WINNERS
Billionaires and Millionaires. Some Facebook investors and employees had a very good day. A few of them became billionaires and quite a few became millionaires.
Facebook. The fact that there wasn't much of a pop in the stock after trading began means that Facebook left little money on the table when it priced the offering at $38 per share.
Selling shareholders. More than half the stock offered was sold by investors and employees who had gotten their stock privately before the IPO. The lack of a big pop means they, too, left little money on the table when they sold.
California. The State of California stands to collect something like $2 billion in taxes from sales of Facebook stock by state residents. With the state's finances in the fiscal ICU, that's like manna from heaven.
Short sellers. The fact that the stock closed barely above the offering price indicates that many shareholders are looking at Facebook as a short term play. Like wolves scanning a herd of caribou for any animal displaying signs of weakness, short sellers are always on the alert for flagging shareholder interest. They may find a juicy target in Facebook.
LOSERS
Nasdaq. The opening of trading in Facebook was delayed for "technical" reasons that are now being poked into by the SEC. Press reports indicate that order execution for many investors was sloppy and slow. Not the kind of publicity Nasdaq needed from the highest profile IPO of the year.
Morgan Stanley. MSCO got the highly coveted lead underwriter position. Then it had to earn its fee when the stock began threatening to drop below the $38 IPO price. MSCO may have bought a shipload of stock toward the end of Friday, when trading opened, in order to keep the price above $38. Tomorrow, the second trading day for Facebook, could bring more challenges.
Money managers. Mutual fund managers and other money managers like IPOs with big opening day pops. They use their market connections to score a big allotment of the IPO, and sell some of it into the pop, getting a fast buck that's needed. Most money managers don't match the S&P 500, and non-typical gains like IPO pops are important to help them stand out from the crowd. Facebook wasn't a good IPO for them.
Tech companies planning IPOs. The tepid Facebook pop may put a damper on IPOs planned by other tech companies. The "technical" problems encountered by Nasdaq, market of choice for tech companies, won't add to anyone's enthusiasm. If investors don't have a good time with a high profile IPO like Facebook, they'll be wary of other, less glamorous ones.
Mark Zuckerberg. Billionaire, just married, he's got to feel like he's at the top of the world. The market will disabuse him of that notion in a couple of trading days, at most. He'll learn that public company stocks are traded short term, which means that he's expected to deliver, every quarter on the quarter end. Whatever his long term goals for the company, the short term performance will have to be gorgeous, and then more gorgeous the next quarter, or the stock price will be hung, drawn and quartered (pun intended). It gets personal, too. One lousy press release from the company, and bad things will be done to his effigy. He'll be made to understand, not in a fun way, that short sellers will be a permanent presence in his life, trying to financially actualize schadenfreude. Sooner or later, one or more of Facebook's officers, directors and employees will leak inside information to family and/or friends, and embarrass the company when federal authorities swoop in. He'll feel betrayed, but he won't be able to prevent it. He'll feel every uptick and downtick of the stock's price, because shareholders will make sure he feels ticks. Any significant failings by the company will lead to his introduction to the most prominent class action plaintiffs lawyers in America. As SEC rules compel him to make disclosures about his compensation, perks, transactions with the company, holdings of company stock and a variety of other things, he might end up feeling like he has less privacy than the most effusive of Facebook users. Surely, Zuckerberg has already been counseled by his advisers about all of the foregoing. But the reality of his new life running a public company won't sink in until he lives the full, graphic experience. There's a price to pay for going public, and the bill collectors are gathering.
Showing posts with label short sellers. Show all posts
Showing posts with label short sellers. Show all posts
Sunday, May 20, 2012
Wednesday, February 24, 2010
Why the Derivatives Market Will Surpass the Stock Market
After the financial crisis of 2007-08, and now the ongoing sovereign debt crisis, the derivatives market will, for many, live in infamy. Mortgage-related derivatives have pretty much disappeared, although many old ones continue to bedevil the banking system. Derivatives products for governments have been suddenly thrust into the spotlight by the sovereign debt crisis, and it's likely that these products will lose popularity as a result of their newly-found notoriety.
But the derivatives markets will live on, and mostly likely thrive, because the heat is on in the stock markets. Today, the SEC placed controversial limitations on short selling. If a stock's price drops 10% during a trading day, short selling will be permitted only if the national best bid price for the stock rises. This limitation will continue for the rest of the trading day and the following trading day. A number of hedge funds, including some that are known to focus on short selling and others not, opposed this restriction. So did at least one large bank, Goldman Sachs, which earns a lot of profits from proprietary trading.
