There are just a few links and summaries this week. Sorry for the short list. More promised next week. I spent additional time with students last week (it was finals week), and traveling to see Mom this weekend. Happy Mother's Day! It's summertime, and the living is easy ......


Are Commodity Funds a Long-Term Bet?
Daisy Maxey - WSJ
* Discussion of commodity-focused mutual funds, and whether the above-average gains for these funds can continue. In general, yes. Returns have been high, but demand remains strong for raw materials, which makes it likely these funds will continue to do well in the long-term, even if there are short-term corrections.

Commodities: Bubble or Not?
David Enke -
* Sorry for the blatant self-promotion, but if you enjoyed my recent commodity bubble discussion post (here and at, or did not enjoy it and/or felt I was way off-base, then you might want to check out the comments at the seekingalpha site. It has generated a lot of additional discussion, some of which is worth reading - pro and con.


Credit-Default Swaps: Weapons of Mass Speculation
Jonathan R. Laing - Barron's
* Barron's discusses the Credit Default Swap (CDS) market. A short primer on what a CDS is, followed more extensively about how they are being used for speculation. The article includes the typical mention of how hedge funds are making a killing, but then talks more about how regulators and on-air personalities may have contributed to the movement of CDS prices every time they discuss whether the monolines would be downgraded. Again, not a detailed article on the CDS market in general, and the purpose it serves, but interesting in how it is being used to profit from rumors and speculation, as with other markets.

Hedge Funds

GLG star's exit could cost $4bn
James Quinn - Telegraph UK
* Another article about what happens to investors that try to leave a hedge fund once the fund manager departs. Redemptions fees get increased or waived, based on your loyalty.

Private Equity

Wharton Private Equity Review: Harnessing the Winds of Change
Wharton - University of Pennsylvania
* The spring review discusses changes in the private equity arena. In particular, there is discussion of how since the credit markets have shut down, it is more difficult to obtain the lifeblood of private equity - cheap money. As such, PE funds are looking for other opportunities. Many are finding that they are needing to hook-up with strategic buyers and corporations, or consider going back to a previous mainstay - distressed investing. Some funds are also considering more international opportunities, some of which may be driven by changes in the tax code, or anticipated changes in the tax code. There is also a nice round-table discussion of the challenges with starting a new private equity firm.

Quantitative Finance and Financial Engineering

A Trader's Perspective on 130/30 Funds
Christopher Holt -
* Interesting article of 130/30 investment funds from the perspective of a trader. What is the conclusion? Despite the academic discussion of the pros and cons and general rationale for the strategy, a 130/30 strategy is nothing more than a simple short-selling strategy. In fact, there is nothing magical about the 130/30 fund. The amount of short-selling and subsequent leverage could be quiet different, given different circumstances. The article goes on to give some general 1X0/X0 mechanics as a starting point for those interested in developing their own long-short strategy, as well as what is and is not practical - such as whether the short funds can be properly and fully redeployed.


Boom in 'Dark Pool' Trading Networks Is Causing Headaches on Wall Street
Scott Patterson and Aaron Lucchetti - WSJ
* Article on the "dark pools of liquidity" that are multiplying by the second. The dark pools are simply secretive electronic trading networks that match buyers and sellers anonymously, allowing them to distribute big blocks without displaying their intentions, or moving price. The problem is that there are probably too many, and they are getting more notice. Nonetheless, hedge funds and others that need to move big blocks are using then extensively. Of interest is how securities firms and their clients are expected to increase their use to about 20% of their stock orders by 2010. This is certainly worth considering for those considering technical analysis. A further problem is that users of the dark pools obviously know about extreme buying and selling pressure that is about to affect the stock, in a sense having quasi-insider information. Depending on the size, they can shop around to get the best bid or ask. Of course, this has gotten the SEC's attention. The traditional exchanges and OTCs, on the other hand, such as NYSE and Nasdaq, are looking to get a piece of the action.

Will FedEx Put A Damper On Demand Expectations?

