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Derivatives: No Longer Used For Hedging But Exclusively For "Alpha Generation"
Maybe the pervasive “this time is always different” meme has been perpetuated to the point that the market actually believes it, or maybe it’s just old fashioned greed, but whatever the case, market participants (and this means central banks, retail investors, and everyone in between) have an extraordinary inclination towards Einsteinian insanity.
Never mind, for instance, that the Fed’s attempts to “smooth out the business cycle” (breaking it in the process) have everywhere and always served only to create bigger and bigger bubbles that have led, invariably, to crashes that are ever more spectacular/devastating - what we need is more intervention by central planners bankers. Forget the fact that throughout the course of human history, minting endless amounts of fiat currency always fails - in the words of new BOJ board member Yutaka Harada, “we just need to print more money.”
And certainly pay no attention (despite the tendency for these types of discrepancies to self-correct) to the divergence between the S&P and trivial things like the U.S. macro picture and/or forward earnings estimates...
... the U.S. economy is the cleanest dirty shirt and Jeremy Siegel is probably contemplating Dow 40K as we speak, so just hold your nose and buy.
Given this steadfast refusal to learn from yesterday’s mistakes, it isn’t any wonder that when Citi recently surveyed 43 banks, 29 asset managers, and 31 hedge funds regarding their outlook for the credit derivatives market in 2015, the consensus was that “there seems to be plenty of room and enthusiasm to use derivatives to take leveraged risk." Phew: for a minute there it looked like leveraged risk taking with derivatives might go the way of the Dodo in the post-crisis world, making Bruno Iksil the last great example of how much fun one can have stomping around in off-the-run CDS indices with depositors’ money.
It’s also comforting to know that among those Citi surveyed, the general consensus was that
"...there seems to have been a shift from using derivatives as a hedging tool, to using them more for alpha generation [as] most products are now used more for adding risk and directional views."
So investment professionals and sophisticated market participants are quite eager to take leveraged risk with derivatives with an eye not towards “hedging” (i.e. mitigating risk), but towards “alpha generation” and expressing “directional views” (i.e. gambling). In fact, nearly two-thirds of those surveyed listed either “alpha generation” or “adding risk” as the primary reason for trading single-name and index CDS:
For credit tranches, the combined figure was 82%:
The takeaway: banks and “sophisticated” investors are increasingly eager to take leveraged risk with derivatives in order to make directional bets on credit spreads. That certainly sounds like a pre-crisis mentality to us and it naturally won’t end well if the (re)proliferation of risk-taking via these instruments manages to embed an outsized amount of counterparty risk in the system.
Finally, in what surely was an effort to furnish readers with a bit of comic relief, Citi asked respondents if they “were concerned about investors taking more levered risks using derivatives” (here’s where one can gauge the extent to which those we entrust with our investments took the lessons of 2008 seriously). The results:
* * *
Bonus chart: Other types of structured products are making a comeback as well, with ABS issuance (backed by everything from car loans to student debt) hitting its highest level since 2008:
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Like using a derivative to exponentially increase my bet at the craps table.
<Step right on up Mr. Yellen. Shooter at the table.>
I'm still astounded by this press release from the Swiss National Bank when they state that they are "prepared to buy foreign currency in unlimited quantities."
Unlimited = infinite.
http://www.snb.ch/en/mmr/reference/pre_20110906/source/pre_20110906.en.pdf
III. DEMOLITION BY DERIVATIVES; DISINTEGRATION OF THE DERIVATIVES MARKET; “DERIVATIVE DEATH STAR” IMPLOSION
I wonder if most people know why derivatives exist.
There is so much money sloshing around, thanks to central banks, that if you were to make "investments" in the actual securities- stocks, bonds, etc. you could quickly buy ALL OF THEM. Yes, literally ALL OF THEM.
Therefore, you need a different venue (casino) to play in. Derivatives. As long as there is a counter-party to accept the other side of your bet, you're good to go.
That's the basic reason why the derivatives world is many times the size of the actual securitized world.
It's not like traditional leverage. It's worse than that. It's leverage WITH THE RISK THAT YOUR COUNTER-PARTY WON'T BE ABLE TO PAY OFF IF YOU WIN TOO BIG AGAINST THEM.
It also, by virtue of its size, moves the price of the underlying securities. It is the engine that drives the price of what regular people know as stock and bond prices, etc. It also happens to be insane.
If you could place a big enough bet on black at the Roulette table that you could FORCE the ball to drop on black, would you consider that insane? You would be right. And that is exactly what derivatives do.
