Posts Tagged ‘derivatives’

Will China set off a derivative meltdown?

Thursday, September 24th, 2009

In Satyajit Das’s book, Traders, Guns & Money, he started off with a story of an Indonesian noodle making company getting embroiled in a complex currency derivative contract (that it did not fully understand) with a bank. Unfortunately for that company, a currency Black Swan event turned up and as a result, under the obligations of the derivative contract, the financial viability of the company was threatened. Big shot lawyers and experts were called up from both sides. The defence alleged that the Indonesian company was deceived into entering the contract whereas the bank’s lawyers insisted that the company signed the contract out of its own accord in full knowledge of its obligations. The bank’s lawyers screamed expletives, insisting that the Indonesian company honour its end of the derivative contract, or else the matter will go to court.

Today, many Chinese state-owned enterprises (SOE) found itself in the same situation. SOEs like China Eastern Airlines, Air China and shipping giant Cosco had entered derivative contracts with Deutsche Bank, Goldman Sachs, JP Morgan, Citigroup and Morgan Stanley. The Chinese are not happy with the derivative contract. So, those SOEs (assumed to have the backing of the Chinese government) sent legal letters to those American investment banks and told them, in effect, to get stuffed with the derivative contracts.

The question, as this article said,

In that case, have the banks taken advantage of them or is it simply a case of caveat emptor?

Would the SOEs end up in a court dispute with the banks (as the banks believe, the derivatives contracts are legally enforceable ones struck in Hong Kong, Singapore and London)?

The situation is much more complicated than that just a few court cases. If the banks dragged the Chinese into court, the Chinese government can retaliate by withholding the banks’ banking license in China, which will result in a tremendous loss of their businesses in China. On the other hand, if they negotiate with the Chinese, then it will set a dangerous precedent for their other counter-parties who are in the same situation as the SOEs. Should that happen, US$2 billion derivative contract default can set off a chain-reaction of other defaults.

Such a chain reaction will light up a bigger time-bomb. There are still hundreds of trillions (in notional value) worth of derivative contracts in the global financial system. As we explained with an example in Chained together, for better for worse, defaults can beget even more defaults.

As this article wrote,

Yet any escalation of the defaults to multiple countries could see a second wave of bank failures and, at the very least, a bad double-dip recession. And that’s without the increasingly worrying creeping protectionism around the globe.

An escalation is certainly deflationary.

Would the Chinese government attempt to light up such a fuse? We don’t know, but we can imagine that such an outcome will benefit them greatly. You see, during the Panic of 2008, deflation led to a surge in the US dollar and US Treasury bonds and a collapse in the prices of stocks, gold, silver, oil and other commodities. The Chinese would love for that to happen again because it will give them another golden opportunity to sell their US dollars and US Treasuries to buy real assets (e.g. gold, silver, commodities and resource/energy stocks).

This is something worth watching.

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Posted in Looking Forward | 12 Comments »

Is it a good time to buy Australian financial stocks?

Tuesday, September 30th, 2008

By the time you read this, the global financial markets will be in mayhem, thanks to Congress’s rejection of Henry Paulson’s bailout plan. Last night, the Dow fell 777 points, the greatest one-day drop since the crash of 1987. Central banks are busy pumping hundreds of billions of dollars worth of credit into the financial system as the credit market freezes up. Stock markets around the world are plunging.

Some people reckon that this is a good opportunity to buy Australian stocks, especially financial and bank stocks, which are hardest hit. After all, the mainstream belief is that the Australian banking system is rock solid and prudently regulated. That implies that the sell-off of financial and bank stocks will be overdone and lead to opportunities for value-oriented investors.

What do we think of this idea?

The problem with this idea is that it is only half-right. This half-right idea is dangerous. Sure, it may be true that the Australian banking system is strong. But this is based on the premise that the current situation will extend into the indefinite future. This leads to the very crucial concept of Black Swans. Due to a quirk in the human mind, it is very easy for one to understand Black Swans nominally, but when it comes to decision-making, act as if one has totally lost that understanding. To understand the concept of Black Swan, we highly recommend our earlier article, Failure to understand Black Swan leads to fallacious thinking. We must stress that it is crucial that you understand the content of that article before reading the rest of this article.

