Derivative Dribble

HIGHLY RECOMMENDED: Washington Post takes us inside AIG-FP (“If they give back the money, then they will walk. And they will walk into the arms of AIG’s counterparties.”)

My latest for The Atlantic

HIGHLY RECOMMENDED: This Blog

Tuesday March 17, 2009

Fortune does a good job getting the facts straight about CDS

Friday March 13, 2009

Berkshire downgraded by Fitch

Thursday March 12, 2009

Gates back on top as crisis wipes out other billionaires

Monday March 9, 2009

Hilarious

Friday March 6, 2009

Alpha Ville on the ocean of looming corporate defaults

Thursday March 5. 2009

Citi drops below $1

My latest for the Atlantic

Wednesday March 4, 2009

FDIC might go insolvent

Tuesday March 3, 2009

Derivatives market remains profitable business for J.P. Morgan

Very interesting data on the multiplier effect from the CBO

Tuesday February 24, 2009

My latest article for the Atlantic

Monday February 23, 2009

FT on the prospect of a depression in Spain

Rick Santelli rouses traders over Obama’s housing plan

Sunday February 22, 2009

Citi in talks with U.S. Government over common equity stake

Thursday February 19, 2009

Must read: Buiter rips apart Obama’s housing plan

Saturday February 14, 2009

Collective decision making in animals and humans

Thursday February 12, 2009

New York edges closer to expanding rent control

Wednesday February 11, 2009

Rep. Kanjorski tells us how close to the edge we were

Treasury’s 6 and a half page plan to save the world

Tuesday February 10, 2009

Great article by the FT’s John Authers on the prospects of an equity bounce-back

Friday February 5, 2009

U.S. cuts almost 600,000 jobs

Wednesday February 4, 2009

My latest article for the Atlantic Business Channel

Tuesday February 3, 2009

E.U. pushes CDS exchange

Monday February 2, 2009

For my fellow music lovers: Classic Arts Showcase on YouTube

Consumers turn to thrift

Unemployment hits China

S&P says 200 defaults expected

Thursday January 30, 2009

Crash like this expected only once over next 34,000 years

Contraction bad, but better than expected

Wednesday January 28, 2009

John Authors on the perception of a bargain

Capacity drops in France and Italy

World growth worst in 60 years

Tuesday January 27, 2009

Japanese CDS spreads widen

The original Carlo Ponzi

Madoff Jr. gets busted in $400 million Ponzi scheme

Great article from Atlantic’s new business section

Monday January 26, 2009

Iceland’s government tumbles under pressure

Unemployment rate looms over banking sector

Redemptions slam hedge funds

Wednesday January 23, 2009

Obama thinks stimulus package could be ready mid February

Muni derivatives under investigation

Cocoa prices on the move

Very interesting John Authers video on the prospect of a slow down in China

Pope goes digital

U.K. officially in a recession

Wednesday January 22, 2009

Google beats the heard

N.Y. Times provides some perspective on the severity of the crisis

U.S. accuses China of currency manipulation

Tuesday January 21, 2009

Bank market capitalization, then and now

John Authers article and video on the second wave of banking turmoil

Black Rock’s profits plummet

Monday January 20, 2009

Obama sworn in

Reality might be a hologram

Banking crisis part II?

Thursday January 15, 2009

Volatility back on the rise

California to go insolvent in weeks

Big numbers for foreclosures in 2008

The wealthy slammed by the down turn

Testosterone and income

Roubini predicts more gloom

Bank stocks plummet

Mortgage rates hit record low

Wednesday January 14, 2009

Credit markets show signs of life despite rest of world

Martin Wolf takes on Obama’s stimulus package

CDS market predicts bleak future for sovereigns

Greece downgraded

Retail takes a nose dive

Banks need bigger TARP

Tuesday January 13, 2009

Citi gets closer to break up

Still no Russian gas flowing into E.U.

Pension funds hammered, seek Federal money

Release of TARP funds faces stiff opposition

U.S. imports plummet

Bernanke says fiscal measures not enough

Monday January 12, 2009

John Authers takes a look at sovereign default and the Euro

Proprietary trading winding down

Banks suspected in facilitating purchase of weapons for Iran

Barney Frank proposes drastic changes to TARP and Hope For Homeowners Act (a summary of the bill and the actual text can be found here)

