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Non-Tech : Derivatives: Darth Vader's Revenge
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To: Bobby Yellin who wrote (309)10/3/1998 5:13:00 PM
From: ahhaha  Read Replies (2) of 2794
 
It's a pretty good assessment of the way things have developed. I would only disagree with the claim that recent currency movements have been caused by the unwinding of hedge fund positions. Such transactions volume represents less than 1% of the daily NY Fed clearance. Mark strength, for example, has been building at the margin for years and has dynamically made an upside breakout. That wasn't due to hedge fund transactions.

Similarly, it has been persistence of T-bonds on the upside driven by flight capital from Japanese private banks, that blew the perfect hedges of LTCM. Hedge funds can't adjust the short T-bond, long GNMA spread because of rapidly translating spread divergence as a function of time where the hedge is assumed to be time independent. The structural basis upon which the spread depends is high correlation between interest rates and all debt securities. When you have a non-interest rate exogenous factor like the Japanese T-bond buying, and you have GNMA's which are linked more to flat interest rates, you can't adjust to delta zero the respective positions without adding long GNMAs requiring inaccessible quantities of margin. You can still manage the previous positions, but it requires shrinking the exposure and taking loses by covering T-bonds and selling GNMAs. Merriweather wouldn't do that because it meant major losses. That wasn't politically acceptable since the concept of LTCM is minimization of risk.

If anyone wants a more detailed explanation of what was going on at LTCM, feel free. I've been there myself with OPM.
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