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Alpha in Practice

Alpha in Practice. Eric Falkenstein. Alpha Examples. Best way to find alpha currently, is to see what alpha was like in the past Current alpha, as obvious as shown here, I, nor anyone else, would show you. Option Market Makers in 1980s. Outsiders could not arbitrage Bid-ask too large

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Alpha in Practice

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  1. Alpha in Practice Eric Falkenstein

  2. Alpha Examples • Best way to find alpha currently, is to see what alpha was like in the past • Current alpha, as obvious as shown here, I, nor anyone else, would show you

  3. Option Market Makers in 1980s • Outsiders could not arbitrage • Bid-ask too large • No way to see real-time prices • Barriers to entry • Ephemeral • In the early 80’s, pit traders could make $100k+ arbitraging put-call parity

  4. Put-Call Parity creates identical future values with different instruments Call(strike=k) + K = Put(strike=k) + Stock

  5. The Result Since the payoffs are the same, the price must be the same. Thus, in terms of prices, Call(strike=k) + K = Put(strike=k) + Stock If C<P+S-K, buy C, sell rest If P<C+K-S: buy P, sell rest Arbitrage: certain profit if held to maturity of call and put

  6. Forward vs Future Euro Trade

  7. Conveity Adjustment • Convexity adjustment to forwards • Forward=e-rt(f-k) • Futures=a*(f-k) • f (forward) correlated with r (discount rate) • Ho-Lee adjustment

  8. Current Futures vs. Forwards Embodies Convexity Adjustment

  9. Convertible Bonds • CB=Bond+option at stock price K-call by issuer at interest rate I • CB=Bond+Option • 100=8% Bond + 38% Vol Option=7%Bond + 45% vol Option • Volatility in option about 8% below ‘actual’ volatility • Spread about 50% above actual volatility • CFOs don’t mind selling options cheap

  10. Convertible Arbitrage Strategy Decline Good times, good times… Party over

  11. Pairs and mean reversion • Pair: Coke and Pepsi • Go long Coke if Pepsi goes up, but not Coke • People made millions, simple strategy ex post

  12. Index Funds • Remove 1% in annual expense • Don’t alter gross expected return • Lower volatility • Growth to 20% of market: Index Mutual Funds, ETFs, about • Lots of Alpha here • Tough sell, though. Bogle had a tough time.

  13. Automating • Generally, anything where you can measure inputs and define outputs, with enough data is done better by computers • Market making • Underwriting credit • Example. FICO scores • Delinquencies, Past defaults • Length of credit history • Amounts owed • Lines outstanding

  14. Old way: narrative about credit Knowledge not cumulative Take a half day to analyze

  15. Scale Efficiencies not Easy • Create a database, create model • Easy to screw up • Ed Altman, Loan Pricing Corp, S&P not able to make a model though they had opportunity • Moody’s RiskCalc works, is profitable

  16. Most of Finance is About Relationships, Favors, People • Finance is about intermediation, savings to investors • Directing a set of savers, or investors, gives you power, responsibility, and thus value • Regular Business wiles • Helpful, discrete, coalitions, competent, energy, etc. • Helps to know alpha, which is the final product

  17. Alpha Games • Value comes from • Brand, reputation, connections, regulations, scale efficiencies, scope efficiencies, an incurious or limited competence from customers, a secret process, inimitable excellence • Don’t ask someone you don’t know very well what their value-add is an expect an honest answer

  18. Risk Taking in Practice • In the standard model, risk taking in admired ex ante, not rationally regretted ex post • Example: 50-50 chance to win $2 or lose $1 • When you lose, it is unfortunate, not stupid • In reality, risk taking is derided ex ante, embarrassing when it fails • Go long banks in winter 2009 • Going long banks in summer 2008 • A ‘bad’ risk is merely considered foolish, not ‘risk’ • Ask a businessman their biggest risk: a successful contrary bet

  19. They Don't Do What they Say • Market makers (traders) • Provide liquidity, manage risk • Privileged access to stale retail trades • Long Term Capital Management • Trading Wizards • Dumb relative value trades • Short US vol vs European vol • Long US Swap spreads • Long Russia • Pairs (Shell vs Royal Dutch, VW)

  20. They Don't Do What they Say • James Cramer’s 90s hedge fund • Deft trades based on fundamentals • Trading shenanigans • Asset Liability Committees • Manage yield curve exposure • Smooth earnings • Bank Economists, Stock Analysts • Provide insight on future prices • Generate trade ideas • KMV Default Model • Predict default with special sauce • Special sauce: ketchup and mayonnaise

  21. Alpha Games • Easy to say you have alpha, because it presumes a risk adjustment no one agrees upon • Risk is essential for defining alpha • Risk is indefinable • Say ‘you manage risk’ is like saying ‘I have alpha’

  22. Conclusion • Alpha often easy once you see it • Don’t think an idea is too simple to be good • You can still screw it up when its there • Within organizations • Need low-cost access • Some ideas only work at scale, or in complement • Most ephemeral • Big Alpha hard to sell • Then: index funds • Now: beta arbitrage, MVPs

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