Backwardation in Gold Prices?

May 2, 2013 – 5:53 am

Izabella Kaminska at FT Alphaville clarifies what’s going on.

By John Parsons | Posted in commodities, dynamic risks, exposure, markets | Comments (0)

Would you like fries with that McSwap?

May 1, 2013 – 7:14 am

McSwap

Last week the OTC swaps market took a big step towards the creation of standardized interest rate swaps. Pushed by the buy-side, ISDA developed a “Market Agreed Coupon” or MAC contract with common, pre-agreed terms. From the ISDA press release:

The MAC confirmation features a range of pre-set terms in such areas as start and end dates, payment dates, fixed coupons, currencies and maturities. It is anticipated that coupons in the contract will be based on the three- or six-month forward curve and rounded to the nearest 25 basis point increments. Effective dates will be IMM dates, which are the third Wednesday of March, June, September and December. The initial currencies covered include the USD, EUR, GBP, JPY, CAD and AUD. Maturities will be 1, 2, 3, 5, 7, 10, 15, 20 and 30 years.

This is good for end-users. Dealers have long used superfluous customization as a tool to blunt competition and maintain margins. Creating a subset of contracts with standardized terms will make the interest rate swap market more efficient in many ways.

Some in the industry worry this just feeds the trend to futurization of swaps:

“It’s quite speculative to try to figure how this will turn out, but on the one hand a more standardised product is presented as more homogeneous, which is good for OTC markets, while on the other, you could argue the more a product is standardised, the less differentiated it is from futures and ultimately could lose out to straight futures activity,” says one New York-based rates trader. “I think there is a fear that this standardisation process creates a much easier path towards futurisation. You could argue this is one step closer towards promoting the success of swap future contracts.” (RISK magazine, subscr. required)

But that ship had already sailed. The G20 specifically rejected the old model of faux customization, and mandated standardization in support of improved transparency and clearing. Whether standardization happens within the OTC swaps space, or via futurization is a detail.

By John Parsons | Posted in Dodd-Frank, financial innovation, markets, OTC reform, regulation | Comments (0)

Smooth Talk About Gold

April 23, 2013 – 6:52 pm

Bruce Bartlett used his New York Times Economix blog post today to argue that “Gold’s Declining Price Is a Reversion to the Mean”. He buttresses his argument by pointing out that,

In a recent paper, the economists Claude B. Erb and Campbell R. Harvey present strong evidence that the gold market was severely overbought. The increase in gold prices did not represent a change in the trend of inflation. As the chart indicates, even with the sell-off, the price of gold is still high and has a long ways to fall to get back to the “golden constant” that gold-standard advocates cite as proof that the dollar should be pegged to gold.

Bartlett Harvey

Read More »

By John Parsons | Posted in commodities, dynamic risks | Comments (0)

CSI: prop trading investigation squad.

April 21, 2013 – 8:57 pm

Does JP Morgan’s derivative portfolio hedge its other lines of business? This picture says ‘no’.

Does JP Morgan’s use derivatives to make prop trade bets on interest rates. This picture suggests ‘yes.’

 

Piazzesi et al.

Let me explain.

Read More »

By John Parsons | Posted in Dodd-Frank, hedging, measuring risk, regulation, speculation | Comments (4)

Can Hedging Save Cyprus?

April 17, 2013 – 7:43 am

Lenos Trigeorgis has a piece in the Financial Times’ Economists’ Forum advocating the use of GDP-linked bonds for Cyprus.

Suppose that its steady-state GDP growth is 4 per cent and that fixed interest on EU rescue loans is 3% per cent Instead of the fixed rate loan, Cyprus could issue bonds paying interest at its GDP growth minus 1% (the difference between the average growth rate and the EU bailout rate). If GDP growth next year is 0 per cent, lenders would pay the Cypriot government 1%, providing Cyprus with some relief in hard times. But if after, say, 10 years GDP growth is 7 per cent, lenders would instead receive 6 per cent. In essence, during recession EU lenders will provide insurance and interest subsidy to troubled Eurozone members, helping them pull themselves up, in exchange for higher growth returns during good times. Increased interest bills in good times might also discourage governments from sliding back into bad habits.

