Join Wayne Winston for an in-depth discussion in this video On financial analytics, part of Wayne Winston on Analytics.
Well, we have previously alluded to portfolio optimization or asset allocation. In other words, if you have money to invest, how should you allocate that among different investment classes. So that you get a desired expected return at minimum risk. And Harry Markowitz was actually a mathematician, statistician, won the Nobel prize for economics in 1990 for that development of portfolio optimization. So, many large companies are involved with projects like, a drug company decides do I go ahead with the new drug.
P & G decides do I go ahead with a new cosmetic product. An auto company decides do I go ahead with a new car. And you, the problem is you don't know these products will be successful. So the science of capital budgeting involves trying to figure out what products we should go ahead with. So we used the simulation tool that we discussed earlier to analyze the odds a new car will be successful. For example, if we find there's only a 20% chance a new car will make money for a car company, they probably shouldn't go ahead with that car. If there's a 90% chance, they should probably go ahead with that.
Another example comes from the mortgage market. So basically, Citibank would own a lot of mortgages and as you may or may not know, banks will sell mortgages to other banks. And so basically, if you think the mortgages are going to be prepaid, it turns out you should sell that mortgage if you're a bank. Because you're not going to make as much money on it because you make money when they make the payments later. So basically Citibank would try and analyze the likelihood a mortgage was going to be prepaid. And they thought it would be pre, prepaid a lot, then they would sell that mortgage to another company and that helped them a lot.
So, let's talk about great investors of all time. Renaissance Technologies is a quan fund that basically manages their asset allocation totally mathematically. And they have had by far the best performance record over the last 20 or 30 years of any investment funds. Of course, you need a couple million dollars to get into Renaissance Technologies. But they're run by a great mathematician, Jim Simon, who developed algorithms that nobody knows how they work except the people at Renaissance. But they've had fantastic performance.
So, you may have seen the movie 21, which talked about how to win money at blackjack with card counting. So who invented card counting? Well it was Edward Thorp who was a great mathematician who basically ran his own hedge fund for years. And did fantastically because he used mathematical analytics to run that hedge fund. He used something called Kelly Growth to optimize the bets his hedge fund made in different investments. And he did fantastically well. So you may or may not know what a stock option is. So what is a call option? Suppose a stock is selling for $30, you could buy a $32 six month call option on that stock.
What does that mean? If in six months the stock goes above $32, every dollar the stock goes above $32, you get payed a dollar. So, if the stock went to $35, you get three dollars. 35 minus 32. Went to 36 you get $4, 36 minus 32. If the stock went below $32 you get no money. So, it was an unsolved problem for years and years. What is the right price for a stock option? So, in the early 1970s Black, Scholes and Merton developed the method called the Black-Scholes model to price stock options.
But basically analytics was used brilliantly to figure out the right price for a stock option. And every trader on Wall Street and business school student is exposed to that Black-Scholes option pricing model. And so options are used in the corporate world for hedging. So basically, Procter and Gamble as an example, has foreign exchange risk. If the value of the Euro drops. What Procter & Gamble gets in Europe is worth less. And so basically they want to hedge that risk and, using options and other what we call derivatives. They can hedge the risk from foreign exchange fluctuations to give them a tolerable level of risk.
Other sources of risk that are hedged include interest rate risk, which is important now because we're not sure what's going to happen with interest rates. Commodity price risk. In other words, if I buy fuel oil if I'm an airline. I want to hedge the price risk fuel oil because if the price of fuel oil goes up a lot, it would really hurt an airline. So they hedge that risk using what's known as futures and options.
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