Now, what’s wrong with Australian banking and financial stocks?

Well, the issue is not with their future earnings. Based on statistical probability of the past, there is no reason to doubt the forecasts of their future earnings. The more cautious analysts may even adjust their forecasts downwards to account for the expected reduction in earnings due to the credit crisis. Thus, a sell-off in banking and financial stocks may lead to their prices looking very undervalued.

This is where the fallacy such thinking begins. As we said before in Two uncertainties of valuing a business- risk & earnings,

Between earnings and risk, the latter is the most subjective of all in the business?s valuation. In a world of Black Swans, risk is not something that can be easily quantified into a precise number (discount rate). It is also a number that cannot be verified for correctness.

In other words, earnings are very much ‘visible’ and taken into account. But risks are ‘invisible’ and therefore, get ignored and overlooked. That is where the grave error lies. Risk is the playground of the unknown unknowns. The problem with such stocks is that at this stage of the credit crisis, they are particularly vulnerable to the unknown unknowns. In other words, these unknown unknowns will have a massive and colossal impact on their earnings. As we explained before in Common mistakes in failing to see economic turning points,

The importance of a particular event is the likelihood of it multiplied by its consequences. Black Swan events are events that are (1) highly unlikely and (2) colossal impact/consequences. One common mistake investors (and many professionals) make is to look at the former and forget about the latter i.e. ignore highly unlikely but impactful events.

Why do we say that?

A simple word answers this question: leverage.

Due to the amount of leverage (in the Australian economy, banks balance sheets and the global financial system), when the unknown unknowns pops up, earnings can go terribly, utterly, totally and massively wrong (we are running out of adjectives here). For example, as we quoted Brian Johnson in How safe are Australian banks?,

?We?re talking banks geared 25-30 times, whereas the global peers may be geared 15-20 times… even a moderate loan-loss cycle creates negative earnings,? he said.

The Australian economy itself is highly leveraged. As we explained before in Outlook 2008,

Currently, Australia?s total private debt is around 160% of GDP, which is at a unprecedented level even exceeding the Great Depression (when it was just 80% of GDP). Australia?s economic prosperity is financed by debt. However, it is such high levels of debt that can accentuated the inevitable bust.

As we refuted Shane Oliver in Aussie household debt not as bad as it seems?,

A severe downturn to the Australian economy may or may not be statistically likely, but given the level of unprecedented leverage, you can be sure the impact will not be small.

The global financial system is still highly leveraged, particularly with derivatives (see How the CDS global financial time-bomb may explode?). As we said before in Potential global economic black hole: credit default swaps (CDS),

Currently [January 2008], the CDS market is valued at around $45 trillion, which is three times the GDP of the US.

The notional value of derivatives world-wide is said to be at the range of hundred of trillions of dollars.

Australian banks are highly leveraged to a highly leveraged economy in a highly leveraged global financial system. To put it simply, there is only a razor thin margin for ‘error.’ When there’s no ‘error,’ all will be fine. But if there’s an ‘error,’ there can be a colossal bust. Please note that we are not predicting financial Armageddon. For all we know, maybe there will be no ‘error.’ But should it slips in, the last thing you would want to hold are the banking and financial stocks.

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Posted in Looking Forward, Market Observations | 16 Comments »

Chained together, for better for worse

Wednesday, September 17th, 2008

As the drama unfolds in Wall Street over the past week, you may wonder what the big deal is. So what if Lehamn Brothers collapses? So what if AIG and Washinton Mutual go down the grave too. Why are the financial markets, central bankers and governments all over the world so jumpy about all these failures?

One word to explain it: contagion.

