Perspectives on Value
Vol #134: June 22, 2023
Finance is, by definition, all about the money.
Whether you treat it as a scorecard or spending power, making whatever pile you have bigger (or at least not smaller) is the number one objective. Greenhorns talk about what their number is, as in how big that stack has to be for you to walk away. If only it was that simple.
The last time government bonds were yielding 5%, I was young enough to be playing that game. I remember sitting around with other interns talking about how even if we got jobs as janitors at the fund, as employees we could put half our money into the company’s flagship macro vehicle and half in T-bills, and “you’d only need like a million bucks to be set”.
Rates quickly fell as my young peers and I heard the early canaries of financial crisis singing. The superstar of the cohort ahead of me had IndyMac in his book and the risk desk was literally breathing down his neck every morning at the open. When Bear Stearns first fell off a cliff, my classmate from Phase III spent three months on the bench after a skittish day of coverage.
The money games then took a more cynical turn, and we had a chat room called “Prison Pricing”. How much money would it take for you to spend 1, 3, X years in the slammer. (I forget the contract specs about whether or not you were labeled a felon.) More realistically we also debated whether it was worth it to spend a season on an Alaskan fishing boat.
Money isn’t just about a number though, and wealth is denominated in far more ways than a bank account has zeros. It’s the ability to say no to anything, or yes to everything. Wealth is having time to do the things you want with the people you care about. It’s a nebulous concept who’s true definition matters only to the author of the life lived.
Finance masquerades as straight forward arithmetic. Compound interest is the closest thing there is to magic. Buy stock for $100, sell it for $200, and pocket $100 minus the capital gains rate. Your investment portfolio is the collection of the stocks and bonds in your account. Net worth might add in your house appraisal and subtract the mortgage. Haircut the private placements and crypto tokens by at least 25% in this market, and you have a good idea of your number.
If net worth is the sum of all these line items, how do we determine their individual value?
A transaction represents the meeting of a buyer and seller, so it’s clear what the most recent value of an actively traded and fungible good is. Things that don’t trade are much more difficult. What is the value of a suitcase full of used clothes?
From a replacement value perspective, it could actually be quite high. If a bag of my shirts fell into the trash, it’d be a sizable bill to replace that exactly. However, that's quite different from what someone might be willing to pay for a sack of my dirty laundry.
When I bought a new pair of loafers this spring for $200, my mental accounting says I should get at least 3 years of use out of them if I keep them out of the rain and don’t wear them cycling (much.) My bean counter has done the appropriate depreciation and says these are still worth at least $175 to me. But I need to put a very different number on a customs form when I ship them back stateside. According to a popular suitcase shipper; “Typically a suitcase of used clothing will have a used resale value of under $150.”
It’s well known in behavioral finance that people tend to value things they own more than other people would “objectively” value those - the endowment effect. I know that once the tag comes off those designer shoes, the price should plummet, but it almost feels like I’m short changing myself. Even if my shoes don’t show up on my net worth spreadsheet, my pride demands these are valued closer to what I consider “true” value.
In this specific customs context, a bunch of dirty clothes and lightly scuffed soles that haven’t been gussied up for eBay ain’t worth a hill of beans. Even the IRS agrees; when taking a deduction for donated clothing, they remind you that “Used clothing and other personal items are usually worth far less than the price you paid for them.” (emphasis mine.)
Customs agents and tax men are important arbiters of value. Making sure you determine the appropriate value for your imports and income might be subjective, but there are plenty of guidelines to ensure that your process is reasonable and justifiable.
It might not be all that surprising that a soft sided duffel has squishy measures of value. But even in markets trading tens of millions of contracts a day, valuing an options book is more complicated than it seems at first glance.
The most obvious way to determine the value of an actively traded security is to look at the midpoint of the bid and ask. Assuming reasonable liquidity, the point between where the buyer and seller refuse to budge any tighter is a good estimate.
This perhaps obscures the true value of the position. If you own 10 contracts that are marking at $0.45 on a market that’s $0.40-$0.50, the brokerage account will say that’s worth $450. But if you needed to turn around and pay a bill for $450, things might get tight. In addition to commissions, there’s a good chance you won’t be filled at midpoint.
Average customer improvement levels in liquid names are about 30% of the difference of the bid to mid. This is called a “30 EQ” and means that for every ten pennies of available improvement, all but three went to the customer. (Low EQs are good for customer, bad for market maker). On a nickel wide bid to mid, there are five pennies, so a trade at $0.44 means a 1/5 or 20 EQ, and a trade at $0.43 means 2/5 or 40 EQ. There’s at least $10, more likely $20, of hidden slippage that will cause your realized cash to fall short of your mark on that book.
