Inverted Economics II – Hedging

In Part I, we discussed the ramifications of being long or short in today’s markets. Today I wish to reflect on Hedging.

A Hedge is when a company, fund or individual will buy or sell one asset to offset a possible loss in another. This occurs often in the futures market, when one will transfer liability to a second party. The second party may be a speculator (who accepts the risk of the trade) or it may be another party who has reason to accept the contract. These contacts are signed months and sometimes years in advance, so it is understood both why these agreements are made, as well as the risks involved.

The more commonly known Hedge Fund, is an investment fund designated to such vehicles. However, although it would seem inherently safe to invest in, the rules and regulations regarding them are quite strict. For instance, to invest in such a fund one must have either a net worth exceeding $2 Million (excluding main residence) or receive an income greater than $250,000 per annum.

Why? What risks can possibly lie beneath the apparent?

In truth though, these funds are highly risky and the reason being is two-fold. Firstly, many times a hedge fund may place their bets improperly. If, for instance, a bet is made by selling a perceivably overvalued asset and buying an undervalued one, the spread between the two assets may further increase. In addition, the entire basis for valuation may be ill-advised and could cost a fund millions.

However, such risk are the risks investors and speculators alike take on daily. What enables these funds to amass (and in many cases forfeit) their fortunes is Leverage. In a high-net-worth system the markets have established a derivatives market. This market is far more speculative even then the stock markets of old, inasmuch many of the trades involved are both unregulated and highly leveraged.

This means that the trader may gain or lose many times his initial investment, and in relatively short amounts of time.

An example from Minyanville

At the notional levels we are talking about, tenfold the notional value of cash markets, there is no such thing as benign derivatives. Interest rate swaps, the most benign of all derivatives because of past low volatility, are huge. Counter-party A enters a swap with counter-party B to hedge a rise in fixed rates. Now that A is hedged it allows them to take on more of some risk. B sells futures to hedge their price exposure. Fine. But the problem is both A and B only require only a small amount of collateral posted to do this trade. If the volatility in interest rates picks up and B defaults to A, A is not hedged and the risk they took because they thought they were hedged must be unwound. This multiplies to other counter-parties.

It’s as complicated as it sounds and it’s for no reason that the famed investor Warren Buffett labeled these derivatives as “financial weapons of mass destruction”.

The derivatives market involves north of $400 Trillion worth of speculative trades. Like a good game of poker the amount limited on the table is the amount the cumulative party will bet. But when the cards go down, so do the hopes of many.

Furthermore, imagine that you are in a casino with many tables each enjoying their own game, with horse-shoes lending as much as players will accept and the pit bosses smiling from the “eyes in the sky”.

But as anyone knows the game does end. And those who don’t recognize this, go home only with their head in their laps… and a bill for the drinks.

Has the system gone mad? Have we lost it? Indeed we have, but its nothing new. We do this every 25 years or so. We pile in and we load up with a greed for fortunes, when we break-even – we thirst for more, but when we win – we double our bets.

But the chips are few, the night is no longer young and the casino is closing. Drunk men came to wager their life fortunes . Even the simpleton came to bargain with his children’s college money or take collateral against his prime residence. He also wants in, he too wants to be one of the rich boys. But he’s come too late. All that’s left by the tables are the lenders waiting for their money back.

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