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Professor Nicholas Epley explores the drawbacks of social connections.

Opportunities in liquidity and risk transfer services

In finance, there are three ways to make money: holding systematic exposure, otherwise known as “beta” or factor returns; forecasting of cash flows, or “alpha;” and providing intermediary services, such as risk transfer and liquidity provision to the market, an approach Nobel laureate Myron Scholes, MBA ’63, PhD, ’70, calls “omega.” According to Scholes, omega “requires differential skills to understand uncertainty” and understand why entities are willing to pay to carry inventory forward in markets.

Scholes focused on omega during his presentation at the second Options Trading and Volatility Seminar, held at the InterContinental Hotel Chicago on October 19. Scholes, who currently is Frank E. Buck Professor of Finance, Emeritus at Stanford University, was awarded the Nobel Prize in 1997 for his work with Fischer Black and Robert Merton on the Black-Scholes Options Pricing Model, a formula that forever changed the way options were priced in the industry.

“The Black-Scholes formula is widely used in many options trading firms today,” said Evening MBA Program student George Kalant, co-chair of the Chicago Booth Trading Group (CBTG), which hosted the event. “A lot of individuals in the business were here today.”

Classmate and fellow CBTG co-chair David Feldstein added: “Most people in today’s audience are in options trading, market making, and proprietary trading. We invited Dr. Scholes because he can speak to that type of individual.”People in finance make money by compressing time and providing services more efficiently. Scholes believes that “investors in the market are willing to pay for risk transfer services—the ability to turn over their portfolios and knowingly give up returns in order to gain the ability to transfer risk.

“If someone is giving up returns to transfer risk, that implies one could earn returns by providing risk transfer services,” Scholes said.

To highlight this point, Scholes gave the example of an investor who holds a long-dated private placement bond that has default risk associated with it. The investor transfers the interest-rate risk by swapping out the fixed interest rate for a floating rate. He then transfers the default risk by purchasing a credit default swap (CDS), thus making the security virtually risk free. The bond is then completely hedged against interest rate and default risk and becomes something that could be liquefied at a low cost.

“The cost of the risk transfer is the liquidity piece,” explained Scholes. It is the same as “the cost of protection, and over time, arrangements are introduced to reduce the costs of providing risk transfer services.”

There is a philosophical battle between alpha and omega described by Scholes. People who favor alpha think they know the generalized risks better, and believe money is made by using superior prediction technology. Scholes sees this method as very difficult. Instead, he argues that the returns to hedge funds, and the success of the “Warren Buffets of the world,” come from understanding intermediation and uncertainty. Other investors are willing to pay for services of intermediaries, to have risks transferred, he said.

“Paying omega providers or speculators to come in and take risk forward, in my view, is still a growth area and falls more and more away from commodity markets and to corporations and investors,” said Scholes.

At a time when so many in the industry are concerned about Dodd-Frank regulation eliminating sales and trading as a profession, Full-Time MBA Program student Anastasia Zabolotnikova found it interesting that Scholes “highlighted the importance of intermediaries as a third source revenue, an omega.”

“If there is no omega, then people don’t do the arbitrage, and if they do not use the intermediary, then alpha could go away or beta could suffer,” Zabolotnikova said. “People try to think of [omega] as the cost of alpha, but I liked how he separated it.”

—Kalliope Dimitrakopoulos
Photo by Beth Rooney