Category / Derivatives, Hedging and Convexity

Nothing to see here, move right along February 6, 2014 at 9:40 pm

Dear me, can’t a billionaire write a bunch of long-dated exotic derivatives without those pesky kids sticking their noses in? Warren is getting a rough ride from Dan McCrum repeatedly, and today from Matt Levine, and he doesn’t quite deserve it. Here’s why.

  • First, level three assets are not necessarily toxic. They can just be hard to value precisely. Even if Warren had just sold 20 year plain vanilla equity index puts, they would be level three, as there is no ready market in twenty year implied vol (although you can make a pretty decent guess from where the ten year is).
  • Warren is naked short. Black Scholes and related approaches are valuation techniques which work if you are hedging (and you can indeed replicate the derivative by following your model’s hedge ratios). There is actually quite a good theoretical argument (if not an accounting standards one) for him not to mark to market – an argument that would be more convincing if he has written an insurance policy that is then transformed into a derivative via an SPV. We don’t know that he hasn’t done this. But we do know for sure that Warren’s strategy is to write insurance and invest the premiums. As long as he collects enough premium and his risks are diversified, he’s happy: for him, at least at 50,000 feet, the business model is all about collecting premiums and investing them. Writing long-dated puts is a good way to raise cash – as long as you don’t have to post collateral (which Warren didn’t).
  • Even if he has written a worst-of put, this was not a particularly exotic derivative in 2006-7. Back then people were playing with a whole range of basket options (see for instance the mountain range trades originated by Soc Gen’s traders and rapidly taken up by the rest of the street). While these trade types might not be in options 101, they haven’t been cutting edge for twenty years.
  • One of the hard things about running an equity derivatives book is getting enough long-dated vega. No one wants to sell it; everyone wants to buy it.
  • So the reason there was a trade is the age-old two people wanting different things. Warren wanted cash, and saw the premium as good compensation for the insurance he was writing. His counterparties saw cheap vega that was hard to buy any other way, and a good credit. Two well informed parties with different takes on the world trading with each other is not, I am afraid, a scandal.

Pricing far out of the money derivatives in the P measure January 24, 2014 at 12:03 pm

OK, not the most attractive title in the world I know but bear with me.

Most derivatives are priced in the Q, or risk neutral measure. This is the right thing to do when you are willing and able to hedge. Essentially in the Q measure the cost of a derivative is identified with the price, according to your theory, of hedging it.

You can’t do that sometimes, often because the necessary hedge instruments are not available. This is one practical distinction between derivatives and insurance: derivatives are hedgeable, insurance isn’t. Therefore you shouldn’t price insurance in the Q measure: instead you care about the real world (as opposed to the risk neutral) distribution of outcomes.

This is important when we think about things like Warren Buffett’s basketball trade. Buffett has written insurance (not a derivative*) to protect Quicken Loans against the risk that someone will correctly predict the winner of every game in the National Collegiate Athletic Association’s men’s basketball tournament – something Quicken has offered a billion dollars for.

This is actually an interesting thing to price. If you view the tournament as IID coin tosses, then of course the insurance is worth nothing. But of course it isn’t, partly because some teams are better than others, and partly because there will be entrants to the competition with private information. It isn’t much of an edge to know that a star player is off form, but excluding a favourite team skews the distribution for very unlikely outcomes, especially if you let insiders collude by assuming, say, that someone knows the outcome of every game involving, say, ten specific teams. Moreover, you don’t just need enough premium for this insurance to pay for the expected loss; you also need enough to pay for your cost of capital supporting unexpected loss, which will be a lot as the distribution is very fat tailed. Add in the cost of actually doing all this analysis, and pretty quickly you get to a multi-million dollar premium. Indeed, something I call (after a long-retired trader) Stavros’ law probably applies: never sell any put for less than a cent of premium, no matter what the model says it is worth.

*Don’t get me started, though, on the hypocrisy of Buffett’s public statements about derivatives vs. what Berkshire actually does.

