Live Science: The Financial Fiasco: Emotional, Irrational, Inevitable

James Grant, editor of Grant’s Interest Rate Observer, was quoted in The New York Times as also pointing out the irrational side of financial decisions: “People keep stepping on the same rakes because money, like romance, is only partly an intellectual experience. Money, like sex, brings out some thought — but also much heavy breathing and little stored knowledge.”

On a societal or global level, why don’t more cautious-minded people balance out those who take foolish risks? In essence, Kuhnen says, people are unwilling to bet against irrationality all the time because they might “simply run of money while betting against the irrational guys.”

Bloomberg: Taleb’s `Black Swan’ Investors Post Gains as Markets Take Dive

Universa Investments LP, the Santa Monica, California-based firm where Taleb is an adviser, has about $1 billion in accounts managed to hedge clients against big moves in financial markets. Returns for the year through Oct. 10 ranged as high as 110 percent.

The Black Swan Protection Protocol bought puts and calls on a portfolio of stocks and S&P 500 Index futures, along with some European shares. The Black Swan Protocol doesn’t rely on commodities, currencies or insurance on bonds known as credit default swaps

Forbes: Dimon, Munger, Rohatyn: No More Vegas

Munger wants Wall Street balance sheets reduced by 70% and insists that the firms “be a market maker, a broker, an underwriter and a custodian of securities but not the hedge funds they have become.” He wants to restrict leverage to 50% on every securities transaction except for the Treasury trading desk where “you’re dealing with the safest securities around.”

 The abhorrent excessive compensation on Wall Street is bound to be severely reduced. If Wall Street firms can only be leveraged 10 to 1 instead of 30 to 1, then the excessive gains made on borrowed funds will be reduced by two-thirds. So the path to $5 million to $10 million annual payoffs will be more reasonable but still in the millions. Hamptons summer homes will be reduced in price. Private jets will be out of range for many. Applications to law school should go up.

Will screw up the RoI calculations for a lot of recently minted MBAs.

First, what the heck are ODIs: If ODI is not one-day international, what’s it?

ODI or ‘offshore derivative instrument’ includes PNs, but there are more. Such as, equity-linked notes, capped return note, participating return note, investment note and similar instruments issued by FIIs (foreign institutional investors) and their sub-accounts outside India against their underlying investments in listed or proposed to be listed securities (shares, debt or derivative) in India.

. . . entities which otherwise are not eligible to invest, e.g., hedge funds, use the ODI route to invest in the Indian market.

“The value of outstanding ODIs with underlying as derivatives currently stands at Rs 1,17,071 crore, which is approximately 30 per cent of total PNs outstanding. The notional value of outstanding PNs, excluding derivatives as underlying as a percentage of AUC is 34.5 per cent at the end of August 2007.”

Hmm. Not chump change. And quite important in the current context - where hedge funds are liquidating everything in sight to meet redemptions and margin calls.

So, here is what the SEBI decided to do today: SEBI revises P-note norms; lifts 40% cap in ODIs

. . . the restrictions on offshore derivative instruments in will be removed. The 40 per cent cap on ODIs in both cash as well as derivative contracts will be lifted.

I would be surprised if this juices up the market in the near future; but seems good for the longer-term.

OK, there is enough blood on Dalal Street to warrant a contrarian long position.

Based on a highly scientific combination of modified P/E ratios, oversold indicators, the degree of gloom & doom on CNBC, and my inability to stay away from fire sales, I put on the following long positions today:

• Bought JUNIORBEES at 57
• Bought the Nifty Midcap-50 October future at 1650
• Bought the Nifty-50 October future at 3616

Buyer beware! Now, off to my prayers.

• Bespoke: High Yield Spreads Near Record Highs

• Bloomberg: Pantaloon Says India Malls Waiving Rents as Supply Slows Demand

Pantaloon Retail India Ltd., the nation’s biggest publicly traded retailer, said malls are waiving rents and offering to pay for interior decoration as excess supply and slowing economic growth erodes demand.

Malls in India’s top eight cities have about 20 percent of their total 40 million square feet (3.7 million square meters) of space vacant, according to real estate broker Cushman & Wakefield Inc.

• Economic Times: It’s a futures shock for many cos with F&O membership

Nearly half the stocks in the derivatives segment on NSE had a daily average turnover of less than Rs 10 crore in the cash market, at the time of their inclusion in the futures and options (F&O) list.