Posted by Bull Bear Trader | 5/09/2008 04:06:00 PM | , , , , , , | 0 comments »

FedEx warned Friday afternoon, cutting its fiscal Q4 earnings forecast for a second time this year (it warned earlier in March), citing increases in fuel prices, which had increased by 7% ($100 million) since giving its last estimate. The company now expects earnings for the quarter ending in May to be in the range of $1.45 to $1.50 a share, compared with previous forecast of $1.60 to $1.80 per share. Not surprisingly, the shares are down in Friday after-hours trading.

A few observations. First, for those that follow FedEx, this was somewhat to be expected given their earlier warning, but troublesome nonetheless. Furthermore, anytime a company warns on Friday afternoon, when they expect that everyone will be home with family or in The Hamptons, this is also sometimes a tell that the company is in trouble. This again is certainly not encouraging.

So what does this mean for the overall economy? Just recently we discussed how the Dow Transports were making a small rally earlier in the year, even as the Dow Industrials were relatively flat. While not a perfect indicator, the transports have at times been a leading indicator for the industrials. From a previous post we discussed why:

The logic behind the indicator being that if product is being shipped from supplier to retailer, than retailers are experiencing lower inventory and increased demand, eventually resulting in both the supplier and retailer booking revenues and earnings. The leading transportation indicator occurs since the transports are the first to signal demand, with the transportation companies also being the first to actually get paid for their services, resulting in higher valuations and stock prices. Both the suppliers and retailers have to wait a few months before seeing increased revenues at the retail level, or increases in accounts payable at the supplier level. As a result, increases in the transports can at times signal future revenues and stock prices for the industrial companies.
A current comparison of the charts for the DJIA and DJTA gives us no real conclusion:

As expected, there was a nice breakaway in transports in late January, followed a few months later in March by the industrials. The recent moves this week in the transports, while down, are still above the current uptrend line. Nonetheless, the industrials have appeared to roll over slightly. Certainly higher oil prices and recent new developments (i.e., problems) with some financial companies are most likely having some impact on the broader market.

Of course, FedEx, and even the over the road shipping companies, such as YRC Worldwide, may no longer tell the whole story. Given the strength and demand of the once maligned rails, it will be important to see results from companies such as Union Pacific, Burlington Northern Santa Fe, Canadian National Railway Company, and Norfork Southern before we can declare that shipping and transportation are weakening, and that lower demand will result in lower profits for the production-driven industrials. With the rails it is also important to see what is being shipped, given that recent agricultural and energy demands have seen an increase in business for moving coal and crude oil, along with wheat, corn, soybeans, and fertilizers. The energy commodities in particular, along with higher levels of corn production, will provide an increase in freight levels, while at the same time signaling pressure on the energy consuming industrials, thereby weakening the significants of the DJTA indicator.

Tickers: FDX, BNI, UNP, NSC, CNI

More On The Berkshire Put Selling

Posted by Bull Bear Trader | 5/09/2008 11:50:00 AM | | 0 comments »

To read a little more detail regarding the Berkshire Hathaway selling of index puts, check out this post at the Financial Crookery Blog. We have recently discussed this issue, but this article goes deeper into the ramifications, in particular looking at the impact of vega and dividends when writing puts with long expiration dates. Nice read and well worth the time.

Tickers: BRK.A, BRK.B

Commodity Bubble?

Posted by Bull Bear Trader | 5/09/2008 07:20:00 AM | , , , , , , , | 0 comments »

Recently there has been a lot of discussion as to whether the run-up in commodity prices is a bubble or not, or whether there is a fundamental factor at work, primarily a sustainable supply-demand imbalance.

A recent WSJ survey found that 51% of those surveyed said that demand from China and India was the prime factor for high energy prices, with 41% blaming demand for rising food costs. Supply constraints were listed by 20% as causing higher food prices, while 15% felt that supply was resulting in higher energy prices. Only 11% felt that a speculative bubble was in the works.

