Alpha in Practice Eric Falkenstein Alpha Examples

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 1980 s 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 $100 k+ arbitraging put-call parity

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

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

Forward vs Future Euro Trade

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

Current Futures vs. Forwards Embodies Convexity Adjustment 5/1/2009 6/17/2009 9/17/2009 12/17/2009 3/17/2010 6/17/2010 9/17/2010 12/17/2010 3/17/2011 6/17/2011 9/17/2011 12/17/2011 3/17/2012 6/17/2012 9/17/2012 12/17/2012 3/17/2013 6/17/2013 9/17/2013 12/17/2013 3/17/2014 6/17/2014 9/17/2014 12/17/2014 3/17/2015 6/17/2015 9/17/2015 12/17/2015 3/17/2016 6/17/2016 Futures 0. 95 1. 01 1. 23 1. 34 1. 58 1. 84 2. 15 2. 40 2. 67 2. 91 3. 14 3. 30 3. 44 3. 56 3. 69 3. 74 3. 82 3. 90 4. 04 4. 10 4. 18 4. 23 4. 25 4. 28 4. 32 4. 38 4. 39 4. 41 Forward 0. 94 1. 01 1. 22 1. 34 1. 58 1. 83 2. 14 2. 38 2. 65 2. 88 3. 11 3. 25 3. 39 3. 50 3. 62 3. 67 3. 74 3. 81 3. 94 3. 99 4. 05 4. 10 4. 11 4. 13 4. 16 4. 21 Conv. Bias 0. 00 0. 01 0. 02 0. 03 0. 04 0. 05 0. 06 0. 07 0. 08 0. 09 0. 10 0. 11 0. 13 0. 14 0. 15 0. 16 0. 17 0. 18 0. 20

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

Convertible Arbitrage Strategy Decline 1994 -03 Ann. Ret Ann. Stdev Sharpe 10. 3% 4. 5% 1. 26 Good times, good times… 2003 -08 Ann. Ret -7. 8% Ann. Stdev 12. 6% Sharpe -0. 81 Party over

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

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.

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

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

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 Risk. Calc works, is profitable

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

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

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

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)

They Don't Do What they Say James Cramer’s 90 s 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

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’

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