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  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. India MBA Devils and Derivatives Warren Buffet has called Financial Derivatives the Weapons of Mass Destruction. These Financial WMDs were in our own backyard in Wall Street. Anyway, we had to invade Iraq to find WMDs of the other kind..... 1
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. During the start of the new millennium, while few people noticed, Wall Street began hiring brilliant scientists to work on a series of secret experiments that would shape the world’s economies in ways that we might never have imagined. With a new set of formulas developed by physicists, wealth could be made by managing risk scientifically. Wall Street banks could pump billions of dollars of mathematically created wealth into the world economies. This would make way for American domination in the global finance. 2
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. Attention was poured into perfecting a financial contract known as the Derivative. Essentially, the derivative was a contract whose value was linked to underlying assets such as stocks, bonds, stock market indices, or interest rates on Treasury bills. In the exciting world of derivatives, Physicists and mathematicians in Wall Street began applying the principles of mathematics to discover the art of managing risk in the financial markets. Warren Buffet was uncomfortable with the financial risks associated with derivatives. In fact he chose to call them Weapons of Mass Destruction in the financial space. 3
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. The quantitative analysts working in Wall Street and London came to be known as Quants. They were to apply the principles of physics and mathematics to study the financial markets. Their ultimate goal was to find mathematical formulas to outperform the global financial markets. With less regulatory headaches, London has become a favorite destination for Quants seeking fat paychecks. To remain beyond the outreach of American regulators, American investment banks experimenting with financial innovations have an office in London. Meanwhile, the banks in Wall Street managed to convince regulators that these new innovations can soften economic shocks. Incidentally, though risk cannot be eliminated, it can be stealthily transferred from Wall Street to unsuspecting banks in Europe. 4
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. While an army of physicists in Wall Street got into analyzing support and resistance points of stock market charts, the market was flooded with books written by physics professors and physicists. Fabio Oreste wrote a book titled Quantum Trading : Using Principles of Modern Physics to Forecast Financial Markets. Anatoly Schmidt authored a book titled Quantitative Finance for Physicists. Jan Dash came out with an extremely informative book titled Quantitative Finance and Risk Management : A physicists approach. 5
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. Considering that many of these physicists became incredibly wealthy, their techniques must have worked in Wall Street. Meanwhile, economists like Fischer Black, Myron Scholes, and Robert Merton came up with another set of mathematical formulas to price options and derivatives in the stock market. Myron Scholes, Robert Merton and John Meriwether founded a Hedge Fund named Long Term Capital Management (LTCM). However, the hedge fund collapsed after a few profitable years. The fund might have collapsed due to incorrect financial modeling. 6
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. Speculators utilize financial contracts known as Options to hedge risk In financial markets, a contract known as an Option gives the buyer the right to buy or sell an asset for a particular price over a specific time horizon defined by the time of expiry. However, the right to do the transaction is not obligatory. A Call Option typically gives the right to sell at a specific price within a time horizon. A Put Option bestows the right to sell at a certain price within a specified time horizon. In Wall Street parlance, buyers are called Holders and sellers are called Writers. The price at which the asset can be purchased is known as the strike price. The cost of the option is known as the Premium. Speculators also use strategies known as Short Position and Long Position. In short position, a speculator borrows stock from a broker to sell at a time when the stock price is high. At a later date, when the stock price falls, the speculator buys the stock at the lower price and return them to the broker. Using this simple strategy known as Short Selling, a speculator can make money on a stock whose price is expected to fall in the near future. Short selling involves the sale of stock that a speculator does not actually own. In cases where the speculator expects the stock’s price to rise, the stock may be purchased with the sole intention of making a nice profit by selling it at a higher price in the future. 7
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. Fisher Black came to be regarded as the high priest of finance. Fisher Black and Myron Scholes came up with the famous Black-Scholes formula for pricing options. The Black-Scholes formula neatly factored in prevailing interest rates, stock prices, time horizon until expiry of option, strike price of option, and general volatility of a particular stock. Thus, a call option over a longer time horizon would cost more. The difference between strike price and current price would also cost more. Volatile stocks would also cost more. Meanwhile, as interest rates would rise, call options would also cost more. Fundamentally, the use of options in trading emboldened investors and encouraged excessive leveraging with borrowed money. Investors would buy put options on stock investments deemed to fail. 8
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. Sophisticated investment strategies founded on these formulas were employed by a new genre of funds known as hedge funds. The hedge funds would not only make possible returns as high as 35 % during the normal course of business, but also keep losses to a minimum in the event of a sudden downturn. Hedge funds had the structure to counterbalance risks and weather stock market crashes better than most other types of funds. However, hedge funds did suffer a few jolts during the Asian financial crisis in 1997, and the Russian default crisis in 1998. By about 1990 hedge funds became very popular with high net worth individuals and institutions capable of investing hundreds of millions of dollars. In America, the hedge fund industry handling billions of dollars remained largely unregulated and operated beyond the reach of the Federal Reserve. 9
  • India MBA : Devils and Derivatives, Copyright © 2011 by Shivaprasad Srikantia. All Rights Reserved. While Quant modeling could look into problems of day to day volatility, it was difficult to factor in catastrophic movements like September 11. In fact, Quants rarely factored in political situations that could set off a financial crisis. For instance, political upheavals in the troubled Middle East regions could destabilize the prices of crude oil, and send ripple waves through the stock market. In the modern world, calamities occur very frequently. In fact a famous mathematician named Benoit Mandelbrot has drawn attention to the alarming frequency with which such events occur and cause large movements in stock prices. Incidentally, Benoit Mandelbrot caused quite a bedlam in financial circles when he authored a book titled The Misbehavior of Markets : A Fractal View. Some Quants might be uncomfortable with Mandelbrot theories. Incidentally, a researcher named Louis Bachelier began looking at the stock market movements as normal distributions, whereby the randomness observed was tied around what physicists describe as Brownian motion. 10