demon of our design

If one looks around, there are a tons of innovations happening in the financial sector.

  • From the instruments side, the world has graduated from simple plain vanilla options to exotic derivatives, CDO's on CDO , an alphabet soup of all mortgage derivative products. Ideally all these should help in better management in risk, right ?
  • There are more players in the markets, different types of players, hedgers, arbitrageurs, speculators, market makers, hedge fund managers, prop desk traders etc. These players should be smart enough in making the market more stable ???
  • Tons of legality around stock markets and asset trading, new rules to shorting etc,
  • Infrastructure to support trading has grown by leaps and bounds. On your vacation to hawai, lying on a beach, you can execute a complex derivatives trade with a click ,
  • Price transparency wise , again a big yes
  • More crisis, More boom bust cycles.

All the above should have made the investors more wise and made the markets efficient, less volatile. However we are seeing the markets becoming more volatile, more manias , more structurally inefficient products being traded,..Does it sound like an irony ? Well, this book sets out to explain WHY ? The author has been a trader in MorganStanley , Smith Barney, LTCM, and has worked on a host of significant roles that his view can be understood not from a passive spectator narration of somebody but from a perspective of a player in the market. This means that it will be more – matter of fact – rather than color it from journalist flavor.

Today morning, for some reason I could not concentrate on my work at all . Spoke to Kiran for sometime and it helped me a bit to get over my mood, and then figured out that I need to get DRUNK to restore my sanity. In my case, getting drunk is equivalent to reading a superb book from my inventory . I had this book in my inventory for quite some time and felt that the best way to get over my bad mood was to read this wonderful account of " Demons of our own design". Let me try to give a summary of the book , chapter by chapter. Each chapter is a gem.

DEMONS OF 87:

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This chapter took me through the 1987 oct 19 S&P Crash by 20%. There are some unique reasons which the author quotes for explaining the crash. One word that is synonymous with the crash is "Portfolio Insurance". This was a strategy to hedge against a market crash by shorting S&P Futures. All was rosy until the markets actually begins to take a beating. Ideally since the portfolio is hedged, people shouldn't have lost money. However this strategy is a lame strategy if every portfolio manager has the same game plan to bail out . Yes that's what happened .Market became ILLIQUID. Well, this part I was anyway aware. However new stuff that I leant from this chapter is the role of Cash Futures Arbitrageurs. When there was a huge sell of S&P Futures, and combined with a fall of stock market, there was a great spread between cash market and stock futures market. Thus a different breed of players started to take the market in a precipice. Traders longed stock futures and shorted the stocks thus aggravating the already free fall of S&P, free fall of S&P Futures and the immense amount of hedging that happens for portfolio insurance products at the money. Note that gamma for at the money option is max. This means the more market putters around the floor of the portfolio loss set, the more managers with delta hedge and it becomes more expensive to delta hedge than have a losing trade..Yes, that's what happened according to the book. It was expensive to delta hedge and cheaper to hold on to losing position…WOW!! What sort of market that would have been ?

Biggest take away from this chapter is the fact that – Time frame in which futures market operates is VERY different from time frame in which spot markets operate. Hence the crisis in the futures markets will take time to get communicated in the stock markets and this time delay aggravates the crisis even more as other arbitrageurs, buy side folks, market makers try to have their own strategies and at the end , manage to screw up the entire market.

New Sheriff in the Town

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This chapter talks about the rise of fixed income trading and instruments in 1980's. Cites a few major disasters that occurred in the fixed income world. Orange Country, Citron Fund which went long on short term interest rates and long on long term interest rates:) . But inverted yield curve killed the fund and it was saddled with 1.7 Billion Loss .
The next account in this chapter is about Nick Leeson who single handedly brought Barings bank down , by entering in to a straddle on Nikkei 225. Straddle is great if the market stays put. However it is a loss making position if the market moves a lot. Essentially it has negative gamma. And yes Nikkei moved like crazy and Leeson who was showing abnormal profits from account 88888 went bust.
Another trader who brought Kidder (of Kidder Peabody) down was a harvard grad , Joe Jett who used an accounting loop hole in STRIPS sales and showed profit until Kidder couldn't digest the losses.
The author also mentions the rise of index-amortizing swaps, use of APL language in Morgan stanley and its limitations about not being able to perform fast Montecarlo valuations, make a good read. The chapter ends with the most important question –

If WallStreet is swarmed with so many risk managers, why is there a crisis ? The problem is risk managers look for what is already present and measure it like crazy..However risk management is about what one cannot see. It is about BlackSwans …Alas!! World like to believe in " What I see is What I believe" philosophy .

Salomon Rolls Dice
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This chapter takes the reader through the build up of bond trading infra in Salomon. The only takeaway from this chapter is the MCI/BT merger trade which Salomon lost. In any merger obviously prices converge. If I hold a long short portfolio then if the merger happens, I make money. The only thing that matters is the probability of the merger. In Salomon's case, it got this bet hugely wrong. In the end Traveler's group and Salomon merged in 1997 and the next chapter in this book talks about how Salomon was killed after the purchase

They bought Salomon, then they Killed it

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The highlight of this chapter is the way it describes the tracking error on yield curve trades which killed the US arb division in the merged entity. Thus Salomon props teams operations were shut down and the traders were politely asked to leave. One of the great takeaways from this chapter is the mention of liquidity and its associated problems. The essential trait of investment portfolio- ability to liquidate is the very root of crisis most of the times. How do models take care of Liquidity risk ? I have no clue. By putting in a friction rate, is the liquidity risk captured ?

LTCM – Lesson in Leverage

seesaw leverage small

Well, lot of folks know about LTCM. I know a little bit about it from my previous readings. What does this book offer me new ? That was approach I took before reading this chapter.Well, at the end of it, I didn't get anything new from this narration

Complexity, Tight Coupling and Normal Accidents

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This chapter is about complexity and the way finance with all the myriad interactions, is made ineffective by more controls. More controls need not necessary make the markets less prone to disasters.2 classic examples from the engineering world are discussed, Three Mile Island case and ValueJet case which are tight coupled systems where myriad controls did not help avert the disaster. A great analogy in this chapter is that of postal system where the system is tightly coupled but not interactively complex. This means that a single failure in communication is not catastrophic. It is a fairly less interactive system, meaning , the failure or errors are not fed in to the system and they don't aggregate over time. University with department is another example of system with less interactive complexity.However , it is not the case with Financial markets. We are dealing with interactively complex , tight coupled systems where errors, crisis effects the markets in a non linear way. Extra controls are going to add more variables to the system and make it more error prone than less.

I will summarize the next part of the book which is based on Hedge funds in another post.

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