Sunday, October 12, 2008

Derivatives blowup may hit insurance and car makers

This blog looks at the implications of failed investment bank Lehman's call on their "insurance" in the form of derivatives contracts. If everyone can handle the the cash call when it comes, good; if not, maybe a domino effect - one failure unbalancing another in a chain reaction. In particular, will hedge funds , who tend to play with borrowed money, be able to honour their contracts, or will they be the weak link in the chain?

Next up, says "George Washington", are the insurance and auto companies. It seems Standard & Poor's fear these could be the last days for GM and Ford.

I'm given to understand that players in derivatives usually balance their position with bets both ways; but they tend to be big bets. It's like a seesaw with an elephant at each end: if one elephant steps off, or turns out to be a baby compared to the other... What's the chances of $55 trillion of derivatives being well-balanced at all points?
So there are good reasons to think that next week is going to be more exciting than most of us would wish. Friday's Dow volatility may be repeated.


Nick Drew said...

players in derivatives usually balance their position with bets both ways

depends on the derivative

if it's a short option (i.e. you've sold the option for someone else to be able to exercise - with some strong resemblences to an insurance policy), the situation is frequently even more frenetic when a technique called 'dynamic delta-hedging' is used

details don't particularly matter: the relevant point is that a 'dynamic' hedge means 'constantly being modified' (by successive new deals in the market), with the entertaining aspect that the more likely the option is to being exercised against you, the more you need to 'chase the market', i.e. your actions tend to push the price even further in the direction that works against you

like a starving donkey chasing the carrot-on-a-stick

and in markets like this, all manner of options that were thought to be out-of-the-money (= most unlikely to be exercised) come swinging right into the money

Sackerson said...

Would an example of that be what I've heard referred to as "roasting a teddy" - finding out someone's got a short position and bidding up the share higher and higher to clean him out?

Nick Drew said...

it is certainly the case that when the market smells blood in the shape of a firm with an ugly, large, hard-to-hedge position (e.g. LTCM, and the earlier Metallgesellschaft incident) it knows what their subsequent actions will need to be; can therefore take positions accordingly; and will go after them with great ruthlessness

Soros et al have done the same, effectively, with FX and other plays