Yesterday, I pointed to Warren Buffet's critic of financial derivatives. Since at one point of my life I was training to be a derivatives trader on Wall Street (thank God I didn't do that), here is some more insight into the problem. Financial derivatives are complex financial instruments that are used by just about every mid to large sized company in the world. They are typically used to shed risk (currency, commodity, market, etc). However, in many instances they actually create more risk. The reason is due to the fact that financial derivatives are constructed through theoretical models informed by historical financial data. These models break down when faced with ahistorical data usually the result political or counter-party risk that can't be measured numerically.
The classic example of this is the Mexican peso melt-down of 1994. In that situation, political support of the peso's fixed exchange rate against the dollar had created a data set that implied that there was a very small risk of change. When that data was fed into theoretical models like the Black-Scholes option pricing model, the resulting price of an option on the peso was valued at very low levels. Political risk, in the form of the Mexican government deciding to allow the peso to free float against the dollar, wasn't accounted for. The result was that when the Mexican government did exactly that and everybody who owned options on the peso instantly made a thousand fold return on their money. The people writing the options took a bath. I suspect that many went bankrupt (counter-party risk). A variant of this happened to LTCM on their investments in Russia and almost set off a global financial panic.
The unanticipated political and counter-party risk in derivatives is compounded often by their complexity. Derivatives are often too complex for anybody but the most savvy financial engineer to understand. For example. I had an acquaintance from Japan that once told me how his bank (Sanwa) entered into a complex interest rate derivative. An unforeseen circumstance happened (interest rates dropped well below expectations) and the net result was that the bank ended up paying the counter-party interest on the $200 m it had lent it. Imagine paying interest to the person you lent money to!
In calm and predictable times the widespread use of derivatives don't pose a problem. In turbulent times, they pose a very difficult problem. We are currently in turbulent times. A time when markets are moving in ahistorical ways. Oil and gas prices are moving to 10 year highs. The major economies of the world are moving in the lock-step rather than a more normal and stable counter-cyclical fashion. The dollar is wobbly against the major currencies. Etc. Every step we take towards war in Iraq or Korea makes the situation more critical.
Here is what could happen. Unusual market movements could result in several hedge funds going belly up. They are chopped up and the buyers begin to unwind their positions at firesale prices (or they unwind their positions rapidly to avoid being chopped up). This in turn causes more market gyrations. Several major multi-nationals that have CFOs that use derivatives excessively are now faced with massive loses on their holdings. Given that they were going through tough economic times there isn't the cash on hand to allow them to pay their way out and they end up going bankrupt. Their unexpected default is the unforseen counter-party risk on the derivatives they were party to. In a short period of time, this creates more market gyrations until there are currency panics, the economies of several small nations fall apart, trade dries up, investment dries up, etc. General financial chaos ensues.
The problem with this scenario is that nobody knows if it will occur or not. Nobody is watching the flows of money or regulating how derivitives are handled. We don't know how many of these financial neutron bombs (in that they destroy wealth and companies but leave the people and buildings intact) there are. We are in uncharted waters. [John Robb's Radio Weblog]
9:22:59 AM 
|
