Revisiting barrier bond

In Analyse einer Barriere-Anleihe I was estimating the present value of a barrier bond emitted by Berliner Landesbank, which referred to the stock price of Daimler: The payout would be 100, if the price was either allways above the barrier of 70%, or, if it dipped below the barrier, but closed above the initial price at the maturity of the bond. In every other case, the buyer would get the value of the stock at maturity. For details on the bond, go here.

Using stochastic modelling on a 13 year history of the Daimler stock price, I estimated a present value at offering of 98.6% assuming a risk free rate of 2% for the 2 year maturity (I checked the sensitivity of the result to the risk free rate, but even at a -0.5% the mean present value is at 99.4%, so a slight loss).

Today I wanted to check what the actual payout would have been.

payoutEnd = function(basis, barriere, kurse)
  basis = as.numeric(basis)
  barriere = as.numeric(barriere)
  kurse = as.numeric(kurse)
  if(all(kurse >= barriere))
    res = kurse[1]
  } else if( last(kurse)>basis)
    res = kurse[1]   
  } else 
    res = last(kurse)
## [1] "DAI.DE"

plot of chunk unnamed-chunk-2

Okay, so it seems the price never went below the barrier of 42.462, and the final payout was 100%:

payoutEnd(1,0.7, DAI.DE[,3]/DAI.DE[1,3])
## [1] 1

So, using hindsight, this would have been a good investment given the 7% coupon.

So I finally understood Monty Hall

Lately I have been binge-watching Mythbusters, and one of the more curios myths they took on was the Monty Hall problem. The Monty Hall problem is named after a US TV show, were the candidate had the chance to win whatever price was behind one of three doors, where the other two doors had no price. The twist is that after the candidate choose, the moderator would show what was behind one of the other two doors, obviously one, where no price is, and the candidate now had the chance to switch the door.

Now, intuitively one would say that being shown what is behind a door will not change the chances, and the candidate has a 1 in 3 chance to win the price. Now the myth is, that switching the door will increase the chance to win substantially.

One might say, this is not really a myth, as it can be shown statistically to be true. But I am bad at combinatoric, so after seeing in Mythbusters how far ahead the switching strategy is, I wanted to redo their experiment as a Monte Carlo simulation.

First, we set up the experiment, and sample the winning doors, and the initial selection by the candidate.

# monty hall problem

n = 100000

prices = sample(3,n,1)

selected = sample(3,n,1)

df = data.frame(prices = prices,
                selected = selected,
                shown = NA,
                wins_stay = NA,
                wins_switch = NA)

##   prices selected shown wins_stay wins_switch
## 1      2        1    NA        NA          NA
## 2      3        2    NA        NA          NA
## 3      3        2    NA        NA          NA
## 4      3        2    NA        NA          NA
## 5      1        1    NA        NA          NA
## 6      2        3    NA        NA          NA

Next, we define how the moderator has to choose, which door to show in each case. And this is the first hint to why the likelihood to win is higher if the candidate switches: We need to differ between the cases were the candidate chose the winning door or not, because in the case of the candidate choosing a losing door, the door to be opened by the moderator is predetermined – it’s the one which is not winning.

shown = apply(df, 1, function(x){
  x = unlist(x)

  # x[1] - winning door, x[2] - choosen door
  # candidate choose winning door

  } else {
    return((1:3)[-c(x[1], x[2])])
df$shown = shown
##   prices selected shown wins_stay wins_switch
## 1      2        1     3        NA          NA
## 2      3        2     1        NA          NA
## 3      3        2     1        NA          NA
## 4      3        2     1        NA          NA
## 5      1        1     2        NA          NA
## 6      2        3     1        NA          NA

Next, we calculate the winning likelihood, if the candidate always stays with the initial selection

selected_stay = selected

df$wins_stay = prices == selected_stay
##   prices selected shown wins_stay wins_switch
## 1      2        1     3     FALSE          NA
## 2      3        2     1     FALSE          NA
## 3      3        2     1     FALSE          NA
## 4      3        2     1     FALSE          NA
## 5      1        1     2      TRUE          NA
## 6      2        3     1     FALSE          NA
## [1] 0.33196

It’s not very surprising that the percentage is 1 in 3, which is the initial likelihood without any additional information.

