The implied volatility "smirk" was introduced in quantitative
finance after 1987 crash. Prior to that it was just flat. Then
a different dynamics could develop - as the market moved
down sharply through the put strikes, the market makers
required to hedge more and more by selling it short, causing
a crash in the process. So, these are "quant models" again,
just like "quant models" in subprime credit. They failed
this October despite the volatility "smirk" in exactly the
same way they did in 1987, only much bigger, which is why Citi
fired their equity derivatives chief specialist and is about
to get nationalized. The losses for the options market makers
in October were enormous, and Citi was the key player. So was
BAC. Puts are insurance for the equity markets, similar to
CDS in the credit markets. -ggg-
Which brings me to the point - you can't "regulate" CDS by
putting this on the exchange - you will have to ELIMINATE
derivatives to diffuse the bomb. The amounts out there cause
systemic risk, and it does not matter if they are traded OTC
or on the exchanges -g- A simple way to REDUCE that market
is to allow failure of responsible parties, no matter how
big they are. C, AIG, BAC in particular. You played the
moral hazard game, you pay. -g- |
