Ed's Letter: Meditação
2
2 wilmott magazine EDITOR’S LETTER It isn’t hard to see why Avellaneda is universally respected, and what’s more actually liked Meditação T his issue we present the result of some very engaging discus- sions with Marco Avellaneda, the lauded Courant professor who manages to straddle academia and the finance industry with seemingly effortless ease. On Avellaneda’s vitae alone it was fairly obvious why he was deserving of the full cover story treatment. He has been a major influence for over two decades spanning work on his Uncertain Volatility Model, Monte Carlo methods, the use of entropy, diffu- sion methodology, the list goes on. But what was a delight to discover was that Avellaneda has evidently thought and continues to think very deeply about what it means to not only participate in two worlds that might at first seem incompatible, but also what allows such a person to have a con- tinual positive impact on his sphere of influence. It isn’t hard to see why Avellaneda is universally respected, and what’s more actually liked. Self effacing and generous with anecdotes, opinions and a healthy respect for self analysis, the discussions were a pleasure to be part of. In the course of the interviews, the subject took the time to talk about his own thinking with regard to where the quant community needs to be looking in establishing a safe harbour for the skillsets and some- what embattled culture that have developed to this point. He is currently concentrating on building his own kind of risk management company and says “I believe there is a life for quants, provided they remain fiercely independent and compensate themselves well, but remaining fiercely independent.” Words to live by. A few issues back Aaron Brown extolled the benefits of behavioral economics experimentation. In this issue he discusses another of the experiments from the set he ran with Donna Howe, Michael Miller, and Kent Osband at a recent GARP event. “The game consisted of six identical rounds. Each team would submit a sealed bid for a security that paid one hundred (fake) dollars if I drew a black chip out of the hat, nothing (real) if I drew a red chip. We took the median price and the eight teams that bid higher than the median bought one security (paying the median price in return for receiving $100 if a black chip was drawn), while the eight teams that bid lower than the median price sold the security (receiving the median price, but having to pay $100 if a black chip was drawn). A team that bid exactly the median had no trade.” The author claims no scientific validity to the results, participants were self-selected and may have known of the effects beforehand. No controls were employed, there was no blinding. He offers the results as anecdotal and suggestive only. Satyajit Das takes us on an alternative journey into the seemingly familiar world posited on the idea of “robust economic growth, combined with the belief that governments and central bankers can exert substantial control over the economy to bring this about.” Invoking Chicago econo- mist Harry Johnson writing with his wife Elizabeth about England in the 1970s he quotes: “…faster economic growth is the panacea for all … eco- nomic and ... political problems ... faster growth can be easily achieved by a combination of inflationary demand-management policies and politically appealing fiscal gimmickry.” However, what happens in a world with no growth? A possibility closer to reality than perhaps is comfortable to admit. This issue we introduce a new columnist, Noah Silverman, who is quickly making a name for himself in the world of crypto currencies. Crypto-currencies are a new type of asset that have been rapidly grow- ing in popularity over the past few years. It is, in effect, a form of a digital bearer bond with no underlying asset. Some people consider these new currencies an asset for investment and trading, others consider it a viable currency for purchasing goods and services, and a few consider the whole thing a giant Ponzi scheme destined to collapse. Noah will be publishing a series of articles in Wilmott magazine dis- cussing different aspects of this new asset class. His goal, in this first article, is to provide a comprehensive overview of this new asset class. In future he plans to discuss more details regarding the underlying technology, as well as investigating pricing, risk, and trading strategies. Sri Krishnamurty, familiar to many readers as the go-to guy in the MATLAB world, begins a new series of articles responding to the techno- logical advances that have facilitated major innovations in the financial industry over the last decade. “Algorithms running on super-fast comput- ers have enabled significant innovations and thus have revolutionized how algorithmic trading and high frequency trading is done. Simulation and back testing in risk management are vastly scalable due to innovations in parallel and distributed computing. Quants have been in the forefront to leverage technology to enhance the performance of their models whether it is for speed, performance or scalability. Every aspiring and practicing quant needs to be aware how technology can enhance their model devel- opment and deployment efforts to maximize the performance of their models.” Heed these words! Rachel Ziemba turns her magnifying glass this issue to Egypt, placing in context recent dynamics and how the events of the last several years have undermined its resilience and investment prospects. Protests across many large emerging markets again marked the beginning of the summer of 2013. “Egypt’s latest round of protest culminated in the removal of its president and new political timetable. Egypt’s political experience, lack of inclusive institutions and interlinked political and economic vulnerabilities, contributed to this development, suggest the new government may also struggle to take hard decisions and indeed showcase the importance of developing resilient institutions. “ Mike Staunton takes us back to the