Tuesday, August 21, 2007

Leverage in the Market - Article by Rick Bookstaber & My Reply

On August 17th, Rick Bookstaber posted an article that he wrote for Time Magazine. My comments to him, and a link to his article, are set out below:
I really liked the Time piece.

You neglected, I assume for brevity’s sake, to mention the leverage inherent in derivatives, which is incalculable.

What is known is that notional value of OTC derivatives outstanding is more than $415 trillion at 12/31/06 (per Bank of International Settlements Quarterly Review, June 2007). This is a nearly four-fold increase from the $111 trillion at 12/31/01.

The vast majority of these positions are hedged against securities (or physical assets, as appropriate) or other derivatives, but some are speculative positions.

There are a great many players in these markets, each with their own proprietary positions and strategies (almost all of which are closely guarded secrets – although recent events indicate that, as you noted elsewhere, some appear to be highly correlated - as you wrote in your post of 8/16). I believe, therefore, that there are significant potential liquidity and counter-party risks (particularly given that there are still a number of problems in the recording and settlement of these positions per BIS).

Furthermore, the ability of hedge fund LPs to redeem their interests for cash on a somewhat regular basis (perhaps requiring the unexpected unwinding of illiquid positions), while technically not leverage, means that these funds are exposed to the risk of a run of redemptions (subject, of course, to the terms of the specific LP agreements).

All of this complexity, I believe makes any estimate of effective leverage almost, if not completely, incalculable.

As long as markets remain somewhat rational, there shouldn't be a problem. As you point out in your book, however, tail events DO happen and the impact would be potentially catastrophic. Hopefully I'm overstating the potential impact.

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