So what should we take of this? Those surveyed felt that the supply-demand imbalances were the major cause of higher commodity prices, and not speculation. Furthermore, demand is driving the growth and higher prices, and not simply lower supply. This is something often debated, but those surveyed felt differently on average - we have enough for now to go around, people are just demanding more of it. This makes sense to me, given that China and India are continuing to increase their energy needs to grow their economies and increase the standard of living for their citizens. This higher standard of living is putting further pressure on food commodities, no only to consume directly, but also to feed livestock as the demands for protein-based foods increases in these areas of the world. Supply may eventually become more of an issue, but demand appears to be driving prices.

As with any survey of economist and analysts, there were "two-handed" inconsistencies. The same survey group felt on average that the price of crude oil would fall to about $105 by the end of next month, and to about $93 by the end of 2008. Demand is high, supply in check, but prices will fall? Possibly, and this course is the argument surrounding the falling dollar. But this is not what the responses feel. Only 15% believed that currency (i.e., dollar woes) were causing higher energy prices, and only 7% felt they were contributing to higher food prices. This is somewhat surprising given the amount of talk recently about how weakness in the dollar is contributing to the high cost of crude oil, with some estimates showing nearly 50% of recent price increases resulting from the falling dollar.

In the end, even with the discussions of crude oil prices being too high, and pronouncements of $150-$200 a barrel prices in the next 6-24 months (bringing back images of Internet valuation calls in the late 1990s - where a yearly price target was raised one day, only to see the stock move to that new level a few days later), it is still difficult to foresee a complete collapse of commodity prices, at least a sustained collapse over the long-run. Will there be sell-offs and short-term corrections? Yes. Will there be volatility? Absolutely. Will there be adjustments as the dollar strengthens? Most likely. But will there be a total collapse in demand? It is doubtful. Demand destruction is always a worry, but people will always want to eat, and emerging countries will need energy to continue their growth, just as the United States has in the past, and will continue to in the future.

So as commodity investors, in particular energy investors, what do we do? The safer investments may still be in the "consequence" plays, i.e. the seed and fertilizer companies for the food commodities, and natural gas for the energy plays. The Potashes of the world still have tremendous demand and pricing power. Natural gas, while also having a nice run-up recently, is still trading at a lower BTU multiple than crude oil. Using historical comparisons, natural gas still has room to move to the upside, even with crude oil leveling off. If crude reverses its upward trend, this lower than historical multiple may also cushion the fall of natural gas if crude oil was to begin selling off.

The moves in energy have no doubt been sharp, and the prices do seem high, but this may in fact be the issue that we struggle with when considering investments in commodities. We have not seen $125 crude oil before, and the recent spike does seem over-extended, so it certainly seems scary. Of course, if crude oil was a stock, and the company had the same level of demand, pricing power, growth forecast, future supply issues, and strong technicals, many of the same investors might be jumping into the stock, while at the same time shying away from crude oil. Of course, commodities and stocks are very different animals, and stocks also top and end badly, or at least have large corrections, even for good companies (i.e., Google), but the analogy is not totally lost. The key is to eliminate the emotion as much as possible and examine the fundamentals and technicals for what they are. When they change, they change - and this could happen today, tomorrow, or next year. But when they are in place, they are hard to ignore. Right now they look pretty good.

Tickers: POT, AGU, MOS, MON, UNG

Private Equity Investing In The BRIC Countries

Posted by Bull Bear Trader | 5/08/2008 09:18:00 AM | , | 0 comments »

We tend to only focus on private equity in the U.S., but private equity investment is increasing across the globe. As for the four BRIC countries (Brazil, Russia, India, and China), India is leading the pack in the amount and number of deals being done. In U.S. dollars, there was $7.4 billion of private equity investment in India last year, compared to $2.1 billion in China, $3.2 billion in Brazil, and $924 million in Russia. As for the number of deals, India was also at the top with 119 deals completed last year, compared to 73 deals in China, 17 deals in Brazil, and 19 deals in Russia. Reports also have 42 private equity deals so far this year in India, worth approximately $1.1 billion. As a comparison, through Q3 of 2007, 295 U.S. private equity firms had raised $199.4 billion, which was more than the $154.1 billion raised by 232 firms in 2006. Still a long way to go, but private equity is on the move internationally, and surely will see increased growth as sovereign wealth funds look for places to put their new found commodity wealth.

