The Art of Streetplay

Tuesday, July 19, 2005

A Refocusing On Liquidity Risk

I met an interesting guy today.
One point that he made was a fundamental paradigm shift from 'risk' to 'capital', and how it might be of more value to think of things not necessarily in terms of risk but in terms of capital-- how the accumulation, flow, supply and demand of capital is in many ways a more 'pure' driver of profit and loss. He mentioned having a discussion with another of the top brass at Citigroup regarding the lack of performance Citi was getting from a certain variant of a spread option. They reached the conclusion that it was not model adequacy necessarily which was creating issues; rather, it was the simple fact that it wasn't a liquid enough instrument. He spent the greatest amount of time on GM and Ford as a case in point; how it was an ideal example of how the supply and demand of capital (or lack thereof) wreaked havoc on hedge funds and banks alike. The correlation died, and while people can attempt to backfit in exactly how those securities (the mezz, the equity, and the super high grade debt piece) co-moved in the way they did, it essentially came down to supply and demand-- a large number of people putting on one position, another large number of people putting on another, a trigger event causing a spark, and there simply being no bid.
Discussion of capital flow is a perfect segue into another extremely important concept to keep in mind-- markets are non-Gaussian. Yes, we have all heard this numerous times and yes, Black Scholes is fundamentally flawed as a result, but I'm not sure it's possible to reinforce this enough.
We value derivatives by figuring out how much it will cost to hedge them. Other people may value things differently, but other people are probably wrong, to be honest. A distinction must be made between basis risk and position risk. When you put on a correlation trade on GM as was done before, and you know that in the event of structural shocks to GM, the bid will dry up on the security which secures the hedge will dry up, it is simply stupid to call your risk anything but positional. You are putting on a position-- yes, it might be fucked up, but it is nevertheless a position because you can't hedge away the systematic risk.
The important thing when putting on a derivatives position then becomes-- who are the other people in this market, where are the bids and the asks coming from, and how can I exit my trade, either synthetically or physically, should an event occur which may trigger a need to sell? If there are one or two constituencies dominating the supply of bids and/or offers, you are probably looking at a market which will be vulnerable to a dislocation. Think GM and hedge funds. Think convertibles. These are where the potential profit opportunities may come from.
Last thought. Two equivalent securities are trading at different prices in different markets. Does this mean the market is stupid? Not necessarily in the slightest. It probably means there is a capital flow imbalance creating the difference in price. How can one re-align the prices of those two securities? By finding a way to transfer risk from the less liquid security to the more liquid security. Find some way to get capital flowing. If you can create a financial instrument which will get capital flowing into the less liquid security, more power to you- you will make your profit, and you will also have distilled/disaggregated/de-concentrated the risk of that security. The main risk I am referring to is liquidity risk, which goes hand in hand with hedging costs, the ability to hedge, tying back into the discussion of basis vs position risk. That is what derivatives can do for us more easily.
Final idea. CDS is an example of a market where, in essence, we the banking community are net short. Quite a bit. While we may be actively trading these instruments to some degree, it is arguably safe to say that as the primary issuers, we are net short the securities (please correct me if I'm wrong). We are short way more than there is notional for the underlying corporate bonds. Not only that, the underlying corporate bonds are illiquid. This touches on the final point, which is that derivatives trading is changing in some ways. There is credit risk to these derivatives. Financial instruments like CDS have become extremely liquid- why? Well, for one, we haven't really worried all that much about counterparty risk. Too complicated! But where has that counterparty risk gone? It is still out there, and it is a systematic risk. We cannot fully hedge these securities, no matter how hard we may try, so what will happen when (not if) the CDS market sustains a serious shock which makes clear to the world the supply demand imbalance?


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