Beruflich Dokumente
Kultur Dokumente
- Part 2:
Extremistan
by Edward O. Thorp* and Steven Mizusawa*
1. Introduction
Consider an investor who allocates a fixed fraction of his wealth to a stock index at
the start of each period and the remainder to U.S. Treasury bills. This article was
motivated by the question of whether the investor can be better off buying calls on the
index instead, in order to limit his one-period downside risk (in Nassim Talebs evocative
terminology, bad Black Swans)?
Previously, we assumed that stock index returns follow a stationary lognormal
distribution the world of Black-Scholes and Long Term Capital Management. Taleb
calls this world where Gaussian statistics prevail Mediocristan. Here we explore the
world of Extremistan by using a distribution with fatter tails than the lognormal.
2. Assumptions and Formulas
Portfolios are limited to either T-bills plus a stock index or T-bills plus call options
on this stock index. We assume no transactions costs for simplicity. After considering
various proposed fat-tailed distributions, we chose to make up our own, a t-distribution
with four degrees of freedom, truncated at zero (i.e. set equal to zero for negative
values of the argument). The arithmetic mean
and variance
match those we used for Mediocristan. The resulting density function was
( )
( )
and
( )
) )
for
for
For simplicity, the index pays no dividends. Again, the portfolio is revised annually.
Calls are European, i.e. only exercisable at expiration. Recall that the Black-Scholes
formula for European calls results if we take the lognormal distribution and replace the
expected growth rate by the riskless rate. If this mean-growth-rate-shifted lognormal
distribution is ( ) then
( )
) ( )
However, because we have only specified a terminal distribution of index prices, and
not one resulting from a process with known transition probabilities, we dont have a
no arbitrage model for call option pricing.1 Proceeding by analogy with equation (2),
and choosing
(year), we priced the options in a risk-neutral setting using the fattailed density function of equation (1).
Let ( ) equal ( ) after shifting its mean so that its expected growth rate equals the
riskless rate, i.e.
1
( )
( )
Note that when ( ) is mean-shifted to get ( ) the point where ( ) becomes nonzero is at some number
whereas for ( ) it was at
Now calculate
from
( )
Note that
) ( )
where ( )
( )
for
( )
) )
and
for
Alternatively, we could have truncated the risk neutral t-distribution at zero, for
finding it by the same process we used to find ( ).
Table 1 compares the call prices we used for Extremistan with those for
Mediocristan. The differences are small in magnitude across the entire range.
However, the truncated distribution leads to much greater maximum drawdowns
than in the lognormal case as Figures 1 and 2 show. Figure 1 shows the simulated
cumulative distribution of the maximum drawdown for the lognormal. The five curves
represent fractions of 0.2, 0.4, 0.6, 0.8 and 1.0 in the index. As the fraction increases,
the curves of course move progressively to the right. Figure 2 displays the same
graphs for the truncated distribution.
and
Lognormal
Student t
.2
.4
.6
.8
1.0
1.2
1.4
1.6
1.8
2.0
.809
.619
.429
.245
.104
.0325
.00785
.00158
.000286
.0000479
.809
.620
.433
.253
.105
.0299
.00861
.00315
.00142
.000748
Figure 1.
Figure 2.
Figure 3: Geometric growth versus standard deviation for values in the Tables where
g>= .05 and v<= .5. Extremistan.
0.1300
0.1200
0.1100
f1
Geometric Growth
0.1000
f2
f3
f4
0.0900
f5
f6
0.0800
f7
f8
0.0700
f9
RisklessRate
0.0600
StkIndex
0.0500
0.0400
0.0000
0.0500
0.1000
0.1500
0.2000
0.2500
0.3000
Standard Deviation
0.3500
0.4000
0.4500
0.5000
Table 2: Geometric Growth for Extremistan, r=.05, T=1 year, using truncated Student T distribution with 4 degrees of freedom, Mean of 1.12749, Variance of 0.0518805.