Not So Fast Yahoo!

Posted by Bull Bear Trader | 5/08/2008 06:35:00 AM | , | 0 comments »

Now that the Microsoft's takeover attempt of Yahoo! is over, Google does not appear to be as willing to move so fast in setting up a partnership with Yahoo!. Apparently, Google executives are now divided as to whether to pursue an advertising deal with Yahoo, and also divided as to what benefit it does for Google to help prop up a competitor. Microsoft is also continuing to move away from the Yahoo! discussion, and is now talking about possibly striking a deal with Facebook - although Facebook is apparently not excited about selling the entire company. Microsoft bought a 1.6% stake in the company last year, valued at $240 million. If their valuation stays the same, Microsoft would need roughly $15 billion to takeover the company, and probably a little more to get the deal done. If offered, it will be interesting to see if Facebook CEO Mark Zuckerberg takes the same approach as Jerry Yang and the Yahoo! board. A $15 billion valuation would be hard to turn-down.

Tickers: YHOO, MSFT

Yahoo!'s Disregard For Shareholders

Posted by Bull Bear Trader | 5/07/2008 09:11:00 AM | | 0 comments »

Yahoo! announced yesterday that its annual shareholder's meeting will be on July 3rd. The announcement also states that:

"Under Yahoo!'s amended and restated bylaws, notice of a stockholder's nomination of persons for election to the Board of Directors of Yahoo! at the 2008 annual meeting must be received by the Corporate Secretary at the principal executive offices of the Company no later than the close of business on May 15, 2008."
Therefore, by 1.) announcing the meeting details right after the Microsoft fiasco, and by referring to their recently amended bylaws that only gives shareholders 10 days to put a new slate of directors together for consideration at the board meeting, and by 2.) having the annual meeting the day before the July 4th holiday, when may shareholders will have other travel plans, Yahoo! is once again showing total disregard for its shareholders.

I would not be surprised to see the current board start to get nervous and begin making outside comments, or at least hear current shareholders rattle the cage a little. As with many poison pills and shareholder rights provisions, the provisions themselves often come back to hurt the very shareholders they are suppose to help.

Ticker: YHOO

Use VIX, But Do Not Trade VIX Derivatives

Posted by Bull Bear Trader | 5/07/2008 08:58:00 AM | , , | 0 comments »

Nice article at the Daily Options Report about why you should not trade VIX calls as a way to trade volatility. Check out the whole article, but as a highlight:

Primarily because the guy on the other side of the trade understands them better than you do. Particularly if he is running a big derivatives portfolio with all sorts of variance risk, while you are seeing the recent VIX poundage and want to speculate that has gotten overdone. And you don't fully understand the bet you are making here. Which is absolutely nothing to be embarrassed about; it's an extremely confusing product masquarading as something not so complex.
In a sense, the VIX is an estimate of the volatility of SPX options. As such, the VIX options are therefore derivatives of a derivative, making the analysis more complicated than most of us want and need to bother with. You are better off using the VIX as an indicator of overall market volatility, and then trading options on other assets off this information.

Writing Puts To Acquire Stock

Posted by Bull Bear Trader | 5/06/2008 07:07:00 PM | , | 0 comments »

Nice article at the Crossing Wall Street blog about shorting puts to acquiring stocks at cheaper cost. The basic idea is that if you want to buy a stock, why not just sell puts against it, receive the put income, and then wait. If the stock goes up, you at least get the put premium as income. If the stock goes down, you capture the stock at a lower price. Of course, the immediate risks are that 1.) the stock goes up and you do not get to participate in the upward gains, other than the put premium income, and 2.) the stock goes down a great deal below your written strike price, forcing you to buy a cheaper stock for a higher price. For 1, you do give up potential gains, but are not adding negative downside risk. For 2, this certainly does involve downside risk, but if you bought the stock, you would also incur a loss, possibly more, since you probably bought at a higher price and also did not gain any option premium income to offset your purchase price. Buying the stock and placing stops would involve less risk, but given a gap down at the open, you would also not see the benefits of the stops, and would have similar risk as the put position. If the move down is slow, then monitoring of the option can reduce some of the same risk, but not all. Of course, the strategy works when long-term options are written in order to generate more income, and is obviously more profitable when the implied volatility of the option is high.