A look at China

Sovereign downgrades looming

Friday January 9, 2009

Cash flowing back to emerging markets

No exit

Obama puts pressure on Congress over stimulus package

Congress points fingers at Treasury over TARP

Thursday January 8, 2009

Citi supports bankruptcy law reform

Very interesting article on government bonds

Dismal retail figures

Wednesday January 7, 2009

Gas supply to Europe cut

BofA finally sells stake in Chinese Bank

Rough month for employment

A closer look at Larry Summers

German bond auction fails: bad sign for sovereigns

Tuesday January 6, 2009

Pending home sales drop to record lows

Oil picks up steam

Monday January 5, 2009

Dim lights ahead

A bit of unexpected historical perspective on the credit crisis

Wednesday December 31, 2008

John Authers constructs a timeline of the disasters of 2008

Steepest drop ever for commodities

Muni market dries up as states face looming budget gaps

A brief history of numbers

Paulson says U.S. lacked tools to handle crisis

Tuesday December 30, 2008

Good series of video interviews of Roubini

All about numbers

U.S. home prices plummet 18%

Automakers consider change to supply model to prevent supply-side failures

The economics of climate change

Monday December 29, 2008

Retail bankruptcies and store closings on the rise

Corporate profits likely to continue losing streak

Conventional media outlets seek partnership with internet big wigs

John Authers sees gloomy future for equities

High hopes and big numbers

Tuesday December 23, 2008

U. Chicago points fingers at the bailout

Interactive applet rating financial big wigs

Monday December 22, 2008

Pound sinks to record low against basket of currencies

Toyota predicts first loss ever

Oil continues to slide despite OPEC cuts

Friday December 19, 2008

Mortgage interest rates drop

China blocks sale of assets

Sarkozy forces lending

Early Christmas for automakers

Thursday December 18, 2008

Gather ye rosebuds while ye may

Mining sector calls for unprecedented cut backs

Obama taps new SEC chief

Wednesday December 17, 2008

Tis dangerous on the high seas!

Deflation hits E.U.

Thrifty Texan to buy up banks

Public perception dims

More monoline madness

Tuesday December 16, 2008

Up to your ears

Free money!

Monday December 15, 2008

The long arm of Madoff

Derivative Dribble spots economic news faster than the MSM

Friday December 12, 2008

Bifurcation of the debt markets

Goldman predicts slow recovery for oil

California gets downgraded

The story of 2008

The ever entertaining Jim Rogers

India gets roped into the slow down

Senate puts the brakes on the Big 3

Thursday December 11, 2008

When fiat fails

It was a very bad year

This time the floor is falling

Wednesday December 10, 2008

The beginning of a market for toxic instruments?

Deflationary pressure in China?

Costly advice

John Authers looks back

Tuesday December 9, 2008

The title speaks for itself

Russia walks the sovereign plank: debt downgraded

OTC commodities central clearing house ready for launch

Corporate default rates set to rise

Monday December 8, 2008

BREAKING NEWS: Federal legislation proposed to regulate OTC Market

The invisible hand and the sovereign strangle

Video game nerds prove recession proof

Friday December 5, 2008

Economics at ground level

More truly awful news, this time it’s California

Distraction from all the bad news

Thursday December 4, 2008

Black Friday yields red November for retail

China Investment Corp won’t invest in U.S. financial institutions

$25 Oil

Wednesday December 3, 2008

CDS Index hits record level

Some rather awful news

Great explanation of Money Markets

Real yield on Treasuries dip into negative territory

Tuesday December 2, 2008

Bigger than the bail out

The ever increasing interest in CDS

Paulson v. Paulson

Monday December 1, 2008

BRIC nations to offer consumption through downturn

U.S. officially in recession

The Swiss financial throne under siege

Wednesday November 26, 2008

Banker’s Compensation

The space near zero

Shift from OTC to exchanges gains more momentum

Ship while you can

Tuesday November 25, 2008

The science of petty crime

New lending facility for instruments backed by consumer debt

Monday Novemer 24, 2008

Treasury pony’s up huge money

Buffett discloses info on Berkshire’s portfolio of financial weapons of mass destruction

More historical data on declines

Daily Liquidation

Citi gets early Christmas present and Paulson works another weekend

Friday November 21, 2008

Goldman predicts bleak outlook for U.S. Economy

One way ticket to safety

Thursday November 20, 2008

Slightly cooler heads in Iceland after IMF/Nordic bailout

The CDS Market becomes the new economic indicator

I’ve seen more and more of this type of analysis. The CDS market is becoming more and more relevant as an economic indicator. Keep up the good work Alpha Ville!

Inventories Swell Kudos to Naked Capitalism!

Following the money supply

Wednesday November 19, 2008

More monoline downgrades

CDS markets predict bleak future

CDS clearing house seems likely

Tuesday November 18, 2008

Detroit gets coals for Christmas

Fun with economic data

Japan wins economic beauty contest

Historical perspective on volatility

CIA Factbook v2

Monday November 17, 2008

Highly recommended: Interviews with Jim Rogers

The dangers of subjective valuation

Good article, even though I disagree

New York City real estate falls from grace

Greetings from Earth!

