Saturday, April 28, 2012

did black-scholes cause the meltdown? /too facile to blame it alone/ http://www.bbc.co.uk/news/magazine-17866646

3 comments:

Arvind said...

It is silly to blame the derivative product while turning a blind eye to the problems in the system where the underlying product is traded. Derivatives help in managing risk by transferring the risk from one participant to another. That does not eliminate the total risk within the system.


Blaming a mathematical tool that aids in pricing the transfer of risk is even more silly.


You should be looking at the fractional reserve banking system, the massive leveraging, lending to people without the ability to repay loans, and the bad investments, not the formula behind the pricing of the transfer of risk from one party to another.


BBC's Communists do not understand finance and as soon as they learn a term or the name of some hedge fund, they repeat it to act intelligent and blame that term/hedge fund for all problems. This works very well in leftist circles where you do not need cause-effect relationships to make your case.

non-carborundum said...

Arvind

The massive leveraging is possible only through derivatives. There is no limit to how far you can go from the underlying asset, for instance "asset backed securities" (ABSs) that have other debt as assets. Then you can take a bunch of the ABSs and turn them into something else. Soon you have a whole lot of people holding on to paper with claims on other paper.

Derivatives are definitely to blame. Commodity prices would not vary so wildly if there weren't speculators screwing up the market trading futures in the first place, creating a need for companies to spend on risk hedging instruments.

At the same time you seem to advocate a gold standard. Isn't paper money a kind of derivative of gold reserves. Derivatives are ok but this is not?

Arvind said...

NC,

Paper money is NOT a derivative of gold. It is printed on the whims of the politicians and has no connection to gold (except in rare cases like the Swiss Franc which is partially backed by gold).

The prices of various commodities actually stabilize due to speculators bringing in information after performing research and betting accordingly. The wild swings you see are due to the speculation on whether the government will print money (QE3). In other words, the speculation is due to government monopoly of money.

The EXISTENCE of derivatives do not cause a collapse. The existence of derivatives based on assets that lack proper foundation led to the collapse. In the example you give, the asset backed securities, in particular the mortgage backed securities, were securities based on housing loans that could never be paid back.

Why did banks give such loans? Because the US government forced them to give loans to poor people just as Chidambaram wants to set apart 15% of all bank loans for Muslims. They were not going to get back the money. So they made new contracts and TRANSFERRED the risk to others.

Note the word TRANSFERRED. This means that they (e.g.: Goldman Sachs) did NOT inject additional risk into the system. They merely transferred the risk they held to their clients.

Even in your example, you use the words "turn them into something else." That is correct. Turning them into something else simply camouflages the risk and/or transfers the risk to another party. It does not inject new risk. You need to look at the source of the original risk and derivatives have nothing to do with them.

Having said all this, there is one other point. If two people want to enter into risky transactions and lose money, that is their choice. If you do not buy derivatives, you won't lose money on it. If a bank collapses, tough luck. You should do your due diligence before depositing money into a bank. That is how things should be.

In reality, the government claims to "insure" the deposits which is of course a lie. They make the taxpayers pay for the bailouts every single time and never have enough cash to insure anything. This promise from the government results in people depositing money into banks without any worries. Then there is of course fractional reserve banking. Those are the points you need to fix instead of chasing mirages like the formula used for pricing a financial instrument.