Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.
I am an avid reader (and loyal Minyan) of your columns, and clarifications. It really helps to know a pro's perspective.
I was reading an article on Business Week this weekend about the banks engaging heavily on derivatives trade and essentially making large profits on them. I understand that derivatives trades are zero-sum game. And all I see are banks and brokers making large profits quarters in and out. Even Fannie Mae (FNM:NYSE) and Freddie Mac (FRE:NYSE) make profits.
So the question is who is on the other side of these trades? It can't be public/consumers as they do not have enough buying power to compete with banks etc. I mean, who is losing money? Or is it just borrowing from the future? I would appreciate the light on this.
Also, I was at car repairs shop today. I used to pay the usual $ 55/hr not so long ago (2-3 years back). I noticed that I had to pay $80 this time. I complained that my salary has actually been reduced over this period and there is no inflation as per the government.
The manager's response: his salary has not also gone anywhere in last three years. My health insurance has gone up significantly as I now pay 10% of the total along with a much higher (double) monthly premium. My son's preschool fees are also on steep rise. Boston's metro fares have gone from 60 cents to 1.25 in four years. I wonder if such data makes it into government inflation statistics, and if not, why not? Who has the authority on these statistics?
Minyan Shikhar Srivastava
Your assumption that derivatives are a zero sum game is a matter of debate, but I actually lean towards it NOT being zero sum.
Let's look at an example. Suppose FNM decides to buy a put on bonds thinking that interest rates might rise. This can either be a hedging activity, if their portfolio is susceptible to such an event, or speculative activity if they are just making a bet. (We do believe that FNM does speculate by over-hedging positions; this has been referred to in the New York Times.)
They transact with JP Morgan, by far the largest principal in such transactions, who sells them the put. This leaves the bank exposed to a rise in interest rates. In order to hedge this, the bank sells bond futures equivalent to the delta exposure dictated by the calculus of the derivative. The bank is thus "delta" hedged against a rise in interest rates: the loss on the put will be offset by a gain in the short bond position if rates increase.
The bank still has gamma risk: the delta of the derivative will change as interest rates change. But as long as rates do not rise in magnitude or velocity more than the price of the put indicated, the bank can continue to re-hedge, selling more bond futures as rates continue to rise and the contingent liability of the put becomes more "real".
In this situation, both FNM and JP Morgan can make money. The only problem is when rates rise precipitously and the bank cannot keep up with their re-hedging program or if rates increase for a time and then decrease suddenly causing the bank to re-hedge the other way. JP Morgan's real bet is then the volatility of interest rates, not direction.
In this case the option does not seem to be zero sum: both counter-parties make money. Some have argued that it is zero sum because as the bank sells futures, there is a futures buyer and that buyer loses from the fact that the bank continues to sell futures: the buyer never would have bought the futures and never incurred a loss but for the gamma created by the derivative in the first place.
I understand and appreciate this last fine point, and I do believe that the gamma risk introduced from derivatives is significant and possibly very harmful. Especially when participants like FNM and JP Morgan are given such leeway in building up that risk.
But I also have illustrated that derivatives under a normal cycle are not zero sum: counter-parties can both make money via re-hedging activities.
As for the buyer that lost money because of the gamma effect, it is a by-product that may become truly serious one day.
In answering your question about inflation statistics, the Bureau of Labor Statistics has discretion over the calculations for both the PPI and CPI. Any complaints should be directed toward them.
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