Just seen on youtube: Myron Scholes on liquidity, risk transfer, chaos, the role of hedge funds and how they are interelated (Stanford Graduate School of Business, April 2004):


Definitely worth watching. Of course, if we could travel back in time and take part in the Q&A, we would have asked him what he thinks about the principal-agent problem (HFs und especially prop desks who have at best a medium term view vs. ignorant investors, shareholders, and management) and short to medium term market distortions due to crowded trades / traders riding the bubble.

Ever wondered how a portfolio of corporate bonds with the same rating* (monthly re-balancing) performes after adjusting for the "risk free" rate?

The first graph shows the BofA Merrill Lynch 1-3 year Euro Corporate Indices (AAA,AA,A,BBB) after adjusting each with the 1-3 Year AAA Euro Sovereign Index. The second graph (different scale) does the same with European Currency High Yield Indices (portfolios have a slightly higher duration).


The last graph compares the excess return of the Eurostoxx 50 TR index with the excess return of the "CCC and lower" bond index:


NB: The BofA Merrill Lynch indices are re-balanced (rating) on a monthly basis. Keep in mind that fluctuation in the time series can be due to the low number of issuers, high number of financials vs. non-financials, etc.

* based on an average of Moody’s, S&P and Fitch

The FT writes:

Collateralised loan obligations are vehicles that pool loans to many junk-rated companies and fund themselves by issuing different tranches of debt of varying risk. This CLO debt has rallied so sharply that analysts expect the US market for new issues to spring back to life soon.

"It has been an astounding recovery up and down the capital structure," said Dan Smith, a senior managing director at the GSO unit of Blackstone which specialises in debt and has created many of these structures.

The lowest ranking slices of debt, the so-called first loss tranches, of many of these securities now trade at about 50 cents on the dollar, up from five cents on the dollar (emphasis mine).

That's hard to believe... Half a year ago Bloomberg wrote:

[CLO] pieces graded AA, the third-highest level of investment grade, rose to 47 cents on the dollar from 23 cents in the past month, Morgan Stanley analysts led by Vishwanath Tirupattur wrote in a June 5 report. Securities ranked A have gained 13 cents to 23 cents since the end of last month, the report said.

Yesterday somebody posted the following chart over at The Business Insider:

The accompanying comment was as follows:

"As a schizophrenic world quickly lost its dollar-hating-euro-love, look how quickly Credit Default Swap (CDS) spreads for European nations exploded upwards. All it took was roughly a month, as exemplified by the spike for Greece. This Greek financial crisis was all it took to end talk of the euro as a replacement for the U.S. dollar".

Now here is what you see when you look at the US CDS spread and the GDP weighted CDS spreads of the eurozone countries* since the Lehman collapse:

So nothing crazy has happend recently. Especially relative to the US. The difference and the quotient of those spreads over the last year looks like a nice realization of a mean-reverting process:
OMG, I can't wait to sell this finding to a stat arb hedge fund!

* without Luxembourg and Malta (no BBerg quote)

Viewed through the eye of a statistician.

IMF: Re-Remics are being used to resecuritize senior private-label mortgage-backed security (MBS) tranches that have been downgraded from their initial AAA levels. In a typical Re-Remic, a downgraded tranche is subdivided into a new AAA-rated senior tranche and a lower-rated mezzanine tranche (see figure). About $25 billion were issued during the first half of 2009, mostly against MBSs backed by prime mortgages. Given that most of the AAA privatelabel MBS tranches issued between 2005 and 2007 have been downgraded, the potential for this market to grow is substantial. However, although these transactions are playing a useful role in dealing with the overhang of legacy assets, they are partly driven by rating/regulatory arbitrage.