Class dismissed.
you make it sounds as if there is a plan already in motion ... you know the frog theory (getting used to the heat) .... nah
also known as: buy whatever everybody's shorting
that's how to return value to investors
I would not call derivatives a casino, they are basically TBTF banks trading with each other at slightly higher prices to create "profits" and "equity". It is certainly going on longer than many thought it could. The mountain just keeps getting bigger and bigger...
Interesting discussion. I've never looked into derivatives so have some fairly ignorant questions.
When an entity wins big someone has to lose big (pay off). How is this not happening? Is it simply the Fed's "printing" of money flooding in, used to pay off the losses?
If you want to look, grab this PDF from Dallas Fed:
http://www.dallasfed.org/assets/documents/research/staff/staff1203.pdf
Then head down to Appendix C on page 26 for a one page (each) introduction to how credit default swaps and interest rate swaps work. The concepts are actually pretty straight forward. There are tons of other types of derivatives, but these are two of the major ones.
As you come to understand the concepts, the article above will make more sense (if you actually read it). That is to say, originally a muni might have a floating rate loan and was worried about interest rate risk (i.e. their credit card rate going up), so they look towards derivatives to help "hedge" that risk. Now folks are just flat out gambling on the direction interest rates will move the same "product" without having rate exposure using to begin with.
The real problem here is that once you let someone else sell "insurance" on your property, to anyone, in any quantity, and at any amount, the amount of insurance outstanding is greater than the actual property value. By orders of magnitude.
NoDebt had the best comment in the thread though, I hadn't thought of it like that.
Regards,
Cooter
Thanks for the info and link.
I'm trying to think of a time derivative sellers paid off and can't. There is always a bailout or something. I think it was Greece or Cyprus where they imposed a 50% write down in the value of their bonds but the credit default swaps did not pay off because the borrower did not actually default.
In one book about a guy who made $200,000,000 out of the Lehman crisis he said that at a certain point he got scared the counterparties would never pay off on the credit default swaps he had bought, so he sold them in the open market - for some large multiple of what he paid for them a year earlier - but did not actually collect on them.
In reality there is no way the sellers can pay off on all the credit default swaps. They don't have the money.
It's all a lot of fun until the house can't make the payout.
That's when things get interesting.
it would have been great if Hank Greenberg was CEO - he could never be strong armed - he would have never let AIG pay up on fraudulent CDO's and watch the show
Fed just bails them out. Too big to fail you know. It's all Bullshit!!!
Good thing the gubmint made sure these things were well protected....from any and all regulation. They are, always have been and always will be a form of gambling. "Hedge against risk" is similar to Fox News "Fair & Balanced".
Excellent comment. I hand't figured that out, but it makes A LOT of sense.
Regards,
Cooter
that's sep-2011...
HA HA HA HA HA.
This is just unbelieveable,
I ask how any sane human is expected to even half way believe.
And thanks Tylers, I know this was presented with ultimate sarcasm.
I rarely reply to the first poster because it feels like I'm trying to jump the queue to be at the top. But since I reckon CD got the metaphorical craps table of the derivatives market exactly right, I'll place my post here.
It is quite frankly ridiculous to call most derivatives, "shadow financial instruments" to give them the veneer of respectability. They are pure gambling vehicles, nothing more. A thing that is vaguely related to something in the real world, but based on nothing other than a chit detailing the duration and direction of the bet. It affects nothing, it makes nothing, it buys nothing, it sells nothing, it grows nothing, it employs nothing. A bet on how many drops of rain might form (monetized) rivulets down your window pane during the next year have as much significance on the economic output of the nation: ZERO.
Many derivatives, such as CDS, are used like insurance to mitigate risk to protect the buyer of bonds. Except that in naked credit default swaps, the buyer of CDS doesn't even have to have any bonds to protect against a credit event. This means multiples of the notional value of the bonds can be sold to any speculator and the good part? CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. It is all off-book. That is INSANE.
Derivatives are encouraging to people to purely bet against the solvency of a nation or company. Guess what? If your neighbours start buying fire insurance on your home, it is in their interest to burn it down to the ground. And when it does, where will the protection seller get the money to pay all the neighbours? The counterparty risk to trillions in notional value of derivatives is, in two words, fucking laughable. The seller of the CDS is not required to maintain reserves to cover the protection sold. That's right, the banks are selling insurance that can NEVER be paid.
So let's recap. Derivatives are pure gambles vaguely related to the real world, whose transactions are not reported and hidden from accounting. They are sold by banks to speculators in amounts that will never be paid in the event of a credit default. So, if a risky reference entity like Greece defaults, the banks that issued the CDS defaults on the contract at the same time - a double insolvency for the price of one - and the speculator has squandered all his premiums for nothing. I just can't get my head around how fucking insane this is, but here is an example of a standard ISDA CDS Contract.