. . . in over two dozen stocks, the liquidity has dried up to such an extent that trading volumes have been below Rs 1-crore mark on most of the days, even for companies having a market cap of over Rs 1,000 crore. And this in the week of contracts expiry, when volumes usually shoot up as traders either square up or carry forward their positions. 

What’s interesting is that total F&O turnover hasn’t declined as much as CM turnover. So it seems that index futures & options have gotten even more popular, perhaps driven by the boom in structured products.

• Yahoo Finance: Options Clearing Corporation Statement Regarding SEC Short Sale Ban

OCC also appreciates and understands the need to curb abusive practices involving short selling, however, as written, this order does not allow for an Options Market Maker exemption to ensure liquid and orderly markets starting on Monday. This will have dire consequences on the US equities markets.

In the UK, the FSA ban on short sales does provide market maker relief. The lack of such relief in the SEC order will harm a marketplace that a great many investors have come to rely on to manage risk in their equity portfolios.

In other words: WTF were you thinking?

• Bloomberg: SEC Considers Revising Shorting Ban in Options Market

Options market makers would have been prohibited from making short sales starting next week under the ban adopted today to keep speculators from driving down stock prices. The Options Clearing Corp., which guarantees all trades exchange- listed options, said a ban would have proved “disastrous.”

Under rule announced today, market-makers such as Interactive Brokers Group Inc. and Susquehanna International Group LLP would be unable to short a stock to hedge their risks when clients buy or sell options on financial shares.

“For our retail customers, the costs of adjusting their portfolio has gone through the roof, because the bid-ask spreads have gone through the roof,”

Unintended consequences.

• Daily Options Report (Aug ‘07 post, but relevant): The Bernanke Short Options Squeeze

Which brings us to Friday. Gamma is essentially infinity in the SPX August options. They have stopped trading. They are merely cashed out at the “opening” price. The rate cut and market pop comes an hour and change ahead of the open. All a call short can do to defend his position is chase futures/ETF’s up. Some OTM calls he is short now have a 100 delta between now and the open. Sure there is an offsetting long that can sell the futures/ETF’s, but who has the urgency here? Clearly the squeezed short. And thus the kindling wood lit by the Bernanke match.

Throw in a similar dymamic on all other index/ETF options that expire at the end of the day, and Big Ben literally found the perfect minute to cause the most pain to options sellers.

Poor shorts - wrong place, wrong time.

• DNA: ‘Derivatives business is full of beautiful lies’ (Interview with Satyajit Das)

“Hedging provides certainty —- of death.

Traders lie to sales people and to risk managers. Risk managers lie to the people who think they run the place. The people who run the place lie to shareholders and regulators. Investors and corporations generally lie to themselves about their understanding of derivatives and why they are using derivatives.

The same (sub-prime lending) business model was used in private equity loans, commercial property and infrastructure and it is all going to have to be unwound.”

• Economic Times: Options outdo futures for first time in 8 years

. . . options registered a total volume of Rs 3.12 lakh crore in August, which is higher than that of futures at Rs 3.01 lakh crore. Even the average daily turnover of options (Rs 15,605.09 crore) has moved ahead of futures (Rs 15,022.44 crore) for the first time ever in August.

“Day traders are left with no options but to trade in options since trading in any other category of products attracts too much STT for a transaction to be profitable.”

I would think that the recent flood of structured products also has helped (index) option liquidity.

• NSE: FX Market Tracker

Liquidity in the newly launched rupee (USDINR) futures at the NSE is still low, but it’s too early to draw conclusions. Interesting that 12-month futures are being traded above Rs 45.

• Economic Times: Rate futures may be here soon

. . . the panel has recommended that futures contracts should be based on the 10-year government bond. This could eventually be extended to 2-year, 5-year and 30-year government securities based on market response.

. . . the duration for short-selling must be extended, in such a manner that the tenor of the short sale transaction coincides with the futures contract. The panel feels that at least in the initial stages, only banks and bond houses should be allowed to undertake short-selling for a longer duration, but on the condition that the transaction is delivery-based.

Hope this doesn’t go the way of the SLBM.

• Bloomberg: India to Increase LPG Imports Next Year as Reliance Cuts Sale

India will need to double imports of liquefied petroleum gas in the year starting April 2009 after Reliance Industries Ltd., operator of the world’s third-biggest refinery, reduces domestic sales of the fuel.

