Fun with Derivatives

Fresh off my vacation, I have jury duty tomorrow, but today I got a jump on my fun reading for the courthouse – Traders, Guns, & Money, the anecdote-packed overview of derivatives by Satyajit Das, a prolific consultant, author, and commentator on the topic. Das says that his book “does not attempt to make a case for and against derivatives” (p. xiii), and it’s true that he does point out some of the useful, value-creating functions of derivatives. But this passage (p. 41) is probably more typical, and one I thought deserved being typed out:

We needed ‘innovation’, we were told. We created increasingly odd products. These obscure structures allowed us to earn higher margins than the cutthroat vanilla business. The structured business also provided flow for our trading desks. The more complex products were stripped down into simpler components that traders hedged. …

New structures that clients actually wanted were not that easy to create. Even if somebody came up with something, everybody learned about it almost instantaneously. They reverse-engineered the structure and then launched identical products.

In Das’s account, derivatives can be used to unbundle risk – but market competition makes unbundled risks look an awful lot like commodities. So the answer instead is bundle those risks back together into complex products that (a) customers can’t understand and (b) can earn high margins, at least temporarily. Das concludes his tutorial on inverse floaters this way (p. 50): “Greenspan had been right – risk had truly been unbundled. We had just packaged it right back up and shoved it down the eager throats of the wealthy taxpayers of Orange County.”

Which brings me back to something Mike Konczal (last week’s guest blogger – as my daughter would say, “Round of applause!”) discussed a while back – why do so many “innovative” financial products included embedded options? In Mike’s words, “When I was discussing this prepayment penalty theory with a very smart person from a hedge fund, he told me that selling people embedded options is always deviously clever because people don’t understand that they are buying them, and often don’t understand their value.” That sounds to me like the same thing Das is saying.

Originally published at The Baseline Scenario and reproduced here with the author’s permission.

One Response to "Fun with Derivatives"

  1. Anonymous   August 24, 2009 at 1:20 pm

    Great that you’re back, James! RGE got a bit lame lately. Or maybe it’s because I read much more ZeroHedge. And yes, S. Das is a must-read for anyone trying to understand more about the devious world of derivatives.