Derivatives -- the View from the Trenches

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Eat like a Chicken and Shit like an Elephant… …Naseem Taleb coined that phrase. Given that the markets are efficient and risk averse it is going to be difficult to find cheap options. Here are my own attempts: - Mispricing of skew in exotic equity options: buy guaranteed fund structures and sell put option on the index. - Mispricing of equity volatility skew versus credit default swaps: buy put options and sell credit default swaps. - Never seen events: negative interest rates. Buy zero strike floors. There are plenty opportunity to sell expensive options. My favourites -- at your won risk: - High strike caps. - Buy and hold large diversified portfolios of corporate bonds. The first category of strategies are not easy to actually do and require careful analysis and execution. So essentially there are two ways to get rich: - Hard and inspired work combined with unconventional thinking. - Luck. 22
Model Philosophy Keep it simple -- but not too simple. Focus on the key features of the market and the product that you are considering. The same recipe will not work across different underlyings: Equities, interest rates, foreign exchange, and commodities are fundamentally different. So fundamentally different models have to be used for each market. Use models that can calibrate with close to closed form. Do not attempt to fit the model to all market data. A lot of the data that some traders will claim is the market is simply rubbish. A 95% (whatever that means) fit is good enough. Do not over-complicate: 7 factor yield curve models with stochastic volatility, jumps and ARCH-GARCH are of no use if you can not calibrate quickly or you can not get out an accurate risk reports in finite time. Cross check different models against each other. Write public papers about your models. Study the literature -- not only Hull's book. Use the best possible numerical methods. 23
Page 1 and 2: Derivatives -- the View from the Tr
Page 3 and 4: My Life as a Quant CV: - 1997: PhD
Page 5 and 6: The First Fundamental Theorem of De
Page 7 and 8: Theorem 1 and Option Markets Black
Page 9 and 10: Theorem 1 and Models Theorem 1 ext
Page 11 and 12: Theorem 1 and Technical Results A
Page 13 and 14: Theorem 2: The Gospel of the Jump
Page 15 and 16: But in essence the strategies invol
Page 17 and 18: Theorem 2 and the Equity Volatility
Page 19 and 20: So in front of you, you have an opt
Page 21: The Difference between P and Q and
Page 25 and 26: Foreign exchange - Black-Scholes wi
Page 27 and 28: An Interest Rate Model at Work in J

Derivatives -- the View from the Trenches

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