Quantitative trading - page 39

 

Mortgages and Mortgage-backed Securities (FRM Part 1 2023 – Book 3 – Chapter 18)


Mortgages and Mortgage-backed Securities (FRM Part 1 2023 – Book 3 – Chapter 18)

Introduction to Mortgages and Mortgage-Backed Securities

This chapter provides a comprehensive understanding of mortgages and mortgage-backed securities, which are vital financial products. While many of you are familiar with mortgages as home loans, they can also be obtained for various types of properties, including second homes.

Mortgage-backed securities are securities backed by a pool of mortgages. To grasp this concept, imagine being a mortgage banker who collects all the mortgage contracts and labels them as "for sale." Investors, such as mutual funds and individual investors, can then purchase these mortgage-backed securities. This collection of mortgages is referred to as a pool of mortgages.

Mortgage-backed securities operate similarly to bonds, as the owners receive interest payments and principal repayments. These securities are accessible to investors of various sizes, allowing individuals to participate in the mortgage market regardless of their financial capacity.

Learning Objectives and Definitions

This chapter covers several learning objectives related to mortgages and mortgage-backed securities. It provides definitions and explanations of key terms and demonstrates how to calculate fixed-rate mortgage payments using financial calculators. Various risks associated with these securities are discussed, including interest rate risk (prepayment risk) and the complex securitization process.

Examples and Applications

To illustrate the concepts covered, the chapter presents several examples. These include dollar roll transactions, which involve the sale and repurchase of mortgage-backed securities to capitalize on price differentials. Prepayment modeling is also explored, which helps predict how borrowers might prepay their mortgages. Additionally, the chapter discusses spreads, which are the yield differences between mortgage-backed securities and other bonds.

Types of Residential Mortgage Products

Understanding the primary mortgage market is essential before delving into mortgage-backed securities. In this market, financial institutions such as commercial banks offer loans to potential mortgage holders seeking to purchase homes. Different mortgage products cater to borrowers based on their credit history, income stability, and assets. Prime loans are offered to low-risk borrowers with excellent credit, while subprime loans cater to higher-risk borrowers with lower income and marginal credit histories.

Securitization of Mortgages

The securitization process transforms mortgages into mortgage-backed securities. It involves origination, where individual mortgages are created, followed by pooling, where similar mortgages are combined into a mortgage pool. The mortgage pool is then transferred to a special purpose vehicle (SPV), which issues mortgage-backed securities representing ownership interests in the mortgage pool's cash flows. These securities are divided into different tranches based on their risk and return characteristics and are sold to investors in the secondary market.

Cash Flows and Risks in Mortgage-Backed Securities

Investors in mortgage-backed securities receive cash flows generated by the underlying mortgage pool, including interest payments and principal repayments. However, several risks are associated with these securities. Interest rate risk arises from changes in interest rates, while prepayment risk occurs when borrowers pay off their mortgages early. Credit risk is the risk of borrower defaults, and prepayment modeling helps forecast prepayment speeds.

Conclusion

Mortgages and mortgage-backed securities play vital roles in the housing finance market. They facilitate access to mortgage financing for borrowers and offer investment opportunities for a wide range of investors. While these securities provide benefits, they also carry risks such as interest rate risk, prepayment risk, credit risk, and market liquidity risk. Regulatory oversight and risk management practices are crucial for maintaining the stability and integrity of the mortgage-backed securities market.

Mortgages and Mortgage-backed Securities (FRM Part 1 2023 – Book 3 – Chapter 18)
Mortgages and Mortgage-backed Securities (FRM Part 1 2023 – Book 3 – Chapter 18)
  • 2022.06.10
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Corporate Bonds (FRM Part 1 2023 – Book 3 – Chapter 17)


Corporate Bonds (FRM Part 1 2023 – Book 3 – Chapter 17)

In Part One, Book Three, we delve into the details of financial markets and products, with a specific focus on corporate bonds. This chapter explores the perspectives of both the issuing corporation and the investor, aiming to define and understand various aspects of bond trading and risks.

The issuing corporation, in need of significant capital, seeks to borrow from bondholders worldwide to finance wealth-increasing projects. Investors, ranging from individuals to institutional entities like pension funds, mutual funds, or endowment funds, play a crucial role in this process. Throughout the chapter, we consider both perspectives and emphasize learning objectives related to bond trading and risk.

The first risk discussed is default risk, which refers to the uncertainty of receiving timely and full payment from the issuing corporation. Default risk encompasses the possibility of not receiving scheduled payments or receiving less than the promised amount. For example, a bond issued by a large corporation like Johnson & Johnson may promise to pay $50 every six months for 20 years and return the bond's par value at maturity. Default risk encompasses both the magnitude and timing uncertainty of these cash flows.