beginning of commercial televi- sion in Britain, and provides clues as to why his grin is so pearly white. Well, Gibbs manufactured a toothpaste that happened to be the first product hawked on an unsuspecting British populous when adverts first made an appearance on Brit TV. “Not surprisingly,” he writes “I thought of toothpaste when I read a Master’s thesis late last year from the home of COS, Delft University of Technology, titled “The Gibbs phenomenon in option pricing methods”. Now, the resulting working paper written by Mark Versteegh with his two thesis supervisors, Kees Oosterlee and Marjon Ruijter, has just appeared, albeit with the rather less exciting title “On the application of spectral filters in a Fourier option pricing technique.” In “Dynamic Risk-Based Asset Alloctaion” Kris Boudt, Joakim Darras, and Benedict Peeters observe that in asset allocation, the equal risk contribution (ERC) approach gains rapidly in popularity: portfolio weights are dynamical- ly set such that the asset classes contribute equally to the portfolio risk. As such, the portfolio loads automatically less on the more risky asset and, by diversifying across asset classes, portfolio drawdowns are reduced. When the equity subportfolio is allocated based on market capitalization weights, the ERC portfolio allocation tends to by dominated by the bond allocation. While the resulting portfolio has a low risk, it is in today’s market regime of low interest rates, also characterized by only moderate expected returns. For this reason, American fund managers have advocated to overlay the ERC portfolio with leverage. Such a leveraged risk-diversified portfolio is commonly referred to as a risk-parity strategy. This paper explores two leverage-free alternatives to increase tactically the equity allocation and preserve a completely risk-based asset allocation approach, which dynami- cally adjusts to the changing risk regimes. The first one consists in replacing the market capitalization weighted equity index with a low risk equity index. The second suggestion to increase the equity allocation is to deviate from an equal risk contribution objective to a 60/40 risk allocation strategy. The authors show that these two modifications increase significantly the weight of the equity portion in the portfolio, while still keeping the total risk of the dynamically rebalanced portfolios at a low level. In “The Non-Misleading Value of Inferred Correlation: An Introduction to the Cointelation Model” Babak Mahdavi Damghani presents a paper prompted by growing evidence for the Power Laws type of scaling, of correlation with time, a concept rooted in the original study by Benoit Mandelbrot on concentration of risk. The author completes the cointela- tion mod el recently introduced via a statistical test which uses measured correlation in different time gaps. He also provides an approximation of the expectation in the change in measured correlation via these various time step and use our findings in order to introduce the concept of Inferred Correlation and term structure of correlation. Finally, findings are illustrat- ed through the example of the relation between oil and BP and present few potential applications in the financial industry.
Transcript of Ed's Letter: Meditação
2 wilmott magazine
editor’s letter
It isn’t hard to see why
Avellaneda is universally
respected, and what’s more actually liked
Meditação This issue we present the result of some very engaging discus-
sions with Marco Avellaneda, the lauded Courant professor who manages to straddle academia and the finance industry with seemingly effortless ease. On Avellaneda’s vitae alone it was fairly obvious why he was deserving of the full cover story treatment.
He has been a major influence for over two decades spanning work on his Uncertain Volatility Model, Monte Carlo methods, the use of entropy, diffu-sion methodology, the list goes on. But what was a delight to discover was that Avellaneda has evidently thought and continues to think very deeply about what it means to not only participate in two worlds that might at first seem incompatible, but also what allows such a person to have a con-tinual positive impact on his sphere of influence.
It isn’t hard to see why Avellaneda is universally respected, and what’s more actually liked. Self effacing and generous with anecdotes, opinions and a healthy respect for self analysis, the discussions were a pleasure to be part of. In the course of the interviews, the subject took the time to talk about his own thinking with regard to where the quant community needs to be looking in establishing a safe harbour for the skillsets and some-what embattled culture that have developed to this point. He is currently concentrating on building his own kind of risk management company and says “I believe there is a life for quants, provided they remain fiercely independent and compensate themselves well, but remaining fiercely independent.” Words to live by.
A few issues back Aaron Brown extolled the benefits of behavioral economics experimentation. In this issue he discusses another of the experiments from the set he ran with Donna Howe, Michael Miller, and Kent Osband at a recent GARP event.
“The game consisted of six identical rounds. Each team would submit a sealed bid for a security that paid one hundred (fake) dollars if I drew a black chip out of the hat, nothing (real) if I drew a red chip. We took the median price and the eight teams that bid higher than the median bought one security (paying the median price in return for receiving $100 if a black chip was drawn), while the eight teams that bid lower than the median price sold the security (receiving the median price, but having to pay $100 if a black chip was drawn). A team that bid exactly the median had no trade.”
The author claims no scientific validity to the results, participants were self-selected and may have known of the effects beforehand. No controls were employed, there was no blinding. He offers the results as anecdotal and suggestive only.
