[donshan]

$this->bbcode_second_pass_quote('MrBill', '
')I guess it comes down to this. Perhaps we believe that the markets will save us because we have no choice? The markets automatic adjustment mechanisms of interest rates, integrated capital markets, growth and foreign exchange dynamics have become the sole levers of power that operate rationally and are capable of disciplining prolific national governments. The markets are the only true superpowers left in the world today. Let's hope they brandish their might with care?



today's humour we cannot be serious all the time

[MrBill]

Risk management is assigning the probability of an event and assessing it's potential threat or cost otherwise known as scenario planning.

Some commonly used risk management tools for hedging or mitigating risk are

Interest rates

interest rate futures
interest rate swaps
future rate agreements
bond markets (short selling or reducing duration)

Commodity prices

futures
options
multiple sourcing agreements

Credit risks

credit linked notes
credit linked baskets
credit default swaps
stock markets (short selling)

foreign exchange risks

foreign exchange contracts
cross currency swaps
currency options
non-deliverable forwards

Event risk & Acts of God

insurance products
diversity of supply
limiting geographical risk

Counterpart risk

counterpart limits
settlement limits
industry or sector limits


And many other risk management techniques to limit your exposure to any given risk or to lower your overall risk that one event or several events will destroy your investment portfolio. Of course, you may assess all the risks and decide the cost of hedging your risks is too high in which case you have to either accept those risks or sell your position.

These risk management solutions work at the individual, firm, sector/industry and country level. For example, a country may decide to be the insurer of last resort in the case of an Act of God because they view buying insurance for such events as too expensive. That is a conscious investment decision, so they should have reserves set aside to cover any potential liabilities just in case.

For example, the Japanese may set-up auto factories in the USA to reduce their foreign exchange risk between the yen and the dollar and to minimize their country risk or the economic risk of rising tariff barriers stopping from selling autos in America.

For example, a home owner may buy fire insurance, but also purchase health & disability insurance that protect them if they lose their job or become unable to make their mortgage payments. Or an employee might choose not to invest in their companies pension plan opting instead for a private third party plan, so that if his company goes bankrupt they will not lose their job and their pension.

Higher oil prices? Buy futures or options to protect yourself from higher prices. The list is almost endless. These are just some examples.

[donshan]

MrBill, you must have been reading my mind! Thanks very much for posting the list of risk instruments now in use. I was aware of of a few of them, and have been actively Google searching for just such a complete list of financial derivatives. This is an area where I am still learning. Now I know what to call them.

In this Economics topic is a thread on the Refco collapse and there is one post linking to an Article on Warren Buffet who says these instruments are a big risk to the financial system in themselves.


http://news.bbc.co.uk/2/hi/business/2817995.stm

Buffett warns on investment 'time bomb'

" Derivatives are financial weapons of mass destruction
Warren Buffett
The rapidly growing trade in derivatives poses a "mega-catastrophic risk" for the economy and most shares are still "too expensive", legendary investor Warren Buffett has warned."

...
"But Mr Buffett argues that such highly complex financial instruments are time bombs and "financial weapons of mass destruction" that could harm not only their buyers and sellers, but the whole economic system."
_____

I take it you disagree and do not think that the huge total value of these types of risk hedges does not pose a threat to the financial system.


I would find it interesting to see you post this list on one those other threads discussing hedging, and tell us more about Buffet's accusations.

I excuse myself as not qualified.

I invest in the stock market and have done technical analysis for over 30 years and now track over 500 stocks a day, so I know a little, but options are not my game. I am a trend detector/follower using classical methods and candlesticks.. That said, I often watch, in fascination, the price action of bid and ask prices on my computer screen streaming at many orders a minute, when an individual stock price is crashing because there are hundreds of sell orders and very few buy orders. It is panic vs. greed in real time. I think it represents the free market in action. A mini- crisis for some, and a wipeout for others, big profits for others.

What impresses me about these stock crashes, where it is 'a falling knife" , is how little rumors or even a slight shift in a statistic it takes to trigger such buying or selling panic.

This is what causes me to wonder how the free markets would react to even a hint of a Saudi Monarchy overthrow.

