Michael Lovelady - Visual Quantitative Finance: A New Look at Option Pricing, Risk Management, and Structured Securities

A New Look at Option Pricing, Risk Management, and Structured Securities

Michael Lovelady

Vice President, Publisher: Tim Moore
Associate Publisher and Director of Marketing: Amy Neidlinger
Editorial Assistant: Pamela Boland
Reviewer: Michael Thomsett
Operations Specialist: Jodi Kemper
Marketing Manager: Megan Graue
Cover Designer: Chuti Prasertsith
Managing Editor: Kristy Hart
Senior Project Editor: Lori Lyons
Copy Editor: Krista Hansing Editorial
Proofreader: Paula Lowell
Senior Indexer: Cheryl Lenser
Compositor: Nonie Ratcliff
Manufacturing Buyer: Dan Uhrig

2013 by Michael Lovelady
Pearson Education, Inc.
Publishing as FT Press
Upper Saddle River, New Jersey 07458

FT Press offers excellent discounts on this book when ordered in quantity for bulk purchases or special sales. For more information, please contact U.S. Corporate and Government Sales, 1-800-382-3419, .

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All rights reserved. No part of this book may be reproduced, in any form or by any means, without permission in writing from the publisher.

Printed in the United States of America

First Printing April 2013 with corrections September 2013

ISBN-10: 0-13-292919-8
ISBN-13: 978-0-13-292919-6

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Library of Congress Cataloging-in-Publication Data

Lovelady, Michael Lynn, 1957
Visual quantitative finance : a new look at option pricing, risk management, and
structured securities / Michael Lovelady.
pages cm
Includes index.
ISBN 978-0-13-292919-6 (hardback : alk. paper)
1. Options (Finance)--Mathematical models. 2. Structured notes (Securities)
-Mathematical models. 3. Finance--Mathematical models. 4. Risk management.
I. Title.
HG6024.A3L684 2013
332.6453015195--dc23
2013005466

I would like to express my sincere gratitude to several people who made this book possible. At Pearson/FT Press, Jim Boyd, who believed in the material; Michael Thomsett, who gave the project guidance and direction from beginning to end; Lori Lyons, who served as both patient editor and production manager; Krista Hansing, Russ Hall, and all those who helped with editing, marketing, illustration, and production.

I would also like to thank Don DePamphilis at Loyola Marymount University for giving me the idea to write and Cooper Stinson for reviewing early manuscripts and asking all the right questions.

Also, my friends and family who gave me encouragement and inspiration, and forgave me for missing tee times: Arnold, Barbara, Barry, Bill, Bobbi, Daniel, David, Ernie, John, Kate, Katy, Kristine, Leslie, Matty, Paul, Steve, and Tony.

Above all, for life itself, the Triune God of CreationI always remember.

Michael Lovelady, CFA, ASA, EA, works as an investment strategist and portfolio manager, where he specializes in blending traditional and quantitative styles, including reduced-volatility and yield-enhanced option strategies. Michael developed the synthetic annuity and is the author of Profiting with Synthetic Annuities: Options Strategies to Increase Yield and Control Portfolio Risk.

Prior to hedge fund management, Michael was a consulting actuary for Towers Watson and PricewaterhouseCoopers, where he worked with employers on the design and funding requirements of plans ranging from defined benefit and defined contribution to hybrid db/dc plans. His experience with retirement income strategiesboth as an actuary from the liability side and as a fund manager from the asset sidegives him a unique perspective.

Michael has also been involved in teaching and creating new methods for making quantitative investing more accessible to students, trustees, and others interested in investment and risk management. He developed the investment profilea graphical representation of risk and the basis of a simplified option pricing model, and visually intuitive presentations of structured securities.

During his career, Michael has served various organizations, including Hughes Aircraft, Boeing, Global Santa Fe, Dresser Industries, the Screen Actors Guild, The Walt Disney Company, Hilton Hotels, CSC, and the Depository Trust Company. He is a CFA charterholder, an Associate of the Society of Actuaries, and an ERISA Enrolled Actuary. He currently lives in Los Angeles..

Visual Quantitative Finance presents a simplified, but powerful view of financial mathematics. It is written for trustees, investors, advisors, students, and others interested in quantitative finance, risk management, options strategies, structured securities, or financial model buildingor for those looking for new ways to explain these topics to someone else.

What makes this book different is its visual presentation of formulas and concepts that may be more intuitive, especially for those without quantitative backgrounds. By working directly with the mathematical building blocks of financerandom variablesrather than formulas derived from them, the underlying mechanism of option pricing becomes simple and transparent, creating many advantages:

The Black-Scholes formula can be derived in a few easy steps, with no complicated formulas.

The derivation of the option pricing formula highlights the framework for translating option pricing assumptions into future stock price patterns.

This framework is the keynot only to option pricing, but also to structured securities and risk management in general.

The visual display of random variables emphasizes the simplicity behind quantitative finance, allowing you to look inside the logic of risk metrics and the power of options to reshape risk-reward profiles.

You dont need a prior knowledge of statistical mathematics. Although the tools are developed without stochastic formulas, they may be one of the best ways to learn them.

Metrics that appear complicated when expressed in words or formulas become nothing more than simple lookups in a visual context.

The book provides an important perspective on options and their value in portfolio management. The material for the book was selected to reflect the change in investor attitudes that began with the 20002002 internet bubble and accelerated after the 2008 financial crisis. The change in attitudes has been described in numerous market surveys that indicate investors are (1) tired of traditional portfolios, (2) looking for creative solutions, and (3) not willing to invest in instruments they dont understand.

In response, the use of alternative strategies and the introduction of new funds have grown rapidly, with much of the activity focused on structured securities. Structured securities, ranging from simple covered call strategies to complex institutional hedges, are proving to be more effective than traditional securities at tailoring risk-reward profiles and generating new sources of income.

Even though the trends are clear and investor interest has never been higher, the challenge for many investors is to become comfortable with unfamiliar, often seemingly complex instruments. This is especially true for institutional trustees and retail investors who might not have experience with options or the mathematics behind them.

One method currently gaining traction is the visual presentation of concepts such as Value-at-Risk, which are more easily communicated in pictures than words. This book extends visual presentation to a variety of topics in hopes of making quantitative finance more accessible to a wider audience.