7/13/2011
f-->
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
K
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2
0.0570
0.0577
0.0585
0.0596
0.0610
0.0627
0.0652
0.0685
0.0733
0.0796
0.0861
0.0869
0.0741
0.0493
0.0219
-0.0008
-0.0174
-0.0289
-0.0366
-0.0418
-0.0454
0.0635
0.0648
0.0663
0.0683
0.0707
0.0738
0.0780
0.0836
0.0910
0.0999
0.1055
0.0950
0.0565
-0.0003
-0.0540
-0.0940
-0.1207
-0.1379
-0.1489
-0.1561
-0.1608
0.0695
0.0713
0.0734
0.0760
0.0793
0.0834
0.0886
0.0954
0.1039
0.1122
0.1118
0.0832
0.0135
-0.0763
-0.1543
-0.2089
-0.2436
-0.2652
-0.2786
-0.2872
-0.2928
0.0750
0.0772
0.0798
0.0829
0.0867
0.0913
0.0971
0.1042
0.1120
0.1168
0.1059
0.0534
-0.0522
-0.1768
-0.2786
-0.3467
-0.3887
-0.4140
-0.4296
-0.4393
-0.4456
0.0801
0.0826
0.0854
0.0888
0.0928
0.0976
0.1033
0.1096
0.1150
0.1135
0.0871
0.0043
-0.1429
-0.3052
-0.4317
-0.5134
-0.5624
-0.5914
-0.6089
-0.6197
-0.6267
0.0847
0.0873
0.0903
0.0938
0.0977
0.1022
0.1070
0.1113
0.1122
0.1007
0.0529
-0.0685
-0.2655
-0.4707
-0.6243
-0.7204
-0.7767
-0.8095
-0.8290
-0.8410
-0.8486
0.0887
0.0914
0.0943
0.0976
0.1011
0.1046
0.1076
0.1083
0.1019
0.0753
-0.0026
-0.1751
-0.4348
-0.6920
-0.8774
-0.9901
-1.0547
-1.0917
-1.1134
-1.1266
-1.1349
0.0922
0.0947
0.0974
0.1000
0.1025
0.1043
0.1040
0.0985
0.0802
0.0301
-0.0930
-0.3391
-0.6857
-1.0126
-1.2394
-1.3732
-1.4481
-1.4903
-1.5148
-1.5295
-1.5387
0.0951
0.0971
0.0990
0.1004
0.1009
0.0991
0.0925
0.0756
0.0353
-0.0580
-0.2623
-0.6371
-1.1309
-1.5723
-1.8651
-2.0320
-2.1229
-2.1731
-2.2018
-2.2188
-2.2293
0.0968
Table 3: Std. Deviation for Extremistan, r=.05, T=1 year, using truncated Student T distribution with 4 degrees of freedom, Mean of 1.12749, Variance of 0.0518805.
7/14/2011
f-->
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
K
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2
0.0214
0.0236
0.0263
0.0297
0.0339
0.0395
0.0470
0.0577
0.0737
0.0988
0.1379
0.1926
0.2511
0.2924
0.3071
0.3004
0.2815
0.2579
0.2337
0.2108
0.1901
0.0425
0.0469
0.0522
0.0588
0.0670
0.0778
0.0924
0.1128
0.1426
0.1878
0.2547
0.3401
0.4178
0.4559
0.4505
0.4185
0.3765
0.3339
0.2949
0.2607
0.2312
0.0635
0.0700
0.0779
0.0877
0.1000
0.1160
0.1374
0.1671
0.2100
0.2733
0.3638
0.4723
0.5595
0.5874
0.5604
0.5057
0.4447
0.3874
0.3374
0.2950
0.2593
0.0845
0.0932
0.1038
0.1169
0.1333
0.1546
0.1830
0.2221
0.2781
0.3593
0.4719
0.6003
0.6926
0.7071
0.6576
0.5812
0.5028
0.4326
0.3731
0.3236
0.2827
0.1056
0.1168
0.1302
0.1467
0.1676
0.1945
0.2303
0.2796
0.3494
0.4494
0.5845
0.7318
0.8267
0.8249
0.7515
0.6531
0.5576
0.4748
0.4063
0.3502
0.3043
0.1272
0.1409
0.1575
0.1779
0.2036
0.2368
0.2810
0.3417
0.4271
0.5481
0.7081
0.8752
0.9707
0.9492
0.8491
0.7270
0.6134
0.5177
0.4398
0.3769
0.3261
0.1496
0.1662
0.1864
0.2113
0.2427
0.2834
0.3377
0.4121
0.5166
0.6631
0.8529
1.0427
1.1371
1.0909
0.9589
0.8093
0.6753
0.5650
0.4767
0.4063
0.3500
0.1731
0.1935
0.2182
0.2488
0.2877
0.3382
0.4058
0.4987
0.6291
0.8103
1.0405
1.2599
1.3510
1.2708
1.0967
0.9118
0.7519
0.6233
0.5221
0.4424
0.3792
0.1989
0.2249
0.2567
0.2962
0.3467
0.4129
0.5022
0.6258
0.7996
1.0400
1.3384
1.6063
1.6897
1.5521
1.3098
1.0689
0.8687
0.7119
0.5908
0.4970
0.4235
0.2333
Table 4: Sharpe for Extremistan, r=.05, T=1 year, using truncated Student T distribution with 4 degrees of freedom, Mean of 1.12749, Variance of
0.0518805.