As we explained back in Financial system?messy, tangled ball of yarn,

All these ?wonders? of the modern financial system, namely debt and derivatives, enabled the creation of a complex tangled mess of linkages between participants (e.g. financial institutions, funds, investors, banks, etc). The former (debt) allows the use of leverage while the latter (derivatives) allows risks to be transferred like a hot potato from one hand to the other. That sounds good, does it? But what if the derivative that you used to hedge your risks become useless because the counter-party of that derivative could not honour its obligation? In that case, you may not be able to honour your obligation against another party. Imagine repeating this scenario countless times over, forming a yarn of complex entanglements. What if a small section of the yarn catches fire? What will happen to the yarn as a whole?

To give you a more concrete idea of what’s going on in the financial system, consider this hypothetical scenario from this excellent article, The Ultimate Wall Street Nightmare:

Here’s the great dilemma: The tangled web of bets and debts linking each of these giant players to the other is so complex and so difficult to unravel, it may be impossible for the Fed to protect the financial system from paralysis if just one major player defaults. And if Lehman is not that player, the next one will be.

To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital).

Let’s say you’re personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline.

By itself, that would be a huge risk. But you’re not worried because you have a similar bet with Bank B that interest rates will go up.

It’s like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can’t lose.
Here’s what happens next …

  • Interest rates go up, reflecting a 2% decline in bond prices.
  • You lose your bet with Bank A.
  • But, simultaneously, you win your bet with Bank B.
    So, in normal circumstances, you’d just take the winnings from one to pay off the losses with the other ? a non-event.

But here’s where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can’t raise additional capital from investors. So it can’t pay off its bet. Suddenly and unexpectedly …

You’re on the hook for your losing bet.
But you can’t collect on your winning bet.

You grab a calculator to estimate the damage. But you don’t need one ? 2% of $500 billion is $10 billion. Simple.

Bottom line: In what appeared to be an everyday, supposedly “normal” set of transactions … in a market that has moved by a meager 2% … you’ve just suffered a loss of ten billion dollars, wiping out all of your firm’s capital. Now, you can’t pay off your bet with Bank A ? or any other losing bet, for that matter.

Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with you as well … it defaults on every single one … and it throws your firm even deeper into
the hole.

During the 2nd century AD, just before the official end of the Han Dynasty, China was broken up into warlord’s fiefdoms. One warlord, Cao Cao, was amassing a large navy to defeat the combined forces of Liu Bei and Sun Quan. Cao Cao, used a misguided strategy to protect his navy from being scattered by chaining the ships together. His enemies launched an incendiary attack. Because his ships were chained together, fire spread from one ship to another and none of them could scatter to escape. The result: a massive defeat that paved the way for China to be split into 3 kingdoms.

This is the same for today’s financial system. They are chained together by derivatives.

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Posted in Economics/Finance, Market Observations | 6 Comments »

How well informed is NAB’s CEO, John Stewart?

Monday, July 28th, 2008

On Sunday’s Inside Business interview with NAB’s CEO, John Stewart (regarding the recent write-down of $1.2 billion US home loans securities), there were some things he said that made us wonder how much he understands:

Taking those one at a time, I mean the rating agencies clearly are under pressure but in their defence, they couldn’t have foreseen the meltdown that’s gone on in the United States housing market.

Well, “couldn’t have foreseen” is a very common excuse. As we said before in An example of how the sub-prime contagion may spread, economists from the Austrian School already had strong reservations about the Housing Economy as early as 2004! Very long time readers of this publication would already know that we first voiced out our reservations in October 2006 in The Bubble Economy.

Next, John Steward said:

Well the answer to that really is that the only error NAB made was investing in Triple-A securities which have a one in 10,000 chance of defaulting…

Basically, what he is saying is that NAB was extremely unlucky, which it implies that it is none of their fault that this should happen. But as we said in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

The problem with mainstream thinking in today?s finance and economics industry is that the Bell curve is their cornerstone assumption. In other words, the Bell curve assumption is used extensively to model reality and derive conclusions and forecasts.