Citibank throws garage sale

Japan in technical recession

Friday November 14, 2008

FDIC to insure home mortgages

Eurozone in technical recession

Pensioners driven to theft

Thursday November 13, 2008

More complex than a synthetic CDO

Derivative Dribble considers asking Fed for money

Germany in technical recession

Greenwich points to Wall Street

Would be CDS regulator vindicated (?)

Paulson pulls the TARP from under the market

Pounded

In The Shadows Of Geometry

Comment »

FT Trading Room

In Uncategorized on November 17, 2009 at 8:41 am

All,

Jeremy Grant of the Financial Times has been doing a great job reporting on some of the most poorly understood corners of finance, including OTC Derivatives and High Frequency Trading. The material is assembled on his micro site, the FT Trading Room.

Perhaps the most unique aspect of, and in my opinion the most valuable resource in, the FT Trading Room is the collection of video interviews Jeremy has conducted with industry practitioners, which is available here. These interviews offer a rare and often candid industry perspective on some of the most contentious areas of finance. I encourage all of you to make the FT Trading Room part of your daily reading.

Regards,

Charles

Comment »

Understanding Custom OTC Derivatives

In Uncategorized on November 16, 2009 at 8:39 am

Also published on the Atlantic Monthly’s Business Channel.

Most OTC derivatives are highly standardized, heavily traded products that are more fairly described as unfamiliar than complex. Nonetheless, a small corner of the market comprised of customized, or bespoke, trades has captured the imagination of both the public and the press. The descriptions put forth to date muddle the scale of the market, purportedly in the hundreds of trillions of dollars, with words like “complex” and “arcane,” all to convey a sense of simultaneous condemnation — the result of some vague concept of inherent mischief — and unholy admiration for the wizards who put these “black boxes” together. In an effort to tone down the more florid descriptions of bespoke trades, what follows is introduction to the market conditions that cause certain market participants to prefer bespoke trades to more standardized alternatives.

Pecking Order

All financial agreements involve mutual promises to deliver assets and/or cash. But some financial agreements limit the scope of assets that can be drawn upon under the agreement. That is, each party has only limited rights to the assets and/or cash flows of the other. For example, assume that A wants to enter into an interest rate swap simultaneously with the issuance of floating rate bonds. For simplicity’s sake, we will assume that (i) the swap in question is a vanilla fixed for floating rate swap where A pays a fixed rate to A’s counterparty, swap dealer D, and D pays the floating rate on the bonds to A and (ii) the payment dates on the swap are the same as the payment dates on the bonds. This arrangement allows A to pay the bondholders a floating rate, but still manage its interest rate risk by having its payments under the bonds and the swap net out to an effective fixed rate.

Swap Diagram

But what if the prospective bondholders want to be assured that the swap will not interfere with the credit quality of the bonds? They could insist that A’s payments on the swap be made subordinate to A’s payments on the bonds. That is, A makes payments on the bonds before it makes payments under the swap. This is a basic payment waterfall. This waterfall must be memorialized in both the bonds and the swap agreement, which means that a standardized swap will not do.

Waterfall

In practice, the credit terms of the swap could be much more complex, taking into account various agreements that A has in place, and even differentiate between certain types of payments under the swap, placing each at different levels in the payment waterfall. In short, even the most elementary swap, a fixed for floating interest rate swap, could require intense structuring simply because other agreements require it.

No Market

Another common motivation for bespoke trades is the lack of a market. That is, the risk in question is unique to the party looking to hedge it or too unusual to support a liquid hedging market. For example, assume that A is a heavy oil consumer in town X. Town X is a major delivery point for oil and so there are exchange traded oil futures that track the price of fuel delivered to X. These futures allow A to do a reasonably good job of hedging its exposure to fluctuations in the price of oil delivered to its town X operations. However, A is setting up a venture in town Y which will also consume a large quantity of oil. The price of oil delivered to Y usually tracks the price of oil delivered to X, but can deviate sharply under certain conditions. As such, A would rather not rely on futures tracking delivery to X, but would prefer a hedge that tracks the cost of delivery to Y. A could enter into a swap with dealer D where A pays a fixed rate and D pays the cost of delivery to Y. The net effect of this all-cash swap is that A has locked in a price for delivery to Y.

Further Reading

I’ve written a fair number of articles on the OTC market and related topics, but the well of financial knowledge is orders of magnitudes deeper than the information assembled by this lone wonk. But fret not, because The Qatar Financial Center has set up a simply gigantic resource, QFinance, that is fully searchable and contains information on all corners of finance. It is in essence an encyclopedic compilation of the current state of finance. It seems that most of the entries were written by high level practitioners, with others by academics and regulators. That said, it is a gigantic database, so I have reviewed only a small fraction of the entries. In any case, it is certainly worth checking out.

Comment »

Charles Davì

Derivative Dribble

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Understanding Custom OTC Derivatives

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