Adding fixed income and derivative products to your friendly game of Monopoly: A practical approach

Despite the proliferation of Monopoly game board variants, the rules themselves have changed little (if at all) to accommodate the financial innovations of the last 100 years. This can be rectified largely by expanding the Monopoly rules to include a range of fixed income products and derivative instruments. Implementation is not nearly as difficult as you might imagine.

These suggestions hinge on the expansion of the role of the banker. He doesn’t need a game piece, either. I suppose he could take one just for funsies but he can’t move it around the board. His goal is simply to make as much money as possible.

Financial Innovation

Players may still take mortgages per the traditional rules. However, they may also issue bonds to finance purchases. It is the banker’s responsibility to coordinate issuance of the securities (you can jot terms on a notepad) and ensure principal and interest are paid in a timely fashion. The issuing player and banker may structure notes however they see fit. Coupon bonds and floating rate notes are both fair game. There is no reason you can’t implement bonds with embedded options, either (see Deriving the Yield Curve below).

In addition, the banker may securitize outstanding mortgages. That is, the banker may sell the cash flows from player mortgages to other players. There is no limit to structure (though again, you should definitely write down the terms of these securities). Passthrough securities are probably the easiest structures to implement in-game. It may be wise to standardize the terms of collateralized mortgage obligations ahead of time.

Not enough game pieces for all your friends? Consider having groups of players adopt a real-estate investment trust type structure (haven’t thought through the details of this, yet).

And of course any reasonable banker will charge fees for his services.

Deriving the Yield Curve

Introducing fixed income securities to your friendly game of monopoly will require you to develop a yield curve.

I suggest using the “round” as the basis for the term structure, and random dice rolls to determine the rates at each point along the curve.

As an example, suppose you would like to create a six-turn yield curve. You could roll a die 6 times (once for each term). Simply take whatever number you roll and double it. Having established market interest rates in this fashion it is straightforward to implement fixed income trading into the game. Just make sure to bring your HP12-C with you to game night.

Deriving a yield cure also presents the opportunity for introducing more complex fixed income and derivative products. The 1-round rate, for example, could serve as the benchmark for floating rate notes, as LIBOR does in real life. Issuing players and the banker may add spread as needed to generate interest in their products. This of course opens the door to interest rate swaps and forward rate agreements, though the pricing of such derivative instruments is not a topic I will explore here.

Obviously this procedure will lead to an extremely volatile term structure. Which of course is the whole fun.

All of which leads us to…

How the Banker(s) Lose

To this point I have been talking in terms of one banker. However, there could easily be two, three, or four bankers (you may not even need much paper money, if you can trust your friends to keep an honest set of financials on spreadsheet software – perhaps a subject for another post).

The banker(s) will need to receive some quantity of beginning capital, with which he/they must also a maintain reserve. Let’s make it easy and say 25% of beginning capital.

We could assume the banker’s cost of funds is equivalent to the one-round interest rate described above. The banker must pay his funding costs explicitly each term, as well as meet any obligations she has incurred through lending and securities issuance. If the banker fails to meet these obligations, or depletes his reserves in meeting them, his bank goes bust. It is then up to all the players to hash out what becomes of his assets and liabilities. This translates to a relatively elegant implementation of financial crises, and possibly even bailouts.

Finance is just telling stories with numbers

I recently spoke with one of the founding principals at the financial firm where I work.

“What did you major in?” he asked.

“English,” I replied.

“That’s fantastic,” he said. “That’s a great major.”

I couldn’t help but laugh. His comment was so fundamentally at odds with everything I’ve heard over the last three years as I worked to build up my credibility within the industry. So I asked him why he felt that way — because pretty much everyone else I have ever spoken to about my professional goals has warned me my educational background will always be a huge liability.

He explained that English majors can think critically, put ideas together in a logical way, and most importantly, communicate that information clearly to people who need it. Everything else in finance can be taught on the job, he said.

His comments got me thinking more about my writing, and the path that led me from a writing career to one in finance. And I’ve realized that what I do isn’t so different from writing after all. Finance is all about telling a story (hopefully not fictional — though the way some research is written you would never know it). It’s just that financial stories are written in an entirely different language.

