Category Archives: Finance

Market Volatility Revisited (Coronavirus Edition)…

Not that anyone is counting, but market volatility today is comparable numerically to market volatility in the depths of the global financial crisis of 2007-2009. Today, the CBOE’s implied volatility index (ticker symbol VIX) closed at 54.46. Putting this into a historical perspective, this level is at the 99.43rd percentile for all 7,557 daily observations on VIX recorded daily during the 30-year period spanning 1/2/1990 – 12/27/2019. The last time that VIX closed at this high of a level occurred on November 5, 2008, when it closed at 54.56.

For more information about the (contemporaneous) relationship between VIX and the overall stock market (as measured by the S&P 500 index), see “On the relationship between the S&P 500 and the CBOE Volatility Index (VIX)“:

Coronavirus: Baylor Finance Expert Explains How Uncertainty is Driving Market Fears

Proud of my Baylor colleague David Dicks, whose recent Journal of Political Economy article entitled “Uncertainty Aversion and Systemic Risk” (cf. https://www.journals.uchicago.edu/doi/abs/10.1086/701356) provides insights into how uncertainty unleashes waves of investor pessimism; such is the effect that COVID-19 is currently having on financial markets. Dr. Dicks’ advice for investors? “If you are nervous about the impact of coronavirus, do not call your broker. Get a flu shot and be careful about washing your hands.”

In the following Q&A, David Dicks, Ph.D, Baylor University assistant professor of finance, shares his thoughts on why this uncertainty has damaged the markets, puts the current situation in historic perspective and offers hope to investors.

Catastrophe Bonds Signal Coronavirus Nearing Pandemic Status

Fascinating article about how prices of catastrophe bonds issued back in 2017 by the World Bank now show that the coronavirus may very well be evolving into a global pandemic…

Catastrophe Bonds Signal Coronavirus Nearing Pandemic Status
The World Health Organization says the coronavirus isn’t yet a global pandemic. Bonds that insure against just such a catastrophe say that it probably is.

On the Determinants of Risk Aversion

Last week, we began a series of five Finance 4335 class meetings (scheduled for January 28 – February 11) devoted to decision-making under risk and uncertainty. We shall study how to measure risk, model consumer and investor risk preferences, and explore implications for the pricing and management of risk. We will focus especially on the concept of risk aversion. Other things equal, risk averse decision-makers prefer less risk to more risk. Risk aversion helps to explain some very basic facts of human behavior; e.g., why investors diversify, why consumers purchase insurance, etc.

A few years ago, The Economist published a particularly interesting article about various behavioral determinants of risk aversion, entitled “Risk off: Why some people are more cautious with their finances than others”. Here are some key takeaways from this article:

  1. Economists have long known that people are risk-averse, yet the willingness to run risks varies enormously among individuals and over time.
  2. Genetics explains a third of the difference in risk-taking; e.g., a Swedish study of twins finds that identical twins had “… a closer propensity to invest in shares” than fraternal ones.
  3. Upbringing, environment, and experience also matter; e.g., “… the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons.”
  4. People’s financial history has a strong impact on their taste for risk; e.g., “… people who experienced high (low) returns on the stock market earlier in life were, years later, likelier to report a higher (lower) tolerance for risk, to own (not own) shares and to invest a bigger (smaller) slice of their assets in shares.”
  5. “Exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses.” Furthermore, a low tolerance for risk is linked to past emotional trauma.

Prediction markets’ take on removal of POTUS from office

As of 2:15 p.m. central standard time today, the PredictIt.org prediction market put the odds of President Trump being removed from office at 8%.  Specifically, Predictit.org currently offers for sale a “share” which pays $1 if the answer to the question, “Will the Senate convict Donald Trump in his first term?, turns out to be “yes”.

Allow me to provide further context for this “prediction”.  PredictIt.org is a New Zealand-based prediction market that offers “shares” on political and financial events.  The idea behind  PredictIt.org shares (technically, these are binary options, but I digress) is quite simple – you can buy and sell “yes” and “no” shares which pay off $1 if the answer to the contract question ends up being “yes” or “no”.  If you buy yes (no) but no (yes) is the answer, then your share expires worthless and you have lost the full value of your original “investment”.  However, if you sell yes (no) and no (yes) is the answer, then you don’t owe your counterparty any money and you get to pocket the price received (net of transactions costs) as profit.

Since the payoffs on PredictIt.org shares feature binary payoffs (i.e., $1 if yes and $0 if no),  these shares are canonical examples of Arrow-Debreu, or “pure” securities.  Arrow-Debreu securities pay $1 if a particular state (in this case, either “yes” or “no”) occurs at a particular time in the future.  Thus, the current price for a given PredictIt.org share is the “state price”,  which corresponds to the value today of $1 received when a particular future state of the world is realized.  Breaking the state price down further, its components include 1) the probability of a particular future state of the world, 2) the rate of interest (to compensate for the time value of money), and 3) a further discount (to compensate for risk averse behavior by the bettor) or premium (to compensate for risk loving behavior by the bettor).

Prediction market prices are frequently referred to in the news media as probabilities for future state-contingent events; if prediction market participants are risk neutral and interest rates are negligible, then this is technically appropriate and roughly correct.  What’s fascinating about prediction markets is that they showcase, in very pure form, how market prices reflect the statistical odds of some future event happening.  Similarly, prices of speculative assets generally (e.g., corporate securities such as stocks and bonds and derivative securities such as options and futures) also reflect probabilistic beliefs about future states of the world, albeit in more of an opaque fashion.