Cooking gas is sold at 349.5 rupees a 14.2 kilogram bottle in Mumbai, or about $825 a metric ton. Saudi Aramco, the largest supplier of LPG to Asia, charges $860 a ton for propane and $890 a ton for butane, the two varieties of LPG.

Reliance may prefer to sell all its petroleum products overseas because of export incentives and the cap on domestic prices.

More inflation and/or subsidies in the pipeline?

• Bloomberg: Auction-Rate Writedowns May Be $4 Billion

Citigroup Inc., Merrill Lynch & Co. and UBS AG are among banks that may have to write down a total of $4 billion as they buy back auction-rate securities, according to Bank of America Inc.

Citigroup said yesterday it will offer to buy back about $7.3 billion of the debt from individual investors, while Merrill Lynch, also in New York, said it would take about $10 billion of the assets. Zurich, Switzerland-based UBS may repurchase auction-rate securities valued at $25 billion by regulators.

In other words: Citi, ML & UBS got their ARS handed to them.

• Wall Street Journal: Yoga Bears: It’s No Stretch to Say Traders Are Taking Deep Breaths

Billionaire fund managers Paul Tudor Jones and William Gross both practice Ashtanga, an active form of yoga that involves flowing through a set series of poses. Bond-fund guru Mr. Gross, a founder of Pimco, does yoga five days a week and says some of his best ideas come when he is standing on his head, or sirsasana, supported by the forearms on the floor.

D.E. Shaw, a $39 billion New York hedge fund known for using complex computer models, recently started offering hourlong yoga classes at the office.

Finance “is the antithesis of what yoga is about in terms of inner peace,”

Given the volatility in our markets this month, we too need some Yogic relaxation.

• Economist: A time for pruning

Now hedge funds are trying to market themselves to pension funds and endowments. What those clients want is a controlled balance between risk and reward, and a return that is not correlated with conventional stockmarkets. Given that the S&P 500 index lost 12.8% over the first half, hedge-fund managers kept that promise.

. . . the assets of the 100 largest funds rose from 47% of the industry in 2002 to 66% in 2007, according to GAM, an asset manager. Just as no-one used to get fired for buying IBM computers, no one can be blamed for picking funds run by big managers such as Highbridge or D.E. Shaw.

In the first quarter of the year, the number of individual hedge funds in existence fell slightly (from 7,634 to 7,601); more funds gave up the ghost than were created. But a net 110 funds-of-funds came into existence.

• CXOAG: Smirking Because They Know Something?

A portfolio that is long (short) the tenth of stocks with the least (most) pronounced option volatility smirks, rebalanced weekly, generates a risk-adjusted (market, size, book-to-market) annual return of about 15% before transaction costs.

Firms with steepest option volatility smirks tend to have the worst earnings shocks the next quarter.

Results are consistent with an interpretation that: (1) informed traders with bad news prefer OTM put options; and, (2) the stock market is slow to incorporate the information they reveal.

• DNA: ‘Slash ATF prices, it’s do or die for us’

With the domestic aviation industry set to double its losses this fiscal to Rs 8,000 crore, airlines say it is a do-or-die situation now. ATF accounts for over 40% of the operating cost of an airline and, between June 2005 and now, ATF prices have risen by more than 130% to Rs 71,759.06 per kilo litre in Mumbai.

The issue of overseas operations is quite contentious and the ministry’s viewpoint may well force the hand of the high-powered Group of Ministers, which is examining this proposal, to allow all airlines to fly overseas. Such a move would help carriers to refuel at cheaper prices abroad besides boosting revenues by short-haul overseas flights.

Expect decreasing capacity, increasing prices, all sorts of new fees, and stock market underperformance.

• Via Kirk Report, IDD Magazine: Decoding Algos

In 2008, however, it is the options market, which so far is following similar footsteps to its equity-market cousin, with a bevy of algorithms and innovative trading platforms emerging.

The exchanges reported last summer that spreads had tightened by 60% or more and the size of the quote–contracts available at each strike price–fell by as much as 80%. Since then, the number of penny classes has expanded so that 60% of options trading volume is now quoted in pennies.

