Five Things You Need to Know: Dwarfing the Cash Markets, Bankruptcy, Rate of Change, Risk Control, Superfluous Credit
The derivative markets are estimated at $200 - $300 trillion, dwarfing the cash markets on which they trade
Editor's Note: While we congregate in Vail for Minyans in The Mountains 3, we asked each Professor to prepare some thoughts on fiscal literacy, how to listen to the market and their area of expertise.
1) Derivatives are contingent liabilities that employ leverage of varying degrees. This contingent nature causes the risk to change over time and price, making risk difficult to assess and control.
2) The derivative markets are estimated at $200 - $300 trillion, dwarfing the cash markets on which they trade. This introduces an enormous amount of potential leverage into the system. The markets in general and regulatory bodies in particular do not understand the potential risks.
3) Derivative exposures are held in concentrations at large dealers. Under a high volatility scenario, the contingent nature of the exposures could lead to the bankruptcy of some of our largest institutions.
4) My fund is more concerned with the rate of change, or how fast and how far asset prices
move, than in what direction they move. We compare an expected distribution of prices to the prices of derivative instruments to gauge fair value.
5) The most important element in running a hedge fund is risk control.
- Hedge funds are revolutionizing the investment and intermediary system by making capital ubiquitous and diffusing the concentrated exposures and liquidity functions of large dealer banks. This should create more "mean" volatility but less tail risk in the long run.
- The fiat currency system and central bank creation of superfluous credit has had a cumulative effect over the last several decades. The U.S. is nearing an inflection point where the massive amount of total credit is crowding out the consumer and will be unwound by the markets. Central bank intervention has been the cause and cannot keep the situation stable indefinitely.
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