Derivatives have one function for the banks: Liquidity creation out of nothing, just like fractional reserve banking creates liquidity for making more loans to other people as soon as the agreement is signed, money is created out of thin air by creating and selling a completely fake, never to be paid, insurance against default.
I respect your thoughts/feelings
I respect your thoughts/feelings
Long CR-500 two strokers
Long CR500-AF 2-strokers!
"Ex nihilo, nihil fit."
Then again, bankers fancy themselves doing God's work, so perhaps from nothing comes the big bang.
Every fucking hotshot fuckstick paper shuffler should be forced to consume your explanation. Awesome job YHC-HTSE
Nice comment.
Derivatives like the liquidity creation on leveraged loans.
Derivative liqudity creation is an extension of the loan liquidity creation that for a long time now cannot generate the level of growth (inflation) the economic mechanism needs to remain manipulatively sustainable for them.
2008 the derivative + loan liqudity creation was not enough to generate the needed inflation so up pops QE liquidity creation to top it up.
Loan liqudity creation ... not enough so add
Derivative liquidity creation ... still not enough circa 2008 so they added
QE liquidity creation ...
The Central Banker planning cannot create the level of growth to justify all the debt out there ... and central bank failure will be measured by the negative inflation achieved = DEFLATION.
Ain't that right Carney BOE ... creating billion YOY and still can't generate enough inflation can you even with all the flase / revised figures in pretence.
Most of these trades placed by computers, overseen by 22-year-olds too young even to remember 2008, much less 2000 or 1987.
New Victoria Jackson parody clip: "There's a Muslim in the White House":
http://tinyurl.com/kk6l3yf
I'm making over $7k a month working part time. I kept hearing other people tell me how much money they can make online so I decided to look into it. Well, it was all true and has totally changed my life. This is what I do... www.globe-report.com
i've been meaning to buy some of those cds thingies /s
Don't waste your time.
Just illegally download mp3 files instead.
I download infinite CDS via torrent. Is Torrent a central bank? In some idiotic ways it is. They violate copyright the same way Central Banks do by printing forged notes.
And derivatives. This is what will bring the banks down. Derivative chains of betting on everything. At 100:1 and then the next guy bets on that,
Time to get Maury Povich to do DNA tests on whom is the father? When this crashes all the baby daddies will flee.
I've been meaning to just touch them, those cds thingies, but Mrs. Müller didn't like it at all. She was calling me derivative names and then - bang!, right there, she gave me some headging. Then she said: You try to touch my cds one more time, young man -- and i did, and the same thing happened again. Anyway, I don't know what's so great about headging and why people get so excited about it. I will just do my alpha thing and -- just keep stucking.
My chicken coop will be launched as an IPO. Yeah, that makes all kinds of sense, as much sense as our "free market" where lies are the necessary veil to hide the accounting truth.
Sell to the next sucker, never gets old.
Can I buy in? Alibaba chicken coops. I already have a franchise.
I'll bet you $ 10 that I can create a new ETF called the Chicken Shit Index that will trade as an 3 x levered Inverse and get it accepted by the CFTC, the SEC and Mooshill Obama. To gen the 3x it will use CDS, forward and reverse contracts and Options on ammonia and nitrogen and corn. Its entire goal will be as a down bet on the amount of Chicken Shit being Less than the prior week. Of course we will have an Up equivalent that bets the amount will be more. To be called USHIT & DSHIT.
What could go wrong when there is only 700 trillon in derivitives just type up some more. Can I get a zero interest loan to get myself a few bets going. When its 700 trilon whats a couple million to me
most products are now used more for adding risk
Unpossible!
Free money, minimal risk, zero consequences. What did you expect........?
Tyler this thread is really important. When you discuss Alpha, It's direct financing, before the interest is re~invested in derivatives.\
ALPHA is the intitial return, before it's cross collateralized.
Yen, please explain more. Always enjoy your posts, but this I don't follow. You've said it's important, do I want to make sure I fully understand...
The contract(equity) is alpha.
banks calculate delta based on Alpha and deposits.
If I have equity to lend at a margin ratio, it's called beta, gamma/ I have leverage at the short end of the curve, and leverage on the tail.
I'm not a banker, but I understand why bankers are douche bags. Bankers hedge the curve, so it makes it hard for the Fed to raise rates.
The Fed was buying the curve artificially(sp) until last October.
