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Derivatives Is A Whore

swifz said...
Hi, I just finished the book "Fiasco: The Inside Story of a Wall Street Trader". The last chapter touches about how Japanese companies uses derivatives to create profit out of nothing. Can you please comment on that?


Firstly, I don't really want to plug the book, which to me was a mediocre effort. It is easy to label derivatives as the bad guy. It is not the gun but the one who pulls the trigger - you know the analogy, and the relevant question is also why do we need guns in the first place!?

The gun analogy is quite close actually, derivatives were designed to MINIMISE risk. However, the array of product offerings have been so enormous that almost everyone forgot the main aim of derivatives in the first place. Now, it is mainly a leveraged bet, little capital waiting for th big home run.

You cannot blame derivatives, you can only blame the people buying them for not being informed enough. You cannot really blame the sales trader as its always "buyers beware", you cannot expect salesmen to act with a certain degree of morality, that is wishful thinking. If they can ram it up your ass, they will. Most of the derivatives implosion at companies involved CFOs, CEOs and CIOs who were ill equipped to understand risk and actual exposure of these instruments. Many did not have a proper investing policy and guidelines to follow.

Did Japanese companies ramp up profits by issuing derivatives? You cannot assume that. Back in the hey days (mid-late 80s), Japanese warrants was the way to go. But these were part of a Convertible Bond, which they detach the convertibility part and trade them as warrant. Warrants were so hot that they usually start trading between 18%-20% of actual conversion value. Which is to say a company borrowing a US$200m convertible bond with a 3% coupon, will beable to pocket US$200m, and also get a kicker by selling the warrants to the broker at e.g. 10%-15%. So, yes, money was easy but things get inflated in a super bull market.

So why are derivatives like a whore? If you do not buy them, you can take the high moral ground and look at them disdainfully. If you depend on the whore for your livelihood, e.g. pimps, rent-seekers (i.e. traders, brokers, merchant bankers) ... you couldn't care shit.

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