Satyajit Das takes us on an alternative journey into the seemingly familiar world posited on the idea of “robust economic growth, combined with the belief that governments and central bankers can exert substantial control over the economy to bring this about.” Invoking Chicago econo-mist Harry Johnson writing with his wife Elizabeth about England in the 1970s he quotes: “…faster economic growth is the panacea for all … eco-nomic and ... political problems ... faster growth can be easily achieved by a combination of inflationary demand-management policies and politically appealing fiscal gimmickry.” However, what happens in a world with no growth? A possibility closer to reality than perhaps is comfortable to admit.
This issue we introduce a new columnist, Noah Silverman, who is quickly making a name for himself in the world of crypto currencies. Crypto-currencies are a new type of asset that have been rapidly grow-ing in popularity over the past few years. It is, in effect, a form of a digital bearer bond with no underlying asset. Some people consider these new currencies an asset for investment and trading, others consider it a viable currency for purchasing goods and services, and a few consider the whole thing a giant Ponzi scheme destined to collapse.
Noah will be publishing a series of articles in Wilmott magazine dis-cussing different aspects of this new asset class. His goal, in this first article, is to provide a comprehensive overview of this new asset class. In future he plans to discuss more details regarding the underlying technology, as well as investigating pricing, risk, and trading strategies.
Sri Krishnamurty, familiar to many readers as the go-to guy in the MATLAB world, begins a new series of articles responding to the techno-logical advances that have facilitated major innovations in the financial industry over the last decade. “Algorithms running on super-fast comput-ers have enabled significant innovations and thus have revolutionized how algorithmic trading and high frequency trading is done. Simulation and back testing in risk management are vastly scalable due to innovations in parallel and distributed computing. Quants have been in the forefront to leverage technology to enhance the performance of their models whether it is for speed, performance or scalability. Every aspiring and practicing quant needs to be aware how technology can enhance their model devel-
opment and deployment efforts to maximize the performance of their models.” Heed these words!
Rachel Ziemba turns her magnifying glass this issue to Egypt, placing in context recent dynamics and how the events of the last several years have undermined its resilience and investment prospects. Protests across many large emerging markets again marked the beginning of the summer of 2013. “Egypt’s latest round of protest culminated in the removal of its president and new political timetable. Egypt’s political experience, lack of inclusive institutions and interlinked political and economic vulnerabilities, contributed to this development, suggest the new government may also struggle to take hard decisions and indeed showcase the importance of developing resilient institutions. “
Mike Staunton takes us back to the beginning of commercial televi-sion in Britain, and provides clues as to why his grin is so pearly white. Well, Gibbs manufactured a toothpaste that happened to be the first product hawked on an unsuspecting British populous when adverts first made an appearance on Brit TV. “Not surprisingly,” he writes “I thought of toothpaste when I read a Master’s thesis late last year from the home of COS, Delft University of Technology, titled “The Gibbs phenomenon in option pricing methods”. Now, the resulting working paper written by Mark Versteegh with his two thesis supervisors, Kees Oosterlee and Marjon Ruijter, has just appeared, albeit with the rather less exciting title “On the application of spectral filters in a Fourier option pricing technique.”
In “Dynamic Risk-Based Asset Alloctaion” Kris Boudt, Joakim Darras, and Benedict Peeters observe that in asset allocation, the equal risk contribution (ERC) approach gains rapidly in popularity: portfolio weights are dynamical-ly set such that the asset classes contribute equally to the portfolio risk. As such, the portfolio loads automatically less on the more risky asset and, by diversifying across asset classes, portfolio drawdowns are reduced. When the equity subportfolio is allocated based on market capitalization weights, the ERC portfolio allocation tends to by dominated by the bond allocation. While the resulting portfolio has a low risk, it is in today’s market regime of low interest rates, also characterized by only moderate expected returns. For this reason, American fund managers have advocated to overlay the ERC portfolio with leverage. Such a leveraged risk-diversified portfolio is commonly referred to as a risk-parity strategy. This paper explores two leverage-free alternatives to increase tactically the equity allocation and preserve a completely risk-based asset allocation approach, which dynami-cally adjusts to the changing risk regimes. The first one consists in replacing the market capitalization weighted equity index with a low risk equity index. The second suggestion to increase the equity allocation is to deviate from an equal risk contribution objective to a 60/40 risk allocation strategy. The authors show that these two modifications increase significantly the weight of the equity portion in the portfolio, while still keeping the total risk of the dynamically rebalanced portfolios at a low level.
In “The Non-Misleading Value of Inferred Correlation: An Introduction to the Cointelation Model” Babak Mahdavi Damghani presents a paper prompted by growing evidence for the Power Laws type of scaling, of correlation with time, a concept rooted in the original study by Benoit Mandelbrot on concentration of risk. The author completes the cointela-tion mod el recently introduced via a statistical test which uses measured correlation in different time gaps. He also provides an approximation of the expectation in the change in measured correlation via these various time step and use our findings in order to introduce the concept of Inferred Correlation and term structure of correlation. Finally, findings are illustrat-ed through the example of the relation between oil and BP and present few potential applications in the financial industry.