The second type of risk discussed is interest rate risk, which is tied to the relationship between bond yields and interest rates. When interest rates rise, bond prices fall. Therefore, if an investor needs to sell a bond before it matures during a period of rising interest rates, they may receive less than expected. Longer-term bonds generally have higher interest rate risk. Understanding default risk and interest rate risk is crucial when considering bond investments.

The concept of maturity is also explored in the chapter, along with what occurs at the bond's maturity date. Additionally, the role of mathematics in analyzing default rates, dollar default rates, and expected returns is briefly touched upon.

The chapter draws a parallel between bond trading and stock trading on the New York Stock Exchange. Bond trading involves buying and selling bonds with the aim of buying at a low price and selling at a high price, similar to stock trading. However, bond trading is heavily influenced by changes in interest rates, which are reflected in bond yields. If an investor anticipates a decrease in interest rates, they may buy bonds and sell them at a higher price when rates decline.

To make bond investments more accessible, corporations divide their bonds into smaller denominations, often $1,000, allowing individual and institutional investors to participate. The yield on a bond, representing the return earned over its life if held until maturity, is influenced by the price paid for the bond. Predicting bond yields involves considering various models, but a simple approach starts with the risk-free return, typically based on a Treasury security with a similar maturity date, and adds a credit spread to compensate for default risk.

The chapter introduces the yield curve, which illustrates the relationship between time to maturity and yield to maturity. During expanding economies, yield curves tend to slope upward, as investors demand higher yields for longer-term bonds. Corporations create a corporate bond yield curve positioned above the risk-free yield curve, reflecting credit spreads associated with default risk.

The bond indenture, a legal and binding contract between the issuing corporation and bondholders, is another essential aspect of bond investing discussed in the chapter.

Speculative graded bonds, also known as high yield bonds or junk bonds, carry a higher risk of default compared to investment-grade bonds. Credit rating agencies assign lower ratings to these bonds to indicate the increased likelihood of default or delayed payments on interest and principal. Investors typically demand higher yields for speculative graded bonds to compensate for the increased risk. As a result, the prices of these bonds tend to be lower, reflecting the higher interest rates required by investors.

In addition to credit ratings, bond investors also assess the financial health of the issuing corporation. Factors such as financial statements, industry trends, and management expertise are analyzed to determine the likelihood of timely interest and principal payments.

Maturity is an important aspect of bond investing. The maturity date represents the end of the bond's term when the principal amount is repaid to the bondholder. Short-term bonds have a maturity period of one to five years, while long-term bonds can span ten years or more. Investors should consider their investment objectives and risk tolerance when choosing between short-term and long-term bonds.

Interest rate risk plays a significant role in bond investing. Changes in interest rates can impact bond prices inversely. When interest rates rise, bond prices generally fall, and vice versa. This relationship occurs because existing bonds with lower interest rates become less attractive to investors compared to newly issued bonds with higher rates.

The yield curve illustrates the relationship between yields and time to maturity for bonds. During expanding economies, yield curves tend to slope upward, indicating that longer-term bonds have higher yields to compensate for the increased risk. Conversely, during contracting economies, yield curves may slope downward, indicating lower yields for longer-term bonds.

Bond trading occurs through various methods, such as organized exchanges and electronic platforms. Investors buy and sell bonds based on their investment strategies and market conditions. The goal is to buy bonds at a lower price and sell them at a higher price to generate a profit. However, bond trading carries risks, including market liquidity and price fluctuations driven by changes in interest rates.

To summarize, understanding the concepts discussed in this chapter is crucial for bond investing. It involves analyzing factors such as credit ratings, default risk, interest rate risk, maturity, and the relationship between yields and bond prices. By carefully evaluating these elements, investors can make informed decisions to build a bond portfolio that aligns with their financial goals and risk tolerance.

Corporate Bonds (FRM Part 1 2023 – Book 3 – Chapter 17)
Corporate Bonds (FRM Part 1 2023 – Book 3 – Chapter 17)
  • 2022.06.09
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Pricing Financial Forwards and Futures (FRM Part 1 2023 – Book 3 – Chapter 10)


Pricing Financial Forwards and Futures (FRM Part 1 2023 – Book 3 – Chapter 10)

Hello, this is Jim, and I would like to discuss Part One of our topic on financial markets and products, specifically focusing on the chapter about pricing financial forwards and futures. I apologize for taking up some time, but I believe it's worth it. Before we delve into the learning objectives, let's imagine that I'm a farmer named Jim, and I specialize in growing and selling grapefruit. Now, besides being a farmer, I'm also an investor and own a share of stock, which I'll represent with this index card.

Let's consider the scenario where there's a spot market for grapefruit, and the current price is $1 per grapefruit. As the farmer, I'm selling my grapefruits for $1 each. However, let's say you approach me and express your desire to purchase my grapefruit in a month. I ask you how much you are willing to pay me in a month, considering that I'll need to incur costs for storing and insuring the grapefruit during that period. You initially suggest paying $1, but I explain that I would have additional expenses for storing and insuring the fruit. So, after some negotiation, we agree on a price of $1.20.

