leverage and hedging

Tom Lehman uswa12 at lorainccc.edu
Wed Sep 30 05:04:36 PDT 1998

Dear Sol,

Have you seen anything of British newspaper allegations that British intellegence MI6 has had a spy in the Bundesbank.

Sincerely, Thomas Lehman

Picciotto, Sol wrote:

> 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.
> cheers
> sol
> *******************************************
> 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.

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