Unfortunately, the model of reality is completely incorrect. As such, nonsense such as the ones said by John Stewart get repeatedly perpetuated on TV. As we quoted Nassim Nicholas Taleb in How the folks in the finance/economics industry became turkeys?Part 2: The Bell curve, that great intellectual fraud,

If the world of finance were Gaussian [Bell curve], an episode such as the [1987] crash (more than twenty standard deviations) would take place every several billion lifetimes of the universe.

Given the fact that so many of such Triple-A securities in the US had already blown up, it is simply too ridiculous for anyone to believe that each of the blow-ups is a one in ten thousand year event.

The question is, why are such Triple-A securities given such high ratings when clearly, they are junk? To answer this question, we will refer you to our earlier article, Collateral Debt Obligation?turning rotten meat into delicious beef steak, to understand how CDOs work. Basically, through some ‘brilliant’ financial innovation that utilises complex mathematical models, junk bonds get re-engineered into AAA bonds. Unfortunately, there is a major flaw in those mathematical models. As this article from Platinum Asset Management said,

In particular lower rated tranches of mortgage securitisations (say BBB rated tranches) were pooled. The first cash flow on these tranches was sold as a AAA-security – the argument being that it was improbable that most of the BBB securities would default. This would be true provided that the BBB pools are themselves not highly correlated. If they prove to be highly correlated (as appears to be happening in the subprime mortgage area) then just three BBB tranches defaulting would indicate it was likely that a majority would default. Then the seemingly safe AAA paper might actually be quite risky.

If you do not fully understand what we mean, do not worry about it. The complex maths behind these toxic derivatives are meant to be un-decipherable to mere mortals and we do not pretend to understand all of them ourselves. But this fundamental fact remains: these models are convoluted and wrong. For this reason, perhaps we cannot blame John Stewart for having stuff up because he (and by extension, NAB) is probably being suckered by the dazzling world of derivatives.

Personally, we do not think John Stewart is deliberately being deceptive. Rather, we believe it is more likely that he (by extension, NAB) are simply not well-informed enough. In other words, NAB do not know what is going on. The same probably goes for the other banks too.

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Posted in Market Observations | 12 Comments »

Is the credit crisis the end of the beginning?

Wednesday, May 14th, 2008

We will introduce another character today- Satyajit Das. He is a world-leading expert in derivatives and risk management and has a good inside knowledge of the murky world of derivatives. He is best known as the author of the fascinating book, Traders, Guns & Money.

Unlike the mainstream media and market, Satyajit Das is under no illusion that the credit crisis is over. In fact, as he wrote in Nuclear De-Leveraging,

An alternative and, arguably, better view of the current state of the financial crisis is that stated by Winston Churchill: ?… this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.?

Why is it so?  The short answer is de-leveraging. As we said before in Why are fantastic stocks sold off in a bear market?,

Today, there are so much leverage in the financial system and by extension, the market. Both retail and institutional market participants borrow and employ leveraged derivates (e.g. options, CFDs, futures, etc). The problem with leverage is that, when the market goes against you, your losses are magnified and you find that you are suddenly short of cash (to repay the debts, obligation, margin calls, collateral, etc). Sometimes, the only way to increase your cash level is to liquidate whatever you have- the good investments along with the bad. If enough people are in the same situation as you, this will result in widespread indiscriminate selling in the market.

As long as the de-leveraging process is confined to only the financial markets, the sell-off in stocks presents an excellent buying opportunity. Unfortunately, according to Satyajit Das’s opinion, the de-leveraging process in the financial market is only the first phase of a much larger process. He believes that this process will spread to the real side of the economy (see Analysing recent falls in oil prices?real vs investment demand on the difference between the financial and real sides of the economy), which means that the person on the street will eventually feel the impact. As we said before in The Great Crash of 1929,

Also contrary to popular impressions, that Great Crash was not a one-day event. It was a series of events that marked the beginning of an even more devastating consequence?the Great Depression. In fact, it took a year after the Great Crash for the average person on the street to feel the effects of the ensuing Great Depression.