So what exactly is the rate you are borrowing at to fund that derivative? January 16, 2014 at 10:14 pm

As everyone who has been paying attention knows, JPM had a $1.5B FVA hit in their most recent results. Matt Levine riffs amusingly if sometimes a little inaccurately* about a couple of aspects of this, my favourite part being:

there is… some gap between “my funding cost” and “FVA.” It’s unclear to me how much of JPMorgan’s model is based on their own funding costs and how much is based on some “market” funding cost; the earnings deck talks about “market funding rates” and “the existence of funding costs in market clearing levels,” so it seems that they’re thinking more about a market price of funding than they are about their own cost of funding.

Oh one fun fact about that. That earnings deck says that FVA “represents a spread over Libor”; based on [JPM CFO] Marianne Lake’s comments you can guess that that spread is around 50 basis points. That is, banks fund at around Libor plus 50 basis points.

Libor, you’ll recall, is supposed to be the rate at which banks can fund themselves.

I will resist the temptation to add a smilie.

*Hint: when a lawyer rights about how exactly Black Scholes works, you might want to apply a pinch of salt. Or read a careful account of the story, for instance here or here (where the key role of the replicating portfolio is explained – although I buy the Albanese ‘not fungible with debt’ argument).

Unreliable journalism in commenting on derivatives valuation August 15, 2013 at 10:30 am

Peter Eavis has a Dealbook post which, sadly, reiterates many of the common misunderstandings about derivatives valuation. Let’s start from first principles, and try to understand what is really going on here.

Why are we trying to fair value a derivatives book? First, to create a reliable P/L which accurately reflects the value attributable to security holders. We want the right earnings so that current equity holders are properly compensated for the risk they are taking, for instance. Second, earnings volatility is the paradigmatic definition of risk, so we want earnings to accurately reflect the swings in the value of a derivatives portfolio.

The concept of fair value therefore has at its heart the paradigm that valuation should reflect where something should be sold. Now in practice large portfolios are often sold in toto rather than instrument by instrument, so a relevant question for a portfolio which can be sold this way is ‘how would a bidder value it?’ The answer, typically, is that they would take the mid market fair value then apply a spread to the risks (e.g. a vol point or two on each vega bucket), so a reasonable way to establish fair value, often, is to value at mid then take an appropriate bid/offer reserve. (That last part is important – mid alone isn’t where you can get out, so simply valuing at mid is in violation of the accounting standard and if your auditor lets you get away with that, fire them and get one who won’t.)

We now have two problems:

  • How do you establish where mid market is?
  • How do you decide if this paradigm works for your portfolio?

Neither of these are particularly difficult questions. Where there is a liquid market of buyers and sellers, then you use market prices. Where there is a liquid market in related instruments, you use those prices to calibrate an interpolator model. Where there isn’t either of those, then perhaps you can use quotes rather than real trade prices. Or if that fails, you make something up. In the latter two cases, though, you will typically need a valuation adjustment to reflect likely uncertainty in your price. Take your best guess, but then take a reserve to reflect how wrong that guess might be*.

The method will fail if your portfolio is a large part of the market, or would take a long time to liquidate. In this case the principle of valuing where you could close out the book would suggest taking an extra reserve† to reflect the price change you would cause if you tried to sell the whole portfolio. Just because you are buying and selling 1% of the position each day does not mean that the prices those trades happen at are reflective of where you could get out of the entire position.

In the Whale farrago, JP (it seems) neither took a prudent bid/offer valuation adjustment nor took an adjustment to reflect the size of their position. This has nothing to do with derivatives being murky and everything to do with not complying with the basic idea of marking to where you can get out of the portfolio.

The usual line peddled at this point is that none of this would be possible if all derivatives were traded on exchange. That’s false. Many exchanges are replete with illiquid contracts where the last published trade price is not reflective of where the current market would be were anyone to try to trade. (Just trying looking at pretty much any far from the money single stock listed equity option, or any commodity/energy contract away from a few benchmarks.) Exchanges are not a replacement for good product control teams trying, daily, to test prices: indeed, if their prices are used without thought, they can be far more dangerous than letting the traders tell you where the market is, then diligently checking.

