Saturday, January 26, 2002

I found a pair of interesting new (to me) bloggers, More than Zero and Benjamin Kepple. Kepple, a former Investor's Business Daily writer, has a nice bit of advice on individuals and derivatives: "As an individual investor, you should probably not even consider trading in futures unless you're one of those few people able to trade oil for cotton for orange juice and still make a mint." The old joke is "How do you make a small fortune in futures? Start with a large one." Only the real pros make money in futures. So, ignore those "the widget market is about to explode; a $1000 in widget future options can control $100,000 of widgets" ads. He links to a good article on derivatives at More than Zero but a primer (I've given three quick definitions below) might be an order; I did my dissertation of Nikkei put warrants (long-term options) and learned about tranches teaching Real Estate Finance, but I had to work at following the finance of the piece. Futures: The commitment to buy or sell a set amount of an item at a given time in the future. These can be used to hedge risks, such as farmers entering into futures contracts to fix the price they'll get for their crops or power companies buying electricity futures to lock in a price on the juice. Enron was making a lot of its money managing energy futures. Options: The right to, at the holder's option, buy (call option) or sell (put option) a set amount of an item at a given time in the future. Tranche: Subset/Group. A package of bonds or mortgages are often divided into groups. For instance, a package of mortgages (CMO) will be divided up so that the first group, or tranche, will get the principle of the early repayments, then (once the first tranche is paid off) the second tranche, et. cetera. The MTZ piece describes a Collateralized Bond Obligation where the first batch of defaults get given to the first tranche (they'll pay much less for theirs since they're the first to be screwed). The Media has a fear of the unknown, especially when the fat cats are involved. Joe Farmer will be in the futures market as a part of everyday business. Most business use of derivatives are to manage risk, not bring it on. Enron was not done in by being the manager of an energy futures market but by overleveraging their balance sheet and hiding it from view by shady accounting. However, what the liberal fears, he wants to regulate. By waiving a hand, invoking "Derivatives, complicated stuff you wouldn't (translated, I don't) understand. Scary," the media create an environment that is bad for financial innovation. Derivatives get a bad rap whenever abuses occur. Orange County got screwed by playing with inverse floaters, were interest goes down on the bond when interests rates go up. Those weren't proper for a county money-market fund to be investing in, and the whole derivative industry gets a black eye from a county treasurer who was clueless . The Barings Bank fiasco was another example, where one gonzo broker in Singapore gambled big on Japanese futures and lost big, bankrupting the company. Long Term Credit Management, run by the people, (Robert Merton and Fisher Black) who pioneered modern option pricing theory, went under when their financial model didn't model the market right, leaving the media asking "If the financial rocket scientists can't understand it, who can?" The public doesn't see the upside of derivatives, only the failures. Here's the liberal's thought pattern: (1) Enron went bankrupt (2) Enron was into derivatives (3) Enron and the Republicans wanted looser regulation of the derivative markets (4) The loose regulation of the derivatives must have caused the collapse (5) We need to regulate derivatives more. The first three are true, #4 isn't. Thus, #5 is a bogus assumption based on that logic. Explaining what's happening to the public is crucial in keeping things from getting over-regulated

Comments: Post a Comment

This page is powered by Blogger. Isn't yours?