Now the Fed. will start to tighten the money supply. WON't raise rates. All the cash will flow to Europe. DAX, FTSE ect
$usd drops, no rate increase, bond yield curve opens up ect;
Well. IF the bankera were not allowed to create all these toys then we would have a clear system. WTF? NOBODY should have the power to play in the casino with the life savings of people who actually work. WORK. and produce something. And service is production as well.
Playing with my deposits like a drunk is not,
I'm NOT a banker. I just do my homework.
I try to figure out how we get disrespected<
"I'm not a banker, but I understand why bankers are douche bags. Bankers hedge the curve, so it makes it hard for the Fed to raise rates".
the average guy might be a douchebag, greedy, willing to kill his own for few more bucks (key characteristics for interview if you want the job), however, not necessary the people who make the rules, you know the stanley fischers of the world, so count on them to raise the heat on the frog when the time is right.... thats the reason he got back in the drivers seat.
it seems to me is the same principles and practices since they were giving more receipts than they had coins in deposits.
probably the same names as well: alpha, beta, gamma.... however, these would be knonwn only to very key insiders though so we will never know.... but it seems to me is the same old game of how you take and keep control by controlling money
I like certain exotic cars. Nap Time
Thanks. I've been expecting USD to start weakening on fundamentals. It is the most disconnected major currency in the world.
I came to understand a long time ago that the adjustment would first be through currencies (to get relative valuation correct in the G3) and then gold because China won't end the peg until it has to, and that can only be done by inflating all G3 in gold terms.
I have been expecting one more PM crash, but am wondering if the dollar gets punished for being smellly shirts, then where does gambling go?
Is this why the derivative bubble exists?
Someone please enlighten me.
As we move more and more to; services, financialization, government employ, and welfare....
Where exactly does the "value added" part enter the picture?
We all can't earn a living cutting each other grass. And if we don't "make THINGS" like we used to, where does the alpha derive?
Would I have learned this in business school?
Again, not even a novice...last time I ever "traded" currency was in the 1980's. My view is that all basis trading is done relative to different currencies and not as this article seems to imply "by just buying stocks/commodities/gold" etc.
So your first trade as "trainee" will be the Swiss Franc I would imagine as it has one of the most valuable currencies in the world with absolutely zero economics to back it up. (Save for perhaps a massive amount of gold.)
As a "equity" it looks like a good trade because there isn't a lot of it, it doesn't appear to have any value whatsoever and its trading at a p/e of about a billion. No I don't feel sorry for those short the Swiss franc peg against the euro who were utterly annihilated when the PRIVATE BANK called "the SNB" broke the peg.
That currency still looks like a good trade from a Wall Street perspective. Already Switzerland is trying (unsuccessfully) to reestablish a peg with the euro.
A peg with the Danish Krona looks like a better idea but with Sweden now going full on QE and negative rates as well good luck with that.
All very confusing but sure looks like we are now in the final throes of an epic struggle to see who reestablishes the link between gold and currency first.
There is no shortage of gold.
I would not be surprised to see the US dollar be forced to go back to gold backed monies....but we shall see.
The war effort certainly is big enough...
My comment had nothing to do with currency trading.
I was explaining how banks make $! I was looking out for you!
Ah but there is a shortage of gold sir.
I truly think Ft. Knox is empty. US is so screwed (along with everyone else) but more screwed as they have no "real" assets to back this debt, The "word and credibility" of a reserve currency has been corrupted to mean nothing,
If and when the world insists on some collateral the US will have nothing. Hence WAR.
nothing to see here: the facilities the finance industry has via global central clearing faciltities for the net p/l exposure on the odd quadrillion of gross exposure (net exposure is something like 3% profit as players front run central banks equal to the odd 30 trillion of net counterparty risk held by the central clearing system) is well on the way to being monetized by central banks ...just in case :)
Why not, it's all just zero's and ones on someones computer screen. Go for it.
I'm taking a fucking nap after this explanation<
Derivatives are the opposite of Alpha.
Alpha is "prime equity+ return"
Beta is Alpha+ ROI EX; stock gets sold; VS option position.
Gamma/Delta in financial contract is very risky. Gamma/ Delta vs Alpha = Derivitave exposure.
Derivatives are exposure on the interest of Alpha/ Bitchez
I appreciate your explanations.
NOW tell it to me like I was advising my child on how to budget money.
Let's start with you now got a job that pays you $1000/week.
How does my kid play the same games? And get taxpayers to cover losses? Fair is fair. Why does my kid not get to play?
i think you have to join the american royal family.. yanno, those people who are above the law and take your taxes.. mind you, can't expect much else in a mindless descent into mobocracy.. i mean what else can anyone do? if you pull down the edifice, that would qualify as an experiment since there is nothing obvious to take its place... oh wait...that's qe
Thank You.