Financial instrument valuation involves a lot of grunt work. Multiple data sources, experienced individuals, prudent reserves/valuation adjustments and skepticism are all required to do a good job. That’s true of exchange-traded instruments and OTC ones. The estimation of fair value is an important discipline, but it is vital not to lose sight of the fact that it is, despite all this work, an informed guess. There is no platonic ideal of the right price out there waiting to be discovered, especially not for any really big position whether in securities or derivatives. We can rightly blame JP for not doing a good job in forming its estimate, but we should also understand that perfection is unattainable. If really want to know where you could sell a position in any financial instrument the only way to find out is to sell it.

*You do it that way rather than using a ‘prudent’ (i.e. wrong) mark first because you want the price and its volatility to be the best guess (especially if you are hedging), and second because you want to flag to management and owners the uncertainty in that price.

†One of the many changes in accounting standards that have made things worse in recent years is that these size-based price adjustments are often disallowed in US GAAP. What were the FASB thinking of?

Update. Wot he said, too. Especially the bit about loans. Indeed, this qualifies for quote of the day status:

Compared to, like, banking, JPMorgan’s CIO portfolio was a model of transparent valuation, even with the fraud.

Lehman, five years later May 17, 2013 at 9:06 am

Matt Levine has an excellent dealbreaker post which in turn references a Bloomberg story on Lehman’s derivatives. The facts first:

Almost five years after Lehman Brothers filed for bankruptcy and set off the global financial crisis, managers of the bank’s estate are demanding millions of dollars from retirement homes, colleges and hospitals… [For instance] The Buck Institute for Research on Aging in Novato, California, gave Lehman $2 million in October 2008 to cancel a swap contract used to manage fluctuating interest rates. Lehman [now] says it wants $12.1 million more and has assessed at least an additional $4.7 million in interest, the research center said in its most recent financial statement.

5y USD swap rate after Lehman

There are at least two important issues here. First, as Levine points out, when you closed your swap out with Lehman matters hugely for valuation. (I have cropped the market data he gives to show the USD 5y swap rate in the period after the default: look at that volatility in late 2008.) The CSA you had with Lehman matters too, as does whether you use market valuation or actual close-out (which in turn depends on the details of your master agreement with them), what CSA you had with the party you closed out with, and so on. Moreover, the naive idea that your claim against Lehman is the price you closed out isn’t necessarily true. Levine quotes from the Federal Home Loan Bank of Cincinnati’s 10-K:

We had 87 derivative transactions (interest rate swaps) outstanding with a subsidiary of Lehman Brothers, Lehman Brothers Special Financing, Inc. (“LBSF”), with a total notional principal amount of $5.7 billion. Under the provisions of our master agreement, all of these swaps automatically terminated immediately prior to the bankruptcy filing by Lehman Brothers. The terminations required us to pay LBSF a net fee of $189 million, which represented the swaps’ total estimated market value at the close of business on Friday, September 12… … On Tuesday, September 16, we replaced these swaps with new swaps transacted with other counterparties. The new swaps had the same terms and conditions as the terminated LBSF swaps. The counterparties to the new swaps paid us a net fee of $232 million to enter into these transactions based on the estimated market values at the time we replaced the swaps.

Now, that difference in value could have been a market risk gain based on a period of open exposure in very volatile markets. But it could also be partly a mismatch between the close-out amount the Home Loan Bank paid Lehman and the real market price. You can see how a lawyer might think that there is a case there, especially one paid to maximise the value of Lehman’s estate (for the benefit, let’s remember, of other creditors).

I am not sure how to react to this. The knee-jerk response is to demand that the close-out process is defined so as to lead to less disputable results, but doing that is not straightforward. What is applicable for the (unusual) Lehman-like events probably isn’t appropriate for much smaller (and more usual) close outs. Moreover, any claim on a bankrupt must, ultimately, be subject to scrutiny by the bankruptcy courts, and must adhere to underlying legal principles (like anti-deprivation). So the right policy here is not obvious. But certainly the risk of closing out then, years later, having that process challenged by the defaulter’s estate with the potential for large amounts of interest being assessed as well as the original claim, is material. Whether there is anything that can be done about it is less clear.

JP with madeira and a tea cake* March 17, 2013 at 11:52 am

It seems that JPMorgan’s travails have become a spectator sport, to be enjoyed with a snack of your choice. I am only half way through the senate report, let along the appendices, so I won’t add to the (already comprehensive) guides to the action‡.

