Everybopdy keep talking about interest rate swaps, currency swaps are by far the greater market and is frequently used for speculative purposes.
How do you feel about the situation a few years back when we had oil futures that exceeded actual oil production by several orders of magnitude?
I don’t think HFT is all order processing. A lot of it is trading on technicals
Yes. Derivatives can refer to a whole host of different instruments. Some are more problematic than others. When Warren Buffet referred to derivatives as “weapons of financial mass destruction” he was referring to a subset which were problematic both for being high leveraged and complex. Highly leveraged as in 100% leverage in the case of TRS’s, and so complex he didn’t feel like he had a good handle on the risk involved. These are problematic for obvious reasons.
But Warren Buffet still trades in derivatives. We’ll get back to these in a minute. I was responding to your original post, which follows:
You seemed primarily concerned with the fact that the derivatives market was several times the estimated wealth of the world. Is that not accurate? As others have pointed out, that figure isn’t particularly alarming due to the way derivatives are structured. If you want to talk about how CDS and CDOs are a problem, that’s another discussion.
You’re being a little vague here when you say “money his is wagering” and “amount of the financial original instrument”. It’s not like a you’re just betting 50 on black. So let’s go back to some (simplified) examples.
Let’s say I make make a bet on the value of the S&P 500 using a put option. Let’s also imagine the current price is 1000 and I make my bet of the value of the S&P in 5 years. If I put up 100 million dollars, that sounds like a lot of money at risk, and it is. But I can only lose that entire investment if the value of the stock market drops to 0. If in five years the value of the S&P is 1200, I’ve made 20 million. If it’s 800 I’ve lost 20 million. In 2008 BH had about 37 billion dollars worth of equity puts in its portfolio.
We’ve talked about interest rate swaps before but let’s do it again, hopefully more clearly this time. This is simplified for clarity but I hope the basic idea gets across. If I enter a interest rate swap contract a notional principle is determined. Let’s say its a billion dollars. A simple example would involve one party paying a fixed rate, let’s say 7% to one side, while the other side pays a floating rate to the other, let’s say over the course of the contract it varies between 2-10%. If the floating rate happens to stay at 7% for the length of the contract, no money changes hands. Zip. Let’s say interest rates fall all the way to 0%. In that case party A will essentially be paying party B 70 million and getting nothing in return. That’s bad, but it’s not as though someone is going to get a bill that says 1 billlion dollars at the bottom even in the worst case scenario. BH had about 4 billion dollars worth of these swaps on its balance sheet in 2008.
Remember Lehman Bro’s? Initial estimates on the the payout on their CDS were on the order of 300 billion. Final net payments were about 6 billion as parties were both selling and buying protection and many cancelled out in the end.
I don’t understand what you are arguing. I thought your initial concern was the size of the overall market was somehow too big? I think most people would say that’s not a major issue for the reasons described above. That you made a post on that issue honestly made me think you didn’t have a good handle on derivatives and what they’re used for.
If you think all derivatives are somehow useless or just “gambling”, I would strongly disagree but that’s an entirely different issue than your original post, and a complex one at that. Would you say that hedging, risk management, and the multiple other functions that derivatives are used for are not legitimate? If not, then why not?
If you think they are legitimate but their use must be balanced against their drawbacks, namely overleveraged positions, concentration of risk, complexity, need for regulation, etc. well I don’t see that that is very controversial even in financial circles.
Interest rate swaps are just a relatively easy swap to understand as an example, that’s all. As you know it can get byzantine pretty quickly. The size of the futures market didn’t strike me as particularly worrisome in and of itself though I’ll admit I was only peripherally following it at the time. It’ll be interesting to see what effect, if any, the CFTC rules will have on speculation and actual prices. I can’t say I know the answer. I think I’m in good company though.
I’m curious why you think short selling should be banned. Only naked? Do you mean for all time? Or specifically in response to the European crisis? We tried it in 2008 and it didn’t seem all that effective.
Startups don’t have dividends. Startups are usually not profitable. How many people would invest in a start-up if their money is locked into it until dividends are paid - and dividends mean less reinvestment in the company and thus less growth. Remember Microsoft and Intel didn’t pay dividends until just recently, but early investors in them did quite well, as they should.
Well, not necessarily - many growth companies, for example, don’t pay dividends. Why? Because there are more attractive growth options out there that would be a better use of any funds on hand. Microsoft is probably the most famous example; it only started paying dividends 7-8 years ago.
Incidentally, there is a host of research on dividend policy and possible ‘signaling’ effect on investors. For example, if a company announces that it is going to start paying dividends, some investors might view this as a negative sign, that the company no longer sees any attractive growth opportunities.
Excuse me? Lot of institutional investors hold their bonds to maturity. Most corporate bonds are in the 5 to 7 year maturity range and they don’t change hands all that often.
Excuse me? Your return doesn’t change because you sell your 5% bond for 60% of face value to buy a smaller bond with a 10% stated interest rate, you just adjust your overall interest rate sensitivity (duration) by accelerating cash flow.
Take out government debt, debt issued by financial institutions like fannie mae GICs issued by insurance companies, etc. and say that again.
OK…
If you don’t count debt, not much debt is traded.
You can’t just change the definition of what the bond market is and pretend you’ve made some kind of point.
It sometimes takes a while before a startup starts paying dividends. Microsoft didn’t pay dividends for decades.
Please explain how short selling moderates volatility?
I’ve never understood that. I’ve heard the arguments but at some point it seems to boil down to “more volume and liquidity is good for the market”
Well, generally more volume and liquidity is good for the market. To quote Charles Jones, professor of finance and economics and chair of the finance and economics division at Columbia:
I’ve got to leave my office, but what are you looking for exactly? Journal articles? I could google some later. Here’s a book, Don’t Blame the Shorts, that addresses the demonization of short sellers over the decades.
