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Posts tagged risk
8 Investing Lessons From John Paulson
Nov 23rd
Even as the financial system collapsed last year, and millions of investors lost billions of dollars, one unlikely investor was racking up historic profits: John Paulson, a hedge-fund manager in New York.
His firm made $20 billion between 2007 and early 2009 by betting against the housing market and big financial companies. Mr. Paulson’s personal cut would amount to nearly $4 billion, or more than $10 million a day. That was more than the 2007 earnings of J.K. Rowling, Oprah Winfrey and Tiger Woods combined.
How did he do it? Believing that a housing-market collapse was coming, Mr. Paulson spent over $1 billion in 2006 to buy insurance on what he then saw as risky mortgage investments. When the housing market cracked and the mortgages tumbled, the value of Mr. Paulson’s insurance soared. One of his funds rose more than 500% that year. Then in 2008, he shorted financial shares, or wagered that they would fall in price, profiting again when these companies collapsed.
And are there any investing skills that average investors can learn from his success? Yes. There are no guarantees, of course, but the success of Mr. Paulson and a few other underdog investors lends encouragement to individuals trying to compete with Wall Street’s pros.
Here are eight investing lessons of Mr. Paulson’s $20 billion gamble, the greatest trade in financial history:
1. Don’t Rely on the Experts
Many investors lost big in 2007 and 2008 as housing crumbled and the stock market tumbled. But no one lost more than commercial and investment banks caught with toxic mortgage-related securities. These bankers were the very same ones who created these investments, and Wall Street’s top analysts had vouched for their safety, even as Mr. Paulson and others bet against the investments.
Lesson: When Wall Street is wheeling out its latest can’t-miss product, be skeptical.
2. Bubble Trouble
Some academics argue that financial markets have become more efficient. But a rash of financial bubbles in recent years — including housing, energy, technology and Asian currencies — suggests that markets are becoming harder to navigate, and are more prone to overshooting. Today, investors of all sizes read the same articles, watch the same business-television programs and chase the same hot tips. They invariably head for the exits at the same time.
Lesson: Have an exit strategy — and cash to cushion any tumble.
3. Focus on Debt Markets
Most investors track the ups and downs of the stock market but have only a vague sense of moves in debt markets. That’s a mistake. Early signs of trouble were seen in sophisticated markets that don’t get much limelight, like the subprime-mortgage bond market. These problems eventually felled the housing and stock markets, and the overall economy, a set of falling dominos that Mr. Paulson and his team correctly anticipated.
Lesson: Debt markets can do a better job predicting problems than stock markets.
4. Master New Investments
Mr. Paulson scored huge profits by buying credit-default swaps, a derivative investment that serves as insurance on debt. When risky mortgage bonds tumbled in value, Mr. Paulson’s insurance soared. But many experts were flummoxed by CDS contracts or shied away from educating themselves about these relatively new investments.
Mr. Paulson and his team had no experience with CDS contracts. But they put the time into learning about them.
Lesson: Educate yourself about the range of exchange-traded funds being introduced, some of which can play a valuable role in a portfolio.
5. Insurance Pays
A number of investors worried about a bursting of the housing market, but few did much about it, even though insurance, such as CDS contracts, at the time were selling at dirt-cheap prices. Out-of-the-money put contracts — options that pay off only if the market tumbles — also were trading at reasonable levels. As cheap as this insurance was, many pros ignored it.
Lesson: Don’t underestimate the value of a safety net, such as put options.
6. Experience Counts
Some of the biggest winners in the meltdown were middle-aged investors dismissed by some as past their prime. But they had experienced past market downturns, while some of the bankers and analysts caught flat-footed knew only good times.
Lesson: A historical perspective can be a valuable tool.
7. Don’t Fall in Love
With an Investment. In early 2009, Mr. Paulson became more bullish about the banks and financial companies that he had wagered against in 2008, after determining that these companies had improved their balance sheets. The moves resulted in profits this year.
Lesson: Even the greatest trade doesn’t last forever.
8. Luck Helps
In early 2006, Mr. Paulson determined that housing was in trouble and set out to profit from the impending fall. But some housing experts already had determined that real estate was overpriced; others had wagered against housing but could no longer stomach their losses. Just months after Mr. Paulson placed his historic trade, U.S. housing prices began to fall.
Lesson: Don’t risk too much in any one trade, even one that seems like a sure thing.
Metallgesellschaft’s Case
Nov 19th
Hi David,
I went thru this case and also your and Jacks discussion on the same but i could not get 1 simple concept clear. can you pls help me with a simple example
1) MG had Long position in short term futures.
2) Markets went into Contango.
3) Now if MG is in a long position he is locked it at a price say 20$.
4) Market goes into contango i.e futures price is above spot lets assume now its 25$.
5) Then actually MG is gaining as it had bought futures at 20$ and now the same is 25$
How is MG losing? Can you pls explain me in layman terms with the same example as i gave as i got utterly confused after i went thru the earlier thread.
Thx & Rgds
Amit
conversion factor
Nov 19th
Hi David,
Could you pls clarify this question? I wonder why “as yields lower than 6% imply that the CF for long-term bonds is lower than otherwise. This will tend to favor bonds with high conversion factors, or shorter bonds”? what is the relationship between CF and maturity?
Thanks.