Furthermore, as mention at Crossing Wall Street:

"What makes this technique so effective is that it exploits the fact that option prices do not reflect the expected long-term growth rates of the underlying equities. The reason for this is that standard option pricing formulas, used by option traders everywhere, do not incorporate this variable. With short-term options, this doesn't matter. With long-term options, however, this oversight often leads the market to overvalue premiums. Taking advantage of this mispricing is the foundation of my strategy."
As mention in 1 and 2, this is not without risks, but in some cases the risk amounts to the same as buying the stock (without stops) on the downside, or not buying the stock as you wait for it to go lower, only to have it move higher without you taking a position. The strategy is worth considering, but of course, requires a little more monitoring than a simply buy-and-hold type strategy. Also, if you are looking to reduce/eliminate your downside risk, but still participate in any upward movement, call options might be a more manageable position.

Crude Oil, Is There A Top?

Posted by Bull Bear Trader | 5/06/2008 08:12:00 AM | , | 0 comments »

Crude oil futures contracts are trading above $120 a barrel. Meanwhile, Goldman Sachs is stating the oil may incur a "super-spike" and reach $150-$200 a barrel over the next 6 to 24 months as growth in supply fails to keep pace with increased international demand, especially demand from developing nations. The moves in both crude oil and natural gas should be interesting to watch over the next few months as we enter the summer driving season. The effects of the dollar, which recently staged a short-term mini-rally before giving back some gains, should also be watched.

Volatility And The Uptick Rule

Posted by Bull Bear Trader | 5/05/2008 02:34:00 PM | , | 0 comments »

Jim Cramer and Joe Kernen discuss the change in the uptick rule once again (See the CNBC video here). Cramer has been on this issue for a number of months now, but Kernen does offer some counter-point as to whether this is any different than ganging up and driving a stock higher. While there are different volatility studies that don't conclusively point to higher volatility as a result of changes in the up-tick rule alone, the change in the rule does certainly allow traders to get into and out of a short position much easier. In the past it may have taken a longer time to build a short position, so you were less likely to give up the position unless you were certain the stock was going higher. Now you can move into and out of the position with more ease. To Cramer's point, it also appears that less effort is made to insure the stock can be shorted, and that shares can actually be borrowed, but this is not really an uptick issue. If you are naked shorting - shorting shares you did not borrow - then you are violating the law, regardless of whether you shorted those shares on an uptick or downtick.

Act Like A Hedge Fund

Posted by Bull Bear Trader | 5/05/2008 11:37:00 AM | , , , | 0 comments »

Every three months after the release of quarterly data, we start to hear Congress talk about how Big Oil is making too much money and how we need to initiate some kind of windfall profits tax. Of course, when you look at the data, you see that profit margins for oil companies on a percentage basis are not stellar, or at least not exceedingly high. Compared to other industries, they are quite average. To see the data, check out Mark Perry's blog at Carpe Diem, or do a simple sector/industry sort at Yahoo! Finance.

I do sometimes wonder how many of our leaders talking about windfall profits are even looking at the data (or care to). I also wonder if they realize that when you tax something you tend to get less of it. The issue is obviously more complicated than this, but it is important to also make sure we consider the unintended consequences of our actions and decisions. Ethanol is a good example. Right or wrong, it is affecting commodity and food prices. Of course, as a trader or investor, what is important is not only noticing the obvious, but also considering the consequences. In doing so, one can use their insight to hopefully profit from the changes in the regulatory, tax, or program mandated landscape.