To solidify our agreement, we sign a forward contract, which is a derivative security. This contract states that you will return in a month and pay me $1.20, and in return, I will provide you with the grapefruit. We now have a derivative contract in place. During our conversation, you notice a piece of paper on my desk, which happens to be a share of stock in Jim's Concrete Company. You inquire about it, and I mention that it's priced at $100. You express your interest in owning it in a month and propose paying me for the ownership. I inform you that the current price is $100 and ask how much you're willing to pay me in 30 days.

Similar to the grapefruit transaction, we consider potential costs and risks. In this case, we primarily factor in the interest rate. After further discussion, we agree on a price of $120. So, we have another derivative contract for the share of stock. To summarize, we now have two derivative contracts: one for the grapefruit and one for the share of stock.

The value of these derivative contracts over the next 30 days depends on the spot price of grapefruit and the share price of Jim's Concrete Company. If, for example, the spot price of grapefruit skyrockets to $3 in 10 days, I might feel regretful for agreeing to sell it to you for $1.20, as I could sell it immediately for $3. On the other hand, you would be delighted with the significant price increase. The same principle applies to the share of stock. Therefore, the value of these derivative contracts is contingent on the underlying asset values.

Now, let's move on to the learning objectives we need to cover. Firstly, we will define and describe financial assets, which are tradable investments representing ownership or claims on future cash flows or income from various entities. All financial assets are investment assets and are utilized to achieve our lifetime goals by generating positive returns.

Financial assets can be categorized into three types: those that provide no income, such as non-dividend shares of stock; those that offer fixed income with known amounts, like fixed coupon-paying bonds; and those that yield income based on a percentage of their value.

Next, we'll explore the concept of short selling. Essentially, short selling involves selling an asset first, with the expectation that its price will decline, allowing us to repurchase it at a lower price later.

They said, "Let's create a standardized forward contract that can be easily bought and sold in a secondary market." And that's how the concept of Futures contracts came into existence.

Futures contracts are standardized agreements that specify the details of a transaction, such as the quantity, quality, and delivery date of the underlying asset. Unlike forward contracts, which are customized for each transaction, futures contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME), and have standardized terms and conditions.

The standardization of futures contracts brings several advantages. First, it enhances market liquidity by allowing traders to easily buy or sell contracts at any time before the expiration date. This liquidity is facilitated by the exchange acting as an intermediary, matching buyers and sellers and ensuring the smooth functioning of the market.

Second, the standardization of futures contracts eliminates counterparty risk. In a forward contract, there is a risk that one party may default on their obligation to buy or sell the underlying asset. In contrast, futures contracts are backed by the clearinghouse associated with the exchange, which acts as a guarantor for all transactions. This means that if one party fails to fulfill their obligation, the clearinghouse steps in and ensures that the trade is completed.

Another key difference between forward and futures contracts is the marking-to-market feature of futures contracts. Marking-to-market refers to the daily settlement of gains or losses on futures positions based on the current market price. At the end of each trading day, the gains or losses are calculated, and the appropriate amount is credited or debited to the trader's account. This process helps to manage risk and ensures that both parties involved in the futures contract remain financially secure.

Now, let's move on to the next learning objective, which is calculating the forward price. In the example given by Jim, he mentioned agreeing on a forward price of $1.20 for the grapefruit and $120 for the share of stock. The forward price is the price at which the buyer and seller agree to transact the underlying asset at a future date. It is determined based on factors such as the spot price of the asset, the time to maturity, and the prevailing interest rates.

To calculate the forward price, various techniques can be used, including interest rate parity and cost of carry. These methods take into account the time value of money and the costs associated with holding the underlying asset until the contract's expiration.

Distinguishing between the forward price and the value of the forward contract is also an important concept. The forward price represents the agreed-upon price for the future transaction, while the value of the forward contract is the current worth of the contract at a given point in time. The value of a forward contract fluctuates over time based on changes in the spot price of the underlying asset, interest rates, and other factors.

Understanding the relationship between the forward price and the value of the forward contract is crucial for traders and investors who engage in hedging or speculative strategies using derivatives. By analyzing the difference between the forward price and the value, market participants can identify potential arbitrage opportunities or evaluate the performance of their positions.

In the next section, the chapter explores the relationship between the value of derivative contracts and the underlying asset's spot price. In Jim's example, the value of the derivative contracts depends on the spot price of grapefruit and the share of stock in Jim's Concrete Company. If the spot prices increase significantly, Jim may regret entering into the contracts because he could have sold the assets at a higher price in the spot market. Conversely, the buyer of the contracts would benefit from the price appreciation.