Large dealers think about this at scale. The statements from the clearing companies would always show the value of the portfolios marked at the midpoint. We would additionally run a “cost to close” valuation on our book that asked how much we’d expect to lose if we had to close out a) at the opposite side or b) midpoint + N ticks.
Sometimes the opposite side was the best case. If you have a sizable position in an illiquid name, you could be paying through multiple levels to close (likely). Other times you could get lucky and collect edge on a closing side order (much less likely).
As the cost to close value shifted, it reflected both underlying markets and your overall position. A bigger number could mean either more trading, or moreso trading in less liquid names. This would be parsed by tier and volume level to ensure you’re seeing exactly where the costs are coming from. As liquidity ebbed and flowed in the overall market, it was best reflected in the tightness of bid-ask spreads.
This was also an important exercise to be ready for the occasional pricing of books. While increasingly less common with larger trading entities, when there were more of the smaller shops, entire books would sometimes get shopped around. For a partnership shutting down, the question was “how much can we pay you to take all this risk off our hands.” If it was less than their cost to close, you could likely make a deal.
A funny quirk about value for liquidity providers is that most of it is realized up front, but the maintenance and bills on it are due later. For firms with structural alpha - e.g. they get to advantageously post bids and offers and interact with customer flow - their positive mark happens as soon as the trade is affected (assuming they didn’t get picked off by another professional).
When the market maker contra side to your $0.43 closing order gets a fill, she immediately sees $20 of green PnL on the day. She now owns a ten lot that’s worth $0.45 a contract and she only paid $0.43. Now comes the dynamic hedging, risk management, capital requirements, and interest costs.
Last week when talking about execution we said that the best outcome for most traders is to do no harm, and get filled exactly at the midpoint. Market makers' best case is that they have on average priced volatility properly, and that the edge they collect, minus the transaction costs to maintain that, eventually flows through to the bottom line.
The reality was much dimmer. Markets moved intraday and adjusted to imbalances, so only a fraction of your edge collected on any given trade made it to your end of day PnL. Then only a fraction of that PnL stuck to your monthly number, as anything from informed flow to structural costs ate away at your gross. Despite what Reddit conspiracies tell you, market makers aren’t offensively manipulating the price, they’re doing everything in their power to defend against something toxic.
On a day to day basis, it was easy to tell the great from the good, and the good from the not so great. But it always took a few days or even weeks for value to sort itself out along the fringes. If the name was less liquid, it was possible for edge differences to take many days to sort out. The longer that edge persisted without materializing into PnL, the less likely it was to be real. This “half life” was only a few days.
There are a few times of year that the accountants demand a more exact value. The end of the month mattered for scorekeeping, but the end of the quarter meant comp, and the end of the fiscal year meant the tax man. An arbitrary day is the point here, but churning markets don’t care what the Q’s prefix is.
When you collect your edge at the trade’s outset, it has a certain endowment effect to believe you’re due the dollars that are already in your account. But so long as the contracts are still open, the other side is paying par for a zero coupon bond that has yet to mature. We all hope it works out, but there’s still risk on the table.
Because contracts are continually being opened and closed, there also needs to be some formulation for how to mark profits and losses for tax accounting purposes. The current legislation is mostly mark-to-market, with some special considerations thrown in.
Prior to the 1986 tax reform, there were some major loopholes for futures and options dealers. At a high level, you could continually roll profits forward by entering into trades that were loss making in the current year but carried their value forward. This way you never paid taxes until the trades were closed.
Along with the dozens of other loopholes that Bill Bradley and company closed in the Showdown at Gucci Gulch, the dealers could no longer perpetuate their rolls, and had to mark their books to market every year. They did get the major concession of Section 1256 treatment - where gains and losses are treated as 60% long term and 40% short term.
Like wealth, value is a word that has as many subjective as objective meanings. Value is an economic concept that defines the utility of an item in as precise of terms as possible. This is required for financial dealings of every type. Knowing where that mark is imprecise matters.
But value is also a moral concept, indicating a framework of beliefs for what we hold dear. It is dependent on both context and the eye of the beholder. Even the most green visored attempts to pin it down leave you feeling like nailing Jell-o to the wall.
At the most granular levels, values are fuzzy. By the laws of significant digits, your answer can only be as precise as the least precise component, ergo wealth is subjective. But more than just a LIFO / FIFO choice, wealth is subjective because the values reflect something unique.