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Non-Tech : Derivatives: Darth Vader's Revenge -- Ignore unavailable to you. Want to Upgrade?

To: Henry Volquardsen who wrote (9)	9/2/1998 1:29:00 PM
From: Peter Singleton	Read Replies (1) \| Respond to of 2794

Henry, thanks for your informed opinion ... incredibly helpful. Can you comment on the enclosed exhange from the LongWave discussion list? Both of these guys are pretty smart. Howard Hill is a professional trader, and knows derivatives real well. George Ure is, I guess you would say, a professional bear, but a real smart guy in his own right. Hill makes the summation point you make, but George responds with a concern that notational value is at risk in special circumstances. Peter George Ure: Paul Erdman did a piece for CBS marketwatch recently and pointed out the systemic issue: The real exposure with derivatives is what happens when a derivatives deal goes south in mid transaction - and the counterparty trade blows up. What seems to occur is this ripples through the system. It seems likely that the disruption will "go critical" when a single bank defaults on several counterparty agreements. Erdman's review involved a German bank that defaulted on trades in process in 1974 and is worth thinking about. The counterparty offsetting trade can evaporate with a single default, leaving those huge notional numbers as quite real. In rational (read:solvent) times counterparty trades limit risk. In "exuberant" (read:like now) times, counterparty integrity is not a good bet. Too many banks are too weak. G-1 Howard B. Hill wrote: > While the notional numbers are huge, the actual cash exposure is small. Most > postions are laid off with matching trades with another counterparty. Only a few > participants think they are smart enough to be exposed in these markets. It's > cross-market "correllations" that can really screw things up. Examples include > Merrill and JP Morgan writing "prepayment swaps" or options in the the early '90s > without realizing that historic mortgage prepayment models were out the window > because of automated refinance marketing and loan underwriting. Historical need > for 200 basis points advantage fell to 50 basis points, as we probably all > remember from the cocktail party conversations of '92 and '93 about how many times > people had refinanced their mortgages. > > I doubt the Japanese banks have willingly taken exposures in the derivatives > markets, other than maybe Nikkei warrants, or maybe yen-dollar forward rate > agreements. > > PeterS7326@aol.com wrote: > > > Kit, Stephen, > > > > Precisely my point. > > > > If the Japanese banks have cumulative derivative exposure greater than the > > world's GNP, and one (e.g. LTCB) goes down, how do you keep the others from > > melting down and taking the world financial system with it? This would be the > > financial event of a thermonuclear reaction. > > > > I'm sure there are folks on this thread who understand derivatives and > > derivative exposure enough to assess how real this danger is. I know I don't. > > > > I think we run a risk if we think the worst case financial system scenario is > > 1929 - 1932 ... with time to make money on the way down. A waterfall crash > > over a number of months, heralding a global depression, and eventual dollar > > crash offers lots of chances to take defensive financial positions (and even > > ones that make money). > > > > There's gotta be someone here who understands this well enough to shed some > > light on the risk of a meltdown so big and so fast that our puts, our cash, > > our t bills, etc get wiped out along with the long positions in stocks and > > bonds. > > > > Peter

To: Henry Volquardsen who wrote (9)	9/2/1998 2:15:00 PM
From: Worswick	Read Replies (1) \| Respond to of 2794

Henry thanks so much for your reply and taking us through the difficult thickets of the derivative world. I'd like to ask you a few question if you would put up with my probably naive grasp of the world of derrivatives. You wrote: "The reality of Orange County was that it was a pure and simple case of over leveraging. It was no different than buying stocks on heavy margin. OC was effectively buying term securities with borrowed money. The derivatives just made it easier. The blow up was the result of bad decision making not an unrecognizable risk." My question is wasn't Orange county putting out there a bet on the direction of interest rates and they simply got caught in front of the wave and crushed? I know the term "derivative" is a melange sort of terminology for a wide variety of hedging instruments. In the world of derivates as a professional what is the instrumentality that posses the greatest amount of risk in the next, say, three months? I wonder your opinion of the instruments...and their risk as a long term observer of the field. What are GKO's? If you can still bear with me ... finally, let's go to a real world situation here for a moment. In the next 430 to 60 days Latin America will attempt to roll over huge amounts of short term paper. Presumably, the market will take to this like fire ants in inside of say... your old Boy Scout uniform. Now, assuming we have a debacle here (amongst others circling round us like particularly aggressive misquitos) then bond pirces will drop creating.... the dreaded GAP downwards. Presumably, the bank's workman like well managed and of course well studied little hedges on these bonds will work. Each side of the trade will do the right things and we will all be fine. Right? However....however...what if already weakened American banks, German banks, Japanese banks can't pick up their legs of the trades? It seems to me we have country risk, event risk, and interest rate risk here. ... is this a recipe for the future? My very best to you and thanks for putting up with these probably uninformed questions, Clark Nb. As a military history fan I wonder if you remember Henry the specifics of the British retreat from Kabul(Afganistan) on Christmas day of 1841? Do you recall the outcome?() This is the sort of thing I fear in the derivative world. () ...as historian of the subcontinent I'll tell you if you don't know.