I’m catching up on old newsletters now – a combination of job and taking my email off what is now my daughter’s iPad means I have a considerable backlog – and I found this gem in Matt Levine’s newsletter from two weeks back ($; Bloomberg).
“it comes from monetizing volatility, that great yet under-appreciated resource.”
He is talking about equity derivatives, and says that this is “not such a good explanation”. While it may not be such a good explanation when it comes to equity derivatives itself, I think it has tremendous potential outside of finance.
I’m reminded of the first time I was working in the logistics industry (back in 2007). I had what I had thought was a stellar idea, which was basically based on monetising volatility, but given that I was in a company full of logistics and technology and operations research people, and no other derivatives people, I had a hard time convincing anyone of that idea.
My way of “monetising volatility” was rather simple – charge people cancellation fees. In the part of the logistics industry I was working in back then, this was (surprisingly, to me) a particularly novel idea. So how does cancellation fees equate to monetising volatility?
Again it’s due to “unbundling”. Let’s say you purchase a train ticket using advance reservation. You are basically buying two things – the OPTION to travel on that particular day using that particular train, sitting on that particular seat, and the cost of the travel itself.
The genius of the airline industry following the deregulation in the US in the 1980s was that these two costs could be separated. The genius was that charging separately for the travel itself and the option to travel, you can offer the travel itself at a much lower price. Think of the cancellation charge as as the “option premium” for exercising the option to travel.
And you can come up with options with different strike prices, and depending upon the strike price, the value of the option itself changes. Since it is the option to travel, it is like a call option, and so higher the strike price (the price you pay for the travel itself), the lower the price of the option.
This way, you can come up with a repertoire of strike-option combinations – the more you’re willing to pay for cancellation (option premium), the lower the price of the travel itself will be. This is why, for example, the cheapest airline tickets are those that come with close to zero refund on cancellation (though I’ve argued that bringing refunds all the way to zero is not a good idea).
Since there is uncertainty in whether you can travel at all (there are zillions of reasons why you might want to “cancel tickets”), this is basically about monetising this uncertainty or (in finance terms) “monetising volatility”. Rather than the old (regulated) world where cancellation fees were low and travel charges were high (option itself was not monetised), monetising the options (which is basically a price on volatility) meant that airlines could make more money, AND customers could travel cheaper.
It’s like money was being created out of thin air. And that was because we monetised volatility.
I had the same idea for another part of the business, but unfortunately we couldn’t monetise that. My idea was simple – if you charge cancellation fees, our demand will become more predictable (since people won’t chumma book), and this means we will be able to offer a discount. And offering a discount would mean more people would buy this more predictable demand, and in the immortal jargon of Silicon Valley, “a flywheel would be set in motion”.
The idea didn’t fly. Maybe I was too junior. Maybe people were suspicious of my brief background in banking. Maybe most people around me had “too much domain knowledge”. So the idea of charging for cancellation in an industry that traditionally didn’t charge for cancellation didn’t fly at all.
Anyway all of that is history.
Now that I’m back in the industry, it remains to be seen if I can come up with such “brilliant” ideas again.