September 26, 2008

Derivatives 101

In the wake of the collapse of WaMu et al. many people are worried and probably just as confused as our politicians as to what caused all this financial turmoil. A lot of the blame has been directed towards “Derivatives” and its improper use. I’d like share a few thoughts on these illusive financial instruments.

What are “Derivatives”?

Here’s a definition from Wikipedia:
Derivatives are financial instruments whose value changes in response to the changes in underlying variables. The main types of derivatives are futures, forwards, options, and swaps. The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.

Here’s a definition from Warren Buffet:
Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Here’s a view from someone who deals in them for a living:
When I first traded “Derivatives” in London in the early 90’s, the financial services industry commonly referred to them as “Contracts for Differences” (CFD’s) which sort of hints at the true nature of these financial contracts. Basically, they are (private) contracts between two parties to take a “bet” on an outcome in the future price of an underlying asset while the future price “difference” and only the price difference is settled in cash. Since the parties typically don’t own the underlying asset, nor wish to purchase the underlying asset, these derivative contracts for “differences” are usually highly leveraged and that’s exactly where the danger lies in using them. Far from its originally intended purpose, they are by no means only used to reduce risk, but just as often, they are used for speculative purposes.

Once the conceptual framework on how to price some of these contracts was in place, these legal bets could be made on anything the only limit being the imagination of those who wrote the contracts i.e. the PhD’s in Mathematics & Physics a.k.a. “Quants” who came up with the models for pricing them. While some of these derivatives have been extremely complex and often conceptually questionable (e.g. weather futures), enter the new millennium and you can see derivatives contracts in our daily lives. In fact, you may even have some friends who have entered into a derivative transaction.

Yes you guessed it…
If you bought a house with 5% or less down payment, you’re essentially a holder of a derivative contract – why? Because that’s about the same leverage you have when you trade futures, forwards or options: your standard financial derivative contracts. In fact, someone who bought a house “zero” down is essentially taking on a much higher risk than the riskiest or most highly leveraged futures contracts. Typically the lowest margin requirements for futures are 1% and “trading a mortgage” with “zero” down is riskier than that.

Now, those official voices (industry executives, regulators, politicians etc.) who claim that a mortgage meltdown and the resulting credit crisis could never have been predicted should look at the fundamental basics of derivative contracts and apply them to the housing market, then it’s not all that difficult to predict forthcoming problems.

Buying any asset on a highly leveraged basis is risky!
In fact, those of you who trade stocks more frequently know that you can only buy stocks in a margin account with 50% minimum initial margin requirement. Translate that to the property market: anyone who buys a house “zero down” is taking on 50 times more risk than the average stock investor trading stocks on margin. Of course, there are fundamental and conceptual differences between asset classes; and real estate, being one of the most stable and anti-inflationary forms of investments, has generally produced above average returns over a longer investment horizon. However, from a risk stand point, one should agree that a 100% leveraged purchase of any asset is an extremely risky endeavor and not for the average Joe. High leverage makes for great returns when you’re on the right side of a trade. But, it can wipe out a portfolio in a short time if leverage is taken to extremes and markets are going against you, the effects of which can currently be seen in the mortgage and credit crisis.

Now if you’re not yet completely confused or bored at this point, I would highly recommend reviewing Warren Buffet’s Annual Letter to Shareholders from 2002. He decicated an entire section to derivatives; it’s a great primer on derivatives and what he thinks of them and it shows his incredible foresight of the dangers ahead.

If you like a copy of the entire letter, please email me at:

Have a great week-end!

September 20, 2008

The end of free markets?

Dear Friends and fellow investors

I’d like to attempt to share my perspective on one of the most memorable weeks in financial markets. Yesterday, the financial markets reacted extremely bullish to the news that the U.S. government was crafting a sweeping bailout plan for the battered financial services industry. The plan to mop up mortgage debt is said to cost $700 billion - so what? The U.S. government seems to have an unlimited balance sheet and a few more hundred of billions (give or take) just means more US treasuries owned by foreigners and a further dilution of the value of the US dollar. Should we be concerned? I would say very much so.

Nobody could possibly put a cap on potential losses - $700 billion appears to be an arbitrary number and without a realistic assessment of the potential risks we are basically letting our government write blank checks. While this sort of open-ended bailout plan is a questionable idea, what concerns me equally is the fact that we’re showing signals of an end to the free markets. When the SEC, presumably under a lot of political pressure, curbed short-selling on 799 securities of financial institutions, that to me is the worst signal for a free market and even a free market economy.

