Financial Python

Studies in Finance and Python

Archive for January 2010

Monte carlo and fundamental analysis

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A recent discussion about stock options and the creation of Trefis (and it's ability to model firm value in a friendly way) made me wonder: Why isn't monte carlo isn't used more often in standard valuation models? Every b-school graduate has used @Risk or Crystal Ball, so associating probability distributions to revenue, expense, and other model drivers should be vaguely familiar at least.

This occurred to me because Trefis has a "crowdsourcing" feature that allows users to share their valuations with each other. If one could extract the driving assumptions from all these models (assuming there area lot of them for a given firm), I imagine the resulting valuation distribution might approximate a monte carlo model a single analyst might come up with.

But why do this? Growth estimates (e.g. sales, expenses, etc.) reflect an analyst's opinion about the stock, right? If you don't believe your valuation and outlook, what's the point? By articulating a risk profile for a given valuation, one is forced to consider the risk picture more broadly. Even if your expected valuation agrees with the last trading price, the risk profile of the valuation can still be used (via options) to account for other potential outcomes. One could even compare the "fundamental" risk profile with that implied by stock options to determine whether there are meaningful differences in opinion. I know Bloomberg has implemented the variance-gamma option model that allows analysts to extract a return distribution that takes into account the implied volatility skew. Combining this with a Black-Litterman exercise to estimate returns for a given portfolio (e.g. S&P500) might make for some interesting analysis.

For example, I imagine a portfolio manager might apply the Black Litterman approach to the SP500 and determine where the firm's fundamental analysts diverge meaningfully from returns implied by the current 'optimal' index pricing/weighting. By adding a risk profile layer to this basic analysis using monte carlo, the portfolio manager might find ways to trade a portfolio of options more effectively than simply buying or selling the underlying stock as he attempts to trade into his optimal exposures. Indeed, even if the firm's fundamental analysts agree completely with the returns implied by the Black-Litterman exercise, the individual firm risk profiles could suggest some micro or macro hedging via individual stock options or index options.

One concern is term mismatch. Stock options are short-dated options whereas fundamental analysts typically (or should I say allegedly?) look for fundamental value to be realized over a longer term (years vs. weeks or months). I suppose one could look at LEAPs, but I'm not sure how practical it is to trade those longer-dated contracts.

Anyway, food for a future notetoself. Maybe I just ate too much thai food.

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Written by DK

January 22, 2010 at 2:28 am

Posted in Finance

Synthetic tranches intuition for stock option guys

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I had a couple of interesting conversations comparing equity options to tranches, so I thought I'd develop some of the parallels here.

I'm assuming you're already familiar with equity options, however, so let me walk you through an example. Let's assume there is a stock index that, for argument's sake, can vary between $0 and $100. Now, consider the following series of call spreads on this index.

  • Call spread A = long call option with a strike of $0, short a call with a strike of $3.
  • Call spread B = long call option with a strike of $3, short a call with a strike of $7.
  • Call spread C = long at $7, short at $10.
  • Call spread D = long at $10, short at $15.
  • Call spread E = long at $15, short at $30.
  • Call spread F = long at $30, short at $100 (I know we've limited the stock to $100, but work with me here).

Let's say the index trades at around $1.50. Call spread A is most sensitive to changes in the index price (relative to the other call spreads) since it is "at-the-money" (ATM). In contrast, the $30-$100 spread offers little value since it is so far "out-of-the-money" (OTM). If the stock price increases to $5, call spread A has moved completely "in-the-money" (ITM) and is no longer as sensitive to moves in the underlying index (the maximum PnL for the spread has been realized). Call spread B is now the ATM option portfolio. As the index price moves, the value of each call spread will fluctuate depending on whether it is ITM, ATM, or OTM. Another way to look at it is in terms of option premium. If the index is trading at $1.50, I'll likely get much more premium by selling call spread A or B than call spread F.

Now let's consider the constituents of this index. Let's say it's made up of biotech companies that are highly dependent upon a certain upstream compound, pending FDA approval, for their businesses to succeed. If the compound is approved, these companies are going to make tons of money and the value of the index will likely approach $100. If it is not approved, the value of the index will approach $0. Your estimate of the compound's likelihood of approval will bias your estimate of call spread relative value. If you think approval is more likely than expected, you may be able to purchase the $30-100 call spread cheaply since it's OTM. If enough people agree with you, the premium associated with the $30-100 call spread will be driven higher until it reaches some equilibrium level. This reflects the binary nature of the approval process and the highly correlated expected returns of the index constituents.

The example would be much different if the index was made up of a well-diversified group of companies, spanning different sectors, etc. Some constituent stocks will go up and some will go down, but one might expect the distribution of potential index values to approach something more bell-curved than the binary outcome described in the biotech example. In this case, the value of the $30-100 call spread will remain low since the index probably won't generate those higher expected returns (again, relative to the biotech example).

Now stop. Replace the "$" signs in the example above with "%", generalize the "biotech vs. diversified" discussion in your head to correlated vs. uncorrelated, and substitute "expected loss" for "expected return." You officially understand standardized synthetic tranches. Tranches on the standard CDX index work in exactly the same manner. The expected loss of the index is tranched into 0-3%, 3-7%, etc., slices. If the index is implying a loss of 1.5%, for example, the 0-3% tranche is the ATM tranche. The intuition regarding the greeks, discussed in previous posts, follows naturally (delta, gamma, rolldown/theta, vega/correl01).

One common stumbling block is the whole expected return vs. expected loss business.  To be explicit, credit guys are primarily concerned with expected loss (default risk) whereas equity guys are focused on expected return. If I buy protection on the 0-3% tranche, I expect default risk to increase. When I buy the $0-3 call spread, I expect the stock price to increase. So remember, when you talk about CDS, you should talk explicitly in terms of buying and selling protection.

  • Buy protection = I expect things to get crappier (I want to short the credit)
  • Buy call option = I expect things to improve (I want to get long the stock)

So from a directional perspective (crappier <–> better), I suppose buying tranche protection is more like buying a put spread on a stock/index. For whatever reason, though, I prefer to think of it as buying a call spread on expected loss. This preference is driven by the quoting conventions of credit vs. stocks. CDS is quoted in spread (which reflects default risk) while stocks are quoted in terms of price.

The same term structure considerations are also applicable, though one should remember CDS maturities (e.g. 5, 7, 10y) are much longer than equity options.
 
Anyway, there are direct lines one can draw between stock options and standard synthetic tranches. Hopefully this helps bridge the gap.

And for something totally unrelated, here's a link to an oldie but goodie:

Written by DK

January 9, 2010 at 7:14 pm

Posted in Finance