NEVER GIVE ~UP NEVER QUIT!
Those of us with common sense know this $800 trillion or so is nothing but a Ponzi scheme. The only question is how long until the bubble pops and the taxpayers are once again tapped, largely in secret, through the Fed with its fiscal backstop to buy the crap and fill the hole. I'm sure there will be a public face of it, maybe "Tarp II", which will of course be repaid with "profits" to the Treasury. Funny how so many "fiscally responsible" people concern themselves with such things as Social Security and Medicare, while ignoring the real money being stolen.
but trickle-down works still, right?
only down the side of a beer glass..
if it ever worked it would have been thought of in ten thousand years of human history..
there is no substitute for working for your own living and ignoring some snake oil salesman who says "i can't print iou's to make you wealthy".. that goes for governments, central banks and the false prophets who say that prices can only go up
So then, all netted and no worries.
Here is the hard part: if you are in the market (and rational) you know it will continue to rise as long as the FED keeps pumping it up. That means it is killing the currency however so you are fighting to get lots of soon to be worthless currency...LOTS OF IT!!!
I suppose there could be time to get out and spend some of that soon to be worthless paper but it could also collapse fast and leave the big winner stuck with piles of paper that no one wants.
IT IS NOT SEXY AND I'M ONLY MANAGING MY OWN FUNDS BUT I PREFER GOLD EVEN IF IT GOES TO ZERO (IN THAT WORTHLESS CURRENCY). freaking cap lock key is right by the 'a' on this POS keyboard...
The coxxuckers give the masses 0.0001% on their savings. What the fuck do they expect? But let it be known that some of us are more than ready to take the short ride on FAS, TNA, TQQQ to zero and FAZ, TZA and SQQQ long to the moon on a moment's notice.
My view of the hedge market, through the making of the Frank Dodd act and the subsequent modification of 2008. Speculation in the direvatives is primarialy for the benifit of the government and the main bank, the Federal Reserve. The exceptions are very clear, that is the 500 hour rule in the area of speculation.
why mot it is the gift that keeps giving?
- executives and managers can meet goals for promotion & bonuses
- Derivatives are a force multiplier for finance, right?
Hedge funds don't report this data, right?
the insurance companies lobbied to make these things non-insurance products so there wouldnt be any regluation on them.
and insurance companies often or did write CDS on whatever it is.
Mental Fortitude will win the day.,
This just took a shot at 90% of all investors using options. Way to take a shot at middle class...
not sure if sarcasm or not but the article is talking about credit derivatives
no retail investor fucks with these things unless they are buying the CDS etf or are insanely rich and can afford to buy CDS which are sold in high notational value.
Not to worry. Goldman Sachs is on the other sdie of the trade.
Don't worry. Once they ever get ICE completely finalized and running and shape a veneer of 'regulation' on this it will all be fine.
When you have a ten times global GDP derivatives market stacked on top of the real economy thing have got to be top heavy.
Top heavy, always means instability.
This is probably why we are seeing small problems, resulting in big problems. The top heavy financial system sways on small movements below, amplifying these small shifts into something much larger.
We have already seen the results of the construction of a financial house of cards on top of the shaky foundations of sub-prime.
When the foundations are poor the structure above is guaranteed to fail.
A small section of the US housing market (sub-prime) collapsed, which should have just caused a problem in the US.
The financial house of cards and complex financial instruments exported this problem around the world and nearly brought down the Western financial system.
What other shaky foundations have the investment bankers been building on?
Greece perhaps .......
Q: What happens if your insurer cannot payout?
A: Disappointment.
Better call Saul.
http://www.designfloat.com/blog/wp-content/uploads/2010/11/uncle-sam-11.jpg
You talk to their monoline carrier?
C'mon...Daddy needs $240M of new shoes. <blows on stack of derivative contracts>
Why Hedge when you are backed by the future public?
they ought to let the retail trader get in on this shit (CDS)
STOP proferring the lie that CBs are here to smooth the biz cycle. This is lie. CBs are here for one purpose, to assist in the transfer of all a respective country's wealth to thier TBTF WS Banks.
CB's and their TBTF WS Bank owners, CREATED teh curreny BIZ CYCLE, which is NOT a BIZ CYCLE but the ONLY thing a CB can create which is BOOM and BUST.....Bubbles here and there thru cheap or free money, that the taxpayer will forever pay back when the TBTF Bets loose (they don't share the winnings) followed by Financial Repression where innocent savers are then stolen from via FedRes actions, to slowly recapitalize the TBTF WS Banks via guaranteed spreads and more free monies to gamble in ;the next industry bubble.