Re-Remic issuance is being driven by a number of factors, including the need to maintain the AAA ratings that many investors require to hold these securities. Maintaining AAA status canresult in substantial capital requirement reductions.For example, the new Basel II risk weight on a BB-rated tranche is 350 percent under the standardized approach, whereas it is 40 percent on an AAA-rated resecuritization. Also, for banks and insurers, big rating downgrades can trigger “other-than-temporary-impairments,” which have to be recognized immediately through the income statement. These consequences can be avoided by replacing the downgraded securities with new AAA-rated Re-Remics. In the figure, the new AAA-rated senior tranche comprises 70 percent of the structure, with a mezzanine tranche that absorbs the first 30 percent of losses. Additional credit enhancement is provided by an option for the new senior tranche to be resubdivided into two “exchange classes” should it lose its AAA rating. Also, there is a hedge fund demand for the mezzanine tranches as a means to take a leveraged credit bet. The holder of the senior tranche that was downgraded to BB could then hold the new AAA tranche, and sell the mezzanine tranche to an investor desiring distressed securities. Hence, only 30 percent of the original holding is sold at distress prices, and the risk-weighted par value of the holding goes from 350 to 28 percent (70 percent of 40 percent). Even if the bank were to retain the mezzanine tranche, the riskweighted par value could still be less than the original 350 percent.
For example, for single security-backed Re-Remics, the default probability-based rating methodologies used by DBRS, Fitch, and S&P will typically pass the underlying bond’s rating through to the new mezzanine tranche (emphasis mine). Hence, in the example transaction, the total riskweighted par value would decline from 350 to 223 percent (70 percent of 40 percent on the AAA-rated tranche plus 30 percent of 650 percent on the BB-rated tranche).¹ In this regard, it is notable that Moody’s has been virtually shut out of the Re-Remic rating business, possibly because it rates on the basis of expected loss, which is tougher on mezzanine tranches than the default probability basis (Fender and Kiff, 2005), and thus issuers prefer not to have Moody’s rate their potential securitization.

Although Re-Remics and similar repackaging transactions are playing useful roles in dealing with the legacy asset overhang, they also serve to illustrate the vulnerability of ratings-based regulations to gaming and shopping. Also, these new securities remain exposed to further downgrades if economic and housing market conditions worsen. However, the information underpinning these securitizations and the methodologies applied to their ratings are likely more robust than before and thus pricing is likely to reflect risks more appropriately.

Source: Restarting Securitization Markets: Policy Proposals and Pitfalls, IMF

¹ The new risk weights would be even lower if they were calculated with the securitization exposure weights (20 and 350 percent, respectively, on the AAA and BB tranches), rather than the resecuritization exposure weights (40 and 650 percent). The Basel Committee has defined a resecuritization as a securitization where “at least one of the underlying exposures is a securitization exposure” (BCBS, 2009), but some market participants are hopeful that single-security repacks may not be considered resecuritizations (Mayer Brown, 2009).

Richard Thaler is quoted in the latest issue of The Economist saying the following about the EMH:

The [Efficient Market Hypothesis] has two parts. The “no-free-lunch part and the price-is-right part, and if anything the first part has been strengthened as we have learned that some investment strategies are riskier than they look and it really is difficult to beat the market.” The idea that the market price is the right price, however, has been badly dented.

If I understand the paper Efficient market hypothesis and forecasting by Timmermann and Granger correctly, then the hypothesis does not have two parts but there are actually two completely different versions. The first one talks about informational efficiency, which is about forecasting, and the second one is built on the notion that the prices should reflect intrinsic values.

The first version basically says that when you trade on the basis of publicly available data you can only expect to earn the risk-adjusted return. This does not rule out fat tails, stochastic volatility or even bubbles. More technically:

.

E[Q_t+1R_t+1 | Ω_t] = 0

.
where Q_t+1 is a discount factor (containing investors preferences/risk aversion) and Ω_t is a given information set. As you can see, we are only talking about the conditional expectation and not about the conditional variance, higher moments, or the shape of the return distribution. The message is that just because their has been a market crash that doesn't mean the EMH is wrong. [Actually, is there a reason why the intrinsic value of companies should not drop by half?]

The other question is what investors actually do with the information set at any give point of time. Was the information set we had in 2007 already screaming that house prices will crash and investors didn't make use of this information or did the extent of the problem only gradually build up in the information set?

The only thing I know for sure is that the more I think about this the less I think I know what I'm talking about. The good news is that I don't think I'm alone!