A valuation model, for example, is nothing more than a formal mathematical structure for a particular story, the way one narrative structure may work better for a certain fictional story than another. At the end of the day a valuation model tells the story of a company, or another asset, and why it might be worth X as opposed to say, Y. The characters may be cash flows and discount rates as opposed to adventurers and monsters. Sure, a discounted cash flow valuation of Unilever may not read like Lord of the Rings, but both the valuation and the novel are telling stories, and both should flow logically from beginning to end. I happen to find valuation every bit as compelling as swords and sorcery (a kind of mental illness, if you ask my girlfriend). A decent salary doesn’t hurt, either.

The moral of the story, as far as I’m concerned, is that we need to disabuse ourselves of the notion that there are “math people” and “writing people,” or “creative people” and “business people,” and that these labels are somehow mutually exclusive. It simply isn’t true.

“The percentage will always stand fast”

Fools Die by Mario Puzo

My favorite Mario Puzo book is not The Godfather. Instead it is Fools Die. At first glance you might think Fools Die is a rambling chunk of literary fiction that is more a catalogue of events than an actual novel. However, this structure is quite appropriate  because in all actuality Fools Die is about randomness.

Perhaps nothing illustrates this point better than the scene where the casino boss, Gronevelt, takes one of the characters out for an educational gambling binge (only in describing a novel like Fools Die could I write a phrase like “educational gambling binge” with a straight face):

Cully remembered one period in the history of the Xanadu Hotel when three months straight the Xanadu dice tables had lost money every night. The players were getting rich. Cully was sure there was a scam going on. He had fired all of the dice pit personnel. Gronevelt had all the dice analyzed by scientific laboratories. Nothing helped. Cully and the casino manager were sure somebody had come up with a new scientific device to control the roll of the dice. There could be no other explanation. Only Gronevelt held fast.

“Don’t worry,” he said, “the percentage will work.”

And sure enough, after three months the dice had swung just as wildly the other way. The dice pit had winning tables every night for over three months. At the end of the year it had all evened out. Gronevelt had had a congratulatory drink with Cully and said, “You can lose faith in everything, religion and God, women and love, good and evil, war and peace. You name it. But the percentage will always stand fast.”

[…]  By the middle of the second week, Gronevelt, despite all his skill, was sliding downhill. The percentages were grinding him into dust. And at the end of the two weeks he had lost his million dollars. When he bet his last stack of chips and lost, Gronevelt turned to Cully and smiled. He seemed to be delighted, which struck Cully as ominous. “It’s the only way to live,” Gronevelt said. “You have to live going with the percentage. Otherwise life is not worthwhile. Always remember that,” he told Cully. “Everything you do in life use percentage as your god.”

If there’s a practical lesson in all this it’s don’t play the lottery. But I think there’s something vaguely spiritual going on here. Maybe a super dysfunctional kind of zen (oxymoron, anyone?).  In the words of the Greek statesman/philosopher Solon: “let no man be called happy before his death. Till then he is not happy, only lucky.”

The most elegant description of a hedge fund ever written

The most elegant description of a hedge fund ever written appears in The Fear Index, by Robert Harris:

” You see that girl over there, the one in that group with the short dark hair that keeps looking at you? Let’s say I’m convinced she’s wearing black knickers – she looks like a black-knickers kind of a gal to me – and I’m so sure that’s what she’s wearing, so positive of that one sartorial fact, I want to bet a million dollars on it. The trouble is, if I’m wrong, I’m wiped out. So I also bet she’d wearing knickers that aren’t black, but are any one of a whole basket of colours – let’s say I put nine hundred and fifty thousand dollars on that possibility: that’s the rest of the market; that’s the hedge. This is a crude example, okay, in every sense, but hear me out. Now if I’m right, I make fifty K, but even if I’m wrong I’m only going to lose fifty K, because I’m hedged. And because ninety-five percent of my million dollars is not in use – I’m never going to be called on to show it: the only risk is the spread – I can make similar best with other people. Or I can bet on something else entirely. And the beauty of it is I don’t have to be right all the time – if I can just get the colour of her underwear right fifty-five percent of the time I’m going to wind up very rich. She really is looking at you, you know.”