Instead I want to focus on four key issues which emerge from this debacle.

  1. CIO wasn’t hedging. Like Matt Levine, I had bought the firm’s line that the original portfolio was a macro hedge against the loan book. It is now clear that while that might, in the mists of time, have been the original motivation, the CIO’s office had turned into a prop trading center by 2012. This happened without, as far as I can tell, any authorisation, any redesign of the risk framework, or any changes in oversight. Mind you, given that the risk framework was not based on how well they were hedging anyway, that is hardly a surprise.
    The Machiavellian analysis of this is that they were trying to prop trade while avoiding Volcker. My gut feeling is that it wasn’t that: they were simply out of control.
  2. As Lisa says, mis-marking is key here. The practice whereby, in complete violation of what the accounting standard actually says, US banks are permitted to mark derivatives anywhere between bid and offer must now receive attention. Supervisors must ensure that firms mark at where they can exit the position as it is absolutely clear that external auditors cannot be relied upon to police valuation practice.
  3. My earlier conjecture that capital management was central to the whale losses is born out. But it is worse than I thought: capital optimisation was mostly about changing the model so that it generated lower numbers. This was wholly cynical, and is bound to increase the pressure to reduce the capital benefit available from the use of internal models§.
  4. While JP undoubtedly kept things from the OCC, the OCC’s process allowed JP to make model changes without sufficient oversight, did not exercise control over valuation practices, and had little idea what was going on in the CIO. After all, the story was broken by journalists based on public information.
    While all the focus so far has been on JP’s mis-deeds, JP’s supervisors do not emerge from this covered in roses.

It will be interesting to see if the Senate can keep up the (encouragingly bipartisan) momentum here. One is uncomfortably aware that a confrontation may be brewing with politicians and public on one side, and the big banks, the OCC, and perhaps the FED on the other. If it really does pan out that way, the legitimacy of current regulatory arrangements may not survive the fall-out.

*The reference is to an extraordinary radio interview that Paul Roy, ex-head of equities at Merrill, gave about the old days on the London Stock Exchange, in which he claimed his equity traders used to enjoy a glass of madeira, or perhaps champagne, as a mid-afternoon pick-me-up. O Tempora, O Mores.

‡See also here and here. One delicate point, by the way, which I have not seen anyone really pick up on, is what ‘lag’ means in the transcripts. It seems to mean the time between general economic improvements affecting the HY vs. the IG indices, but it could also mean the difference between it affecting the spread of the components vs. the index itself. Given that JP’s opponents where hedging mostly using the components, JP was very exposed to the index/components basis.

§See the recent speech from Stefan Ingves here. Ingves says that “Major [Basel Committee] projects currently under way include: … completing the review of the trading book capital requirements. This entails an evaluation of the design of the market risk regulatory regime as well as weaknesses in risk measurement under the framework’s internal models based and standardised approaches.”

No one owns stock February 8, 2013 at 9:03 am

A timely reminder from Matt Levine:

nobody owns stock, they just own interests in their brokers’ interests in DTCC’s interest in stock. “Oh I own AAPL shares,” you say, but you don’t; you own like a second derivative on Apple shares. A delta-one derivative but still.

What Taleb might mean November 20, 2012 at 7:35 am

It is perhaps to my discredit that I don’t have the interest, stamina, or bloody mindedness to go through Taleb’s technical papers (HT FT Alphaville*). Still, a glance at them and hefty dose of imagination quickly gave me what I think he might mean in the first few pages, at least from 50,000 feet.

The first thing to note is that options have vega: they are sensitive to changes in implied volatility. For our purposes vega can be thought of as a measure of sensitivity to being wrong about the asset return distribution. Naively it’s `I thought it was log normal with a 30% volatility, and it turned out to be log-normal with a 31% volatility – how much did I screw up?’

