Derivatives: Darth Vader's Revenge Message Board

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Non-Tech : Derivatives: Darth Vader's Revenge

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To: Worswick who wrote (908)	4/12/1999 12:35:00 PM
From: Henry Volquardsen	Read Replies (1) of 2794

Hi Clark, Now, I seriously believe that this market can go to 30,000 by 2010. Reading Barron's I see :) As I posted here, I believe, last week I tend to be naturally cautious towards equities. I have to pinch myself whenever I get bullish equities, currently my entire left side is black and blue. Just one comment regarding systemic risk. During our discussions on derivatives I have gotten the impression that a lot of people believe that I think there is no risk in the system. In fact I believe there is a lot of risk but that people are worrying about the wrong risks or misidentifying risk. People look at the very complex derivatives and assume they contain many risks that are not clearly defined and therefore difficult to completely hedge. There is some truth to that feeling. They then look at the volume numbers showing trillions of dollars of derivative exposure and make an intuitive leap that suggests all that exposure contains unhedgeable risk. That is not correct. The large majority of derivatives are pretty mundane straight forward stuff. Interest rate futures, currency forwards, plain vanilla interest rate swaps etc. The pricing risk on these products is pretty transparent and there will be no major surprise from this direction. The real risk, I believe, is in more mundane areas. One we have mentioned on occassion is leverage. The leverage becomes enormous. But even this is controlable to a degree. Banks have been paying a lot of attention to documenataion and clearing mechanisms. This won't prevent problems from excessive leverage but will help act like a circuit breaker and help prevent cascading failures. My own personal favorite for risk is operational risk. Executing these contracts can be somewhat intricate. If you don't have high quality, well motivated back office people it can cause problems. I have seen banks lose more money because of operational snafus than from having unidentified trading risk. You are correct that the pile of blocks is getting higher. And a fall is inevitable at some point. On the positive side the fall will always be to a higher level than the last fall. We do learn from our mistakes as we go along. There has been a lot of practical evidence over the last year to show the system has become pretty resilient. When the inevitable fall comes it will be from an unexpected direction. History does repeat but never verbatim. But we will not fall as far as some of the gloomier types hope.

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