Posted by: nealc | November 22, 2009

Madan’s hidden put NYQFS

Attended Dilip Madan’s Blackrock NYQFS talk. Again a good, thought-provoking talk. The audience was smaller than what I saw for Heston’s talk, but this talk was much more interesting to me. I think it was the words ‘capital requirements’ which perhaps scared off any self-styled cowboys.

There were several ideas which were new to me in this talk. First he said there is a hidden put option in the limited-liability structure. This is a new way of looking at corporation/management agency-type problems which had been studied since Adam Smith, Berle and Means, and others, but I’ve never seen the further links to Black’s equity-as-call-option and public bailout before. This has always been a grey area, the ability of a limited liability company to fail and put all its debt and risk onto the government. Presumably it’s a pillar of capitalism, even Adam Smith mentions this when he discusses projects which only the government could profitably take on like bridges, but it’s still quite poorly understood, very much a blind spot. What is noteworthy here is that Madan was able to infer several interesting dollar figures on real financial firms from his new framework using VG processes.

The basic idea is that a limited liability firm owns a hidden put option. If things go bad, the management can declare bankruptcy. The bondholders and stockholders can wrangle over whatever’s left of the company, but after they’ve taken whatever is left, then the rest, all negative, goes on to the taxpayer. The management don’t suffer loss — they carefully manage their put option. In particular they’ve been doing this ever since the shell companies and holding companies of the Great Crash and before, each company a limited-liability firebreak to the next — a free put option lying on the sidewalk as Madan might say.

Exactly what goes to the taxpayer though? This raised several questions from the audience. What happens, for instance, is that a company could receive a limited liability. It could then, for instance, short a stock. For a while the CEO could receive a healthy bonus if the stock does poorly. The stock could then quickly skyrocket, and the CEO could then declare the company bankrupt. The bank which loaned the stock to the CEO would then not get the stock back and suffer a loss, which may cause it to collapse if there are correlated defaults, which could then require a bailout and hence a put.

It’s basically a bailout put. But Madan was able to tease some very interesting figures out the option volatility surface with his VG processes; but I’m not sure the volatility surface has so much special information as to be able to determine the value of the bailout put of a bank.

Madan was able to find capital requirements based on the volatility surface, but again if a bank met the revised capital requirements then the volatility surface would change; in particular, might a bank be able to manipulate its volatility surface in the option market and circumvent the capital requirements? (If we accept the possibility of bear runs and manipulation in stocks, then why would we rule out manipulation of options?) Someone else pointed out that the volatility surface during a crash is very unstable; Madan replied that one could use the surface in stable periods.

This is, in itself, an interesting position — that the stable market contains within it a preconception of the crash — but doesn’t it, in the surface?

Truly one of the most interesting talks I’ve attended in a long while.


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