The second point is that vega is highly strike dependent. A 1% change in vol for a five year ATM option might make only a 2% difference in option value: it makes nearly an 8% difference for a 200% strike on the same underlying. This is (I think) what Taleb calls tail vega. It is simply the observation that being wrong about the distribution matters more for out of the money options. Pricing far OTM options is fragile: one knock of the distribution and you are screwed. Far OTM puts are particularly bad because vols rise as the markets crash, and you get crushed by both the gamma and the vega.

In contrast there are some products that are not very sensitive to being wrong about the distribution. What a savvy tail risk hedger tries to do is either buy cheap protection – i.e. find implied vols that are ‘too low’ – or find a product which is relatively vol insensitive yet is still long the downside.

The hard part is that ideally you want to do this analysis not with respect to a mis-parameterised distribution – it’s log normal but we don’t know the vol – but rather with respect to some class of distributions. What class do you pick, though? Too general, and you can’t prove anything, plus there are lots of distributions that really don’t occur in nature that you are trying to talk about; too narrow, and you risk missing the `real’** one. So the whole game in work like this is figuring out what class is general enough to capture some interesting fat tailed distributions, yet narrow enough you can prove something***. This is grandiosely termed meta-probability, but all it really is is hunting for a tractable class of distributions to do the meta-theory on.

*You would get a precise link except my session on the FT website has timed out and I can’t be bothered to login again. Honestly you would think the FT is trying to reduce readership…

**To the extent that even makes sense (which isn’t far).

***I am pretty sure I can come up with return `distributions’ (under a sufficiently loose construction of the term) that break all of Taleb’s theorems, but they would be insanely pathological – something Lebesgue integrable but not Borel measurable would be a good start. What, you wanted something continuous?

So about those Ozzie swaps September 28, 2012 at 8:43 am

From the Wheatley review final report:

5.9 Therefore, the Review recommends that the number of currencies and tenors for which LIBOR is published be reduced. Specifically:

  • publication of all LIBORs for Australian Dollars, Canadian Dollars, Danish Kroner, New Zealand Dollars and Swedish Kronor should be discontinued;
  • for remaining currencies, publication of LIBOR for 4 months, 5 months, 7 months, 8 months, 10 months and 11 months tenors should be discontinued;
  • continued publication of overnight, 1 week, 2 weeks, 2 months and 9 months should also be re-considered.

The maturity restrictions are probably not a big deal but the currency ones are. As IFR says, this could trigger years of lawsuits if the floating rate for trillions of dollars of swaps disappears.

The Libor problem in three illustrations August 10, 2012 at 10:11 pm

From the Wheatley review (HT Lisa Pollack at FT alphaville), three illustrations.

First, how many contracts use Libor?

Using Libor

Quite a lot then, especially swaps.

Second, which Libors do all those swaps use?

Using Libor

3 and 6 month. OK.

Third, which Libors actually trade?

Using Libor

Ah. So 3m kinda trades and 6m doesn’t trade. Still, what could do wrong with a multi-trillion-dollar business linked to a fictional interest rate?

Swap pricing in the face of regulatory uncertainty July 6, 2012 at 10:43 am

There’s a problem in corporate swaps. It’s this.

  • Basel 3 has a capital charge for CVA risk.
  • This charge increases the price that some corporates will have to pay for their swaps, given their current credit support arrangement.
  • The EU may or may not grant an exemption from this charge for many corporates. It’s a political issue, and impossible to call.
  • So given you don’t know if you will have to pay the charge or not, do you price it in?

Risk magazine amusingly tells us:

Three banks that spoke to Risk for this article all claimed to be assuming there would be no exemption. They also said rival dealers are doing the opposite.

You might say ‘of course they would say that’. But there is a problem here, and it isn’t going to be resolved any time soon.

Models, prices and liquidity July 5, 2012 at 10:39 am

It is relatively simple to see the liquidity of a bond. You see how many times a day (or week, or year) it trades.

A commenter on a prior post suggested that the number and spread of these quotes is also a useful indicator of liquidity. I’d agree, with the caveat that a quote is not necessarily good in the size you have, nor is it necessarily a firm commitment to trade.

For OTC derivatives markets, though, things become murkier. This is because most derivatives have a maturity, and as time passes, that gets shorter. Your on-the-run five year swap today becomes a four year 51 week swap next week, and that isn’t liquid.

