The good, the bad and the ugly
Are derivatives good or evil? The question continues to haunt us. The derivatives-related disasters of the past decade suggest that these instruments cannot possibly be entirely good. Warren Buffett's view of them as "weapons of mass destruction" is understandable, given all the examples of how misused derivatives can potentially cripple financial markets.
Even with the best of brains and technology, derivatives can be dangerous tools. Long Term Capital Management (LTCM) collapsed in 1998, a year after two of its shareholders, Robert Merton and Myron Scholes, were awarded the Nobel Prize for their renowned stock options valuation formula. LTCM went bust, say dealers, because its models had wrongly estimated volatility, correlation and liquidity risk.
We're confronted again with the dangers of volatility, in the aftermath of the global stock market correction in May, and we look at this issue in our cover story (page E2). Several large traders with positions in Asia were apparently caught out on the wrong side of volatility trades and suffered big losses, say dealers. Others, however, had accumulated long-volatility positions in markets such as India - whose stock indexes were the the most volatile in Asia in May and June - and profited handsomely.
Nonetheless, the volatility exposure of banks and hedge funds remains a systemic risk to financial systems. LTCM showed the hazards of taking huge bets on volatility, and how a lot of the complex contracts used by hedge funds could become illiquid and difficult to unwind under stress conditions. Not surprisingly, the latest annual survey by the US-based Centre for the Study of Financial Innovation cite 'credit risk', 'derivatives' and 'hedge funds' among the top-ten risks globally (see page 11).
Volatility has also had an impact on the structured products market, where restructuring of worst-of equity-linked notes has increased in recent months (see page E6). Asian dealers are warming to the concept of restructuring and want to be seen to have the flexibility to restructure products if market conditions change. This is becoming an increasingly crucial part of after-sales service. After all, mark-to-market losses are an inherent risk of any investment, and are not necessarily associated with bad products. Rather, they have become a test of how quickly dealers can provide pricing and liquidity, and turn market conditions in their favour.