[MrBill]

I was not able to get that article from the WSJ here, so if anyone has a electronic copy I would very much appreciate the chance to read it? Thanks.

Those comments by Mr. Buffet are a few years old. He bought an insurance company through his Berkshire Hathaway Group and there were some significant off-balance sheet liabililties stemming from derivative trades. Such was his fury about all derivatives.

In many cases, derivatives are less risky than trading the underlying. For example, I buy DEC WTI at $60.00 which is 1000 barrels or a value of $60.000. As I trade on margin, I only have to put up $4800 in collateral and I can trade. Lately we have seen moves of 3.5-5.0% per day. Let us say a 5% move on 60.000 is $3000. You put up $4800 in margin and after one day you may have to post another $3000 which brings your investment/risk to $7800. Now you have to decide to close the position or keep it open. Everyday you leave it open you risk having to pay another $3000. Remember at every price there is a 50/50 chance the price will go up or down. This is very risky.

Now let's say instead you decide to buy an option because you think DEC WTI may go higher. You may pay $4800 for that option on 1000 barrels which will expire on NOV.20 for the DEC contract. Over the next month, the most you can lose is your original $4800 in premium. If the price goes first lower and then higher you're fine. If it goes higher you're fine. You only lose your premium if the price goes lower and the option expires worthless. Then you have lost your $4800, but you would have lost that and more if you had been long the underlying DEC WTI contract. In this case, options which are a derivative are far safer than buying the actual security or contract.

However, the derivatives Mr. Buffet is talking about are not plain-vanilla puts & calls. He is talking about the so-called exotic options that incorporate such weird & wonderful features such as knock-ins, knock-outs, contingent liabilities and make great use of leverage. These products should only be traded by rocket scientists and Noble laureates in maths & physics. They are effective risk reduction strategies when used properly, but when abused their characteristics make them very dangerous.

For example, an insurance company tries to match its assets & liabilities, but are restricted from investing in certain products. In a low inflation, stable investment environment, it is very hard for them to earn a premium so that they can payback any claims in the future. Let's say they need 3% real-growth per year to pay-out claims and 30-year treasuries are yielding 4.5% which is just 2.5% after inflation. This makes their future liabilities much greater than their income stream. They may not mandated to invest in riskier assets like low grade corporate bonds or equity markets.

What do they do? They employ structured products, which incorporate certain assumptions. Basically, they buy options that allow them to profit more than the going market rate if they are right, but in return for earning a higher yield today, they have to take the risk that they will be called upon to accept less favorable yields in the future if their view is wrong. Now, if they are right, happy days. They collect the premium, they invest at a higher rate, the contract matures, they pay the claim and make a profit for their shareholders. However, if they are wrong, they end up earning a much lower rate, having to pay the claim out of their shareholder's equity and everyone says it is because they invested in derivatives.

One man's lifeline is another man's noose. These specific risks inherent in any structured product have to be carefully understood by the buyer, by the risk manager, the credit officer, etc. However, all too often, when people are making money they do not look at what risks they are taking to make money. Then when they lose money, they blame the product which they didn't understand. Well, I could go on, but you get the idea.


By the way, you do not have to invest in each of these products individually or separately. You can invest in proxies to capture some of the underlying benefit to offset risks elsewhere. People often complain to me that banks only pay them a misery rate of interest, while they are announcing record breaking profits. I say, why didn't you invest in the bank's stocks instead of putting money into deposits? Then you would benefit from stock appreciation and dividends. Well, you can lose money investing in bank stocks, too, but the point is to look at your underlying risk and find a suitable investment vehicle for you to offset that risk.

[donshan]

$this->bbcode_second_pass_quote('MrBill', 'I') was not able to get that article from the WSJ here, so if anyone has a electronic copy I would very much appreciate the chance to read it? Thanks.

[MrBill]

$this->bbcode_second_pass_quote('donshan', '')$this->bbcode_second_pass_quote('MrBill', 'I') was not able to get that article from the WSJ here, so if anyone has a electronic copy I would very much appreciate the chance to read it? Thanks.