But financial mathematics has an attraction. It brings an appearance of precision to some very imprecise arts.
But my test as to whether you really understand financial mathematics is whether you can meaningfully apply it to simple real world problems. If you can get maths to do that it is not wasted and can add something to your risk management.
So – in this line – think of this post as a second year university financial mathematics course without the maths.
David – the financial salesperson extrovert and his sports betting junkie
David (not his real name) was financial sales guy I knew kind of well. Like most financial sales guys he was an extrovert. He worked with analysts – and they were all introverts. If you put him in a bus with his colleagues on the way back from some Christmas function he would try to get everyone singing Scottish football songs. This was amusing but usually unsuccessful. To the extent it was successful I blame alcohol and not David’s out-of-tune lead. [Dave – if you are reading this – your singing wasn’t bad – it was just memorable.]
Anyway Dave had fifty bucks left in an old sports betting account. He reckoned that he could bet the entire sum every week for six months and end up with more money than he started with.
This sounded impossible – and I was prepared to fund the experiment if I was wrong.
David may have been a sales guy – but he was no fool. He divided his stake into five equal amounts and bet on five near certainties. A typical sort of bet might be for Roger Federer to win the second round at
He wouldn’t get great odds – the bets often paid only 1.05 times the sum wagered. But he would win all five bets most weeks.
The odd week he would lose one – and the four winners would wind up losing 16% (=1-4*1.05/5). It would take him a few weeks to recover – but he recovered – and little harm was done.
I lost track of how David was going – but you can see what is going to happen. Week in, week out the David will make a profit. He might have a setback – but it would be manageable. He looked like a consistent winner.
Of course if he did it for long enough his number would be up – and he would bet on five losers. It is highly unlikely to happen in any particular week – but done for long enough it was inevitable.
The strategy will have the property of making regular seemingly-consistent profits – but taking irregular large losses. Off six months of data it was almost impossible to tell if he was adding value with his wagering – but my guess is he probably wasn’t.
So what has this got to do with financial mathematics?
Well what David was doing was betting on likely outcomes. If you bet on likely outcomes you make money most the time but when you lose you lose big.
I call this selling volatility in the sports betting market. You can model it just like selling volatility in the finance market (but hey – I am saving you doing a financial maths course).
Selling volatility in financial markets is just betting on the world staying within likely parameters. I can design you a hedge fund that would make a profit almost all the time –and has fantastic consistent returns.
Maybe I could even convince rating agencies I am a genius. But the only strategies I know that are consistent have a blow-up risk. That is what selling volatility is all about. I know several Australian funds (and there were many more) which blew up precisely this way late last year.
If you watch for long enough it is amazing how often you see people selling volatility. And they often don’t even know they are doing it. Over times I hope to point a few out. But that is subject matter for later posts.