The fact that professional traders opposed the short selling ban indicates that the prospects for the derivatives market are good. If the pros can't short sell stocks, they'll look for derivatives contracts that accomplish the economic equivalent. Indeed, a big bank like Goldman might take the lead in developing such contracts. An important reason why derivatives were so central to the growth of the mortgage market is that the lack of regulation of mortgage-related derivatives allowed the big banks to develop products and ways of doing business that were highly profitable (at least in the short run, but that's what matters for determining executive bonuses). There is considerable demand in the markets for the ability to sell short. The only question is what alternatives could be created to circumvent the new short selling restrictions.
The obvious stratagem would be to create a derivative in the nature of a single stock futures contract or a similar forward contract for delivery of the stock. Any such contract would presumably not be listed on a U.S. commodities exchange (the point is to avoid regulation), but would be traded over-the-counter. If necessary, it could be transacted overseas, in a friendly regulatory environment where the government didn't necessarily coordinately closely with U.S. regulators. If the firm offering such a derivative wanted to cover its exposure, it could itself trade in this friendly environment to hedge the customer contracts it sells, and just about no one would know the better.
Then again, the firm offering the derivatives equivalent of a short sale might not want to cover its exposure. The big money in proprietary trading comes from making one-sided bets in markets where prices are volatile. The day-to-day humdrum of market making in a stable market is like operating a grocery store--you make pennies at a time if you make pennies at all. If a firm thought itself skilled at making proprietary bets, it might take on unhedged exposure in the hope of hitting a home run. Sometimes, these bets pay off, and the temptation will be there in a world where the size of one's bonus establishes one's social standing. Without regulators around to frown about undue risk, temptation may triumph, as it did in the mortgage derivatives market.
Either way, the new short sale restrictions will hinder the small, individual investor trading a few tens of thousands of dollars in an online brokerage account. But the big boys with financial muscle will further the evolution of the derivatives market.
Another sign that the derivatives market is destined for growth is the news story that emerged in late January reporting that the exchanges are thinking about asking the SEC for authority to price quotes and transactions in increments less than a penny. See http://www.reuters.com/article/idUSTRE60P4PQ20100126. Apparently, alternative tradings systems like the so-called dark pools are pricing in sub-penny increments, and the exchanges are thinking they might need to meet the competition. The problem will be that the bid-ask spread (the difference between the bid price at which investors sell stocks and the ask price at which they buy stocks) will shrink when sub-penny prices are used. The bid-ask spread approximates the profit potential for brokerage and specialist firms making markets. As it shrinks, the profitability of the stocks business will diminish as well. Big bonus mania will push the financial firms toward the derivatives markets, where opacity is king and bid-ask spreads are indeterminate from the customer's standpoint (or, as much as the traffic will bear, from the dealer's standpoint). For a real-life illustration of how opacity and big profits intertwine, see http://blogger.uncleleosden.com/2010/02/will-wall-street-get-pass-on.html.
If serious reform of derivatives regulation by the U.S. and other major economic powers was in progress, the blessings of transparency would spread across the derivatives market and stratagems to circumvent the short selling restrictions would be harder to develop. Furthermore, the expansion of the derivatives market that is rendered inevitable by the shrinking margins in the stocks business would be fairer to investors. But the prospects for meaningful reform have diminished as the stock market has partially recovered and Wall Street has mounted a relentless anti-regulatory lobbying campaign. That leaves unchecked a humongous loophole in the regulatory structure through which the big banks can shove investors' money into an opaque and ungoverned environment where, as with mortgage-backed and mortgage-related investments of the early and mid-2000s, another shadow banking system can evolve, bubble up and pop again.
But the derivatives markets will live on, and mostly likely thrive, because the heat is on in the stock markets. Today, the SEC placed controversial limitations on short selling. If a stock's price drops 10% during a trading day, short selling will be permitted only if the national best bid price for the stock rises. This limitation will continue for the rest of the trading day and the following trading day. A number of hedge funds, including some that are known to focus on short selling and others not, opposed this restriction. So did at least one large bank, Goldman Sachs, which earns a lot of profits from proprietary trading.
