Monday, July 2, 2007

A Good Discussion about Derivatives and Some of the Recent Problems

The following from the WSJ discusses derivatives and some of the underlying problems.

. . . . derivatives are financial instruments whose value is derived from underlying securities, such as stocks or bonds. A stock option, for instance, is a derivative that gives investors the ability to buy or sell a stock at a specified price, to cash in on future price movements.

A rising concern is that many derivatives are "illiquid," or don't trade very often, making it hard to value them accurately. This can pose a problem for hedge funds, which generally need to place a value on their holdings every few months or so.

. . . . A recent study by Paris risk-management firm Riskdata shows that roughly 30% of hedge funds that invest in illiquid securities smooth out returns with price estimates for these securities that are potentially self-serving, compared with just 3% for funds that invest in highly liquid securities such as stocks. The implication is that these funds aren't using market prices to adjust holdings' values.

In other words, a number of hedge funds have been tinkering with results, making them look less volatile.

There are well-known benefits to derivatives. They can help spread around risk, potentially making systemic breakdowns less common.

Derivatives also give investors sophisticated tools to protect themselves against market downturns. When one bet turns sour, another perks up. That is why derivatives are often seen as a form of portfolio insurance. Credit-default swaps, for instance, can give investors protection against borrowers defaulting on their loans.

That has helped trigger a significant decline in market volatility in recent years. Stocks, bonds and other securities don't bounce around as much as they used to, due in part to these powerful shock absorbers.

The decline in volatility has allowed investors to take on more risk. But what happens if the shock absorbers don't work the way they are supposed to, as was the case at Bear Stearns? Investors thinking they are driving a hot rod could suddenly find themselves at the wheel of a clunker.

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