Prof. Jayanth R. Varma's Financial Markets Blog

Photograph About
Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

Subscribe to a feed
RSS Feed
Atom Feed
RSS Feed (Comments)

Follow on:
twitter
Facebook
Wordpress

January
Sun Mon Tue Wed Thu Fri Sat
         
           
2021
Months
Jan

Powered by Blosxom

Sun, 31 Jan 2021

The rationality of r/wallstreetbets

Much has been written about how a group of investors participating in the sub-reddit r/wallstreetbets has caused a surge in the prices of stocks like GameStop that are not justified by fundamentals. I spent a fair amount of time reading the material that is posted on that forum and am convinced that most of these Redditors are perfectly rational and disciplined investors, and have no delusions about the fundamentals of the company.

Rationality in economics requires utility maximization, but does not constrain the nature of that utility function. It does not demand that the goals be rational as perceived by somebody else. Rationality of goals is the province of religion and philosophy: for example, Plato’s Form of the Good, Aristotle’s Highest Good, Hinduism’s four proper goals (puruṣārthas), and Buddhism’s right aspiration (sammā-saṅkappa). Economics concerns itself only with the efficient attainment of whatever goals the individual has. Even the Stigler-Becker maximalist view of economics (Stigler, G.J. and Becker, G.S., 1977. De gustibus non est disputandum. The American Economic Review, 67(2), pp.76-90) does not seek to impose our goals on anybody else, and does not require that the goals be pecuniary in nature (consider, for example, the Stigler-Becker discussion about music appreciation).

It is perfectly consistent with economic rationality for a person to buy a Tesla car as a status symbol and not as a means of going from A to B. Equally, it is perfectly consistent with economic rationality for a person to buy a Tesla share as a status symbol and not as a means of earning dividends or capital gains. Buddha and Aristotle might take a dim view of such status symbols, but the economist has no quarrel with them.

It is in this light that I find the Redditors at r/wallstreetbets to be highly rational. There is a clear understanding and Stoic acceptance of the consequences of their investment decisions. In this sense, there is greater awareness and understanding than in much of mainstream finance. When Redditors knowingly pay prices far beyond what is justified by fundamentals in the pursuit of non pecuniary goals, they are only indulging in a more extreme form of the behaviour of an environment conscious investor who knowingly buys a green bond at a low yield.

There is overwhelming evidence throughout r/wallstreetbets that these Redditors are focused on non pecuniary goals:

TL;DR: This sub was created to lose money.

/r/wallstreetbets is a community for making money and being amused while doing it. Or, realistically, a place to come and upvote memes when your portfolio is down.

Yo, health check time: Get proper sleep, Eat proper food, Stretch occasionally, HYDRATE. I’m sure we’ve all been glued to our screens all week, but please make sure you take care of yourselves.

There is a crystal clear understanding that most trades will lose money:

Buy High Sell low - what you do as a newcomer.

First one is free - A phenomena where you are so retarded and don’t know what the [expletive deleted] your doing you somehow make money on your first trade.

… if you don’t know any of this there is really no reason for you to be throwing 10k at weeklies you’ll lose 99% of the time.

We don’t have billionaires to bail us out when we mess up our portfolio risk and a position goes against us. We can’t go on TV and make attempts to manipulate millions to take our side of the trade. If we mess up as bad as they did, we’re wiped out, have to start from scratch and are back to giving handjobs behind the dumpster at Wendy’s.

… and also for the most part, they’re playing with their own money that they can actually afford to lose even if it hurts for a year or two.

Options are like lottery tickets in that you can pay a flat price for a defined bet that will expire at some point.

Indeed mainstream regulators could borrow some ideas from r/wallstreetbets on how to disclose risk factors in an offer document. When a risky company does an IPO, a prominent disclosure on the front page “This IPO was created for you to lose money” would be far better than the pages and pages of unintelligible risk factors that nobody reads.

Posted at 20:19 on Sun, 31 Jan 2021     View/Post Comments (2)     permanent link


Thu, 14 Jan 2021

SPACs and Capital Structure Arbitrage

Special Purpose Acquisition Companies (SPACs) have become quite popular recently as an attractive alternative to Initial Public Offerings (IPOs) for many startups trying to go public. Instead of going through the tortuous process of an IPO, the startup just merges into a SPAC which is already listed. The SPAC itself would of course have done an IPO, but at that time it would not have had any business of its own, and would have gone public with only the intention of finding a target to take public through the merger. Both seasoned investors and researchers take a dim view of this vehicle. Last year, Michael Klausner and Michael Ohlrogge wrote a comprehensive paper (A Sober Look at SPACs) documenting how bad SPACs were for investors that choose to stay invested at the time of the merger. Smart investors avoid losses by bailing out before the merger, and the biggest and smartest investors make money by sponsoring SPACs and collecting various fees for their effort.

As I kept thinking about the SPAC structure, it occurred to me that at the heart of it is a capital structure arbitrage by smart investors at the cost of naive investors. The capital structure of the SPAC prior to its merger consists of shares and warrants. However, in economic terms, the share is actually a bond because at the time of the merger, the shareholders are allowed to redeem and get back their investment with interest. It is the warrant that is the true equity. If the share were treated as equity, it would have a lot of option value arising from the possibility that the SPAC might find a good merger candidate, and the greater the volatility, the greater the option value. A part of the upside (option value) would rest with the warrants. But if the shares are really bonds, then all the option value resides in the warrants which are the true equity. Naive investors are perhaps misled by the terminology, and think of the share as equity rather than a bond; hence, they ascribe a significant part of the option value to the shares. Based on this perception, they perhaps sell the detachable warrants too cheap, and hold on to the equity.

From the perspective of capital structure arbitrage, this is a simple mispricing of volatility between the two instruments. Volatility is underpriced in the warrants because only a part of the asset volatility is ascribed to it. At the same time, volatility is overpriced in the shares since a lot of volatility (that rightfully belongs to the warrant) is wrongly ascribed to the share. One way for smart investors in SPACs to exploit this disconnect is to sell (or redeem) the share and hold onto the warrant, while naive investors hold on to the share and possibly sell the warrant.

Capital structure arbitrage suggests a different (smarter?) way to do this trade. If at bottom, the SPAC conundrum is a mispricing of the same asset volatility in two markets, then capital structure arbitrage would seek to buy volatility where it is cheap and sell it where it is expensive. In other words, buy warrants (cheap volatility) and sell straddles on the share (expensive volatility). At least some smart investors seem to be doing this. A recent post on Seeking Alpha mentions all three elements of the capital structure arbitrage trade: (a) sell puts on the share, (b) write calls on the share and (c) buy warrants. But because the post treats each as a standalone trade (possibly applied to different SPACs), it does not see them as a single capital structure arbitrage. Or perhaps, finance professors like me tend to see capital structure arbitrage everywhere.

Posted at 11:21 on Thu, 14 Jan 2021     View/Post Comments (0)     permanent link