Just recently, those investors and traders that realized fertilizer companies would do well given the need for more corn production, or that chip makers would benefit from tax breaks to solar companies, or that the railroad companies would do better given high trucking fuel cost - along with the need to transport increased commodity production, have all profited from their knowledge and foresight. Looking out for the next "consequence" can sometimes make us profits, while easing the additional burdens we may be incurring in the rest of the market and economy. In a sense, smart investing and trading can allow us to act more like a hedge fund by increasing our returns while reducing our overall level of exposure to the market and those that control prices and policy making.

Buffett's Derivative Play

Posted by Bull Bear Trader | 5/05/2008 07:51:00 AM | , | 0 comments »

In its recent first quarter statement, Berkshire Hathaway released that it has bought derivatives on various stock indexes that were set to expire between 2019 and 2028. The indexes of interest for Berkshire include the FTSE, Euro Stoxx 50, Nikkei, and S&P 500. The derivative plays included multi-billion dollar positions that involved selling puts on the indexes. The report has Berkshire with $4.5 billion in premiums and $4.6 billion in liabilities at the end of 2007.

Apparently, Berkshire is not done and is continuing to increase its position in Q1, where premiums increased by $383 million by selling additional puts. This increases its derivative liabilities to $6.2 billion. In Q1 the positions went against Berkshire, causing it to record a loss of $1.2 billion. Given the long expiration dates, the losses appear to be mainly mark-to-market accounting losses, and not positions that have been closed. Each of the indexes that puts have been written against have been down collectively for the year.

Of interests is that since $4.5 billion was generated in premiums in 2007, the notional value of the assets (indexes) themselves could be estimated to be in the range of $70-$100 billion. While Berkshire's insurance businesses has surly used derivatives to hedge risk, this direct move into derivatives is both surprising and understandable at the same time.

On the one hand, Buffett has repeatedly talked about derivatives being "financial weapons of mass destruction," and something that has contributed to the current problems we are experiencing in the markets. Granted, there is a big difference between writing naked puts and exposure to a CDO-squared, where counter-party risk is not only huge, but often at times unknown. Nonetheless, it is an interesting move and turn of events.

On the other hand, Berkshire's large insurance businesses have been providing a large float for Buffett to redeploy. The writing of naked puts will now provide extra income that can be put to work, albeit at a different level and degree of risk. Furthermore, the move signals that Buffett feels that any market correction is over, and that the indexes are going up. If you believe this, as Buffett apparently does, then selling puts would seem less risky, and would also give you the cash you need to begin buying relatively cheap assets that you expect will be moving up from recent lows. Buffett has said as much, stating recently that he believes the worst of the credit crisis is over for Wall Street and the markets, even though individuals will still feel pressure. With the recent moves, Buffett is certainly putting his money where is mouth is. Finally, in addition to market direction bias, this move may also be giving us clues about the insurance business, and the level of float that Berkshire needs and expects to receive in the future. Time will only tell how all this plays out for Berkshire and its shareholders. I am sure some are surprised, excited, and a little anxious.

Tickers: BRK.A, BRK.B

There is a nice article at the Financial Times giving an introduction to Value-at-Risk (VaR), along with a discussion of the good and bad aspects of using VaR for risk management. A few illustrative examples are also given. It is worth a read for those without much math background, or those who would like a quick and simple introduction and explanation of VaR.

In general, VaR calculations find the maximum loss that is not exceeded for a defined probability over a given period of time. Sound confusing already? Let us put it another way. As an example, one VaR calculation might find that we are "95% confident that we will not lose more than $1 million over the next month." In other words, the most we expect to lose this month is $1 million, and we are 95% confident that losses will not exceed this figure. Past normally distributed return and volatility values of our asset or portfolio allow us to make such a calculation.

While the calculation is useful and intuitive, it is not without its problems. Worth noting from the article is how VaR is backward looking, such that if the distribution of volatility and stock returns change, the values given by the VaR calculation will over- or under-estimate the risk. To have more confidence in your calculations, it is important to make sure you are using past data that is similar to the data in the current time frame you are concerned with.

