The Art of Streetplay

Thursday, July 14, 2005

Thoughts on a Variant of Information Cascades; Examples; Relationships to Hedge Funds

When disaster strikes, all correlations go to one. Why look at information cascades only? Situations may cascade as well. For example, private equity firms and many hedge funds frequently use large amounts of leverage. The pain inflicted on them by losses and by rising interest rates is not really a linear one. Once a hedge fund, for example, loses a certain amount of money it will probably need to de-lever to hold steady its target leverage ratio. Where will it get that money from? From its existing portfolio. Should the company need money enough, it doesn’t matter whether the stocks in its portfolio are good or not. The fund will need to liquidate in either case, because it needs the money. Stock sales by one fund will have little impact on the overall market, but if the market turns on a wide enough base of funds (it has a tendency to do that), and a decent number of funds induce selling pressure in an effort to de-lever, the market will decline further. As the market declines further, all those people out there with long positions will again take a beating, and once again the funds are faced with rising leverage ratios—a potential vicious cycle has been created.

Putting on the forensic hat, one can notice similarities between cascading situations. Most notably, cascades form when the support which has fueled your gain will not be there to support you in loss-- cascades typically have weak support. Leverage is a weak support. And there is widespread leverage in the marketplace today, especially due to the prevalence of hedge fund on funds, which have multiple layers of leverage.

It would probably be very profitable to identify situations in which cascades have formed, because these are the situations which have the potential to spiral out of control in a logical, pseudo-predictable manner. They are usually situations which over shorter increments follow a linear pattern, but past a certain threshold, become non-linear.


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