Let me be straight on this…short selling (i.e. selling what you don’t have) may be a concept that is alien to many people; some even consider it unpatriotic to do so. And while I am not generally recommending short selling to average investors, fact is that a market can often not function, certainly not function efficiently, without short sellers. For instance, we cannot have a functioning Options Market if market makers aren’t allowed to cover their positions by shorting stocks. In “short”, “short sellers” are not the culprits, nor are they to blame for the mortgage meltdown.

In our foreign exchange business, we have been telling clients for the past decade that they should carefully evaluate whether or not to invest in the Saudi Stock market or other markets of GCC countries. Our rationale was very simple: These markets don’t allow investors to sell short; often in a major market decline, they wouldn’t even let investors sell their existing positions either. Instead, so our rationale, they should invest in the “safer” international markets and preferably in US markets because they are free markets in an open and free market society.

I am not alone in this assessment.

  • Yesterday Alan Greenspan declared: “Banning Short Sales is a terrible idea”.
  • Jim Cramer, the co-founder of added: “We are approaching financial stone age…”

This bailout plan may be a temporary fix, but in my view it will more likely be aimed at treating symptoms only. And what it really boils down to: the average Joe will be footing the bill. It is even more appalling when you learn of some of the exit packages of the outgoing CEO’s of the miserably failing financial institutions. In my little book of common sense, a failing company cannot possibly endorse multi-million dollar exit packages and neither should our government.
You could also argue that, by taking on a huge amount of leveraged debt, our Treasury has effectively become the largest hedge fund in the world. Sometimes hedge funds make huge profits but they too can be on the wrong side of a trade. Scary to think of the consequences of our government potentially buying Pandora’s box…

A government bailout plan on this massive scale is essentially market/price manipulation. And historically speaking, market prices have never been successfully manipulated in the long term. Market interventions only provide temporary short term fixes; eventually prices tend to move towards at an equilibrium price established by supply and demand.

On an economic and social level, market manipulation reminds of the great socialist experiment that eventually ended with the fall of Communism. While I’m cautiously optimistic about yesterday’s market reaction, I am not so sure if I like the signs of things to come…

Good luck and good trading!

September 15, 2008

Should anyone follow analysts recommendations?

Ever wondered how conflicts of interest may affect the recommendations of analysts in the financial services industry? Check out the demise of Lehman Brothers and let’s look at the recent ratings posted on Yahoo Finance:

Not a single analyst of the ones surveyed by Thomson/First Call posted a “Sell” recommendation for Lehman Brothers. In fact, earlier this month, there were still 3 “strong buy” and 4 “buy” recommendations posted. As late as September 11, 2008, Citigroup merely posted a downgrade from a “Buy” to a “Hold” recommendation.

Granted, taking losses hurts, especially when you were holding a stock that was typically trading above $50 until early 2008. But what was the rationale of holding a stock that’s essentially done, “toast” as one trader put it? Just because the losses would be too painful to realize?

When Citigroup’s ”Hold” recommendation came out, a disillusioned investor would have been in severe pain, but could have still received as price of about $4 for his/her shares. Yet, how does that compare to the 20 cents we’ve seen today. When a company is essentially dead, why should an investor hold on to the stock? What does it take to get an analyst to change his/her mind - how far must a stock price fall before a “buy” becomes a “sell”?

A probing investor cannot help thinking that there may be some foul play involved here.

Curious to hear some comments on this.

Happy Trading!

September 05, 2008

The best investment advice you’ll never get

Another interesting week has gone by and the markets continue to be volatile. The good news is, despite a higher than expected unemployment rate (6.1%), the US markets ended the day a tad higher. Not too bad compared with the 2-2.5% declines we’ve seen overseas today.I hope those of you who had been invested in commodities and energy related investments took the warning signs from my previous message in June to heart (Market Insights: The next bubble?).

Hopefully your exposure to commodities is relatively small at this point. Oil closed just above $106 today, there is some talk that OPEC may put a price support at around $100. We’ll see…Along with the fall in energy prices, European currencies have depreciated over 10% since Mid-July; the US$ has been on a relative rebound recently.

That being said, I will continue making my case for a diversified portfolio and to invest in low-cost index funds rather than trying to outperform the markets by stock picking.

I highly recommend reading the article below (click on link), it’s an eye-opener on some of the illusions created by the financial institutions, but it’s also a good primer on mutual funds. If you have any questions on it, send me an email. I can also show you a comparison of the actual fees of mutual funds, low-cost index funds and ETF’s (Exchange Traded Funds).

The best investment advice you’ll never get:

Happy reading, be well and stay diversified!

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