Friday, February 8, 2013

Transferring risk for fun and profit

Some people claim, financial markets are the zero-sum game.

While it is true for futures and option markets (derivative markets in general), the situation may be quite different for stock exchanges.

There are two main reasons for this difference:

First, not everywhere and not all equities are shortable (i.e. short sale is not available). For example, on the Warsaw Stock Exchange, shorting stocks is virtually not available for retail investors (some equity futures are available, though). In addition, even if shorting is possible, there may be a substantial difference in long and short positions. Therefore, the drop in stock prices doesn't necessarily mean that somebody is gaining or that the equal amount of money is earned by the holders of short positions.

Second, the value of a stock depends on marginal price changes. Hence large price changes on small volumes can immensely impact ones position without causing transfer of value between investors. The accounting value can be created from virtually nothing or destroyed. Imagine you buy 10,000 shares at $100, worth $1 million. Later there are 100 transactions with increasing prices, each with volume of 1 share. As a result, the price of your stock rises from $100 to - say - $200. Based on the marked value, your portfolio is worth $2 million now. But is there an adequate liquidity available to sell it at this level? More realistically you should weight your portfolio using available volume.

Zero-sum games are connected with closed systems. All transfers are conducted between the players of the game. However, one can "export" the consequences connected with the game to external parties using "latent" derivatives.

One kind of such a "latent" derivative is bank credit. An investor may ask bank (or a broker) for a credit using his stock as collateral. In such a situation, bank shares the risk of decrease in price of securities, while usually being excluded from the potential increase in their value. It is especially dangerous if the value of the portfolio is inflated on low volume transactions as shown above. Creditors usually discount equities to mitigate such a risk, but their valuation models may inadequately factor in tail risk.

Derivatives allow to transfer and potentially distribute risk. Sometimes the parties taking the risk may not be adequately qualified and often does not have all the information required to properly asses the situation (recall the situation with CDO and CDS).

Yes, there is always the price for taking the risk. However,  the transaction is occasionally skewed toward the party who knows the underlying (i.e. traded security) or even is able to influence it - by taking advantage of marginal pricing. In addition the face value of the derivative may be a multiple of the value of the base instrument, which makes price manipulation easier.

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