If Satyajit Das is right, then in the future, we will look back at the credit crunch as just the beginning events of a greater scheme of things.  Currently, from the looks of things, the first phase is over. The effect is that money has become more expensive (see Rising price of money through the demise of ?shadow? banking system).

Next, another process is currently under way- the returning of bad quality assets into the bank’s balance sheet. As we explained before in What is SIV?,

The recent deterioration in the credit market is severely disrupting the SIV funds because of the high cost of obtaining short-term funding. As a result, many of the lenders have to buy back the mortgage assets from the SIV, resulting re-loading those mortgage asset into its balance sheet.

As Satyajit Das said,

High inter-bank rates and the deceleration in bank lending reflect, in part, banks husbanding their cash resources to accommodate the involuntary increase in assets.

In addition to this return of bad assets to their balance sheet, the banks also have to contend with losses incurred by the write-down of bad debts. What will happen then? As we said before in Banking for dummies,

As you can see by now, the banking business is a balancing act of managing a portfolio of assets and liabilities. Since the banking industry is a highly regulated one, there are rules for them to follow in this balancing act.

Now that the banks’ balance between assets and liabilities are out of equilibrium, what will happen? To restore balance, banks will have to raise capital (i.e. issue shares for cash) and/or cut down on lending and/or sell assets. Indeed, central bankers and foreign sovereign wealth funds have been very ‘helpful’ in this balance restoration process (see Central banks & pawnshops and Why did the foreigners bail out cash-starved financial institutions?).

As Satyajit Das continues,

The new capital noted above will merely restore bank balance sheets. Growth in lending and assets will require additional capital. The banking system?s ability to supply credit is significantly impaired and will remain so for the foreseeable future. Credit is clearly being rationed in the global financial system. If the banks are not able to re-capitalise, then the contraction in credit supply will be sharper.

Guess what will happen when the supply of money and credit contracts sharply? This is what we call “deflation” (see What is inflation and deflation?). During deflation, businesses and individuals have to de-leverage. Already, this process is already under way in Australia. When reading the mainstream newspapers, you will get to read numerous reports that credit is tightening. For example, take a read at Debt down as rates hurt in the Sydney Morning Herald,

The value of debt taken on by consumers and businesses slumped in March as higher interest rates continued to bite, according to figures published yesterday.

…

An economist at Lehman Brothers, Stephen Roberts, said the decrease in credit use was further evidence of the global credit crunch rippling through the broader economy as companies and consumers wind back their exposure to debt.

In Australia, with total private debt to GDP ratio of around 170%,  you can be sure that there will be more de-leveraging in the private sector to go.

This is the beginning of the next phase where the real economy is affected. In the next article, we will show you how this phase will unfold.

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Difference between OTC and ET derivatives

Thursday, May 1st, 2008

No doubt, as you read the financial news media, you will often see the word “derivatives” popping up here and there. For those who are not in the finance industry, you may wonder what derivatives are. Today, we will depart from our usual macroeconomic musings and delve into the world of derivatives.

“Derivatives” is a very broad term, just as the word “animals” is. Basically, a derivative is a financial instrument that derives its value from an underlying instrument, ranging from stocks to commodities. Examples of derivatives include options, futures, forwards, swaps (e.g. credit default swaps), contract-for-difference and so on.

In every derivative transactions, there are always two parties (obvious) and a legal contract. This gives rise to two types of derivatives based on how the contract is negotiated:

