Strategy Guide Note: Actually, the concept of expected value is very similar to risk arbitrage. Read both columns and decide for yourself (-Huy).

Many people, including myself, have noted that there is a large amount of risk in holding BWLLS through adjustment. Given the facts that:

1) BWLLS’ new calculated TAG is only slightly above that needed for an adjustment (50.34 vs 50),
2) HSX uses a different source for numbers, unavailable to traders, to calculate TAGs, and
3) HSX has had data entry errors in two bonds in the past two weeks

there is a very real chance that BWLLS will not be adjusted upwards.

On the other hand, if he is adjusted, he will jump from his current price of $944 to $1400, a whopping 48% gain! How do you weigh the potential gain on one hand to the chance that it won’t happen on the other? One way is to adjust BWLLS’ gain for the risk involved, but this is a bit arbitrary, since your risk adjustment has to do with your personal preference to seek or avoid risk. Another, more mathematically precise way, is to calculate the “Expected Value” of the purchase, assigning probabilities to various outcomes. This is how mathematicians and professional gamblers decide whether a bet is a good one. Here is how you do it:

There are two possible outcomes for BWLLS:

1) BWLLS is adjusted. If he is adjusted, he will move to $1400, prompting a mass sell off. You should be able to sell your bonds for around $1300, however, so lets use $1300 as the value for this outcome.

2) BWLLS is not adjusted. If he is not adjusted, this will also prompt a mass sell off, probably also knocking the price of BWLLS down about $100, so lets use $844 as the amount of value from this outcome.

The next step is use our wisdom and experience to assign probabilities to the possible outcomes. Given that IMDB data has been used to successfully predict bond adjustments many times before, we know there is a strong correlation between the data that HSX has and the data the IMDB has. Also, lacking any information to the contrary, it is as likely for HSX’s box office data to be OVER what the IMDB has as it is to be under (that is, there may be random error in the data, but the data is unbiased in any specific direction) . However, if HSX’s data is under at all, it will quite possibly lead to no adjustment. Therefore, I will assign a probability of .5 to each outcome, meaning there is a 50/50 chance for each outcome to occur.

Once probabilities are assigned, we multiply the probabilities for each outcome by the value from each outcome, and add them together. ($1300*.5)+($844*.5) = $1072.

So, given these probabilities and these outcomes, the Expected Value of BWLLS after the adjustment is $1072. Which amounts to an expected 14% gain on $944 bond.

It should be noted that if you believe the probability for Outcome 1, an upward adjustment, is below .22, (a 22% chance) then the expected value of the purchase is one which will lose you money, but for any probability greater than that, the bond is a buy.

Feel free to assign your own probabilities, but I believe the chance of an upward adjustment is greater than 50%, since I believe HSX is accurate more often than not, and I believe that an error in the data is as likely to happen downwards as it is upwards. This doesn’t mean the adjustment will happen, but it means I think it is a good bet.

Lord I was born a gamblin’ man

Tom Miller