First of all, this book was unexpectedly difficult to find unused, and it was surprisingly expensive ($48!). But, it came highly recommended from Kris Abdelmessih, who I enjoy reading.
Risk
Finance is the study of risk, even though risk does not have a perfect definition. You may have thought finance was also the study of money and saving and budgets and loans. There is some of that, but risk is central.
The most common systematic approach to evaluating the risk of an arbitrary portfolio or position is to ask what is its value-at-risk or VaR. The idea behind the VaR is reasonable enough. It asks what is the worst case loss that can result from the given position, assuming we would be unable to liquidate it for a given period of time.
Haircut, or margin. This refers to the portion of the notional that needs to be supported by your own capital. So if you have $100 worth of IBM supported by $16 of your own money, with the rest borrowed, then you have a 16% haircut.
Understanding forwards:
- A forward contract can have any strike price, but there’s always one unique strike that results in the forward contract itself having a zero current value. This unique strike price is called the fair forward price.
- To find it, figure out your second best alternative. You could either buy a forward struck at F or you can borrow S to buy the stock. If you borrow, you have to pay back S plus the interest rate at maturity, but you’d also have received the dividends from owning the stock. So you could either exchange F for a share of stock at maturity, or S plus the interest owed minus the dividends earned. Therefore, F = S + interested owed - dividends until maturity.
Arbitrage
Is arbitrage impossible, or commonplace? Yes.
“Accumulate risks that are hateful to others; dispose of risks that are hateful to you. That is the whole of financial hacking; the rest is commentary.”
The key part of this golden rule of financial hacking is.. the semicolon.
That semicolon is the epitome of financial hacking. It takes two somewhat related concepts and joins them together in an uneasy alliance that is not quite as tight-knit as a comma and not quite as arms-length as a period; not quite as together as with an ‘and’ and not quite as opposite as with a ‘but’.
In our world, these two somewhat related concepts are fundamentally related yet relatively mispriced assets; the semicolon is the trade.