  1. Over-The-Counter (OTC)– For OTC derivatives, the contract between the two parties are privately negotiated and traded between the two parties directly. Therefore, the contract can be tailor-made to the two parties’ liking. This arrangement is very flexible, but there are disadvantages:
    • The value of your derivative is as good as the credit-worthiness of your counter-party. If your counter-party goes bust, your derivative becomes worthless.
    • It is very hard to pass on the derivative to a third-party because the contract is already signed between the two original parties.
    • It is very hard to discover the ‘market price’ of a derivative contract because there is no transparency in the pricing and it is very hard to value unique contracts uniformly on a mass scale.
  2. Exchange-Traded (ET)– For ET derivatives, the situation is different. They are traded via an intermediary, the exchange, which is a strong institution with deep pockets. Therefore, technically speaking, even if Tom and Dick trade a derivative between each other, their counter-parties are not each other- rather both of their counter-parties is the same exchange. In other words, if Tom sell an ET derivative to Dick, the exchange acts as a buyer to Tom and a seller to Dick. The advantages of such an arrangement is:
    • Since all market participants’ counter-parties is the exchange, the derivative contracts are standardised.
    • There is no credit risk between market participants. For example, if Tom has no need to fear if Dick defaults on the contract. If that happens, it is the exchange that has to bear the consequences.
    • There is a very visible and transparent market price for the derivatives.

So, since we have mentioned a lot about credit-default-swaps (CDS) in our past articles, we can now tell you that CDS is an OTC derivative.

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Prepare for asset repricing, warns Trichet

Wednesday, January 31st, 2007

In this news article, Trichet, the president of the European Union central bank warned that that instability of global financial markets can lead to ?re-pricing? of assets. He said that:

There is now such creativity of new and very sophisticated financial instruments . . . that we don’t know fully where the risks are located… We are trying to understand what is going on?but it is a big, big challenge.

As we mentioned in Spectre of deflation, the majority of global liquidity is made up of derivatives which is estimated to be valued at US$450 trillion. However, world GDP is estimated to be only US$46.66 trillion?only one-tenth the size of the value of derivatives!

With such massive quantity of derivatives sloshing around the global financial market, there is very little wonder that no one, not even governments or central banks can fully understand what is going on. Thus, opinions on derivatives are highly polarized?some think they are beneficial because they reduce risks by spreading it, whereas others see that they are currently too dangerous because they encouraged too much leverage and risk taking behaviour. Whichever the truth is, we believe that with all these absurdities in the financial world, it is more likely that risks are underestimated than overestimated.

Now is the time to reduce both debt and leverage. Start hedging.

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Liquidity?Global Markets Face `Severe Correction,’ Faber Says

Tuesday, January 16th, 2007

Marc Faber, the legendary contrarian, predicted the 1987 stock market crash, had this to say. He singled out emerging markets for a correction, especially Russia, followed by China (see China is tightening liquidity) and India. In that correction, all asset markets will be affected.

What is the rationale behind Faber?s prediction?

First, we have to understand the concept of ?liquidity.? What is ?liquidity?? There are other meanings for the word ?liquidity?, but for the purpose of this article, we will stick to the quick and dirty definition of ?liquidity? being ?money? in the financial system. Now, how do we define what is the ?money? in liquidity? Traditionally, ?money? is just what it is?cash and deposits. But today, with the advances in finance, ?money? is no longer as easily and clearly defined as before. As a result, money substitutes are becoming proxies for money and playing a much more important role in global liquidity than before. Examples of money substitutes include credit (e.g. mortgage-backed securities) and derivatives.

Now, what has liquidity got to do with the asset markets?

As you may have noticed, stock markets around the world are in record high territories. What is driving the stock markets is liquidity?the sheer weight of money and money substitutes chasing after a limited supply of assets (bonds, stocks, art, etc), resulting in skyrocketing prices. Therefore, any crunch in liquidity will result in collapsing asset prices.

How is it possible for liquidity to be crunched?

The problem with liquidity is that most of the ?money? in it is made up of money substitutes, most notably derivatives. Today?s modern financial system is such that when the central bank ?creates? money, money substitutes get spawned multiple times. The outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom. The financial assets between the apex and bottom include cash deposits (spawned and multiplied from hard cash through the fractional reserve banking system) and credit (e.g. securitised debt). In such a liquidity pyramid, the values of financial assets at the lower part of the pyramid are derived from and backed up by the financial assets above it. Since much more of global liquidity are composed of ?money? in the lower part of the pyramid, any contraction in the upper parts of the pyramid will result in a multiplied contraction in the lower parts. If the liquidity contraction is severe enough, asset prices will fall precipitously, which in turn may trigger even more contraction in liquidity. This is called a ?market crash.?