Finally, we have to compute the door the candidate chooses if he switches.

selected_switch = apply(df,1,function(x){
  x = unlist(x)
  (1:3)[!(1:3)%in%c(x[2], x[3])]

df$wins_switch = prices == selected_switch
##   prices selected shown wins_stay wins_switch
## 1      2        1     3     FALSE        TRUE
## 2      3        2     1     FALSE        TRUE
## 3      3        2     1     FALSE        TRUE
## 4      3        2     1     FALSE        TRUE
## 5      1        1     2      TRUE       FALSE
## 6      2        3     1     FALSE        TRUE
## [1] 0.66804

Following the switching strategy, the candidates chances are 2 in 3, which counter-intuitively is quite logical: The candidate will loose in each case where his initial selection was correct (1 in 3), but will win in each case where his initial selection was wrong (2 in 3).

Oh, and here is a nice clip explaining it much better:

What happens with my AAA-rated bond portfolio in the next 30 years?

One question a client asked was how rating migrations would effect their portfolio in the long term, and how to adjust the asset allocation to keep a stable average rating. As a small demo and proof of concept, I wrote a small shiny app. It allows you to adjust the portfolio weights based on the rating categories, the duration of the portfolio, and  the growth rate of the portfolio.

Going off the peg – the Swiss case

So, the Swiss National Bank dropped its peg of the CHF against the EUR of 1.20, to the complete surprise of … well, anbydody, I suppose. As a result, the EUR dropped to lows of 0.975, according to yahoo, and remaining at 0.99 at pixel time.


The Swiss case is different from the normal case of a central bank stopping to defend a peg, because usually it has to defend against a depreciation of its currency, usually by selling its foreign reserves. Of course, such a defense is not sustainable in the long run, as foreign reserves are finite, if the fundamentals favor a depreciation.

Theoretically, these mechanisms have been well understood since the papers from Krugman on currency crises and later by Obstfeld on multiple equilibria, which explain speculative effects in a grey zone of so-so fundamentals, which could, for example, be effected by contagion. The practical results were very visible in the Asian crisis of 1997, and but for the political costs of leaving the EUR, we would have witnessed it in Europe in the last couple of years.

This is a matter close to my heart, as I wrote my diploma thesis on this subject, in an attempt to develop an early warning indicator. But even if that indicator would be still updated, and worked reasonably well, it would have missed the Swiss case – it was looking for depreciations against the central currency. But the SNB defended against appreciation, and theoretically, it should have been able to do so indefinitely, as it could just have kept on selling CHF against EUR.

Another indicator apparently also proved desastrous for a number of retail FX brokers – Value at Risk based on historical volatility. At least one broker declared insolvency, another is talking with regulators and investors about raising fresh capital, a number halted trading CHF. Here is an overview.

With a peg, of course the volatility would decline continously, lowering VaR. This allowed these brokers to decrease the required margin for their retail traders, or increase their leverage, with many brokers requiring only 2% margin. Those trades of course are completely underwater, and unless the traders answer the margin calls, the brokers have serious liquidity shortfall.

So, why did the SNB act like it acted? I can only speculate, of course, but here are some points whih I think are at least noteworthy:

  • While having a positive current account overall, it’s current account with the EU is negative, therefore appreciation would help closing this gap.
  • In a similar way, pegging to the EUR lead to depreciation against the USD and other major currencies, which might have lead to the impression that the pressure to appreciate the CHF against the trade wheighted basket has vanished to a manageable degree.
  • Expectations of European quantitative easing would weaken the EUR further, accelerating the growth of the SNB’s balance sheet, which might have been seen as a political liability.  This I don’t find very convincing, as the SNB is independent from direct government intervention, and a referendum to prescribe a minimum holding of gold as reserves just lost a popular vote, strengthening its independence further.

On Russia

The russion CB hiked the policy rate tonight form 10.5% to 17.0%. In the market this lead to a nearly parallel shift of the yield curve with steepening in the 1-5 year range.


For me, this leads to some question:

  • How large is the duration mismatch of the Russian banks?
  • Assuming it is not trivial, how long will the banks survive the inverted yield curve?

The macro problems of Russia show all the symptoms of dutch disease – a strong ressource sector leading to real appreciation of the Ruble, making the rest of the economy less competetive. The current abrupt reversal following the decline in oil prices kills the forex inflow on which domestic consumption of imports relied, making the interest rake hike necessary. This finally kills investments in the private sector, which would be necessary to capitalize on the new terms of trade by increasing exports and consumption of domestic goods.


PS: Gone with the wind – after gaining  10% in early trading after the hike, the ruble lost all gains before lunch.