Situations Gone Mad, From the Most Complex to the Simplest

Demetri Papacostas and Francesco Tonin

In this chapter, we will explore two situations that in hindsight look absolutely insane. We continue with the hedging theme of the previous chapter, and examine very complex structures that are appealing to every weakness in our human nature and often are just not worth the risk: TARNs. We will spend some time understanding what it is that makes complex trades interesting, before presenting two examples that should be revealing as to how they work. The second has to do with a situation created by the Swiss central bank’s desire to manage economic conditions and trade relationships, but in the end proved devastating for those market participants that were happy to play on train tracks by jumping around the third rail.

COMPLEX TRADES TEND TO HAVE HIGH HEDGING COSTS

The following discussion will hopefully be clear, but be prepared to jump into nomenclature that we have not spent time carefully building up. We introduce and analyse a specific trade that represents to some extent the tip of the iceberg in terms of the complexity of FX trades. Such complexity initially depends on the liquidity in the market since more complex trades generate more hedging costs. Those costs are of