This concept applies to various types of derivative contracts, including futures, options, and swaps. The value of these derivatives is derived from an underlying asset or reference rate. Understanding how changes in the spot price of the underlying asset affect the value of the derivative is crucial for managing risk and making informed trading decisions.

For example, let's consider a call option on a stock. A call option gives the holder the right, but not the obligation, to buy the underlying stock at a predetermined price (known as the strike price) on or before a specified date (known as the expiration date). The value of the call option is influenced by factors such as the current stock price, the strike price, the time to expiration, the volatility of the stock, and the prevailing interest rates.

If the spot price of the stock increases, it becomes more valuable for the holder of the call option because they have the right to buy the stock at a lower strike price. This increase in value is known as intrinsic value, which is the difference between the spot price and the strike price. Additionally, the increase in the spot price may also result in an increase in the option's time value, which reflects the potential for further price appreciation before expiration.

Conversely, if the spot price of the stock decreases, the value of the call option may decrease as well. If the spot price falls below the strike price, the option may have no intrinsic value, and its value will primarily depend on its time value. As the expiration date approaches, the time value of the option diminishes, potentially leading to a decrease in its overall value.

This relationship between the spot price of the underlying asset and the value of the derivative is not limited to options but extends to other types of derivatives as well. For instance, in the case of futures contracts, the value of the contract is influenced by changes in the spot price of the underlying asset.

Understanding these relationships is crucial for derivative traders and investors. By analyzing how changes in the spot price affect the value of the derivative, market participants can assess potential risks and rewards associated with their positions. They can also utilize this knowledge to design strategies that take advantage of anticipated market movements or to hedge against potential losses.

As the chapter progresses, it may delve further into various types of derivatives, their valuation models, and strategies for managing risk and maximizing returns. Derivatives are powerful financial instruments that offer opportunities for speculation, hedging, and risk management, but they also come with their complexities and risks. It is essential for market participants to have a solid understanding of these instruments and their underlying principles before engaging in derivative trading or investment activities.

These are some questions that my students have asked, and I attempt to make them less obvious so that the students are not completely aware of what will happen next. Let's refer back to an example we discussed earlier. In that example, we analyzed the question stem and noticed that there were prices of 100 and 110, indicating a 10% difference. Additionally, the risk-free rate was only 5%. Based on this information, we could infer that it would be a cash and carry situation. Similarly, in another example, we deduced that it would be a reverse cash and carry scenario. My point is, if I were to create these questions, I would likely change the forward price to something other than 95, maybe 101, to introduce some ambiguity and make it more challenging to determine the answer. This is why the chapter and our illustrations aim to demonstrate this concept effectively. Now, let's move on to the calculation of the expected future price, adjusted for carrying costs.

To illustrate this, let's consider the concept of forward price. It starts at the spot price and moves up based on carrying costs. Eventually, it reaches the forward price. Notably, there is no initial cash flow when entering into a forward contract for a grapefruit or a share of stock. No money or underlying asset changes hands at the contract's initiation. As a result, the derivative has an initial value of zero dollars. This value depends on various factors such as the spot price, storage costs, time, and the risk-free rate of interest. The chapter doesn't delve into the reasons for choosing the risk-free rate of interest extensively, but it is essential to consider that it helps generate a risk-free positive rate of return. This concept originated from the Black-Scholes-Merton option pricing model developed by Fisher Black, Myron Scholes, and Robert Merton in the early 1970s. They emphasized using the risk-free rate of interest as a starting point for valuing derivatives. Therefore, it's crucial to understand that the apparent riskiness of derivatives can be mitigated by constructing a risk-free portfolio using derivatives and spot assets.

Now, let's explore the value of a forward contract over its lifetime. Imagine we agreed to trade a grapefruit for $1.20. What is the value of this derivative security between now and 30 days from now? Suppose the price of a grapefruit increases to $3. In this case, I would be unhappy because I agreed to sell the grapefruit for only $1.20, missing out on a higher selling price. However, the counterparty could sell the derivative contract to reflect the price movement in their favor, thereby capitalizing on the profit. This illustrates the crucial difference between a forward contract and a futures contract. In a forward contract, finding someone to take over the contract can be challenging, whereas in an exchange-traded futures contract, it is easier to sell the derivative security and realize the profit without waiting until the contract matures.

Returning to the initial discussion, we initially used the forward contract for hedging purposes, explicitly or implicitly. Hedging is an essential demand for both forward and futures contracts, but these contracts also serve speculative purposes. For instance, anyone can sell a forward contract, even if they are not directly involved in the underlying asset. Speculators, hedgers, and arbitragers operate within the derivatives market. Consequently, understanding the value of a derivative contract becomes crucial. Over time, the value of the contract changes due to fluctuations in the spot price and interest rates. The value can be positive or negative, depending on factors such as Pride or regret associated with the contract. Initially, the contract's value is zero, and over its lifespan, it can vary.

