Beginning with a sadly not-so-apocryphal story of a guy I once knew who was crowing about his new investment in a derivative sold to him (and paid for with someone else's money....see: who's capital is it anyway! rant). The story goes like this: "Gee Tim, I must be the smartest guy in the world....I just got the salesman (who just took me golfing) from the soon to be broke investment bank to sell me a collar for my bosses equity portfolio, and guess what, IT WAS FREE!!! Woooohoooo!!"....(pats self on back, and enjoys victory lap around room). Oh really? You mean you got something for nothing? (See Tims Commandments) "Yep, and that was tough....I'm going to the country club to relax.....just make sure somebody signs that confirm when it arrives" an hour later the raaataatatatatataaaat of the fax machine belches forth the following: "Confirmation of Derivative Transaction" "hmmmm....I wonder what this says" I mutter... Seeing the name alone gave me pause....."Costless, Zero-Cash, Pretty Much Free, Deferred Payment, Buried Interest, Reverse Amortization Arrears Note with a few options included Contract"....hmmmmm.....I'll just call this the COZY-RAM for short.....reading further it became quickly apparent that this guy and just transferred a vast amount of his bosses' wealth to the soon to be broke bank. The reason was that he had ignored the prime meridian of finance, the simple fact that VOLATILITY MATTERS. Comparison of arithmetic and logarithmic returns of $100 Initial investment, Vi $100 $100 $100 $100 $100 Final investment, Vf $0 $50 $100 $150 $200 Profit/loss, Vf − Vi −$100 −$50 $0 $50 $100 Arithmetic return, rarith −100% −50% 0% 50% 100% Logarithmic return, rlog −∞ −69.31% 0% 40.55% 69.31%
THAT IS WHY VOLATILITY MATTERS....... And if you like that, give my friend Yuri a read....  |