VaR is also not designed in its basic form to deal with what are increasingly being called “black swans,” made popular by Nassim Nicholas Taleb in his book of the same name - The Black Swan: The Impact of the Highly Improbable. In essence, a black swan is a hard to predict event that is rare and beyond the current level of expectations, but when it occurs, it has the ability to not only be relatively unique, but also carry a large impact. The events of 9-11, or the recent subprime credit events leading to the problems at Bear Stearns and elsewhere are such events. These events are difficult to predict, and not often seen (like a black swan), but nonetheless have lasting effects. [For what it is worth, both of Taleb's books related to the subject - The Black Swan and Fooled by Randomness - are worth your time].

Another problem with VaR that is often discussed concerns herd mentality. During an event, like a market meltdown, if everyone moves in the same direction and performs the same task (such as panic selling), they are essentially moving to the same location on the normal distribution. This in and of itself will change the curve. What before looked like an extreme event is now much more probable. As such, your level of risk and exposure will also increase.

Personally, while teaching VaR and performing my own calculations for finance organizations, I find that helping them understand the math and basic concepts is relatively easy. This is especially true for graduate students in finance, or those with a basic background in statistics, such as engineers and computer scientists, among others. What becomes difficult to teach and put into practice is understanding the proper distribution of a complex portfolio, especially one that includes non-linear derivative securities. Furthermore, getting a proper historical data set to model the distribution and calculate VaR can be difficult. Linear approximation and non-linear quadratic models have been developed and are often used, but they are also difficult to formulate, or at times require unrealistic generalization and/or assumptions.

Of course, sometimes the math itself gets misused, or is misunderstood. The Financial Times article gives an example offered by David Einhorn, a New York hedge fund manager. For instance, assume that "... you are offered odds of 127 to one on $100 that when you toss a coin, heads will not come up seven times in a row. The chance that you will win is 99.2 per cent. So you can say with 99 per cent confidence that you have no value at risk. Using a VaR model, a bank could hold no capital to guard against a loss on this bet. But in fact there is a 0.8 per cent chance (not an unimaginable black swan) that they will lose $12,700."

In other words, it is unlikely that you will incur a loss, therefore regulators will allow you to hold less capital. Of course, if you do happen to fall into the tail of the distribution, your loss would be significant, so significant that it could take down your company. When derivatives are used, and the non-linearity of options, complex swaps, CDOs, etc., are considered, the tail can become not only long, but also have a bump in it. This has the effect of further magnifying the potential loss and value that is at risk. In fact, the tail can be designed to be even less likely to occur (narrow and farther out, but having a taller bump), making the company look even less risky, but if the event does occur ........ , well, you get the picture. Unfortunately, this type of risk is hard to model, and even harder to understand. It also allows for abuse since it creates incentives to take excessive risk, albeit more remote. No doubt we are seeing the effect of this in the credit markets and elsewhere as we speak.

Buffett Says Buy Index Funds

Posted by Bull Bear Trader | 5/04/2008 06:53:00 PM | , , | 0 comments »

Jason Zweig of Money (as reported at was asked a question about what a young individual in their 30s should invest in. What is the single best investment idea? Buffett quickly suggested investing all they had to invest in a very low cost index fund from a reputable firm, a suggestion he has made on numerous other occasions. Buffett mentioned Vanguard in particular, the John Bogel founded company with a number of index funds to choose from. Of course, Buffett could have suggested another - Berkshire Hathaway. While technically not an index fund, or even close for that matter, it does have some of the diversification effects that an index fund would delivery, albeit Berkshire is exposed more than average to the insurance industry. Barron's also recently declared it fairly priced, after not long ago mentioning that it was a little expensive (before it pulled back). But touting his own stock would not be Buffett's style. Furthermore, Buffett is correct that an index fund would certainly track the indexes better, something that rarely seem to occur with Berkshire anymore, although I would have to run the numbers to be sure. Rather than touting his stock, Buffett is more comfortable touting the individual companies within Berkshire, along with their products - and sampling them with the freedom and joy of a school boy. Then again, I imagine $60+ billion would make you feel a little giddy at times, but how would I, or just about anybody really know.

Tickers: BRK.A, BRK.B