Today I was going through some past editions of The Journal of Portfolio Management and stumbled across a special edition in memoriam of Fischer Black (1997).

In Remembering Fischer Black Jack Treynor writes:

It's easy to forget that over Fischer's career finance changed:

• From a verbal to a mathematical discipline.
• From accounting-centered to economics-centered.
• From suppressing uncertainty to giving it a central role.

Thirty years ago, nobody would have defined finance as the economics of uncertainty. Risk was a cop-out--for explaining why the future had departed from deterministic forecasts. Before the revolution, we regarded randomly fluctuating markets as evidence of irrationality of market prices. Now we view departures from random fluctuations as "anomalies."

In Fischer Black: Some Personal Memories Jonathan Ingersoll writes:

I first met Fischer Black in the summer of 1975 on the day I presented a paper to the faculity of the Graduate School of Business at the University of Chicago--an intimitating place to give a seminar. The people there are always prepared and ready to question your assumptions, your methodology, and your findings.

The paper was a theoretical and empirical analysis of dual-purpose funds using the Black-Scholes option pricing model. Both Myron and Fischer were then on the faculty at Chicago and in the audience. Fischer asked me how I might incorporate stochastic volatility into the model I'd developed.
It was a question for which I was not prepared. The Black-Scholes model did not have stochastic volatility. I had no idea how it might be incorporated into a theoretical pricing model. And the Black-Scholes model itself was still just a fledgling. It had been tested by the authors on OTC put and call data, but not yet empirically applied to any other type of claims. I'm sorry to say, Fischer, I had no answer for you that day in 1975. [...] Since the crash of 1987 and the subsequent growth in implied volatility smiles, the study of stochastic volatility has become something of a cottage industry among both academics and street practitioners who follow derivatives. But Fischer was there long before other were even aware that it was an issue.

This leaves me with two questions:

1. How would developed economies look like today in case no financial innovation would have been made over the last 50 years.
2. Could there be a severe economic crisis without any of those financial innovations (i.e. with consumers still levering up and believing that house prices will ever increase, greedy managers maximising short-term profits, etc.)

It's amazing that--given the current crisis--nobody thought it would be worth to come up with a general defense of financial innovations so far. Just to give an example: Most quants knew about the shortcomings of a given theoretical model. But given those limitations, they at least had a certain pricing tool and started to offer companies who did not want to take a directional risk the possibility to hedge* almost any exposure at more or less reasonable prices.

* ad counterparty risk: No, I don't think that in the larger picture AIG or LEH play such a big role. And lessons learned.

Bill Luby writes (Barron's):

The 30-day VIX time horizon primarily captures what I call "event volatility" that is associated with scheduled events such as important economic data releases, earnings reports, as well as various scenarios associated with high-profile geopolitical and other events which are likely to cast a shadow over the next month.

By comparison, the 93-day time horizon of VXV guarantees it will encompass an entire earnings cycle, a full quarter of the economic-data-release cycle and two FOMC meetings. The VXV is more focused on long-term systemic threats, measuring something akin to "structural volatility" in the markets.

VIX vs. VXV

Investors who trade based on volatility signals usually look for signs that implied volatility is overextended to the upside or downside. This is traditionally done by comparing implied volatility measures such as the VIX to recent historical volatility or to previous implied volatility levels for the same implied volatility measure.

Since the launch of VXV in November 2007, investors have been able to use a third approach: comparing two different volatility indices with different fixed-time horizons to determine the extent to which short-term volatility expectations in the form of the VIX are aligned with longer-term volatility expectations in the form of the VXV.

related items:
VIX:VXV Ratio Sell/Short Signal, Bill Luby
Who is Selling Wholesale Vol and Why?, Zerohedge

Lusardi, Tufano and TNS Global asked 1000 U.S. residents the following question:

You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options:

a) Pay 12 monthly installments of $100 each;
b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now.

Which is the more advantageous offer?

Result:

Here are all the results from the survey. Unbelievable. The questioning was done over the phone which could distort the results a bit but it's nevertheless a disaster.