La única objeción es la longitud del mismo.

Aqui algunos extractos:

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In current accounting argot, most derivatives are Level 2 assets (Mark-to-Model). In practice, this means that they cannot be priced based on quoted trade prices (Level 1) but are valued using observable inputs; for example, comparable assets or instruments or using interest rates, volatility, correlation, credit spreads etc that can be put through an accepted model to establish values.

There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.

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Interestingly, MtM accounting is generally not available outside of financial instruments. An often neglected element of the Enron scandal was the company’s ability to convince its auditors and the U.S. Securities and Exchange Commission (”SEC’) to allow MtM accounting to be used in the natural gas industry. This allowed the company to record current earnings based on the future value of long term contracts.

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Where derivative contracts are marked-to-market daily and any gain or loss covered by collateral to minimise performance risk, movements in market rates can trigger large cash requirements. These requirements may be unanticipated. If there is a failure to meet a margin call then the position must be closed out and the collateral applied against the loss. This may leave the parties unhedged against underlying risks or on offsetting positions creating the risk of additional losses.

For example, ACA Financial Guaranty sold protection totalling US$69 billion while having capital resources of around US$425 million. When ACA was downgraded below “A” credit rating, it was required to post collateral of around US$ 1.7 billion. ACA was unable to meet this requirement.

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In 2006, Alan Greenspan expressed shock and horror at the state of settlements in the credit derivative market. He expressed surprise that banks trading CDS seemed to document trades on scraps of paper. The ex-Chairman, perhaps unfamiliar with the reality of financial markets, had difficulty reconciling a technologically advanced business with this “appalling” operational environment.

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Leaving aside the question of whether naked CDS trading has been good or bad for Greece, it is worth asking whether there exist mechanisms through which such contracts can ever have destabilizing effects. I believe that they can, for reasons that Salmon and Jones would do well to consider.

Any entity (private or public) that faces a maturity mismatch between its expected revenues and debt obligations anticipates having to to roll over its debt periodically. Such an entity could be solvent (in the sense that the present value of its revenue stream exceeds that of its liabilities) and yet face a run on its liquid assets if investors are sufficiently pessimistic about its ability to refinance its debt. More importantly, it may face a present value reversal if the rate of interest that it must pay to borrow rises too much. In this case expectations of default can become self-fulfilling.

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Dudley is speaking here of financial firms, but his arguments hold also for governments that do not have the capacity to issue fiat money. This is the case for state and local governments in the US, as well as individual countries in the eurozone. The main “assets” held by such entities are claims on future tax revenues, which are obviously not marketable. In this case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic.

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El autor de este post cita el siguiente paper: The Leverage Cycle.

]]> http://qfclub.com.ar/2010/03/08/cds-pros-cons/feed/ 0 besanson http://qfclub.com.ar/2010/03/08/paper-mercados-y-temblores/ http://qfclub.com.ar/2010/03/08/paper-mercados-y-temblores/#comments Mon, 08 Mar 2010 21:08:51 +0000 besanson http://qfclub.com.ar/?p=348 ]]> The Scale of Market Quakes

Link al Paper

Abstract:
Investors and financial economists have long debated the benefits of global equity market diversification. Fans argue that diversifying globally reduces portfolio risk without harming long-term return. Some critics counter with the observation that because markets get more correlated during downturns, most of the diversification occurs on the upside when you do not need it, and vanishes on the downside when you do. Certainly, recent events give support to the critics as all markets have suffered. We argue that this observation, while true, misses the big picture. International diversification might not protect you from terrible days, months, or even years, but over longer horizons (which should be more important to investors) where underlying economic growth matters more to returns than short-lived panics or global coordinated events, it protects you quite well.

Link al Paper

(en esta misma entrada hay otros gráficos que también valen la pena ver)

The myth of ETF transparency stems from the fact that ETFs must publish their “creation baskets” at the end of every day. The creation basket is the shopping list of securities—tickers and numbers of shares—an institutional investor (aka, an “Authorized Participant”) must deliver to an ETF issuer if he or she wants to create a tranche of new shares in an ETF. For instance, the creation basket of the SPDR S&P 500 ETF (NYSEArca: SPY) will likely contain all 500 stocks in the S&P 500 in approximately the same weights as those stocks that exist in the index.

Creation baskets are often extremely close to the actual holdings of a fund, but they don’t have to be. For large-cap domestic equity ETFs, they’re usually identical. But as you move into less liquid areas of the market, a significant gap can develop between the contents of the creation basket and the holdings of the underlying fund, all the way until they are so divergent that the ETF issuer just asks for cash.

Abstract:
We construct a financial “Turing test” to determine whether human subjects can differentiate between actual vs. randomized financial returns. The experiment consists of an online video-game (http:\\arora.ccs.neu.edu) where players are challenged to distinguish actual financial market returns from random temporal permutations of those returns. We find overwhelming statistical evidence (p-values no greater than 0.5%) that subjects can consistently distinguish between the two types of time series, thereby refuting the widespread belief that financial markets “look random”. A key feature of the experiment is that subjects are given immediate feedback regarding the validity of their choices, allowing them to learn and adapt. We suggest that such novel interfaces can harness human capabilities to process and extract information from financial data in ways that computers cannot.

Link al Paper

Abstract:
We find that returns on options on individual equities display markedly lower returns over weekends (Friday close to Monday close) relative to any other day of the week. These patterns are observed both in unhedged and delta-hedged positions, indicating that the effect is not the result of a weekend effect in the underlying securities. We find even stronger weekend effects in implied volatilities, but only after an adjustment to quote implied volatilities in terms of trading days rather than calendar days. Our results hold for puts and calls over a wide range of maturities and strike prices, for both equally weighted portfolios and for portfolios weighted by open interest, and also for samples that include only the most liquid options in the market. We find no evidence of a weekly seasonal in bid-ask spreads, trading volume, or open interest that could drive the effect. We also do not find evidence that weekend returns are significantly risker than weekday returns, though the weekend effect does appear stronger when the riskiness of the market portfolio is high. The effect is particularly strong over weekends during which the shortest term options expire, and it is also present to a lesser degree over mid-week holidays. Finally, the effect is stronger when the TED spread is high and past delta-hedged returns are high, which we interpret as providing support for a limits to arbitrage explanation of the weekend effect.

Link al Paper

What is the risk free rate anyway?

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The complete absence of risk has always been more observable in theory than in practice but in the last month or so, swap rates have fallen below gilt yields – can it be right that the lowest interest rate in the market is lower than the traditional risk free rate?  Are government bonds still the right instrument with which to observe the risk free rate?

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Sovereign CDS Q&A

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Q:  Can I estimate probabilities of sovereign default from CDS prices?

A:  Yes, with the cavaet that like all financial instruments, prices are driven by fear and greed and may not reflect the fundamentals.   You need to have an assumption for a recovery rate – let’s use 39% as the average.  So if Greek 5 year CDS is trading at 400 bps per year, this means that in any one year you anticipate a pre-default spread of (4% x 100/(100-39)) = 6.56%, which given markets are efficient (!) must equate with the expected one year default rate.  So on the back of an envelope, ignoring the impact of compounding and the expected timing of a default, the cumulative expected default rate for Greece over the next 5 years is 5 x 6.56%, or over 30%.

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