A long-time options market player such as IB, with one of the most sophisticated technology platforms in the market, is just starting to offer more advanced, options-specific algorithms because, ultimately, options are complicated animals. A stock has a single bid/ask spread at any point in time, but each option has multiple strike prices, at multiple expiration dates, split into puts and calls. The further away from the expiration date, the less liquid the option becomes, and many options are illiquid even at the front month-the nearest expiration date.

Excellent read, esp. for system traders that primarily use option strategies.

• NY Times: Lehman Battles an Insurgent Investor

For eight months now, Mr. Einhorn, a rabble-rousing hedge fund manager, has pilloried the venerable Lehman Brothers in an effort to drive down the bank’s stock price, which he is betting against.

The bank has sold more than $100 billion in assets in recent months to shore up its finances.

Worldwide, financial companies have suffered more than $380 billion in write-downs and credit-related losses in the last year, laying bare their shoddy risk management. Lehman has been singled out because of the large role it played in the mortgage market and its reluctance to disclose information about its assets compared with other Wall Street banks.

It is impossible to quantify Mr. Einhorn’s influence on Lehman’s stock price. But hours before his speech two weeks ago, trading volume exploded for Lehman stock puts, which are options to sell the stock and profit if its falls. That day, more than 200,000 put contracts against Lehman were sold, up 49 percent from recent typical Lehman put trading.

If you were watching the market yesterday (especially after 2pm), you can’t have missed the vertical drop in the Nifty index (and Nifty May futures, but NOT Nifty June futures) at 3pm, followed by a super quick reversal. That’s what this article seeks to explain.

• Economic Times: FIIs let short positions expire in May

Being net short in Nifty May futures and 2 crore contracts still outstanding going into the settlement day, FIIs had a simple choice to make.

With no pressure of a short squeeze, they (FIIs) could either have rolled over these short positions into June or had let them expire in May itself. Since rolling over such huge short positions into June was a bit tricky, they decided to let them expire in May. But, how about making a bit of money before these shorts expire?

The Nifty fell like a stone in the consequential last half hour making an intra day swing of over 3%. No wonder, Thursday’s provisional figure revealed that FIIs were net sellers of Indian equities to the tune of a whopping Rs 1,277 crore. On the other hand, Nifty future contracts expiring in June added a 68 lakh shares in open interest to end the day at a huge premium of 23.35 points as compared to a mild discount on Wednesday.

• Mint: Costs, subsidy delays make going tough for fertilizer cos

Subsidy payments have skyrocketed in the past four years from Rs15,779 crore in 2004-05 to an estimated Rs95,000 crore in 2008-09, or 1.9% of the gross domestic product. Last year, the subsidy stood at Rs40,338 crore, which includes Rs7,500 crore paid through the first-ever issue of fertilizer bonds.

Fertilizer production requires natural gas, naphtha or furnace oil as feedstock, which account for 70% to 80% of the production cost. All feedstock variations are derivatives of crude petroleum and their prices vary with oil prices. In the past two years, the prices of liquefied natural gas, naphtha and furnace oil have increased by 198%, 50% and 71%, respectively. Out of the 28 functional urea plants in the country, 12 use naphtha or furnace oil as feedstock.

Similarly, the prices of crucial raw materials like phosphoric acid, sulphur and rock phosphate have gone up by 331%, 867% and 297%, respectively, in the past two years.

• Mauldin @ Investors Insight: The Geopolitics of $130 Oil

George and his team are calling the beginning of a new era of global competition. The weapons now won’t be the nukes of the Cold War or the suicide bombers of the post-9/11 world but rather exportable oil and food, and the huge piles of cash that come from exporting surpluses.

The real winners are countries that can export and generate cash in excess of what they need domestically. So countries such as Venezuela, Indonesia and Nigeria might benefit from higher prices, but they absorb all the wealth that is transferred to them. Countries such as Saudi Arabia do not need to use so much of their wealth for domestic needs.

The big losers are countries that not only have to import oil but also are heavily industrialized relative to their economy. Countries in which service makes up a larger sector than manufacturing obviously use less oil for critical economic functions than do countries that are heavily manufacturing-oriented.

The United States is an oil importer, but its relative vulnerability to high energy prices is nothing like it was in 1973, during the Arab oil embargo. De-industrialization has clearly had its upside. At the same time, the United States is a food exporter, along with Canada, Australia, Argentina and others.

Yet another unqiue perspective on oil.