Derivatives Blowing Up and Here's Why Of Shoes & Ships & Sealing Wax, Derivatives & Kings …
We occasionally will print, with the author's permission, stories that we receive that we believe are good backgrounders. Given that the Derivatives Market is undergoing a substantial change, the net impact of which is many of the "black box" programs that drive trades no longer work, we present some serious background.
It is now time to talk of derivatives. In fact, it is a particularly good time because in the last two weeks rumors have abounded on Wall St. of serious losses in hedge funds. What is the connection between hedge funds and derivatives? Well, to answer that question I must first tell you what a derivative is, actually.
Most people think they know what a derivative is, but when asked to explain it they go blank. No problem. Today we will build a derivative. Please note that the numbers and rates and percentages are all just for simple example purposes. Big computers figure out these things and there is no way we can explain derivatives in an understandable way if we go into the realms of exactness. [To the professionals who read this, please remember that very few people understand the complex concepts necessary to a real professional explanation. Our goal is to help them understand.]
There are lots of different kinds of derivatives. Some are created to hedge a big insurance company portfolio, some are created to hedge the borrowing costs a bank incurs on its Certificate of Deposit [CD] accounts, and some are just put together to provide certain types of investment income. We will build a simple hedge derivative.
First, we will start by quoting an old Wall St. maxim: Bonds and stocks move in opposite directions.
That is a bit misleading. What it means is when interest rates go up, stock prices go down. Armed with this knowledge, we are going to build a derivative to protect your huge stock portfolio. If we know the stock prices in your portfolio are going to decline on average about 8% we can figure that we should buy a Treasury Bond that yields 8% and we will do just fine. But where will we get the money? Oh, that's right, we can borrow against the value of our stock portfolio [margin].
Stock Portfolio worth $1-million
• We borrow $500,000 on margin and buy $500,000 T-Bonds So we do that, but we only have half the money needed. Hmmm And there is another problem: If interest rates are rising, the dollar price of the bonds are dropping and we aren’t doing this to lose more money. But we can fix that by shorting T-Bonds so when their dollar price goes down, we make money. The problem is that we are paying interest on all the borrowings and covering margin calls along the way, therefore we have to short MORE than $500K in T-Bonds so we short $1,000,000 T-Bonds. But our derivative is only covering about half the expected loss in the stock portfolio. So, we need to do something else to cover the rest of our expected loss.
Since we need more money to do this, we margin the T-Bonds at 80% of value T-Bonds worth $500,000 • We borrow $400,000 by margining the T-Bonds • Now we have $900,000 [$500K from the stock + $400K from the bonds] in borrowed funds all supported by the value of the stock portfolio, which will go down. • And we just sold short $1,000,000 in T-Bonds, which adds $1,000,000 in imaginary money to our cash [and $1-million of imaginary money to our monetary system]. Using this $400,000 plus the $1,000,000 from our short sale of T-Bonds, we buy $US currency futures because we know that when US interest rates go up, the $US rises in value so we expect to make some money off that rise in the value of the $US, but just to make sure we make enough to cover the loss we expect on our stock portfolio plus all the interest charges on our borrowings we also sell short the EU because the EU and the $US have an inverse relationship [but of course we must sell more EU to cover the costs of borrowing and margin calls]. In $US vs. EU trading, when one goes up, the other goes down ... most of the time.
So now we have our derivative: • $1-million in stock hedged with • $500,000 in T-Bonds, hedged with • $1,000,000 short in T-Bonds, plus • $1,400,000 in $US currency futures, hedged with • $3,000,000 short EU currency futures From our original $1,000,000 in stock we now have approximately $6-million in imaginary money supporting it, of which we have an extra $3-million, laying around collecting interest from T-Bills, that we can use to pay margin calls and interest charges. Cool, huh?
Hedge funds are investment companies that hire a bunch of smart people who know how all of the above works, and have big computers to figure out all the relationships between bonds, stock, currencies, etc. Historical data on those relationships is stored in the big computers and is massaged by complex mathematical formulas that are designed to account for any number of things.
The thought process behind all these strategic models and mathematical formulas is the maxim: History repeats itself. Of course, many of the people who live by this maxim have been proven wrong, but this doesn't worry the hedge funds. They are secure in the knowledge that they are the ones who are proven right.
Hedge funds put together derivatives designed to make money by creating relationships like those described above - but the complexity of the basket of investments is MUCH LARGER and the imaginary money created is in the $billions or perhaps $trillions.
There is another old Wall St. maxim: When everyone is hedging, hedges don't work.
For some reason, few people pay attention to this maxim even though it is one of the truest of the true. That is where the BIG PROBLEM starts. When one of the many hedges in a derivative fail to work as planned, it sets off a chain reaction of altered relationships that can actually prove out to be more beneficial. However, the chain reaction can also result in a big disaster.
And that is what is worrying people these days.
And this excellent piece... May 2005 Adult Swim Only Mark Kasriel- PIMCO
I’ll never forget the summer of 1975. The movie "Jaws" came out and, all of a sudden, swimming in the ocean was a fundamentally different proposition. The risks - while always there - became real and clear. Before going back into the water, swimmers needed to understand the risks and how to minimize them. I suspect the corporate bond market is about to undergo a similar transition. The asset class has fundamentally changed; however many investors may not be aware of the changes and related shift in risks and opportunities.
Until recently, the corporate bond market has appeared fairly calm at the surface. Corporate profits have reached near-record levels, economic growth is strong, implied default rates are low and global demand for corporate bonds seems insatiable. Over the past several years, corporate investors could hardly go wrong, and spreads have tightened virtually across the board. But the risks involved in corporate bond investing are closer to the surface than they would appear due to significant changes in the market. Navigating today’s corporate waters requires experience, patience and a full understanding of the risks involved and the opportunities available. Investing in the corporate bond market today is "adult swim only."
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