Also featured as one of “50 Things That Made the Modern Economy”: The Index Fund

Besides insurance, Tim Harford also features the index fund in his “Fifty Things That Made the Modern Economy” radio and podcast series. This 9 minute long podcast lays out the history of the development of the index fund in particular and the evolution of so-called of passive portfolio strategies in general. Much of the content of this podcast is sourced from Vanguard founder Jack Bogle’s September 2011 WSJ article entitled “How the Index Fund Was Born” (available at https://www.wsj.com/articles/SB10001424053111904583204576544681577401622). Here’s the description of this podcast:

“Warren Buffett is the world’s most successful investor. In a letter he wrote to his wife, advising her how to invest after he dies, he offers some clear advice: put almost everything into “a very low-cost S&P 500 index fund”. Index funds passively track the market as a whole by buying a little of everything, rather than trying to beat the market with clever stock picks – the kind of clever stock picks that Warren Buffett himself has been making for more than half a century. Index funds now seem completely natural. But as recently as 1976 they didn’t exist. And, as Tim Harford explains, they have become very important indeed – and not only to Mrs Buffett.”

Warren Buffett is one of the world’s great investors. His advice? Invest in an index fund

Insurance featured as one of “50 Things That Made the Modern Economy”

From November 2016 through October 2017, Financial Times writer Tim Harford presented an economic history documentary radio and podcast series called 50 Things That Made the Modern Economy. This same information is available in book form under the title “Fifty Inventions That Shaped the Modern Economy“. While I recommend listening to the entire series of podcasts (as well as reading the book), I would like to call your attention to Mr. Harford’s episode on the topic of insurance, which I link below. This 9-minute long podcast lays out the history of the development of the various institutions which exist today for the sharing and trading of risk, including markets for financial derivatives as well as for insurance.

“Legally and culturally, there’s a clear distinction between gambling and insurance. Economically, the difference is not so easy to see. Both the gambler and the insurer agree that money will change hands depending on what transpires in some unknowable future. Today the biggest insurance market of all – financial derivatives – blurs the line between insuring and gambling more than ever. Tim Harford tells the story of insurance; an idea as old as gambling but one which is fundamental to the way the modern economy works.”

Plans for next week’s Finance 4335 class meetings, along with a preview of future topics

We will devote next week in Finance 4335 to tutorials on probability and statistics. These tools are critically important to in the measurement of risk and development of risk management strategies for individuals and firms alike. Next Tuesday’s class meeting will be devoted to introducing discrete and continuous probability distributions, calculating parameters such as expected value, variance, standard deviation, covariance, and correlation, and applying these concepts to measure expected returns and risks for portfolios comprising risky assets. The following Thursday will provide a deeper dive into discrete and continuous probability distributions, in which we showcase the binomial and normal distributions.

While I have your attention, let me briefly explain what the main “theme” will initially be in Finance 4335 (up to the first midterm exam on Tuesday, February 18). Starting on Tuesday, January 28, we will begin our discussion of decision theory. Decision theory addresses decision making under risk and uncertainty, which at the very heart of risk management. Initially, we’ll focus attention on variance as our risk measure. Most of the basic finance theories, including portfolio, capital market, and option pricing theories, define risk as variance. We’ll learn that while this is not necessarily an unreasonable assumption, circumstances may arise where it is not an appropriate assumption. Since individuals and firms encounter multiple sources of risk, we also need to take into consideration the portfolio effects of risk. Portfolio theory implies that risks often “manage” themselves by canceling each other out. Thus the risk of a portfolio is typically less than the sum of the individual risks which comprise the portfolio.

The decision theory provides a useful framework for thinking about concepts such as risk aversion and risk tolerance. The calculus comes in handy by providing an analytic framework for determining how much risk to retain and how much risk to transfer to others. Such decisions occur regularly in daily life, encompassing practical problems such as deciding how to allocate assets in a 401-K or IRA account, determining the extent to which one insures health, life, and property risks, whether to work for a startup or an established business and so forth. There’s also ambiguity when we have incomplete information about risk. This course will at least help you think critically about costs, benefits, and trade-offs related to decision-making whenever you encounter risk and uncertainty.

After the first midterm, the rest of the semester will be devoted to various other risk management topics, including the demand for insurance, asymmetric information, portfolio theory, capital market theory, option pricing theory, and corporate risk management.

Volatility, now the whole thing

I highly recommend John Cochrane’s January 2019 article entitled “Volatility, now the whole thing” which builds and expands upon yesterday’s implied volatility topic in Finance 4335. Dr. Cochrane is a senior fellow at Stanford University’s Hoover Institution and was formerly a finance professor at Univ. of Chicago. Cochrane’s article provides a broader framework for thinking critically about the implications of volatility for future states of the overall economy. This article is well worth everyone’s time and attention, so I highly encourage y’all to read it!

Lagrangian Multipliers

There is a section in the assigned “Optimization” reading due Thursday, January 16 on pp. 74-76 entitled “Lagrangian Multipliers” which (as noted in footnote 9 of that reading) may be skipped without loss of continuity. The primary purpose of this chapter is to re-acquaint students with basic calculus and how to use the calculus to solve so-called optimization problems. Since the course only requires solving unconstrained optimization problems, there’s no need for Lagrangian multipliers.

Besides reading the articles entitled “Optimization” and “How long does it take to double (triple/quadruple/n-tuple) your money?” in preparation for this coming Thursday’s meeting of Finance 4335, make sure you have completed the student information survey, subscribed to the  Wall Street Journal, and subscribed to the course blog (if you haven’t already done so).