Wednesday, April 28, 2010

Derivatives

Matt Yglesias has a post about derivatives that actually doesn't make FLG want to stab his own eyes out. In short, he's explaining how derivatives aren't all "bets."

Matt writes:
Consider Norway. Norway is a nice little country that gets to be extra-special nice since it has all this oil wealth. At the current price of oil, Norway’s in great shape. If oil gets more expensive, Norway will be in even better shape. If oil gets cheaper, Norway will be in worse shape. Norway is, in other words, “long” oil in a big way. But if you were a prudent investor, rather than a small country, you almost certainly wouldn’t deliberately choose to invest as heavily in oil as Norway has. Norway is so deep into oil by an accident of geography, not a deliberate choice. So it might well be in Norway’s interest to invest heavily in instruments that pay off if the price of oil declines.

Okay, so Norway could use derivatives to hedge against a fall in the price of oil and all that. Good.


On the flipside, an airline might want to make the reverse bet. Anyone who’s already made large fixed investments in creating an airline is, in effect, “short” oil just as any country that happens to be located on top of oil is de facto “long” oil. So if the airline wants to mitigate its risk, it will want to “bet” that the price of oil will go up. Which is to say that it wants to ensure that if profitability declines due to higher oil prices, that you’ll be compensated via derivatives.

Ok, airlines have a legitimate need as well.

Matt then goes wrong here methinks:
Now for regulatory purposes, you can draw whatever kind of distinction you want between these kind of activities and more properly “speculative” ones. But the distinction isn’t going to be very conceptually rigorous. You could be assembling a portfolio of bonds (speculating, that is) and decide you want to use derivatives to even out the risks involved in your different positions—hedge the riskier positions to make them less risky, in other words. Now you’re hedging. But the reason you’re hedging is that you’re speculating. But the real reason you’re hedging is that just like airlines and Norway you face an uncertain world and are trying to manipulate your exposure to it in different ways. On the one hand, I think it’s unproductive to try to stigmatize some sub-set of this activity as “speculative.” On the other hand, I think it’s equally unproductive to try to carve-out some valorized exemption to the general regulatory framework.

It's not so much wrong, but asking the wrong question. Matt seems to be saying that there's good derivatives use, hedging, and bad derivatives use, betting. For him the distinction seems to be something along the lines of the Marxist distinction between real economic activity and finance. Norway and the airlines are actually pumping oil and burning it. Real things. A speculator is doing something epiphenomenal. Consequently, Matt would like to regulate along these lines if possible.

FLG thinks this misses a larger point. The more and more FLG thinks about financial crises something keeps coming up -- the issue is leverage. Period. Norway is exposed to oil price fluctuations, but isn't really leveraged. It actually has the oil. If Norway began heavily borrowing against future revenues from the oil, then it would be leveraged and the problems arise.

Rather than trying to divine the intentions of everybody engaging in a derivatives transaction, it's far better just to limit the ability to take on leverage. For example, by requiring the use of a clearinghouse with collateral requirements. That way you don't have to valorize anything.

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