Buffet and Black Scholes

Aswath Damodaran (of NYU) takes on Warren Buffet's criticism of academics and their "obsession" with Black Scholes.  I agree with Prof Damodaran on this one.

A couple of reposts from the Finance Professor Blog...

Just working through some of the starred postings in my RSS reader...

The Finance Professor  blog has a nice video of Harry Markowitz talking about portfolio theory and another one featuring Gene Fama Jr talking about asset pricing.

Well worth a view.

Deviations from put call parity have predictive power.

We've been talking about options in class this week and we've covered put call parity.  Put call parity simply states that the call price + the present value of the strike = stock price + put price.  A question that comes up in class is what do deviations from PCP really mean?

A forthcoming article in the JFQA (a top finance journal) finds that deviations from PCP have predictive power.  When calls are relatively expensive compared to puts, the underlying stock outperforms.  Likewise, when puts are relatively expensive compared to calls the underlying stock underperforms.  These results hold the strongest for illiquid stocks that have liquid options.

Inflation linked bonds are back in the spotlight

With global concerns about inflation, the attention turns, predictably, to asset classes that are good inflation hedges.  The FT has a good article on the topic.   Mechanically, inflation linked bonds will provide inflation protection.  But they have a problem - only part of their nominal return comes from inflation - the other part is a real return.  Currently the real return on US inflation linked bonds is basically zero.  If demand for TIPs increases this could go negative (it has in the past).  

Alternatives to TIPs include any real asset.  For example, in the long run, stocks are excellent inflation hedges, although in the short run they often do poorly, in large part because investors don't understand that they are real and not nominal assets.  Commodities are good hedges - but very volatile.  

At the end of the day, trying to bet on inflation is a risky business.

How important is the stock market?

Felix Salmon recently posted an op ed in the New York Times that argues that the US equity markets are becoming less important to the US economy.

The striking number is that in 1997 there were 7,000 publicly traded firms.  Today there are 4,000.  The number of IPOs is way down and the market is increasingly becoming dominated by large cap stocks.  Furthermore, these stocks rarely use the market to raise new equity.  Many small firms that would have listed on the markets are now being funded with private equity.

Felix follows up on his original column and asks what this means for small investors.

Trading on volatility

I was updating some lecture notes on option volatility and was doing a little research on the various VIX (S&P 500 implied volatility) products that are out there these days.  It turns out that there are a whole host of securities (mostly ETNs) that allow an investor to trade various futures positions in the VIX.

Consider the following post on the blog VIX and More.   At the time of writing, you can trade leveraged 5 month VIX futures or if you're wanting to go short volatility you can trade an ETN that takes a short position in 1 month VIX futures.   The graphic at the bottom of the post shows the different products.

A lot of these have fairly small trading volume, so you have to wonder about liquidity.  They also look pretty risky.

Personally though, I'll just stick with my index funds.

Hedge funds searching for ways to short munis

Munis - the name given to municipal bonds - are bonds sold by states and state agencies.   For years munis have been considered safe and boring.  But now, with many states facing severe budget crisis, investors (and in particular hedge funds) are paying close attention to munis.

If you are running a hedge fund, you might sense an opportunity here.  If you believe that the credit worthiness of states will continue to decline, then the price of munis should fall (and at the same time the yield on these bonds will increase).  The obvious strategy then is to go short munis.  The question then is how?

The Financial Times tackles this question.  First it turns out that shorting muni bonds is quite hard as most muni debt is held by buy and hold investors like pension funds who are not interested in lending the bonds out to short sellers.  Second, even though in theory you could buy credit default swaps, the market for muni CDS contracts is pretty thin and as a result there are liquidity issues.  Finally, you could just try and short a muni index, but you won't be able to target a specific state.

For students of finance, this is what we call a "limits to arbitrage" problem.  While in theory the smart money should try and short overpriced bonds, frictions in the market render such a strategy costly or unpractical.   It is important to note however, that this doesn't mean that markets are not efficient, just that they are not perfect.  There is a difference.