Thinking, Fast and Slow

Illusions you cannot avoid

Probably mentioning this book in 2017 is a bit out of fashion, but there are yet loads of takeaways for understanding systematic biases people inevitably have. The author – Daniel Kahneman, who won Nobel Prize in 2002 for his work on human’s judgement and decision making – introduces those biases with realistic examples throughout the book (some of which are deliberately designed to fool you and you cannot escape even if you know it!).

Systematic biases and risk premia

For financial practitioners, those biases are sometimes keys to understand the nature of risk premia because often they are the very reasons why it exists in the first place. Furthermore in this way, they can provide us some guideline to believe whether the premia is persistence or not in the foreseeable future.

There are currently various ways to access to “risk premia strategy” or “smart beta strategy” via ETFs or other formats especially for institutional investors. Asking if the premia is coming from systematic biases or not could be a reasonable indicator to distinguish between genuine premia and transitory market anomaly. If that is a mere market anomaly, and you believe that a systematic bias is not the one causing it, then it may be arbitraged away anytime soon when large money were put into that factor. Or even worse the factor you rode on might be just the result of the statistical trap like the size factor.

Among these biases, what I found interesting were probability effect and certainty effect.

Probability effect

Probability effect is a bias where people put higher “probability” to rare events than they deserve. This is why so many people keep buying lottery tickets and the reason why stocks with higher skewness underperform the peers with lower skewness.

Certainty effect

This is where people value sure things too much than they should from the statistical point of view. People pay more money to shift the probability to 100% from 95% to get relieved. Effectively insurance companies make money from this bias by providing clients the sure protection. Similarly this can explain why put options on S&P500 is far too expensive compared to realised volatility, why there exists the volatility risk premia, and why long VIX futures is always bleeding.

These two are just examples of the fallacy Daniel Kahneman revealed. And by the end of the book, you would realise how stupid we are!

Thinking, Fast and Slow by Daniel Kahneman
http://amzn.eu/8BvvNZd

PutWrite versus BuyWrite: Yes, Put-Call Parity Holds Here Too

Source

PutWrite versus BuyWrite: Yes, Put-Call Parity Holds Here Too
https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=2894610

Author

Roni Israelov: AQR Capital Management, LLC

Abstract

The CBOE PutWrite Index has outperformed the BuyWrite Index by approximately 1.1 percent per year between 1986 and 2015. That is pretty impressive. But troubling. Yes – troubling – because the theory of put-call parity tells us that such outperformance should be almost impossible via a compelling no-arbitrage restriction. This paper explains the mystery of this outperformance, which has implications for portfolio construction.

Summary

Historically PutWrite index outperformed BuyWrite index even though the put-call parity suggests that such a discrepancy should not exist.
The author lay outs three constructional differences that could have caused the outperformance.

  1. Naked beta position: By construction, BuyWrite index is a portfolio of short call option and long S&P500. Once the option expires, BuyWrite index still has a naked beta position which PutWrite does not. The author shows that this transitory equity exposure which lasts 4 hours explains most of the mismatches.
  2. Delta: BuyWrite sells the most closest strike higher than the spot while PutWrite sells the lower strike. The author estimates the two nearest strikes have delta difference of 0.03.
  3. Cash position: Collateral of BuyWrite is invested in 1 month T-bill while PutWrite invests in both 1 month and 3 month T-bill.