Monday, December 30, 2019

Negative Convexity in Action: Ouch

First up, Harvey Bassman, The Convexity Maven, on definitions:
...Wall Street loves to make convexity sound complex (I suppose it’s so they can charge higher fees?). We speak Greek (calling it “gamma”), employ physics as a metaphor (analogizing to it “acceleration”), and use mathematical definitions (since it is the second derivative of the asset’s price change).

Pish, posh. An investment is convex if the payoff is unbalanced for equally opposite outcomes. So if there’s the potential to earn a profit of two on a bet versus a maximum loss of one, the bet is positively convex. If you can lose three versus making two, it is negatively convex. That’s it. The rocket scientists are called upon to help (fairly) price the cost (value) of such possible outcomes. This is why the expansion of derivative trading in the 1990’s resulted in a hiring spree of physics PhD’s....
"Pish. Posh." is a technical term only used by market professionals.
And via Darren Rovell, sports betting maven:
Patriots    24
Dolphins   27

Oh dear.