Monday, February 16, 2009

A definition of financialisation (one among many):

by Duncan Lindo

I wanna tell you a story:
It is a sunny day in early 2007. Robin Banks slips into the hushed corridors of the plush building in mid-town Manhattan that houses his wealth manager. It’s time to try one of these hedge funds.

Robin decides to invest $1milllion and his private bank is willing to lend him $3million more against his stake giving a total investment of $4m. Of course the private bank will charge some interest and a fee for arranging the purchase of the hedge fund stake.

The hedge fund they choose is big on structured credit trades – Collateralised Debt Obligations (CDOs) are the hottest deal in town. First thing, the hedge fund takes its 2% upfront fee. Because they understand the statistical models better than the rating agencies, they decide to go for the riskiest part of the CDO. They buy exposure to the equity tranche of a credit default swap (CDS) Index in derivative format from an investment bank. A fairly standard instrument and therefore one that their investment bank will sell to them for a 5% deposit (initial margin). Robin’s $1m which became $4m becomes $4m ÷ 5% = $80m of equity tranche exposure.

Over at the investment bank they can make money between the price at which they sold the risk and the price at which their models value it - but to capture the profit they need to hedge. Their pricing models tell them that with correlation trading as low as it is their delta hedge is 18.75. So to hedge their exposure to changes in the price of the CDS Index they need 18.75 x 80 = $1.5 billion of the index itself. The investment bank calls their most trusted market maker and starts to work an order for $1.5bn of index – a big order but should be manageable over a day or so. Robin’s 1million became 1.5bn!!

The market maker is more than happy – for such an order he can widen his bid-ask spread and should make 4-5bps running or approx 0.2% of $1,5bn.

Laying off that much risk though moves the market slightly. Across the room the index arbitrage desk notices that the spread between the price of the index and the combined price of the constituents is wide enough for him to put on a trade. It will pay off when the price of the index and the constituents come back into line – even if it’s at maturity. He trades the index and gets to work trading the underlying, single name CDS.

The single name CDS market makers know the index guy and get to work passing the risk to their clients – taking their bid ask. In a few of the less liquid names their hedging trades are enough to move the price of the CDS. Upstairs on the convertibles trading desk, someone notices that the new price for the credit risk (automatically input into their models) tells them that in order to remain hedged they need to trade…so they call their market maker….across the road an equity trader notices the price has changed…time to re-hedge, so they call their market makers…

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