Wednesday, May 23, 2007

On Derivative For Risk Management: Richard Bookstaber's Views

Last Friday's Wall Street Journal featured a long article which constituted, more or less, a review of Richard Bookstaber's new book, "A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation."

The review sketches out Bookstaber's informed opinion that the dynamic use of various financial innovations, specifically derivatives, has contributed greatly to market meltdowns- the 1987 crash and 1998 LTCM, to name two.

Later that day, I saw a corresponding interview with Bookstaber, by the hapless Maria Bartiromo, on CNBC. Bookstaber reiterated most of the points covered in the Journal article. His response to her question concerning why Ben Bernanke would express confidence in derivatives as helping to spread risk more manageably throughout financial institutions, as evidenced by reduced market volatility, while Bookstaber is sounding a warning regarding the potential for increased, dysfunctional volatility, was quite interesting.

Bookstaber said, in effect,

"Yes, it's quiet right now, and things are working. But once they don't, watch out! That's when all hell will break loose."

Without a doubt, he's right, as is Bernanke. I discussed this with my current, and a former business partner at lunch that day. I hadn't yet heard Bookstaber's interview, but the same point was implied in the Journal piece.

The key to understanding the situation is to examine whether derivatives are used statically to guard against an unexpected, sudden market meltdown, or are planned to be used to offset a sudden and unexpected market meltdown. If you are using derivatives for the latter purposes, then, per Bernanke's view, they are beneficial. If, however, you are expecting to use derivatives dynamically amidst a market crisis, then Bookstaber's warning is correct, and, if anything, and understatement.

My partners and I all agreed, from twenty years of observing modern financial market meltdowns and crises, that the one thing of which you can absolutely be sure during a market crisis is that you cannot be certain of being able to trade any position.

Thus, there is a major difference between, say, using derivatives, such as options, as outlined in this prior post about Nassim Taleb's book, The Black Swan, and employing them in mind-numbingly complex combinations which are only underpinned by probabilistic distributional expectations, rather than straightforward, certain relationships. The use of call options to gain exposure to equity price appreciation, while removing the corresponding full exposure of price depreciation, is an example of the former. LTCM's complicated straddles and linked, cross-instrument and -market bets is an example of the latter.

When multiple derivative positions involving different instruments and markets are employed, many more assumptions regarding underlying distributions of occurrences of various price movements, and the probabilistic bets taken thereon, are often made than are realized.

Personally, I think this relates in some sense to the quality of talent going into financial engineering disciplines. Too often, less attention than necessary is paid to assumed underlying price distributions and various probabilistic assumptions on which, ultimately, so much of the value of presumed portfolio 'insurance' rests.

So, in this respect, I believe Bookstaber is right. Getting overly complicated in the use of derivatives invites failure of an investment strategy in the midst of a market meltdown that precludes any certain ability to dynamically reposition a portfolio.

Thus, as we consider options implementation of my basic equity portfolio strategy, I am mindful that it would be a static one, rather than an options approach that assumed any ability to trade in the midst of the type of rapidly-moving, unexpected market conditions. The key to successfully using derivatives is to allow them to function just by being in place, rather than hoping that a string of them move as predicted, according to 'typical' market conditions, or, if not, that they can be traded during such a market maelstrom to try to repair the damage of any incorrect assumptions.

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