leverage and hedging

Picciotto, Sol s.picciotto at lancaster.ac.uk
Wed Sep 30 03:43:53 PDT 1998

As I understand it, a hedge fund like LTCM has multiple leverage, in that it uses mainly borrowed money to take derivatives positions on margin. Only if its positions turn bad does it have to increase borrowings to make margin calls, which is what this bailout is for?

In contrast, a house buyer, at least here in the UK, has to put some of her own equity in, and must borrow and pay interest on the whole of the rest of the purchase price.

Greg's analogy is also useful in pointing to differences in the types of asset involved. The main reason to acquire a house is for its use-value, few people treat it as a pure investment asset. I think this is the main reason house prices are very sticky downwards, certainly here in the UK. Though the end of the 80s boom hit the house market and some mortgagees were stuck with some negative equity, on the whole prices stopped rising rather than actually falling very much, because people could not afford generally to take a loss, so they mostly hung on to their houses, subletting or finding some other way to manage until exchange values came back in line.

I think we should also consider the use-value aspects of assets in relation to the hedging issue. It is certainly a myth that farmers hedge via futures (though they may be lured into them), since thy can use a straight forwards contract. The reason futures prices are broadcast in farm regions is that the market operates as a price discovery mechanism, but its main users are commodity dealers who need to manage their stocks, given supply uncertainties. This is the ABC of commodity market theory, developed e.g. by Holbrook Working. However, the justification of financial futures cannot be made on the same basis, since they do not have the same use-value characteristics of physical commodities, and hence no supply uncertainties.

Much of the hype about the Great Risk Managers in derivatives is based on this false analogy, in my view. I attach a few paragraphs from a paper I recently wrote with David Campbell, and would welcome any comments.




Sol Picciotto Dept of Law Lancaster University Lancaster LA1 4YN, UK phone (44) (0)1524-592464 e-mail s.picciotto at lancaster.ac.uk


The use of financial derivatives is generally justified in terms of their effectiveness in the management of financial risk. The vast growth in their use from the early 1970s accompanied the collapse of the postwar arrangements established at Bretton Woods for monetary management based on fixed exchange rates, pegged to the dollar, which in turn was linked to a fixed price for gold. Though a number of national governments obviously retain a certain power to manage the exchange rates of their currencies, the renunciation of the Bretton Woods principles signaled the collapse of the international attempt generally to manage those rates effectively. The greater exchange rate volatility which followed leads to corollary volatility of base (and therefore prime) interest rates. It is these volatilities which create the arbitrage possibilities which makes financial futures trading at substantial volumes both possible and arguably necessary. In a perfect exchange rate mechanism - say, a perfectly administered unified global currency or a fully contingent financial market, both of which are hypothetical ideals - contract terms relating to future finance are complete and thus riskless. It is the incompleteness of such terms in the presence of exchange and interest rate volatility that creates risk and, to look at the matter the other way around, it is the handling of this risk that is widely thought to call for a large market in financial products.

This functional reasoning is based on drawing a strong parallel between financial and commodity futures. The original function of commodity futures seems relatively clear. The planning horizons of modern units of production and distribution are such that, on any sort of realistic assumptions about the availability of raw material inputs, given the vagaries of nature, it is absurdly hazardous to rely on continuing spot purchases to guarantee availability of supplies. Planned availability obviously also relies on physical warehousing, but warehousing incurs its own costs. An alternative is to purchase (or purchase an option on) a supply for future delivery, which may simply be done through a tailor-made forward contract. The purchase of such a contract deals with the problem of security of supply, but it both avoids and creates a price risk, for the price paid now for goods to be delivered in the future (that is to say, the present price of future supply) may well not match the spot price at the time of delivery. From the perspective of the buyer, if the forward price exceeds the spot price at time of delivery, then security of supply at a fixed price has been purchased at the cost of the difference between the price paid and the spot price. This difference is generally referred to as the 'basis'. Depending on the size of the purchase and the degree to which the buyer's knowledge was imperfect at the time of the making of the forward contract, this risk obviously may be substantial. This would be a disadvantage in relation to a competitor who may have been content to buy supplies at spot prices rather than forward. Thus, the user of a commodity who purchases it forward hedges supply risk by exchanging simple price variation risk for 'basis risk'.

A means of hedging price risk, as well as managing basis risk, is provided by the sufficiently liquid commodity futures exchange. By replacing the tailor-made terms of the OTC forward contract with standard terms as to quantity, quality and delivery, and concentrating dealing onto an exchange, the contract becomes tradable. When volatile differences between spot and futures prices create sufficient arbitrage opportunities, buyers with long positions aiming to guarantee future supply may hedge their concomitant basis risk by taking out complementary short positions. In the perfect short hedge, obligations to buy are completely offset by mirror obligations to sell (adjusted for the contracts which will be settled by delivery of the physical commodity). In practice several successive hedges may well be needed to ensure the perfect hedge, in order to match shifts in the basis risk with the availability of futures contracts with appropriate expiry dates. Hence, the heart of the justification for the active, exchange-based trading of commodity futures is 'the need to finance inventories in the face of fluctuating prices' (Houthakker 1959, 138), with powerful attempts being made to explain spreads as the implicit costs of physical storage (Working 1949). It should be noted that this is a long way from the conventional picture of derivatives as a form of insurance against simple price risk, which was long underpinned by economic theory (Williams 1986, 77-81).

On the basis of this functional justification of commodities exchanges, it is possible to identify the characteristics of commodities which may be considered the 'feasibility conditions' for futures trading in those commodities (Goss 1972, 4-6). These conditions are essentially physical characteristics affecting storage and delivery of the commodity, such as homogeneity. These obviously do not at all easily fit with financial futures trading. Hence, the inventory management function of commodity markets needs at the very least substantial modification if it is to be used to justify financial futures products, particularly the proliferation of derivatives (Veljanovski 1986, 14-6). Many sales of physical goods do, of course, involve payment obligations that involve risk through currency and interest rate volatility, and it should be clear that a proper understanding of complex, long-term contracting must take into account the various ways in which these risks may be managed. These may be built in to the contract itself through clauses providing for currency variation, or force majeure provisions linked to arbitration, as well as the default rules relating to contractual enforceability (commercial impracticability and frustration) and flexibility of sales security instruments, which provide alternatives to the use of OTC derivatives for hedging (Sykuta 1995). Appreciation of this opens a very important line of neglected contract scholarship (Sandor 1973).

However, it must be questionable whether the volume of trade in financial futures can be justified by the need for hedging of the financial risks incurred in normal sales contracting. Without the problem of security of supply inherent to raw material commodities, there is no need to use a derivative such as a swap or a forward contract unless it is considered necessary as a hedge. Thus, a corporate treasurer with receivables in a foreign currency which is liable to depreciate may choose to hedge to ensure that local costs can be covered. This may be done by a forward contract or, if liquidity is important, by taking out an immediate loan in the foreign currency (repayable from the expected receipts). However, these arrangements are entered into precisely to provide a hedge against price risk, and there is no need to have a tradable instrument to manage the basis risk. This very greatly reduces the need, and hence the justification, for traded financial futures. It suggests that the participants in such markets would be limited to financial intermediaries which by definition would have an 'inventory' of financial assets and liabilities. More importantly, it raises questions about the justification for the active management of the financial risks of such an inventory which the futures market provides, and hence about the justification for exchange-traded financial derivatives.

More information about the lbo-talk mailing list