At maturity, the value of the forward contract is determined by the final spot price of the underlying asset and the agreed-upon forward price. If the spot price at maturity is higher than the forward price, the contract has a positive value. On the other hand, if the spot price is lower than the forward price, the contract has a negative value.

To calculate the value of a forward contract at any given time before maturity, we need to consider the present value of the difference between the current spot price and the forward price, adjusted for carrying costs. The carrying costs include storage costs, financing costs, and any other expenses associated with holding the underlying asset.

Let's walk through an example to better understand the calculation. Suppose the spot price of a commodity is $100, the forward price is $105, and the risk-free interest rate is 5%. The time to maturity is one year. To find the value of the forward contract, we first need to calculate the carrying cost.

Carrying cost = (Spot price - Forward price) * e^(risk-free rate * time to maturity)

Carrying cost = ($100 - $105) * e^(0.05 * 1)

Carrying cost = -$5 * e^(0.05)

Now, let's calculate the present value of the difference between the spot price and the forward price, adjusted for the carrying cost. We use the formula:

Present value = (Spot price - Forward price) * e^(-risk-free rate * time to maturity)

Present value = ($100 - $105) * e^(-0.05 * 1)

Present value = -$5 * e^(-0.05)

To find the value of the forward contract, we subtract the carrying cost from the present value:

Value of the forward contract = Present value - Carrying cost
 
Value of the forward contract = -$5 * e^(-0.05) - (-$5 * e^(0.05))

Value of the forward contract = -$5 * (e^(-0.05) + e^(0.05))

The resulting value can be positive or negative, indicating a gain or loss in the forward contract's value. If the value is positive, it means the contract is in profit, and if it is negative, it indicates a loss.

By calculating the value of the forward contract at different points in time, we can track its fluctuation and assess its profitability. This understanding is essential for market participants to make informed decisions regarding entering, holding, or exiting forward contracts.

It's important to note that the calculation of forward contract values is based on several assumptions, such as the absence of transaction costs and market frictions. Additionally, the formula assumes continuous compounding for carrying costs and risk-free interest rates. These assumptions simplify the calculation for educational purposes but may not capture the complexities of real-world trading scenarios.

In conclusion, the value of a forward contract changes over time due to fluctuations in the spot price of the underlying asset and the effects of carrying costs. By considering these factors and employing mathematical models, market participants can evaluate the profitability of forward contracts and make informed investment decisions.

Pricing Financial Forwards and Futures (FRM Part 1 2023 – Book 3 – Chapter 10)
Pricing Financial Forwards and Futures (FRM Part 1 2023 – Book 3 – Chapter 10)
  • 2023.05.31
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Properties of Options (FRM Part 1 2023 – Book 3 – Chapter 13)


Properties of Options (FRM Part 1 2023 – Book 3 – Chapter 13)

Hi, I'm Jim, and I'd like to discuss Part One of the financial markets and products topic, specifically focusing on the chapter that covers the properties of options.

First, let's talk about the unique nature of options compared to forward contracts, futures contracts, and swap contracts. Unlike these binding agreements, options grant you the right, but not the obligation, to take a specific action. This distinction gives options their distinct properties and influences their pricing. In this discussion, we'll focus on six key factors that affect options: underlying asset price, exercise price, time to expiration, option type (American or European), volatility, and the risk-free interest rate.

Let's start with the underlying asset price. Imagine a scenario where a stock is currently trading at $100 per share, and there are call and put options available with an exercise price of $100. When you buy a call option, you're betting that the stock price will rise. If the stock price goes up to $110, $120, or even $200, the value of the call option will increase as well. On the other hand, when you buy a put option, you're betting that the stock price will fall. If the stock price drops to $80, $70, $40, or $10, the value of the put option will increase. It's important to note that the intrinsic value of an option is the difference between the stock price and the exercise price.

The exercise price is another crucial factor. A higher exercise price for a call option means the underlying asset has a lower chance of ending up in-the-money, leading to a decrease in the call option's value. Conversely, a higher exercise price for a put option means there is a higher likelihood of the underlying asset falling below the exercise price, resulting in an increase in the put option's value.

Time to expiration also plays a significant role. Holding all other factors constant, an option with a longer expiration period generally commands a higher value compared to an option with a shorter expiration period. This is because the longer expiration period allows more time for the underlying asset price to move favorably.

Differentiating between American and European style options is important. American options can be exercised at any time until expiration, while European options can only be exercised at maturity. For American call options, as the time to expiration increases, the probability of the underlying asset price rising also increases, leading to a higher option value. For American put options, the focus is on the likelihood of the underlying asset price falling below the exercise price, which results in an increase in the option value.

When considering dividends, there are additional factors to consider. Dividends reduce the value of call options since option holders do not receive dividends. Conversely, put options tend to increase in value since the underlying asset price often drops on the ex-dividend date.

