Financial Hacking

The following sections are included:

• Dedication and Acknowledgments

• Foreword

• Contents

Risk is the “why?” behind finance. Without risk, there is no reason for finance or insurance or derivatives to exist at all. Of course there is risk in the real world. But it can be hard to understand when wrapped in all the complexities of reality. We can gain a lot of intuition about it by exploring it in the context of a plain vanilla world.

Arbitrage is defined in academia as “riskless profit” but it is used in practice to mean “good deal that should make money if all goes well.” It is the basis for both pricing and hedging. But all is not as pure as it seems. There are a lot of philosophical issues behind this most central aspect of finance, and the basis for a financial golden rule.

Sometimes behind the simplest concepts lurk deep mysteries. If we have a good sense of what risk is, and we see what seems like a good arbitrage opportunity, we might think that actually putting on the trade would be easy, straightforward, and fun. We’d be wrong on two of those three.

If you have an interview for a derivatives position in five minutes, and you know nothing about options, this is the chapter for you. You probably won’t get the job but at least you won’t look foolish. And they may simply be screening out fools in this round; you may just buy yourself enough time to learn something more before they call you back.

To really understand a model, you have to go beyond its formal definition and derivation and actually simulate its assumptions and test its predictions. Simulations let you touch and taste the various implications of the model and develop intuition about when the model is useful and when it needs to be corrected.

There are a lot of common mistakes, or bugs, made when developing or testing advanced derivative valuation models, and many of those same bugs crop up even when the model is plain old Black-Scholes. Many highly experienced derivatives traders and researchers will miss at least one of the puzzles and bugs in this chapter. If you understand them here, then you will immunize yourself to them in more complicated situations, and be a step ahead of the competition.

It is almost always easier to come up with a new kind of option than it is to price it. But constantly having to create new frameworks for pricing one-off opportunities means you will occasionally be too slow to participate in the potential profits. The lesson of this chapter is how to make substantial progress in understanding the character of an arbitrary exotic option with a few minutes of casual hacking rather than a few months of frantic research.

Every option whose payoff depends on more than one underlying is an exotic option. This is the center of some of the most interesting recent innovations in the derivatives world.

An exotic world is one where the Black-Scholes assumptions break down, particularly the assumption about constant volatility. Unfortunately, when that assumption breaks down, so do a lot of our intuitions. This chapter’s goal is to build your intuitions back up so that you will not fall victim to fake arbitrage opportunities. It is centered on trying to convince you of the discovery of the best trade in the world. It is up to you to debunk the claims.

Exotic worlds beget exotic swaps. The variance swap is the least exotic. (There is no most exotic.) Understanding how you would have approached the world when variance swaps were first introduced can help you prepare for the new exotic derivatives of tomorrow, where you may well be the very first person to trade them, before valuation software is written, before a model is even hypothesized, let alone tested, before the spreads tighten and the opportunities for first-movers drift away.

Where do you go when you’ve surpassed exotic? Welcome to the wild uncharted land of esotericism. This chapter presents some final puzzles, examples, and musings to launch you into the rare stratified air above vanilla and beyond exotic where magic reigns and only a few can enter.