Wednesday, March 28, 2007

Correlation Risk and Rube Goldberg

In this era of financial globalization, derivativization, carry trades and cross-margining, markets are more correlated than ever before.
  • A British hedge fund manager may be providing margin collateral for his long positions in Shanghai copper futures by writing credit default swaps on CDOs constructed from sub-prime mortgages backed by houses in Newark, New Jersey.
  • A Dutch pension fund manager may be investing the fund's assets in a structured finance product that bets on a steepening of the euro yield curve, issued by a US investment bank by utilizing a sovereign bond from Greece and an interest rate swap with a Japanese trading house.
  • An individual investor in India may be buying a warrant, issued by a French bank, that tracks an index of agricultural prices established by a US investment bank, leveraging his purchase up to 50 times through a loan in Swiss francs.
  • A Japanese mama-san may be investing her family's savings in a local bank's product whose ultimate return depends on interest rates and currency fluctuations in Iceland.
Through highly complex derivatives, risk is now cross-correlated between all the previously unconnected apexes of financial n-polygons. There are those that say that such a construct is less risky, that it is more pliable and resilient. I say, it has spread risk where none is wanted, needed or even understood as being undertaken.

Before we proclaim all this to-and-fro as miraculous "financial innovation", I recommend we wait for the next full business cycle. It may turn out that all that jazz was in reality nothing more than an elaborate Rube Goldberg contraption, primarily designed to conceal a very simple process: The creation and concentration of huge fees.


  1. "I say, it has spread risk where none is wanted, needed or even understood as being undertaken."

    I just love the way you crafted it! Always a joy to read your blog.

    However the reason why I like your stuff so much is fear. Yes FEAR. I'm afraid the whole financial system is getting out of control.

    This is especially true when you put this great engineering in perspective with the massive monetary imbalances on the planet.

    Kind regards from Paris


  2. I agree with Francois: fear ... and measure, clarity and wit.

    Where do you think all those fees are being invested?

    PS Does 'invest' any longer/anywhere mean joining concerns with something of value in order for that value to grow?

  3. Merci beaucoup, Francois and Sally.

    The fees are being heavily invested in FYVR's. No, they are not some esoteric bond or hedge fund, it's the same old, same old "investment" common to all excess:

    Ferraris, Yachts, Villas, Rolexes.

    eh...easy come, easy go.

    Value: Dear Lord, what a huge subject. But you give me an idea for a future post. Stay tuned.

    By the way, calling me witty made my day!!

    Many thanks

  4. Another fantastic post this time explaining how different "financial investments" are now intertwined in ways that bear no relationship to fundamental economic realities. It is astonishing that fluctuations in something like the price of Shanghai copper futures might determine whether a home buyer in Newark can get financing. While normally an increase in the price of copper would, all other things being equal, increase the price of a house, thereby, lowering demand. However, through the magic of derivatives you can now create a situation where a drop in the price of copper will actually reduce the demand for houses in Newark by reducing the availability of credit to prospective home buyers.

    Talk about butterflies flapping their wings and starting hurricanes.

    My rudimentary understanding of economics is that prices normally serve a critical signaling function that helps establish the appropriate equilibirum level of supply and demand in a particular market.

    How can it possibly be stabilizing in the long run to completely distort the signaling function of prices by using derivatives to artificially create relationships between markets that are normally unrelated. Or, even worse, create new relationships that are the complete inverse of normal market correlations?

  5. Dear anonymous,

    Exactly right...this is the most "unsteady state" market I have seen in 25 years. And yet they say it's "lowering systemic risk" - sorry, but I fail to see how.