The problem is typically solved with a model. We build yeild curves, credit spread curves, vol surfaces and so on. The liquid instruments define points on these curves which the model is calibrated to; everything else follows by interpolation. (Or, if you want to take significantly more risk, extrapolation.) A model in this setting is just a fancy interpolator.

The advantage of this system is that it allows market participants – mostly – to price things that don’t trade. You can get a quote on your four year 51 week swap despite the fact that that particular instrument won’t trade this week precisely because its price is in a reasonably clear relationship to that of the five year swap that does trade.

Problem start to arise when the benchmarks themselves become illiquid or otherwise doubtful. The whole system relies on the benchmarks being liquid, so that the are known prices to interpolate between.

This brings us to Libor. If banks don’t lend to each other for three or six months, then 3m and 6m Libor are conjectural. That means that the benchmark swaps (and the Eurodollar futures) are themselves uncertain in value, and liquidity in them might start to decline. At that point you won’t be able to price any interest rate derivative.

Now, I don’t claim that this will happen. But without a floating rate that the market has confidence in, there has to be some risk of it. For me, this is a far more important financial stability issue than Mr. Diamond’s employment status.

Li-what? June 28, 2012 at 7:22 am

Good questions from Dealbreaker, apropos the ongoing Libor issues:

If Libor isn’t just a trimmed average of some numbers that some banks tell someone from Reuters every day, then it is … the risk-free rate? The unsecured borrowing rate for AA banks? The unsecured borrowing rate for an actual assortment of disparately rated, often barely investment grade, rather tarnished banks that mostly don’t actually lend to each other?

Don’t worry, though, there are only a few hundred trillion dollars worth of contracts linked to Libor. Bob is handing back his bonus, and that is an act that one can applaud. But there are more serious issues here than an attempt to move the rate – like what happens to all those swaps that reference 3 or 6 month Libor in a world where there is little or no 3 or 6 month unsecured borrowing by banks.

Quote of the day June 25, 2012 at 9:20 am

From MacKenzie and Spears, apropos JPMorgan:

a ‘hedge’ is not a self-evident feature of the world, but a contestable cultural category.

Yes, Alphaville got there first, but honestly the whole paper really is worth reading. It very much backs up my suggestion a few days ago that it is not models-as-hedge-parameter-generators that were the problem, but rather models-as-indicators-of-absolute-value.

There is also an interesting discussion of what the authors call counter-performativity, and what I would call a crowded trade:

there are multiple mechanisms of counterperformativity, in other words multiple ways in which the practical use of a model can undermine its empirical adequacy… no-arbitrage models may be associated with a distinctive mechanism of counterperformativity, in which the hedging practices those models demand have effects on the market for the underlying assets that undermine the empirical adequacy of the views of asset-price dynamics embedded in those models.

In other words, if many people (or one very large player) is hedging the same position using a model, then the relationship between the derivative and the underlying can breakdown quite dramatically. My first exposure to this was the impact of the LTCM crisis’ on equity derivatives: many players were short long-dated equity vol into retail products, as were LTCM. A big bank, for reasons I won’t go in to, had to close out a big short vega position, and the market mostly knew it. Thus FTSE 5 year ATM vol went from the teens to the forties, and stayed there until the forced close out happened.

The model doesn’t say ‘this works if not everyone is the same way around’ but you would have to be a poor trader or risk manager not to know it…

Paying for resolution, practically May 29, 2012 at 9:51 am

So how would this pay for resolution by writing calls thing work?

Well, first you need to calibrate the system. Fortunately Joe Noss and Rhiannon Sowerbutts (HT FT alphaville) have recently analysed the implicit UK taxpayer subsidy to banks, and concluded that it is at least £30 billion per year across the cycle. As a starting point, let’s assume that we want half of that money back.

That means UK banks have to write £15 billion of physically settled one year at the money equity call options on their own stock to the Bank of England every year. You could determine individual bank amounts based on capital (or something else like balance sheet size); so for instance Bank H might have to write each year enough call options to be worth

£15 billion x Bank H RWAs / (sum of all Bank RWAs)

These would be priced using market implied volatilities, and hedged as usual by the central bank shorting bank H equity.

