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Why Decades-Old Strategies Still Beat The Market Today
Why Decades-Old Strategies Still Beat The Market Today
With so much having changed in the financial world over the years, can decades-old investment strategies still work today? Validea CEO John P. Reese says they certainly can.
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Take It From The Gurus: Boring Is Beautiful
In a recent article for Canada’s Globe and Mail, Validea CEO John Reese says that when it comes to investing, boring is beautiful.
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In some countries, for example France, stocks bought or sold during an account period have their settlement deferred to a designated settlement date. We explain how to value and hedge cash-settled European- or American-style options on stocks whose settlement is deferred. To do this we introduce the notion of “bare” (immediately settled) and “dressed” (deferred-settled) stock prices. It is the volatility of bare prices that is funda- mental.
The market implied volatilities of stock index options often have a skewed structure, commonly called “the volatility smile.” One of the long-standing problems in options pricing has been how to reconcile this structure with the Black-Scholes model usually used by options traders. In this paper we show how to extend the Black-Scholes model so as to make it consistent with the smile.
Part 2, expands on this presentation. Somewhat more more exotic barrier options are explored, and a summary of the mathematical theory behind the valuations is present.
Part 1 of this article describesmany of the mostcommonbarrier optionsavailablea, swell as when to usethem in placeof standardoptions. We alsodescribewhy their sensitiviryto market movesoften exceedsthat of standardoptions.This is depicted in several cases with ables andplots, showingthe theorcticavl dues and sensitivity for diferent market levels.
This paper presents a method for replicating or hedging a target stock option with a portfolio of other options. It shows how to con- struct a replicating portfolio of standard options with varying strikes and maturities and fixed portfolio weights. Once constructed, this portfolio will replicate the value of the target option for a wide range of stock prices and times before expiration, without requiring further weight adjustments. We call this method static replication. It makes no assumptions beyond those of standard options theory.
You can use the technique to construct static hedges for exotic options, thereby minimizing dynamic hedging risk and costs. You can use it to structure exotic payoffs from standard options. Finally, you can use it as an aid in valuing exotic options, since it lets you approx- imately decompose the exotic option into a portfolio of standard options whose market prices and bid-ask spreads may be better known.
Most real-world barrier options have no analytic solutions, either because the barrier structure is complex or because of volatility skews in the market. Numerical solutions are a necessity. But options with barriers are notoriously difficult to value numerically on binomial or multinomial trees, or on finite-difference lattices. Their values converge very slowly as the number of tree or lattice levels increase, often requiring unattainably large comput- ing times for even a modest accuracy.
In this paper we analyze the biases implicit in valu- ing options with barriers on a lattice. We then sug- gest a method for enhancing the numerical solution of boundary value problems on a lattice that helps to correct these biases. It seems to work well in practice.