As we’ve written in a couple of earlier posts, this is easier said than done. But it’s certainly thinking along the right lines.

By John Parsons | Posted in credit risk, debt/liabilities, financial innovation, financial policy, hedging | Comments (1)

Gold’s Random Walk

April 12, 2013 – 7:47 am

A number of journalists are helping to broadcast Goldman Sachs’ latest prediction for gold prices. Goldman’s press agents planted the story in the Wall Street Journal, the Financial Times and the New York Times, among other places.

This is silly. There’s plenty of scientific evidence that the gold price is a random walk. Here’s an old reference: Eduardo Schwartz’s Presidential Address to the American Finance Association back in 1996. There are older and more recent papers finding the same.

Last week I wrote a post in which I mentioned that the time series of commodity spot prices are often mean reverting. They contain an element of predictability. Gold, however, is the exception. Gold is very, very, very cheap to store. And it is widely held purely as a store of value without any use value. Consequently, the spot price of gold quickly incorporates changing market views about future supply availability and any other fundamentals like those itemized in the Goldman report. For all intents and purposes, a physical investment in gold is a financial security, which means that the spot price is a martingale. The distinction I made in my last post between the spot price series for a commodity and the time series for a specific futures price is a meaningless distinction for gold.

By John Parsons | Posted in commodities, dynamic risks | Comments (0)

Games with Risk Controls

April 10, 2013 – 2:08 pm

FT Alphaville has been running a series of blog posts digging in to items raised in the investigation of the fiasco at JP Morgan’s Chief Investment Office. The series is called The Belly of the Whale.

Today’s entry is a must read for anyone who has tried to “control” traders using quantitative risk measures. It’s all about gaming government capital rules. But shouldn’t any corporate officer who has to manage teams of traders have to worry about similar games being played?

 

By John Parsons | Posted in accounting, exposure, governance, incentives, measuring risk | Comments (0)

Margins, Liquidity and the Cost of Hedging

April 5, 2013 – 12:02 pm

JACF

Our paper on end-users and the cost of margins is now out in Morgan Stanley’s Journal of Applied Corporate Finance.

By John Parsons & Antonio Mello | Posted in credit risk, Dodd-Frank, hedging, markets, OTC reform | Comments (0)

Dynamic Hedging or Futile Speculation?

April 3, 2013 – 10:28 am

chesapeake

Chesapeake still thinks it can time the market.

On Tuesday management held its Conference Call to update to investors and stock analysts. Steve Dixon, the acting CEO, said “We’ve also taken advantage of the recent surge in natural gas prices to lock in additional price protection in 2013, and we have begun to hedge natural gas production in 2014 at prices well above $4, a level the market has not seen for some time.”

The company has had problems in the past from its foolish attempts to time natural gas prices. Last time prices were falling and the company took off its hedges. This time prices are rising and its putting on hedges. But the mindset is the same.

Behind this dynamic hedging strategy is a common misunderstanding about mean reversion in natural gas prices. The same misunderstanding applies to other commodities as well.

Read More »

By John Parsons | Posted in commodities, dynamic risks, hedging, speculation | Comments (1)

Two Tales of Debt Financing

March 13, 2013 – 6:04 am

Debt financing is always a gamble. And often a seductive bet.

The Financial Times’ Andrew Jack reports on the pharmaceutical company Valeant which has been on a buying spree financed by debt. For an ambitious businessman with a view, debt is the tool that makes scale feasible. And, as long as everything works out as planned, the returns are great.

But what if they don’t work out as planned? Who’s bearing that risk?

The Deal Professor, Steven Davidoff over at the New York Times takes a look at debt financing concocted the other way ‘round. Instead of used as a tool to enable acquisitions, it is offloaded as a part of a spinoff.

In these cases, it’s often much clearer who is bearing the risk.

By John Parsons & Antonio Mello | Posted in credit risk, debt/liabilities, financial policy | Comments (0)
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