buying up those crappy baseball cards and get them transferred onto the government’s balance sheet.

So who was right? Me, with the model of the Baseball Collectors Guide and the excuse of the business cycle, at $9? Or my dad, who says they are worth whatever somone is willing to pay you in an open market, at $5? How you answer that question should color how you are disposed to to marking assets to the model, versus marking them to the market. Mind you, this was not just an academic exercise – at $5, my dad realizes I’ve made some terrible calls, and is probably going to make me start mowing lawns until I can pay him back. If I could convince him they were worth $9, I would not have to mow lawns (which I sincerely did not want to do) but instead could probably borrow some more…

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Tragedy in AAPLville

January 14, 2009 in Finance

This tragic story popped up in red all over my Bloomberg news feeds this afternoon:

16:35 *APPLE SHARES ARE HALTED BY NASD PENDING NEWS :AAPL US
16:36 *APPLE SAYS JOBS TO TAKE MEDICAL LEAVE UNTIL END OF JUNE
16:36 *APPLE’S JOBS SAYS TIM COOK TO BE RESPONSIBLE FOR DAY TO DAY OPS
16:37 *APPLE SAYS JOBS TO REMAIN INVOLVED IN MAJOR DECISIONS WHILE OUT
16:37 *APPLE’S JOBS SAYS HEALTH ISSUES MORE COMPLEX THAN THOUGHT
16:38 *APPLE’S JOBS SAYS CURIOSITY OVER HIS HEALTH ‘DISTRACTION’
16:54 *APPLE QUOTES TO RESUME AT 4:55 P.M. IN NEW YORK, NASDAQ SAYS
17:00 *APPLE SHARES FALL 9.2% TO $77.50 AT 5 P.M. NEW YORK TIME

Unfortunately, it appears that all is not well with Steve Jobs. The stock dipped 10% afterhours as traders digested the news. RD points out the following data, available from the Nasdaq website:

AAPL afterhours activity, 1/14/09

You can see a steady chain of intermittent, relatively small trades leading up to the 4:35 halt of trading and subsequent announcement regarding Jobs’ health. (The two trades posted at 4:45 and 4:53 are trades from earlier which simply didn’t settle until those times). Take a look at that last trade right before the announcement (I’ve highlighted it in grey for the chronologically challenged).

Yes, it’s 1000 times larger than any recent trade, representing $19mm changing hands. Might that have been someone acting with a little inside information? When trading resumed, the very next trade dropped the share price by 10%. 10% of $19mm is, of course, nearly $2mm. Granted, it’s not clear from this data whether that money was made, lost, or saved in the next half hour, but I leave any further conclusions to the reader.

In any case, we wish Steve a swift return to health.

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