Jerry Marlow Proposal

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Jerry Marlow is proposing to use visual graphics and continuous time financial models to update marketing materials for asset management firms.

Jerry Marlow proposes using visually rich graphics software to explain continuous time financial models that drive asset valuation systems to clients in an intuitive way.

Jerry Marlow proposes using graphics and Monte Carlo simulations to demonstrate concepts like probability distributions, effects of dividends on options, and potential outcomes of retirement plans to clients.

Jerry Marlow, MBA

[email protected]
(619) 987-3599
3 Washington Square Village,
Suite 10G
New York, NY 10012
November 2005
Dear Sir or Ms.:
I am looking for a sophisticated
financial institution that will give me
the opportunity to revolutionize the
presentation materials that their
calling staff uses to market assetmanagement services. If you would
like for your firm to take the lead in
this exciting transformation, please
contact me and offer me a job.
Today every financial firm is
stuck with legacy marketing
materials from the 1950s.
If you look at your firms assetmanagement marketing materials,
chances are youll find that they
drone on and on about efficient
frontiers and other notions that
Markowitz developed in the 1950s.
Not only are these materials boring
to customers and the same as every
other firms marketing materials,
they are out of date and easy to
attack.

The Markowitz and CAPM models are


based on annual holding-period
returns and the notion that annual
holding-period returns are normally
distributed. Meanwhile the models
that your firms asset-valuation
systems use are based on geometric
rates of return and the continuous
time modeling that grew out of the
Black-Scholes-Merton revolution in
financial thinking.
Let the models that drive your
asset-valuation systems drive
your marketing materials.
My proposal is simple: Let the
models that your firm uses in its
asset-valuation systems drive your
marketing materials. Let me use
visually rich graphics software to give
your customers a conceptual
understanding of the models and the
probabilistic way of thinking that they
embody. Then your customers will be
able to appreciate your firms
prowess at building models,
calibrating them to market prices and
using the models to identify overand undervalued securities.

If you are responsible for your firms


marketing efforts, tapping into the
brilliance of your modelers will give
you a way to dazzle your clients (and
perk up your calling staff). If you are
responsible for the modeling that
underlies your firms asset-valuation
systems, funneling continuous time
modeling concepts into your firms
marketing materials will show
professionals in other areas of your
firm the extent to which modeling
prowess determines competitive
advantage.

The models that drive your assetvaluation systems evaluate


probability distributions.
The models in your firms assetvaluation systems are based on
conceptually simple suppositions:
Volatility makes future bond prices
and stock prices uncertain. Interest
rates for different times to maturity
have different volatilities. How the
yield curve might evolve is uncertain.
Because future interest rates and
stock prices are uncertain, every
financial forecast is a probability
distribution.

To value a financial asset is to


evaluate its probability distribution
(or, in some cases, to evaluate how
adding the asset to a diversified
portfolio will change the probability
distribution of the portfolio). The
models that drive your firms assetvaluation systems evaluate
probability distributions.

The likely change in the value of


bonds depends on how your firm
thinks the yield curve is likely to
evolve.

Your firms allocations to bonds of


different durations in large part
depend on the yield-curve forecasts
you use to value bonds. Most likely
your firm calibrates its yield curve
model to the current yield curve and
to the volatilities implied in prices of
options on interest-rate instruments.
If your firm agrees with the yieldcurve forecast implied in market
prices, then you look for bonds that
have prices and other characteristics
that are out of alignment with this
consensus view of how the yield
curve is likely to evolve.

If your firm disagrees with the yieldcurve forecast implied in market


prices, then it sees bonds of some
durations as undervalued and bonds
of other durations as overvalued. It
takes positions accordingly. Your firm
bets that market prices of bonds will
change in ways consistent with its
forecast.
If, in your marketing presentations
and collateral materials, you educate
your customers about how the
potential evolution of the yield curve
affects bond prices then you can
demonstrate your prowess at
evaluating bonds against your yieldcurve forecasts. You can differentiate
your capabilities and approach from
those of your competitors.

Your success at managing


mortgage-backed securities
depends on your prepayment
models.
The propensity of homeowners to
prepay their mortgages largely
determines the cash flows and hence
value of mortgage-backed securities.
Homeowners propensities to prepay
depends on the evolution of the yield
curve and on the history of the
interest-rate environment.
Prepayment models are among the
most challenging of financial models.
Because the history of the interestrate environment keeps changing, to
keep pace, prepayment models must
keep changing. A model that worked
last year may not work this year.
The better your institutional clients
understand how you evolve your
prepayment models to capture the
changing dynamics of the mortgage
market, the more they will appreciate
your prowess at identifying underand overvalued mortgage-backed
securities.