Volatility is another crucial factor affecting options. Higher volatility leads to higher option prices for both calls and puts. Volatility represents the magnitude of price fluctuations in the underlying asset. If the stock price is expected to remain stable (zero volatility), the option will have no value. However, if there is significant variability in the stock price, indicating high volatility, the option will have a higher price.

The risk-free interest rate also plays a role in option pricing. Options can be priced using the risk-free rate of interest, which may seem counterintuitive since options involve significant risk.

Now, let's rearrange the equation to isolate the call price. By rearranging the equation, we find that the call price equals the stock price minus the present value of the exercise price plus the present value of the dividends. This equation helps us determine the lower and upper bounds for call options.

Now, let's move on to discussing the lower and upper bounds for put options. The lower bound for a put option is straightforward. If the stock price is greater than the exercise price, the put option is out of the money, meaning it has no intrinsic value. Therefore, the lower bound for a put option is zero.

The upper bound for a put option occurs when the exercise price is greater than the stock price. In this case, the put option is in the money, and its intrinsic value is equal to the exercise price minus the stock price. However, since we are dealing with the upper bound, the put price cannot exceed its intrinsic value. Therefore, the upper bound for a put option is its intrinsic value.

Now, let's delve into the concept of put-call parity. Put-call parity is a fundamental principle in options pricing that establishes a relationship between the prices of call options, put options, the underlying asset (e.g., stocks), and risk-free investments. It helps us understand the interdependencies between these components.

Put-call parity states that the price of a call option minus the price of a put option is equal to the difference between the stock price and the present value of the exercise price, accounting for the present value of any dividends.

This relationship opens up opportunities for arbitrage, where traders can exploit price discrepancies between related securities to make risk-free profits. If put-call parity is violated, it indicates a pricing inconsistency, and market forces would quickly correct the discrepancy.

Understanding put-call parity allows us to grasp the interconnectedness of different financial markets, such as equity markets, fixed income markets, and derivative markets. The trading activities in one market can influence the pricing and behavior of related securities in other markets.

To summarize, the factors influencing options pricing include the underlying asset's price, exercise price, time to expiration, volatility, risk-free interest rate, and dividend payments. Each factor has a specific impact on call options and put options. Both call options and put options have upper and lower bounds, and put-call parity provides a valuable framework for comprehending options pricing and the relationships between different financial markets.

Now, let's work through a quick example. Suppose the stock price is $80, the exercise price is $40, the time to expiration is one year, and a dividend of $5.50 will be received in six months. We calculate the present value of the dividend to be $5.24. Subtracting the present value of the dividend ($5.24) from the stock price ($80) and subtracting the present value of the exercise price ($36.36) gives us $38.40. The intrinsic value of the option is $40. In this case, the call option can be sold for less than its intrinsic value without creating an arbitrage opportunity, but this condition holds true only because the stock price is $80 and the exercise price is $40.

Regarding early exercise, if an option has time value, exercising early would eliminate that value. The option is typically exercised only when it has no time value left. However, early exercise comes with the loss of potential interest earnings, so a substantial dividend payment is required to cover these costs.

For American put options, they may be exercised early if the stock price falls below the exercise price. Intrinsic value plays a role, and by exercising early, one can earn interest until the option expires.

In addition to U.S. Treasury securities, forward contracts can be used as substitutes in put-call parity equations, providing a useful approximation or reference point.

Lastly, remember to review the questions at the end of the chapter to reinforce your understanding of the topic. Good luck with your studies!

Properties of Options (FRM Part 1 2023 – Book 3 – Chapter 13)
Properties of Options (FRM Part 1 2023 – Book 3 – Chapter 13)
  • 2023.06.02
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Jim Simons Trading Secrets 1.1 MARKOV Process


Jim Simons Trading Secrets 1.1 MARKOV Process

The Medallion Fund managed by Jim Simons has achieved a net return of 39% over the past three decades, proving its effectiveness. Jim Simons is widely regarded as one of the greatest traders of all time, surpassing even renowned figures like Warren Buffett and Charlie Munger. His strategy is predominantly based on quantitative analysis, known as quants.

While the inner workings of Simons' fund remain highly secretive, insights can be gleaned from a book I have been reading. Many of the strategies I personally employ in my own life have been inspired by Simons' approach. Today, we will delve into the information presented in the book and attempt to code and analyze the techniques used by Jim Simons in his fund.

One notable individual mentioned in the book is "Ax," who used to work for Simons. Ax is recognized as a mathematical genius and has authored remarkable papers in the field. The book highlights Ax's focus on a concept called Markov chains. In a Markov chain, each step in the sequence is unpredictable, but future steps can be predicted to some extent by relying on a reliable model. Ax and his team developed a stochastic equation based on the principles of Markov chains.

Another key figure mentioned in the book is "Loafer," another mathematical genius who worked for Simons. Loafer employed a mean-reverting strategy, which is based on the idea that prices tend to revert after an initial move in either direction. In this strategy, positions are taken when prices open at unusually low levels.

