The World Accroding to Robert Merton

JayHecht at aol.com JayHecht at aol.com
Thu Jul 9 14:55:35 PDT 1998


In a message dated 98-07-09 10:59:47 EDT, you write:

<<

Hedging is "like" insurance; replace "exotically hedged options

account" with "State Farm Auto Insurance" -- see the problem with

this inflamatory statement?

>> While one can make this argument, hedging becomes a lot more complex when your on "many sides" of the trade. For example, State Fram doesn't use reinsurance on its preferred business - it doesn't have to because it has an excellent profile of the risk (both frequency and severity) of the universe of its exposure base.

Now let's look at the Barings debacle. Perhaps a rather extreme example, but the way I understand it, the strategy was set to make money on SMALL perturbations (either up or down). When the trades persistently went the "wrong way" (out of the expected bounds) they lost their shirts.

Look, one could imagine an anarchist farming community (by the way State Farm developed in the farming belt) using futures contracts to "lock in" profits on their crops. But the deeper point is, how transparent/understandable is the underlying process. From what I know of the insurance industry, there are A LOT of CEOs who have off-balance sheet liabilities that are not understood!

Jason



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