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Introduction to Visual Quantitative Finance

This chapter begins with an overview of current investment trends, including shifts in investor attitudes and the emergence of new investment alternatives being driven by the application of quantitative finance.
This chapter is from the book

Visual quantitative finance is a different take on the mathematics of investing. It emphasizes an intuitive view of risk and the interrelationships of option pricing, risk management, and structured securities. This chapter begins with an overview of current investment trends that serve as the backdrop for the material covered in the book. The trends include shifts in investor attitudes and the emergence of new investment alternatives being driven by the application of quantitative finance.

I also talk about the personal “discovery” that motivated me to write this book. Like most people involved in asset management, I have struggled often with two things: (1) how to dampen some of the stock market volatility—and losses—that have occurred too often over the last decade, and (2) how to generate higher levels of income in a historically low interest rate environment.

Over time, I have become convinced that adding options—not as trading instruments, but as long-term components of portfolios—is the best answer. But unless an investor really understands options, it is hard to fully commit to a strategy involving them. Unfortunately, really understanding options means getting a little technical—sometimes a lot more than a little. I laughed one day when I saw the title of a paper on computational methods (roughly the same subject as this book). The title was “An Introduction to Computational Finance Without Agonizing Pain. If you have tried to approach this subject, you probably know the feeling. I do.

My personal “discovery” was not really a discovery in the sense that I uncovered some new truth. For me, it was just one of those light-bulb moments when I saw past the differential equations to a simple, beautiful “picture.” What I saw in the picture was an easier way to visualize option pricing. More than that, the picture contained enough information to break down seemingly complex risk metrics and structured securities into basic elements. The picture is a chart of an Excel spreadsheet, shown at the end of the chapter, and used as the framework for most of what is presented in this book.

Growth in Structured Securities

According to Bloomberg, investment banks sold $45.9 billion of SEC-registered structured securities in 2011 and another $11.1 billion in the first quarter of 2012. The securities offer customized risk-return and payoff profiles using derivatives based on underlying stocks, bonds, currencies, and commodities, with approximately 60% of these notes tied to equities (including the S&P 500 Index).1

Registered structured products are just the tip of the iceberg. Demand from institutions and retail investors, looking for better ways to invest, is prompting asset management firms and ETF providers to introduce new funds capable of smoothing market volatility and increasing yield. For instance, AQR Capital Management, the hedge fund company, launched four new mutual funds.

In 2012, AQR Capital Management, the hedge fund company run by Cliff Asness and other former Goldman Sachs managers, launched four new mutual funds.

  • July 13, 2012: AQR Capital Management announced Monday the launch of four new mutual funds .... The funds seek to provide equity-like returns with lower volatility and smaller drawdowns using an actively managed, risk-balanced approach.2

This is one in a string of announcements. Quant funds are rolling out more creative investment vehicles to meet market demand. Most of these vehicles offer forms of risk management and income features that traditional asset classes do not offer. And structured securities are often the means to do it.

Structured securities range from simple covered call strategies to complex institution hedging programs. What they have in common is the ability to tailor risk and reward profiles to match investor objectives in ways that are difficult to do with stocks and bonds.

On the retail side, more investors than ever use options strategies—not only as trades, but as integral parts of investment portfolios. On the institutional side, allocations to hedge funds and other alternatives using options strategies and structured securities are growing rapidly.

Both groups are interested in emerging strategies that combine the explicit use of hedging, insurance, and risk allocations in risk management instead of continuing to rely on traditional portfolio models. Also, in today’s low-interest environment, both groups want access to greater yields, especially those not related to market direction. These investor goals have led to the growing importance of volatility-reducing quantitative methods, particularly methods related to options capable of boosting dividend yields.

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