Five Things You Need to Know: Swapstakes, Derivatives, 1982, Gold, Saddam Husseimingway?
What you need to know (and what it means).
Minyanville's five things you need to know to stay ahead of the pack on Wall Street:
1. Variance Swapstakes!
The recent selloff in global markets is being blamed on derivatives activity on the part of hedge funds and big banks. Naturally.
- An article in this morning's Financial Times quotes some unnamed senior traders as pointing the finger at derivatives as a cause for the recent "forced selling" of equity index futures.
- This lends the recent selloff in equities an aura of "mystique" because very few understand derivatives and a selloff based on derivatives problems is a lot cooler than selling based on something more mundane... such as simple risk aversion.
- "It is impossible to track this type of derivatives trading with accuracy," the Financial Times noted before pinpointing "variance swaps" as to blame.
- What are variance swaps? A variance swap is a contract between two parties agreeing to swap cash flows on the measured variance of an underlying asset during a set time frame.
- Variance is the square of standard deviation.
- The payout on the variance swap is linear to variance rather than volatility. This means the payout will rise at higher rate than volatility. In a period of rising volatility, this can be problematic if someone is over-leveraged based on a model that is predicting a continuation of muted volatility.
- The variance swap provides a trader with a "constant" exposure to volatility with a fixed gamma and time decay that is not dependent on stock prices, therefore providing a "pure" play on future volatility.
- Minyanville Professor John Succo noted a similar situation last October. Describing some of the selling taking place at that time, he wrote: "There is a rather large position in the Street composed of what are called "variance swaps."
- "Essentially, volatility funds and credit funds have bought variance swaps (long volatility) from several large brokers," Succo wrote. "The volatility funds buy them to make bets on volatility. Credit funds buy them as a correlation hedge against credit risk (as credit spreads widen, volatility tends to pick up)."
- Unfortunately, the FT article fails to mention that the initiation of these trades first helped the market go up, Succo notes. "As volatility (options or variance swaps) are sold into the market, it causes volatility to drop. As volatility drops, people take more risk and risky assets like stocks go up. The introduction of these derivatives in the market then creates a contingent situation that when volatility begins to rise these trades must be re-hedged and/or unwound. This furthers an increase in volatility and feeds on itself."
- But you can't have it only one way. "If volatility becomes artificially low because of excess leverage, it invariably returns to normal and may even overshoot (although I think we have seen really nothing yet). Combined with huge compression, high leverage through derivatives, paper think credit spreads, and huge consumer debt, the markets are set to see higher volatility in the future in my opinion," he says.
2. More Derivatives. A Lot More!
The global derivatives market expanded to a record $285 trillion last year, according to the Bank for International Settlements.
- That is $285,000,000,000,000,000,000.
- At least the rate of growth slowed, from 8% in the first half of 2005 to 5% in the second half.
- The growth was led by a 34% increase in credit-default swaps.
- Oh brother, here we go again. First variance swaps, no credit-default swaps. What are credit-default swaps?
- In a credit-default swap, two parties, we'll call them "dudes" for simplicity's sake, enter into an agreement where one dude pays the other dude a fixed coupon (fancy way of saying an interest payment) for a pre-determined time period based on an underlying asset usually the market value of a specific company. The other dude doesn't pay a red cent... unless a credit event occurs.
- What's a "credit event"? A credit event is a bankruptcy, or debt restructuring.
- In a credit event the dude who has been getting paid the periodic, fixed interest payments pays the other dude money based on the decline in the market value of the underlying asset.
- Last night, Alan Greenspan reiterated his concern about the backlog of credit-default swaps confirmations and practices.
- The New York Fed has urged banks to clean up a backlog of 150,000 unconfirmed trades, many of which were simply traded over the phone and written on "scraps of paper," according to Greenspan.
"It was the best of times, it was the best of times," wrote Charles Dickens in 1982 in his best selling novel, "A Tale of Two Equities."* He was referring, of course, to kickoff of what would ultimately become the largest bull market in world history.
- We love 1982. There was a recession. Unemployment was 9%. Inflation was around 8%. Alexander Haig (The original Decider) resigned. And stocks didn't care.
- Why are we thinking about 1982? This morning, Germany went old school, reaching back to 1982 for their Producer Price Index.
- Goods from plastics to newsprint were 6.1 percent more expensive in April than a year earlier, the Federal Statistics Office in Wiesbaden said, according to Bloomberg.
- This is a problem for the ECB. On the one hand, countries such as France are reporting slowdowns in GDP.
- On the other hand, countries such as Germany are reporting inflation at the producer level exceeding expectations.
* Information courtesy Wikipedia.
After closing at a 26-year high on May 11, gold has now shed more than 8%.
- This morning gold futures are off 2.3%, down more than 15 points.
- The dollar, meanwhile, is higher, back above 85 for the U.S. dollar index.
- Some have blamed the selloff in gold on reduced inflation expectations and reiteration of a strong dollar policy as stated by U.S. Treasury Secretary John Snow on television this morning.
- But wait, wasn't the market selling off on increased inflation expectations this week? (Minyanville Professor Scott Reamer doesn't think so).
- Meanwhile, Minyanville Professor Kevin Depew yesterday on the Buzz & Banter noted the technical significance of the 676 level for gold futures. "A move below that level would be a serious breakdown," he said.
5. Sadam Husseimingway?
A novel written by former Iraqi leader Saddam Hussein is now on sale in Tokyo.
- It is the second work attributed to the former Iraqi leader which has gone on sale in Japan, according to Reuters.
- The first, called Zabibah and the King, tells the story of a leader who sacrifices a luxurious life for the sake of his people.
- It is a work of fiction.
- This book is called "Devil's Dance."
- It is a symbolic tale about a tribe of people living along the Euphrates River 1,500 years ago that rises up and defeats an invading army.
- It is also a work of fiction.
- The book was reportedly finished a day before the U.S. invasion in 2003, which may explain the abrupt final sentence: "Aaaaiaiahhaiaaiaaa, run away, run away, run away!"
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