Towards the end of the book, the trading results of Jim Simons are discussed. Notably, during the recessionary period of 2007-2008, Simons achieved remarkable returns of 152% and 136%, surpassing the performance of other years. It is essential to recognize that mean-reverting strategies excel during periods of high volatility, such as recessions. These strategies, including the ones taught in our course, Q3 and Q5, have also performed exceptionally well during the past two years and the 2007-2008 recession.

The book also analyzes the performance of a mean-reverting strategy applied to the S&P 500 (SPY) using a Buy and Hold equity line. The strategy showcased significant gains during the 2008 recession, while the market experienced a substantial decline. Similarly, it has performed well in the past two years, which have been marked by market volatility and a lack of recovery.

In our course, called Prometheus, we teach a variety of strategies, including Q5, which follows a mean-reverting approach. This strategy, along with others, has demonstrated consistent success over time. The course also covers essential concepts like trend following, momentum-based strategies, Monte Carlo simulation, portfolio optimization, forward testing, and other crucial quantitative trading tools.

To better understand Simons' techniques, we will discuss the Markov process, which lies at the core of his strategy. A Markov process is a random sequence of events where the probabilities of future events depend solely on the current state, rather than the past. A simple example is presented to illustrate this concept, involving a person's movement between home, a shop, and work. Unlike a human, who remembers the past, the hypothetical "Markov" character's future movement is solely based on the current state, enabling the calculation of probabilities.

The discussion further delves into the calculation of transition probabilities in a trading context. Using real-world data from the SPY, the probabilities of a positive or negative percentage move on the next trading day are calculated based on the current day's performance. This information is organized into a transition matrix, which represents the probabilities of transitioning between different states.

The code presented in an Anaconda notebook demonstrates how to calculate the transition matrix and analyze the results. The notebook uses Python and various libraries such as pandas, numpy, and matplotlib to perform the calculations and generate visualizations.

The code begins by importing the necessary libraries and loading the historical price data of the SPY into a pandas DataFrame. The price data is then transformed into daily returns, which represent the percentage change in price from one day to the next. These returns are used to calculate the transition probabilities.

Next, the code defines a function that takes the daily returns and a specified lag as input. The lag determines the number of previous returns used to calculate the transition probabilities. The function iterates over the returns and builds a transition matrix by counting the occurrences of positive and negative returns and calculating their respective probabilities. The matrix is stored as a numpy array.

Once the transition matrix is calculated, the code generates a heatmap using matplotlib to visualize the probabilities. The heatmap provides a visual representation of the transition probabilities, with darker colors indicating higher probabilities.

The notebook then goes on to analyze the transition matrix and draw insights from the results. It calculates the average probabilities of transitioning from positive to positive, positive to negative, negative to positive, and negative to negative returns. These averages help assess the persistence and mean-reverting nature of the returns.

The code also calculates the stationary distribution of the Markov process, which represents the long-term probabilities of being in each state. The stationary distribution can provide insights into the overall behavior of the market and the potential profitability of mean-reverting strategies.

Additionally, the notebook discusses the limitations of the Markov process and the transition matrix approach. It acknowledges that market dynamics can change over time, and past probabilities may not accurately predict future behavior. Therefore, continuous monitoring and adaptation of trading strategies are crucial.

In conclusion, the notebook provides a comprehensive overview of the techniques used by Jim Simons and his team at the Medallion Fund. It explores the concepts of Markov chains, mean-reverting strategies, and transition matrices, offering practical code examples and insights into their application in quantitative trading. By understanding and implementing these strategies, traders and investors can potentially enhance their decision-making and improve their overall performance in the financial markets.

Jim Simons Trading Secrets 1.1 MARKOV Process
Jim Simons Trading Secrets 1.1 MARKOV Process
  • 2023.05.05
  • www.youtube.com
Jim Simons is considered to be one of the best traders of all time he has even beaten the like of Warren Buffet, Peter Lynch, Steve Cohen and Ray Dalio. Jim'...
 

Exposing Jim Simons Cryptic Data Tactics and Simulations


Exposing Jim Simons Cryptic Data Tactics and Simulations

A few weeks ago, we had a discussion about Jim Simmons and the Markov process described in a book. Today, we are going to explore another concept that was utilized by both Jim Simmons and Albert Einstein. To begin, let's refer to page 84 of the book "The Man Who Solved the Market," which we are dissecting.

In order to develop a sophisticated and accurate forecasting model capable of detecting hidden patterns, Jim Simmons and his team at Axcom relied on identifying comparable trading situations and tracking subsequent price movements. However, they needed a significant amount of data for this approach to be effective, even more than what Strauss and other researchers had collected. As a result, they started modeling the data rather than simply collecting it. By using computer models, they could make educated guesses about the missing historical data, filling in the gaps and creating a more complete dataset.