This process would lock in the value of those options, assuming that the hedge was successful – and frankly it isn’t too difficult to hedge one year plain vanilla call options in reasonable size: these are not funky credit derivatives. Big market moves would make the central bank money as it is long gamma and long vega; quiet markets, where all was well in the banking system, would result in the central bank failing to capture some of the calls’ value. That’s OK, though; you don’t mind having less in the pot when times are good providing the pot magically refills in bad times, as it will.

Now let’s roughly size the suggestion. HSBC has roughly 40% of UK bank RWAs, so it should pay 40% of the total. That is, each year, it should write £6 billion worth of calls to the Bank in this model, an amount corresponding to roughly 30% of its earnings. One at-the-money call on HSBC is worth very roughly 60p (I am rounding like crazy as this is all very approximate), so this year it would have had to have written calls on 10B shares. Ooops. That’s half the shares outstanding. There’s no way you can hedge a position that big efficiently, and market knowledge of dilution that large would kill the share price.

What do we conclude from this? Well clearly this idea can’t monetise all of the implicit taxpayer subsidy. But it certainly could monetise 10% of it. £3 billion a year in the pot to cover the costs of RBS/LBG/Northern Rock type events would be a good start.

Paying for resolution May 28, 2012 at 10:31 am

Acharya, Mehran, Schuermann and Thakor have an interesting but ultimately flawed idea. They suggest:

a special capital account in addition to a core capital requirement. The special account would accrue to a bank’s shareholders as long as the bank is solvent, but would pass to the bank’s regulators — rather than its creditors — if the bank fails.

This part is not so bad. It does rather imply that all banks will be rescued/resolved rather than giving supervisors the option to go through bankruptcy, but that is perhaps the new reality anyway. The problem comes in how they suggest that the level of the account is set:

the quantifcation of the capital requirement need not depend exclusively on the use of historical data for calibration of the bank’s risks; instead, it would rely on several different approaches, such as market-based signals of bank-level and systemic risk as well as regulatory intelligence gathered through periodic stress tests of the fnancial sector.

This is reasonable from a financial stability perspective, but less so from a capital planning one. Banks need some certainty about their capital requirements whether direct or in a new capital account. Moreover ‘market-based signals’ risk being hugely procyclical.

A better approach would be to force banks to issue a fixed fraction of their earnings to the central bank as equity call options. This would have several big advantages:

  • It is anti-cyclical at both the systemic and the individual bank level;
  • The supervisor could accrue a cash by hedging these calls. This hedging activity would also be anticyclical, shorting bank equity as equity prices go up, and buying back the short when prices fall.
  • Those banks who profited most from the financial system would contribute the most.
  • Banks would have a clear idea of the size of the buffer, facilitating capital planning.
  • Supervisors would make more money hedging the calls just when it is most needed, that is in times of increased bank equity volatility.

Now of course the idea of a central bank having an equity derivatives hedging activity is new and perhaps radical. But radical ideas are not always wrong.

Hedge me up before you go, go May 14, 2012 at 11:26 am

Hedges, pace JP Morgan, are meant to reduce risk. There are, it seems to me, two important ways to hedge. Although real hedges overlap between these categories, the distinction is useful.

First, there are P/L volatility hedges. Here the idea is that risk is earnings volatility, and that you have some position which generates earnings volatility, which you want to remove. At its extreme, you may be happy with the long run risk of the position, but the ride is too bumpy in the short term. Hence you put on a hedge which is likely to move from day-to-day in an equal and opposite way to the position. Buying protection on the CDX against owning a diverse portfolio of corporate bonds would probably count as a P/L volatility hedge.

Second, there are tail hedges. Here something bad, while perhaps unlikely, could happen, and you want something that will pay off to offset your losses in that bad situation. Thus for instance you might buy an out-of-the-money put against owning an equity to hedge against sudden bad news.

Now here’s the interesting thing. Often, the type-two hedges are more effective at protecting the firm when it matters, but type-one hedges can look better. Management scrutinise the P/L every day, but (in many firms, it seems) they don’t have detailed knowledge of the positions. The type-one hedges look good as the P/L doesn’t move. Moreover, risk reports that concentrate on small moves would show them as low risk. Hedges like this often fail in stress conditions though – exactly where type-two hedges work.