7/14/2011
f-->
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
K
0.0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8
1.9
2
0.3265
0.3255
0.3247
0.3240
0.3235
0.3231
0.3225
0.3208
0.3154
0.3000
0.2622
0.1915
0.0961
-0.0025
-0.0914
-0.1693
-0.2396
-0.3058
-0.3706
-0.4356
-0.5021
0.3173
0.3152
0.3132
0.3111
0.3089
0.3063
0.3030
0.2977
0.2877
0.2656
0.2180
0.1324
0.0156
-0.1103
-0.2308
-0.3439
-0.4533
-0.5626
-0.6744
-0.7905
-0.9118
0.3073
0.3040
0.3006
0.2969
0.2927
0.2877
0.2812
0.2720
0.2567
0.2274
0.1698
0.0703
-0.0653
-0.2151
-0.3645
-0.5119
-0.6603
-0.8135
-0.9738
-1.1430
-1.3217
0.2965
0.2919
0.2869
0.2814
0.2750
0.2673
0.2575
0.2439
0.2229
0.1860
0.1184
0.0056
-0.1476
-0.3207
-0.4996
-0.6825
-0.8724
-1.0727
-1.2854
-1.5120
-1.7530
0.2850
0.2788
0.2721
0.2645
0.2556
0.2450
0.2315
0.2132
0.1861
0.1413
0.0635
-0.0624
-0.2334
-0.4306
-0.6410
-0.8627
-1.0983
-1.3507
-1.6218
-1.9126
-2.2234
0.2726
0.2646
0.2559
0.2459
0.2344
0.2204
0.2028
0.1794
0.1457
0.0925
0.0041
-0.1354
-0.3250
-0.5485
-0.7941
-1.0598
-1.3477
-1.6602
-1.9986
-2.3637
-2.7554
0.2591
0.2489
0.2378
0.2252
0.2105
0.1928
0.1706
0.1415
0.1005
0.0382
-0.0617
-0.2159
-0.4264
-0.6802
-0.9671
-1.2852
-1.6358
-2.0206
-2.4405
-2.8956
-3.3857
0.2441
0.2312
0.2170
0.2011
0.1826
0.1605
0.1330
0.0973
0.0481
-0.0246
-0.1375
-0.3089
-0.5446
-0.8362
-1.1757
-1.5609
-1.9925
-2.4713
-2.9973
-3.5702
-4.1893
0.9
0.2266
0.2093
0.1908
0.1702
0.1467
0.1188
0.0847
0.0409
-0.0184
-0.1039
-0.2333
-0.4277
-0.6989
-1.0453
-1.4622
-1.9477
-2.5015
-3.1229
-3.8111
-4.5647
-5.3825
0.2005
Figure 4.
Comparison of the cumulative distribution of Maximum Drawdowns
For Options with K = 1.1, f=.1, T = 32 years ( in Blue) and Stock Index (fraction =
1.0 in
Red).
When
For Options with K = .9, f=.2, T = 32 years ( in Blue) and Stock Index (fraction = 1.0 in
Red).
10
Figure 6.
Comparison of the cumulative distribution of Maximum Drawdowns
For Options with K = .9, f=.4, T = 32 years ( in Blue) and Stock Index (fraction =
1.0 in
Red).
See Ekstrom, et al, Quantitative Finance Vol. II, No. 8, August 2011, page 1125, for a
discussion of when we have no-arbitrage pricing or risk-neutral pricing models. Also
see J. Huston McCulloch, The Risk-Neutral Measure and Option Pricing Under LogStable Uncertainty, http://www.econ.ohio-state.edu/jhm/papers/rmn.pdf.
11