Thus, as long as the central bank can influence the increase in liquidity into the financial system, asset prices will rise. If for whatever reason, liquidity contract severely enough, asset prices will collapse.

The question is, are we now ripe for a contraction in liquidity?

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Posted in Looking Forward, Market Observations | 4 Comments »

The ABCs of hedging

Wednesday, December 6th, 2006

One of the claptraps that we get to see nowadays is ?Hedge Funds.? According to the Encarta dictionary, the word ?hedge? is defined as: ?a means of protection against something, especially a means of guarding against financial loss.? A ?hedge fund? was originally meant for managed funds that employ hedging to protect against any market downturn and perhaps even profiting from it. Today, there are many funds that call themselves ?hedge funds? even though in reality, they do not hedge at all. Those fund managers are more akin to gamblers betting on anything that they can get their hands on, often using huge amount of borrowed money and derivatives to magnify their punts. In addition, unlike the conventional gamblers in the casino, those gamblers are usually absolved from personal losses if they lose their bets. Instead, it is often those poor investors who entrusted their money to those scoundrels who have to pay the price. Worse still, if those gamblers won their bet, they will often be the first to carve out a slice of their winnings. Thus, if you should decide to entrust your wealth to a hedge fund, please make sure the fund manager is not a gambler in disguise and that the fund does indeed hedge. There are too many quacks, swindlers and cheats in the financial industry waiting to devour your money.

Now, as a private investor, how do you hedge your portfolio? In other words, how do you reduce the risk of potentially significant losses in your portfolio?

The most well-known and basic technique is diversification, which is spreading out your investments across different stocks, industry, asset classes and so on. Unfortunately, this technique has major limitations. Firstly, though diversification reduces your risk, it also reduces your chances of making big gains. It is possible to over-diversify, which will result in mediocre returns over the long term. Secondly, diversification will not protect you against major economic catastrophe when deflationary forces wipe out the value of almost every class of investment. Thus, for investors after atypical excellence, diversification is not the most favoured method of hedging because they would rather reduce risks by increasing and improving their skills, knowledge and understanding then by scattering their eggs over many baskets. The best investors would rather concentrate their investments on the ones that they understand intimately than to spread out their investments to make up for lack of understanding. In other words, diversification is a very blunt tool for hedging.

What is the more precise strategy for hedging? For long-term value investors, there is this ?war-gaming? approach. Military planners often go through war games where they work out the outcome of all the possible scenarios and develop strategies to specifically counter each of the unfavourable outcomes. The same can be applied to investing. This risk management approach will determine how you structure your portfolio. Given each of the economic what-if scenarios, what are your plans to ensure that your portfolio will survive and perhaps even thrive? For example, what are your plans for your investments if oil prices sky rocket? What happens if the US dollar collapses? What if the global economic imbalances unwind disorderly? For you to be able to evaluate the ?war-gaming? scenarios, you would need to understand both global and local economic conditions. That is why in this publication, we often delve into economics, which some novice investors mistakenly believe is irrelevant and is the ?job? of the government.

Then there are the more tactical approaches for hedging, which is more relevant for short-term traders but nonetheless can be adapted for long-term investors as well. The most basic of these is the stop-loss. It is a tool mainly used by trader to pre-define the price which they will exit their position regardless of what their emotions tell them in the heat of the battle. Stop-loss does not prevent you from making a loss?they let you pre-define your potential loss before you enter the trade. For those more advanced traders, there are more powerful tools for hedging using derivatives. For example, delta-neutral option strategies allow you to potentially profit from all kinds of short-term market situations and limit your losses to pre-defined levels should you turn out to be wrong.

There are a lot more to hedging and risk management than we can say in this article. We hope this will be a good starting point for you.

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