Hedging the second way is organizationally difficult. It involves educating management why the P/L is volatile from day-to-day, and why the risk reports show substantial risk from small moves (albeit proportionally much less from large ones). It also involves being right about what tail event(s) are possible, and covering those; there is nothing worse than paying for a tail risk hedge then discovering that you have hedged the tail of the wrong risk factor.

If the risk is large enough to get external attention, then the problem is even worse. Trying to explain tail risk hedging to journalists or equity analysts after you have had an earnings miss is difficult, and management don’t want to run the risk of that embarrassing call.

The net result of all of this, I suspect, is that a lot of type-one hedges are put on that are utterly superfluous to the bank, while too few type-two ones are executed.

Floating carcus ahoy May 11, 2012 at 9:20 am

When Magellan emerged from the strait that bears his name into the Pacific ocean, he thought that he was only a few days sailing from Portugal and home. Good try, but no cigar. A similar navigational issue seems to be plaguing folks over last night’s $2B JPMorgan loss. Here are some things we can, and cannot conclude from this ‘egregious’ loss.

Update. FT alphaville makes a similar point about the difficulty of identifying a ‘good’ hedge here.

Does your CVA hedge generate CVA? April 26, 2012 at 9:10 am

Yes, it (often) does. Credit Suisse offers us an example. First, what we know, from CS themselves.

In 1Q12, we entered into the 2011 Partner Asset Facility transaction to hedge the counterparty credit risk of a referenced portfolio of derivatives and their credit spread volatility. The hedge covers approximately USD 12 billion notional amount of expected positive exposure from our counterparties, and is addressed in three layers:

  1. first loss (USD 0.5 billion),
  2. mezzanine (USD 0.8 billion) and
  3. senior (USD 11 billion).

The first loss element is retained by us and actively managed through normal credit procedures. The mezzanine layer was hedged by transferring the risk of default and counterparty credit spread movements to eligible employees in the form of PAF2 awards, as part of their deferred compensation granted in the annual compensation process.

We have purchased protection on the senior layer to hedge against the potential for future counterparty credit spread volatility. This was executed through a CDS, accounted for at fair value, with a third-party entity. We also have a credit support facility with this entity that requires us to provide funding to it in certain circumstances. Under the facility, we may be required to fund payments or costs related to amounts due by the entity under the CDS, and any funded amount may be settled by the assignment of the rights and obligations of the CDS to us. The credit support facility is accounted for on an accrual basis.

Basically, then, three parties own the credit exposure on CS’s OTC derivatives portfolio: the bank themselves, their employees, and a senior hedge provider. Selling the mezz to the employees (in lieu of bonus) is really smart as it gets around all sorts of disclosure and alignment of incentives issues associated with a third party hedge.

What’s left is presumably AAA risk or pretty close. But – and here’s the rub – the hedge provider has written a CDS on it. That’s an OTC derivative. So that generates CVA. Moreover like any senior tranche, while losses on it might be unlikely, there can be serious MTM volatility. So I bet, to keep the CVA down, CS has got its counterparty to agree to daily cash collateral but the counterparty, worried about the liquidity implications of this, has got CS to agree to lend it the money. It’s just a round trip. CS’s loan book lends money to the counterparty, who post it straight back as collateral under the CDS. Look, no CVA on the hedge, and all of our capital requirements on the CVA are gone. Magic, isn’t it?

(HT Dealbreaker.)

CVA securitization February 23, 2012 at 9:33 am

When the RMMG (as it then was) issued the CVA capital rules in Basel 3, I said that they would lead to a number of capital arbitrage deals. Street talk was that the Swiss were first off the blocks; now we learn from Euroweek (HT FT Alphaville) of a deal by RBS:

Royal Bank of Scotland is in the market with a highly innovative capital relief trade, dubbed Score 2011-1, securitising a $2bn book of credit counterparty risk.

There are some challenges to getting both default risk and CVA charge capital relief in a securitization structure, but they aren’t insurmountable. I predict 2012 will see a goodly number more such deals.