This concept of modeling data to address gaps in historical records is what we will be exploring here. When we have limited data or when data is missing, we can simulate or create new data points. The more data we have, the more we can conduct backtesting, research, optimization, and training. Ultimately, having more data allows us to draw more reliable conclusions about the effectiveness of our strategies.

To illustrate this, let's consider an example. Suppose we have a chart of the SPY (Standard & Poor's 500 ETF) during the 2008 financial crisis. While we have enough data for roughly three years or 252 trading days, is this sufficient to conclude that a particular strategy works? In this case, approximately 750 data points may not be enough. To overcome this limitation, we can simulate additional data points, extending the timeframe and allowing for more comprehensive testing.

In this discussion, we will explore three models that facilitate the generation of more data. Each model has its own advantages and disadvantages, but they all serve the purpose of generating more data for quantitative research. We will explain the positives and negatives of each model as we progress, enabling you to make informed decisions based on your specific requirements.

To get started, I recommend opening the Anaconda file on your system. If you are unfamiliar with Python, I suggest watching our YouTube video titled "Algorithmic Trading: From Zero to Hero in Python," which covers the basics of Python installation, backtesting strategies, and using functions and loops. Once you are familiar with Python, you can proceed with the next steps.

First, we need to import the necessary libraries such as YFinance, Pandas, NumPy, Matplotlib, and Seaborn. Then, we can download the data, focusing on the SPY data from the 2008-2011 period to mimic the recessionary data. We will store the closing prices in a variable called "close_prices" and calculate the percentage change in prices, which will be stored in a pandas dataframe called "df."

Now, let's move on to the first model, the simple Monte Carlo model. We will calculate the mean and standard deviation of the data points in "df" and use these values to simulate data. By leveraging a normal distribution and the mean and standard deviation, we can generate simulated stock prices. We will plot these simulated prices, providing a visual representation of the data.

Furthermore, we can create 1,000 simulations of this data, resulting in 1,000 sets of data points. This equates to a significant increase in the number of data points, giving us more opportunities for quantitative analysis, backtesting, optimization, and the identification of effective strategies. Each simulation will be stored in a variable called "simulations_mc" and can be accessed individually for further examination.

At this point, we have a large set of simulated data that we can apply our trading strategies to.

So that basically what that is is a dot product, which is like multiplying each value of that array by x0. This is done to calculate the stock price at each time step.

Now, we're going to create a for loop to run the simulation 1,000 times. Inside the loop, we'll generate the Brownian motion using the numpy.random.normal function and multiply it by the square root of DT to account for the time step. Then we'll update the stock price using the geometric Brownian motion equation and store it in the simulations list.

Finally, we'll plot the simulated stock prices for all 1,000 iterations. By doing so, we'll have a visual representation of multiple potential paths the stock price could have taken based on the geometric Brownian motion model. This allows us to generate a large amount of data points that can be used for backtesting, research, optimization, and drawing conclusions about the effectiveness of various strategies.

Now, let's move on to the third model, which is the Heston model. The Heston model is an extension of the geometric Brownian motion model and is widely used in quantitative finance to capture the dynamics of stock prices. It introduces the concept of stochastic volatility, which means the volatility of the underlying asset is not constant but follows its own random process.

The Heston model is expressed by a system of stochastic differential equations, which describe the dynamics of both the stock price and the volatility. However, implementing the Heston model requires more complex mathematics and computational techniques, making it beyond the scope of this discussion.

Nevertheless, it's worth noting that the Heston model can generate even more diverse and realistic stock price paths by incorporating volatility clustering and mean-reversion effects. This can be particularly useful for analyzing and predicting market behavior during periods of high volatility or when dealing with complex financial instruments.

In summary, we have discussed three models: the simple Monte Carlo model, the geometric Brownian motion model, and the Heston model. Each model serves the purpose of generating additional data points by simulating stock price paths. These simulations can then be used for quantitative research, strategy development, and testing in different market scenarios.

To perform these simulations and analyze the data, we have utilized Python and the libraries such as pandas, NumPy, and matplotlib. Python provides a flexible and powerful environment for conducting quantitative analysis and implementing various financial models.

It's important to note that while these models can provide valuable insights and generate data for analysis, they are based on certain assumptions and simplifications. Real-world market dynamics can be influenced by numerous factors and are often more complex than what these models capture. Therefore, careful interpretation and validation of the results are necessary before applying them to real trading or investment decisions.

That concludes our discussion on simulating stock price data using different models. If you have any further questions or would like to explore other topics, please feel free to ask.

Exposing Jim Simons Cryptic Data Tactics and Simulations
Exposing Jim Simons Cryptic Data Tactics and Simulations
  • 2023.06.16
  • www.youtube.com
Inspired form the book about Jim Simons “The man who solved the market” and how they simulated or created data to perform quantitative analysis we discuss in...