Finance Wizards Part I

When my Barron's article came out (May 12, 2008 issue), I bought the issue at the newsstand (that word has two "s"'s by the way.) Right before my article was a cool one interviewing a bunch of the pioneers in derivatives theory and practice. (Feel free to make cracks about LTCM.) At one point the moderator asked Robert Merton what he thought the most important trends in the future would be, and he gave this intriguing answer:

Market-proven derivative technology allows us to transfer enormous amounts of risk very efficiently. But much of the rest of the world doesn't distinguish between investing and risk transfer. Those two decisions can now really be separated, and that creates extraordinary opportunities.

Country risk could be managed on a massive scale with no capital flows, no trade flows involved. Look at sovereign wealth funds. A lot of people say that they provide a great way for a small country, say Singapore, to diversify its investments. But you don't need a sovereign wealth fund to transfer risk. For example, Taiwan, which is very, very heavily concentrated in chips, presumably has a comparative advantage in that sector, but has no control over the world chip market. So it bears a lot of concentrated risk.

What could it do to get out of part of the risk? Well, it could sell shares of chip companies. But that is a very inefficient way to transfer risk. Instead, they could sell calls on an index of world chip stocks and buy puts. This would synthetically sell off the risk. There would have been no capital flow, but they could transfer a huge amount of risk. How much? Let's say $10 billion--a big number, but one I think could be accommodated in that index, and if not in that, in swap form. (pp. 56-58)

Just to paraphrase what Merton is saying (I think): Obviously if you are a country with one major export, your position is more precarious than another country that has plenty of different exports. So you want to diversify away that risk. However, if you do this by selling off shares to your major companies (which are all concentrated in the same sector), and then using the proceeds to go buy stock of foreign-based companies that are in different sectors, that could involve a lot of transactions.

You could achieve your objective a lot more easily if there is a deep enough market in call and put options on the stocks in your country's corporations. You figure out the range you want to "lock in" for your stock price (for a given company), and then you sell calls with a strike price at the upper bound. Then with the revenues you obtain, you by put options with a strike price at the lower bound. If the total revenue and expenditures is roughly the same, there is no net capital flow in your country, so this operation won't affect your exchange rate. (In fairness, the equity scheme would also allow no net capital flows; I think Merton was getting too caught up with his sovereign wealth fund analogy.)

So now if the world chip market takes off, and stock prices rise above your upper bound, then people will exercise their call options and so your upside is limited. On the other hand, if the chips tank, you have puts that cap your losses at the lower bound price.

Now you might not lock in the exact range you want; it would depend on the relative prices of the put and calls. But the point is you could use them to greatly limit your exposure to the chip market, and since they are inherently leveraged you wouldn't have to use transactions as large as if you did it directly with the underlying stock.


  1. But Bob,

    Why start at the "country level"? Why not consider individual firms and the decisions they make, or for that matter individuals themselves?

    Once the question is put at this level it becomes a less "sophiticated" question, but it makes things a lot easier to understand, e.g., diversification has been around for a long time without these ponderous grande questions posed at the country level.

    Merton is an obfuscater. He blows up financial institutions and portfolios by making grande hidden assumptions, as a matter of habit. Once reality smacks him in the head with his poorly designed equations, poof.

    These financial engineers are really not true sophiticates at all they, are posers. Two of Merton's buddies just got busted for insider trading, what shocked me about this was not the insider trading itself, but the clearly amateur insider trading operation they ran. A mediocre stock broker, who wouldn't know the differnce between regression analysis and psychoanalysis, wouldn't have made the mistakes these two psuedo-sophiticates did that resulted in their getting caught.

    See my full rant on these two amateurs here.

    I can't understand what types of equations these guys could have been creating if they didn't understand the basic data that securities firms create and how their insider trading would have stuck out like a sore thumb. They clearly didn't understand a basic concept such as volume and how significant changes in volume are going to set off huge alarms at the SEC.

    And one of these characters was the founder of the top financial engineering journal!


  2. Dang, I had to leave my office because there was a guy here fixing the water heater. (Note that I didn't call it a hot water heater; as Carlin points out, that would be a rather useless device.)

    I was going to mention that Merton didn't need to talk as if "countries" were deciding things, but as I say I had to exit stage left because the repairman was too chatty.

    But to defend Merton's point, he wasn't saying "diversification" was new, he was saying put and calls on tech stock indices (at a deep enough level that a "country" could hedge its whole industry) are going to be available.

  3. Whoops I meant chip stock indices, not tech stock indices.


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