I have a general opposition to short selling but I can in fact see some merit to permitting them, but they need to enforce enforce delivery requirements with harsh penalties and they need to reinstate the uptick rule.
Short selling creates virtual shares of stock in a company and messes up the supply demand equation for the shares of stock in a company. This is especially pronounced in cases where naked short selling is going on. Actually enforcing and imposing fines for naked short selling would make this aspect of short selling less offensive.
It provides opportunities for stock price manipulators. True story. Stock operator finds a small or medium cap binary stock with a binary event taht is well off in the future. They short the heck out of the stock and when you beat up the stock enough, everyone readjusts their view of the likelihood of the positive event occurring. Its the opposite of pump and dump but prices of beat up stocks are much stickier than the prices of puffed stocks so you can slowly extract yourself at the lower price well in advance of the binary event occurring. I suppose the uptick rule would make this aspect of short selling less offensive.
The primary purpose of the stock market is to provide a liquid stable secondary market for IPOs. We don’t need a shorting mechanism to achieve that.
I suppose we need a shorting mechnism to provide hedging opportunities for options market makers (and having options are a fairly necessary in almost any modern securities market) and if we let them people use it for hedging purposes then why not let people use it for speculative purposes as well (well, I guess we don’t actually have to). Besides, shorts are usually playing devils advocate on companies that deserve more scrutiny (see Enron) and since our securities regulators suck (see SEC) and the accounting firms are not sufficiently independent of their clients to ferret out corporate fraud (see list too long for a single post), perhaps we must rely on the skeptical shorts to bring negative facts to our attention.
So as long as we reinstate the uptick rule and enforce the delivery requirements, I suppose shorting is tolerable.
Sure I have. We don’t really need to encourage secondary markets in government debt and GSE debt. There is enough interbank and otc activity that we don’t need a NYBE the way we need a NYSE. Much of the bond market is not registered and is traded only between isntitutional investors.
Oh yeah and bonds have maturity dates while stock does not.
Well thats because March is national peanut month and everybody knows that consumption of onions correlates exponentially with the consumption of peanuts.
Prices are wrong? A lot of people think that price is pretty accurately determined by supply and demand. Shorting introduces supply tthan actually exists in the market. Is the argument that this is necessary because the holders of the stock are emotionally attached to them so they value their stock more highly than their correct value?
I can think of case where there were the short interst was several times the float so an investor bought the float and requested physical delivery. He held certificates for the entire float and the stock continued to trade several times the flioat over the next few weeks. Another time a company plagued by shortselling repurchased their entire float but the trading in the stock simply continued.
The market simply hasn’t done a good job of proving that they can keep their books in order when we introduce shorting for speculative purposes.
For the record, I’m not blaming the shorts for the crisis (I think I might blame them for drving a sick Lehman into the grave but maybe that would have happened anyways), I simply wonder whether any benefit the practice provides is worth keeping the practice around. I used to short quite a bit to hedge all sorts of risks and to speculate. I don’t think there is anything immoral about it, it just seems to me that this sort of specualtion is not necessary to fulfill the primary function of the stock market to provide a vinrant secondary market for IPOs.
The basic argument, dating back to Miller, is that in the absence of shorting, securities are going to be overvalued routinely. For those reading along, a (highly simplified but hopefully enlightening) example: pretend for the moment Microsoft is trading at 100/share. Assume also that the world is divided equally into optimists, who think it’s worth 120 and pessimists who think it’s worth 80. 100 seems about right, so far. The problem is only the optimists will buy, driving up the price, whereas the pessimists will not. But the pessimists don’t want 0 shares of Microsoft. They really want to own negative shares of Microsoft. By eliminating short sales, you lose the pessimists’ perspective and the security becomes overvalued, because only the optimists’ opinions are being accounted for.
That’s the theory at least. The more difficult it is to short sell and the wider the divergence of opinion about a particular security, the larger this effect becomes. Boehme’s analysis suggests it may be as much as 10% or more in certain circumstances.
Boehme’s paper:
Several authors have pointed out that short sellers get blamed, often unfairly, when markets decline. It’s rather similar to how speculators get dinged when oil prices rise, come to think of it. While there’s no doubt some manipulation going on, It’s worth noting that dedicated short positions are <1% of the hedge fund market. Most short sales are part of long-short strategies. Would you ban the latter with the former?
The hypo doesn’t really work well because of its binary nature.
I can agree that getting rid of shorts (people who create phantom shares and sell them into the market) will raise the price of the shares but I’m not seeing the distortion.
People buy stock absed on what they think its value is. As time passes, they will generally sell the stock to someone who thinks the stock is worth more than they do. Thsi coule be the result of the price of the stock rising past the level that the invstor thnks is the corect price or it could be the result of the investor reevaluating what he thinks the correct price is.
Like I said, I’m not blaming short sellers for the crisis, except that I think that they might have led to the untimely demise of Lehman. I do think that speculation can lead to bubbles and market distortions.
Do you havea cite for the notion that hedge funds hold less than 1% in directional short positions? I don’t think most hedge funds use shorting to hedge their long exposure to the sort of degree t6hat you think they do. They go long on oil and short on computer manufacturers not long on Gm and short on a basket of car manufacturers.
The binary nature was just for illustration purposes. Obviously there will be a distribution. But the point is if only optimists are trading the stock will be overvalued because the pessimists viewpoint isn’t factored in if they aren’t able to short a stock. You don’t see how that’s a distortion if only optimists are setting prices? The paper goes into the details of exactly what effect this has on returns. Do you disagree with their conclusions?
CREDIT SUISSE, 2008. Nice table on page 5, with a bit of explanation on page 3:
Do you understand the difference between short selling and naked short selling?