The fact that professional traders opposed the short selling ban indicates that the prospects for the derivatives market are good. If the pros can't short sell stocks, they'll look for derivatives contracts that accomplish the economic equivalent. Indeed, a big bank like Goldman might take the lead in developing such contracts. An important reason why derivatives were so central to the growth of the mortgage market is that the lack of regulation of mortgage-related derivatives allowed the big banks to develop products and ways of doing business that were highly profitable (at least in the short run, but that's what matters for determining executive bonuses). There is considerable demand in the markets for the ability to sell short. The only question is what alternatives could be created to circumvent the new short selling restrictions.
The obvious stratagem would be to create a derivative in the nature of a single stock futures contract or a similar forward contract for delivery of the stock. Any such contract would presumably not be listed on a U.S. commodities exchange (the point is to avoid regulation), but would be traded over-the-counter. If necessary, it could be transacted overseas, in a friendly regulatory environment where the government didn't necessarily coordinately closely with U.S. regulators. If the firm offering such a derivative wanted to cover its exposure, it could itself trade in this friendly environment to hedge the customer contracts it sells, and just about no one would know the better.
Then again, the firm offering the derivatives equivalent of a short sale might not want to cover its exposure. The big money in proprietary trading comes from making one-sided bets in markets where prices are volatile. The day-to-day humdrum of market making in a stable market is like operating a grocery store--you make pennies at a time if you make pennies at all. If a firm thought itself skilled at making proprietary bets, it might take on unhedged exposure in the hope of hitting a home run. Sometimes, these bets pay off, and the temptation will be there in a world where the size of one's bonus establishes one's social standing. Without regulators around to frown about undue risk, temptation may triumph, as it did in the mortgage derivatives market.
Either way, the new short sale restrictions will hinder the small, individual investor trading a few tens of thousands of dollars in an online brokerage account. But the big boys with financial muscle will further the evolution of the derivatives market.
Another sign that the derivatives market is destined for growth is the news story that emerged in late January reporting that the exchanges are thinking about asking the SEC for authority to price quotes and transactions in increments less than a penny. See http://www.reuters.com/article/idUSTRE60P4PQ20100126. Apparently, alternative tradings systems like the so-called dark pools are pricing in sub-penny increments, and the exchanges are thinking they might need to meet the competition. The problem will be that the bid-ask spread (the difference between the bid price at which investors sell stocks and the ask price at which they buy stocks) will shrink when sub-penny prices are used. The bid-ask spread approximates the profit potential for brokerage and specialist firms making markets. As it shrinks, the profitability of the stocks business will diminish as well. Big bonus mania will push the financial firms toward the derivatives markets, where opacity is king and bid-ask spreads are indeterminate from the customer's standpoint (or, as much as the traffic will bear, from the dealer's standpoint). For a real-life illustration of how opacity and big profits intertwine, see http://blogger.uncleleosden.com/2010/02/will-wall-street-get-pass-on.html.
If serious reform of derivatives regulation by the U.S. and other major economic powers was in progress, the blessings of transparency would spread across the derivatives market and stratagems to circumvent the short selling restrictions would be harder to develop. Furthermore, the expansion of the derivatives market that is rendered inevitable by the shrinking margins in the stocks business would be fairer to investors. But the prospects for meaningful reform have diminished as the stock market has partially recovered and Wall Street has mounted a relentless anti-regulatory lobbying campaign. That leaves unchecked a humongous loophole in the regulatory structure through which the big banks can shove investors' money into an opaque and ungoverned environment where, as with mortgage-backed and mortgage-related investments of the early and mid-2000s, another shadow banking system can evolve, bubble up and pop again.
Tuesday, August 7, 2007
Stock Market Volatility and How It Bailed Out the Fed (This Time)
Anyone with even a passing interest in the stock markets has noticed the surge in volatility in recent months. The Dow Jones Industrial Average seems clinically manic-depressive, flying in the stratosphere one day and bungee jumping with a frayed rope the next day. Daily movements of 200 or even 300 points have become commonplace. Antacid manufacturers and therapists are celebrating.
Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html. But not everything is unknown. Here are a few thoughts to chew on.
1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.
If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.
2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.
The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.
The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.
Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.
3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.
The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.
4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.
Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.
5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.
Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html.
If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.
There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.
A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html) that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.
Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .
www.wtop.com/?nid=456&sid=1212487.
Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html. But not everything is unknown. Here are a few thoughts to chew on.
1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.
If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.
2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.
The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.
The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.
Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.
3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.
The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.
4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.
Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.
5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.
Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html.
If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.
There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.
A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html) that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.
Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .
www.wtop.com/?nid=456&sid=1212487.
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