Derivatives: Darth Vader's Revenge Message Board

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Non-Tech : Derivatives: Darth Vader's Revenge

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To: Freedom Fighter who wrote (846)	3/25/1999 4:22:00 PM
From: Henry Volquardsen	of 2794

Hi Wayne, I would have answered sooner but I checked your profile and had to check the value investor's workshop. You and others here might like participating in a new thread that has started Subject 26868 In the example you mention it is still zero sum in the strictest sense. In your example lets say A has the large directional bet and makes $100. He makes this on positions he has on with market makers B and C. B and C run market neutral books so they have laid off their risk with D. D is another directional player but he could also be a hedger. D has lost $100. Now lets say D is bust and can't pay. B and C now lose the $100 as they have to pay A. As you put it we have 3 in trouble. But no more than the $100 owed to A is lost. D can't pay because he doesn't have the money. He winds up losing nothing, he had nothing to begin with otherwise he would have paid. B and C lose because of sloppy credit work. This what Mr G meant, I believe, in saying it is a zero sum game. It is a technical statement. Remember Mr G is a central banker and used to looking at macro accounts and he was speaking very much in that spirit. FWIW I thought it was a marvelous example of Econ-o-speak. There is an old economist joke. A guy goes up in a hot air baloon when a storm hits. He gets lost in the clouds and blown around for hours unable to see the ground. When the storm clears he finds himself floating above a large open plain. He sees no recognizable landmarks and has no idea where he is. He sees a man standing on the ground beneathe him. He shouts down 'Sir can you tell me where I am?' The man responds, 'Of course, you are in a basket hanging beneath a hot air baloon'. The baloonist shakes his head and shouts back 'thank you, I assume you are an economist'. The man responds 'why yes, I am. How did you know?'. The baloonists responds 'Your answer. It was perfectly precise and accurate, of no practical use and totally beside the point. Mr G's comment about zero sum was perfectly precise and besides the point. I'm pretty sure he knows it as well. I don't want to give the impression that I am saying derivatives are riskless. Quite the contrary. There is a lot of risks in derivatives. The recent discussions we have had about derivatives have focused on the pricing impacts and effect on the market and vice versa. In my opinion that iis not where the real risk is. The market makers focus alot on pricing models and economic risk. It is the back door where the real risk lies. Credit and systems is a lot less sexy than trading and sometimes gets short shrift. That is where the risk is. Now by personal experience is that this risk is real but not overwhelming. As far as the size of the exposure I'll try to put it in context a little. A large portion of that number is on futures exchange. To that extent it is margined. The margin will also act as a stop loss on weak players that will help limit the cascade. Another large portion is interbank transactions. This comes from market makers dealing with each other. A lot of this risk will be going in both directions. Lets say banks A and B are both $ swaps market makers. Over the course of time they have done $800 mln in swaps where A is paying fixed rates to B and $750 of swaps in which B is paying fixed rates to A. On the books this appears as $1.55 bln in exposure. However if one of the banks fails there will be a liquidation. All major banks have gone to using netting arrangements in their interbank dealings. This would mean that most of this risk would be netted. The remaining exposure would be $50 mln. And the risk would only be the market risk not the principal risk. I'm a big fan of Mr Buffet. I don't remember his 'meltdown' comment but ha may have said that. What I will say is that every bank is aware of the systemic risks in derivatives trading. We are all concerned about meltdown risk. There has been a lot down over the last ten years to establishing netting facilities and other credit enhancements that will prevent the meltdown risk. It is worth mentioning that last year the derivatives market went through a tremendous test. Some very large players took some hard hits. Yet the system functioned very well. Ten years earlier it would have been much iffier. I strongly think AG was right. The derivatives industry has evolved tremendously and removed a lot of volatility from the system. (I know I'll get called by someone on that statement <grin>) Discouraging derivatives would increase volatility and risk. Henry

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