Monday, 23 July 2018

​Too clever by half

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  • Peters 475px June 2014

The simple objective of picking investments to make a good return sometimes seems forgotten.

I CAME TO banking quite late. I was certainly not one of that current crop of graduates who have known since they were 13 that all they ever wanted to do was to be a banker. Indeed, I often relate how I must have taken a wrong turning to end up in the foreign exchange department of Barclays Bank International in the late 1970s on my way from a failed attempt to become a movie producer in Hollywood and wherever I might otherwise have been heading. Banking was – and some might say still is – utterly alien to me. But the parental hotel was withdrawing free hospitality and I needed a steady income. Enter, stage left, Barclays.

Spot forex looked easy and I quickly grasped both the principles and the prevailing jargon. But forward rates were something entirely different. That was until it had been explained to me that forwards were nothing other than a combination of the spot exchange rate between two currencies and the differential in corresponding term interest rates – and that forward foreign exchange rates have little to do with where people think the currencies are going. One doesn’t need to be a rocket scientist to grasp that.

Sure, there will be a bias. If someone thinks the actual rate in six months or a year will be higher or lower than the algorithm tells them, they will buy or sell respectively. But the actual rate ultimately tells us little because, if the market rate trades too far away from the algorithmic rate, the difference will rapidly be arbitraged out.

What’s my point?

What I learnt then about forward rates can be carried into the current markets which are driven by forwards, forward forwards, implied forward forwards and so on. There are gazillions of data points which rain down on us every minute of the day but which in reality tell us nothing more than how two or more spot values relate to one another. We then take these otherwise useless figures into second and third derivatives and think of ourselves as being incredibly clever.

MORE MONEY HAS probably been lost by believing implied pricing than has ever been made. I recently recounted how using forward forwards to price reverse floaters in the early 1990s wiped out investors to the benefit of those who didn’t give a fig for what the maths said and just accepted the prima facie appeal of bonds. The purest expression of anything in the future seems to be the Libor strip – whether manipulated or not by a fraction of a basis point here or there is not relevant – which actually reflects where participants believe the market really is going.

Other than that, we deal with modelled constructs that are fine and dandy but which, the more complex they become and the more bid/ask spreads they include, drift ever further away from the modelled pricing when they need to be executed in the real world. Thus we live in two parallel universes, namely the one of the very clever model and the one of the not-so-clever world in which real people have to put the risk on their books.

As long as one is not trying to do more than to delta hedge in the first derivative of liquid products, all is fine. Try anything a bit more sophisticated and it goes wrong. Traders are traders and mathematicians are mathematicians. Nobody expects barrow boys to be good at maths, but somehow we expect mathematicians to be good at trading. Go figure.

I have recently been involved with a pretty large trade in which the seller is valuing his asset based on figures provided by his data feeds, but the buyer is trying to buy and sell the respective cocktail of hedges required in order to asset-swap the security back to a rate risk-free credit product in the market.

Supposedly we have a motivated buyer and a motivated seller, but we can find no discernible agreement on how to ascertain the value of a rather complex CMS bond.

The rising illiquidity in markets is beginning to put perfectly viable products on the scrapheap

MARKETS ARE WHERE buyers and sellers meet. What is the place if there’s an impermeable concrete wall between the two? There is now such an irrepressible element of “It works in practice but can we also make it work in theory?” stalking our business that the simple underlying objective of picking investments that will make a good return sometimes seems to have been forgotten.

Please don’t get me wrong. I am not a banking luddite. I do, however, sense that the rising illiquidity in markets is beginning to put perfectly viable products on the scrapheap for the simple reason that the hedges have become too expensive to trade relative to their model price.

In other words, the tail has come back to wag the dog again.

Before the crisis, we had an environment in which, as often as not, the underlyings were being priced off the derivative – which can’t in itself be right – but we are now at a point where the difficulty in trading some of the derivs is causing something of a market dislocation.

Perhaps our products have simply become too clever. If prices are determined by models that don’t work when markets are calm, heaven help the last one trying to get out if we find ourselves stressed again.

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