A stock forecast is a bell-shaped


curve drawn on a lognormal price
scale.
Since the 1970s the dominant theory
of how stock prices evolve has been
geometric Brownian motion. In
geometric Brownian motion models, a
stock forecast is a bell-shaped curve
drawn on a return axis of continuously
compounded rates of return or on a
corresponding lognormal price scale.
In geometric Brownian motion
models, what is commonly referred to
as the stocks expected return is
modeled as the average return of the
bell-shaped curve.
A stocks value depends both on how
high the bell-shaped curve sits on the
price axis and on how spread out the
bell-shaped curve is. When your stock
analysts value stocks intentionally
or otherwise they are assessing how
high the stocks bell-shaped curve sits
on the price axis and how spread out
it is. If we assume that stocks offer
risk premiums, then how high the
bell-shaped curve sits depends on the
risk-free rate, your firms assessment
of the stocks risk premium and the
spread of the bell-shaped curve.

You use Monte Carlo simulations


to value securities. You can use
visually rich Monte Carlo
simulations to educate your
customers.
Financial modeling has a degree of
mathematical difficulty that most of
your clients have no interest in
mastering. Even so, rich graphics
software makes it easy to educate
customers in the concepts that
underlie financial modeling.
Most of your customers understand
that stock prices and interest rates
jump around. Monte Carlo simulations
allow you to simulate how the prices
of a particular stock is likely to jump
around.

For a given forecast, you can simulate


many possible price paths.

You can tabulate price-path outcomes


with little squares.

The little squares build a histogram.


The histogram is a probability
distribution.
For stocks, the histogram
approximates a bell-shaped curve.
Voila! In a few seconds your
customers understand what it means
that Every financial forecast is a
probability distribution.

The forecast of a derivative


security is the probability
distribution of the underlying
filtered through a strike price.
Not all financial forecasts are bellshaped curves. To make that point in
a way easy for your clients to
understand, we can take them
through a series of simulations like
this:
If, at the time of expiration of a
European call option, the stock price
of the underlying is above the strike
price of the option, then the option
has a positive payoff and return.

If the stock price finishes below the


strike price, then the payoff is zero.
The continuously compounded rate of
return on the option investment is
negative infinity.

If we simulate the options payoffs for


all the outcomes in the stocks bellshaped curve, then we get a
histogram for the option.

The histogram of the option is its


forecast. If the stock offers a positive
risk premium, then the call option
leverages the risk premium.
If you offer your customers marketlinked deposits, then the radically
shaped probability distributions of
options gives them a good way to
understand potential investment
outcomes of their market-linked
deposits.

To value an option is to value all the


possible outcomes in the underlying
stocks bell-shaped curve. In riskneutral valuation, we pretend that the
stocks forecast average return equals
the risk-free rate.

If your staff economists think the


market is in a bubble and the risk
premium of stocks is negative or if
your security analysts think a stock is
significantly overvalued then a put
option will leverage the negative risk
premium into a positive risk premium.
Rich graphics combined with Monte
Carlo simulations allow you to make
points like these very quickly and
without torturing your clients with
stochastic calculus.

With rich graphics software you


can show non-intuitive aspects of
financial models.
Binomial options pricing theory
translates geometric Brownian motion
into a binomial tree. Ordinarily
binomial trees are drawn on log scales
as this one is here. But what happens
if you draw a binomial tree on an
arithmetic scale?

Drawing a binomial tree on an


arithmetic scale shows that much of
the value of a call option comes from
nodes at the top of the tree that are
far above the strike price.

Going back to a log scale, rich


graphics software allows you to show
things like...

how quarterly dividends depress the


potential evolution of price paths,
decrease the value of calls, and
increase the value of puts
.
If you use your page-up and pagedown keys to toggle back and forth
between this page and the previous
one, without doing any work you
readily see the effect of dividends.

With rich graphics software, we


can give your private clients a
visual yet realistic way to think
about their financial futures.
With Monte Carlo simulations running
in a rich graphics environment, for
your private clients we can simulate
potential outcomes of different
savings rates, retirement ages,
spending projections and investment
allocations.

For a given scenario, we can show


how market uncertainty translates
into many potential outcomes. We can
tabulate potential outcomes with little
squares. The little squares create a
histogram.

The histogram is a probability


distribution of the outcomes for that
scenario.

If we add a life-expectancy curve to


the scenario, we can show the client
the probability that he or she will run
out of money before death.

In this scenario, the client saves


more, retires later and invests
differently. To compare the two plans,
all the client has to do is toggle back
and forth between them.

Over the past thirty years a revolution


has taken place in financial thinking
and modeling. Today some of the
smartest people in your firm are busy
figuring out better ways to model and
value the probability distributions
associated with bonds, mortgagebacked securities, equities, derivatives
and other assets. Your firms success
depends upon their success.
Its an exciting story.
I would like to help you tell that story
in a way that your clients and
colleagues can understand and
appreciate. I would like to help you
turn your firms mathematical models
into marketing tools.
Call me.
With best personal regards,
Jerry Marlow
(619) 987-3599
[email protected]

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