The Chicago Board of Trade has reduced the notional coupon of its Treasury
futures contracts from 8% to 6%. Which of the following statements are
likely to be true as a result of the change?
a. The cheapest-to-deliver status will become more unstable if yields hover
near the 6% range.
b. When yields fall below 6%, higher-duration bonds will become cheapest
to deliver, whereas lower-duration bonds will become cheapest to deliver
when yields range above 6%.
c. The 6% coupon would decrease the duration of the contract, making it
a more effective hedge for the long end of the yield curve.
d. There will be no impact at all by the change.
a. The goal of the CF is to equalize differences between various deliverable bonds.
In the extreme, if we discounted all bonds using the current term structure, the
CF would provide an exact offset to all bond prices, making all of the deliverable
bonds equivalent. This reduction from 8% to 6% notional reflects more closely
recent interest rates. It will lead to more instability in the CTD, which is exactly
the effect intended. Answer b) is not correct, as yields lower than 6% imply that
the CF for long-term bonds is lower than otherwise. This will tend to favor bonds
with high conversion factors, or shorter bonds. Also, a lower coupon increases the
duration of the contract, so c) is not correct.
Core Reading Versus AIMS
Nov 19th
Hi all,
Are the core readings supposed to exactly mirror the reading lists given in the AIMS?
I purchased – and subsequently read – the printed copy of the Core readings for the Level 1 exam. However, looking through the AIMS I can see a lot of extra readings that weren’t provided in the Core reading pack. In particular, the Financial Markets & Products AIMS lists chapters 1,2,3,4,5,6,7,9,10 of Hull!! These were not provided in the Core readings pack – and translates into a lot of extra reading in very little time!
Thanks,
John
Regression
Nov 19th
Consider 3 random variables X,Y,Z Suppose corr(x,y) =0.4 and corr(z,y)=0.3 which of the following statements is true?
a) corr(x,z) cannot be negative.
b) corr(x,z) has to be larger than 0.3
c) corr(x,z) cannot be negative
d) none of the above.
can u throw some light on this question.
thanks and do reply soon.
FRM L1 exam format
Nov 19th
Hi there,
I have a question about the exam format for the L1.
I noticed that there will be 2 sessions (morning and afternoon), will this sessions have different chapters? (ie. morning session covers Foundation of RM and QA, afternoon session covers M&P and Valuation) or they are all mixed and have same format for the morning and afternoon.
Thanks in advance,
Jason
Why is small actual volatitlity profitable for a long call option?
Nov 19th
Dear David,
Appreciate your enlightenment on the FRM handbook question (page 335 Example 13.3 5th edition) below. The book’s explanation is that the long call position is profitable when the actual volatility is small but this statement seems contradictory to what I’ve learned about long options that long a option is long implied volatility therefore it benefits from increasing volatility?
Example 13.3
A trader buys an at-the-money call option with the intention of delta-hedging it to maturity. Which one of the following is likely to be the most profitable over the life of the option?
A. An increase in implied volatility
B. The underlying price steadily rising over the life of the option
C. The underlying price steadily decreasing over the life of the option
D. The underlying price drifting back and forth around the strike over the life of the option
Answer Provided: D
Thanks
Liming
19/11/09
Black & Scholes Formula Changue for different instruments
Nov 18th
Hi David.
I have some questions.
In practice, can you teach me in spreedsheet, how changue the black & Schoels formula for: Options for shares that pays dividens, options on indexes and options on currency or Foreign Exchangue.
Saludos from MEXICO
GABRIEL
ABX protection buyer
Nov 18th
Hi David,
I wonder if ABX protection buyer shorts ABX? If so, if there is any credit loss, the protection buyer will compensate the buyer, and meanwhile the ABX price also drops, so the ABX protection buyer who shorts ABX also gains.. is this a double-dip? or I misunderstand something?
Thanks.
PRM Exam Question-Need help
Nov 18th
1) The provision for credit risk in calculated to cover
a. Expected losses
b. Expected and unexpected
c. Unexpected
d. None of the above
2) Marginal Economic Capital is a suboptimal method to analyze
a. The amount of capital consumed by an instrument
b. The movements of economic capital from one business to another on a
marginal basis
c. The marginal increase in the overall risk
d. The removal of the entire business which represents a significant
share of the total economic capital
3) Which of the following should be considered to compute the Gross
income indicator when using Basic indicator Approach as per BASEL 2
a. Income from Insurance
b. Operating expenses
c. Unrealized income and expenses
d. None of the above
4) Which of the following should be considered to compute the Gross
Income Indicator?
a. Income From insurance
b. Operating Expenses
c. Realized P&L from securities in the banking book
d. Unrealized P&L from securities in the banking book
5. Which is not typically included in casual based definition of OR
a. Strategic Planning
b. Legal Planning
c. People Systems
d. Inadequate or failed operations
6. The Altman credit risk approach is modeled by
a. Focusing only on firms that have defaulted
b. Focusing only on firms that have survived
c. Country accounting
d. Quadratic equation of various accounting measure
7. LGD is a function of
a. Capital Adequacy of counterparty
b. Seniority of the claims
c. Market movements between now and default
d. All
8 Let A & B be 2 uncorrelated risky portfolio with Normally
distributed returns. Their Ceteris Paribus is
a. VAR (A+B) = >VAR (A) + VAR (B)
b. VAR (A+B) < VAR (A) + VAR (B)
c. VAR (A+B) > = VAR (A) + VAR (B)
d. VAR (A+B) can be either > or < than VAR (A) + VAR(B)
Email responses to jason dot jason57 at gmail dot com
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