Investing

Felix Salmon writing for Reuters talks about a meeting with Mohamed El-Erian of PIMCO fame...

"On the subject of PPIP, though, I did ask El-Erian about how much value there is in clipping tails. If the government promises to absorb all losses beyond the first 15 cents on the dollar, how much does that raise the amount of money you’re willing to pay for any given asset? I was trying, in effect, to come at a value for the FDIC guarantee in the PPIP plan, but I didn’t get very far.

The answer, you see, is basically “it depends”. Every asset has a different probability distribution, and if you think that there’s a good chance the asset is actually worth 90, the tail-clipping at 85 is much more valuable than if you think the asset in reality is more likely to be worth 110. In short, it’s a long and laborious process of looking at every asset individually determining a probability distribution, and doing some math on it. How many good credit analysts are out there and capable of doing that kind of analysis? I think it’s not nearly enough, but El-Erian is a bit more bullish on that front: he thinks that if you create the right incentives, people will start to work this stuff out."

I've reproduced these paragraphs because Felix and El-Arian have taken something quite well known, put options, and made them sound mystical requiring some special kind of analysis. It doesn't! It requires the use of option pricing. The tail-clipping is simply a put sold by the government. That is why it's worth more the closer the intrinsic value is to your purchase price. Your purchase price minus 15% is the put's strike price. A put is obviously worth more the closer it is to being in the money.

The long laborious process of looking at every asset and determining its probability distribution translates to looking up historic volatility as an input to the options pricing model. In the absence of such data you could use a bottom up variance based on similar assets.

So putting this together, how does the government guarantee work. You believe a bond portfolio is worth 50c. You might bid 35c for the portfolio. Now if the government gives you a put 15% below your strike price you'll bid more because that put has value. Say the put is worth 4c. In that case you can bid 37c and you're still ahead by 2c.

The inputs to price the put are the strike price (15% below your purchase price), the current value (your estimate of intrinsic value), the volatility (calculated either bottom up or from trading data) and the time to expiry (however long the government guarantee runs for).