Monday, January 25, 2010

Book review : Traders Guns & Money

If you are a member of the Sun UK pension scheme, don't fret, we have no plans to sink your money into CDO's, credit swaps or Indexed Currency Option Notes, but it is useful to know how derivatives work and why a subset should rightly be called "Weapons of Mass Destruction".

If you think that none of your savings go near derivatives, then you are probably wrong. The mortgage on your house was probably risk swapped on a Sun E25K, most active equity investments use Futures rather than buying the underlying shares, and when you buy a car, the importer has probably hedged his income on the deal via some type of currency derivative.

This book is really about risk. Market, credit, operational and liquidity risk are the main 4. It contains a number of examples such as Orange County or LTCM and the background behind why such companies failed and other banks have lost telephone number amounts having made similar amounts on the back of their punters. From Wikipedia........
The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1.6 billion through derivatives trading. Orange County was neither bankrupt nor insolvent at the time; however, because of the strategy the county employed it was unable to generate the cash flows needed to maintain services. Orange County is a good example of what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner; had they not liquidated they would not have lost any money as their positions rebounded.

Are you scared now? It is quite telling that the author claims that when asked for advice on where to invest he suggests "under the bed" as the best option.

It is not a text book, but a very good place to start if, like me, you don't know much about derivatives, but would like to find out hope much scope they have to make a mess of your world which you thought was free from their influence. I also want to know something about this area so as a Pension Fund Trustee I am better equipped to spot bulls**t when interviewing fund managers or investment advisors. Remember, they are all better dressed than I am, so they must be right.

There are no guns (the things which shoot bullets) mentioned in the book, but the implications is that derivatives are Traders gun and if handled without extreme care or if they get into the wrong hands, can lead to mass destruction. The book was written pre Credit Crunch and predicted the dangers of CDO's which we are paying for now.

Well written and a serious book which is worth reading with no heavy maths. Even takes Donald Rumsfeld quotes about known knowns, known unknowns, and unknown unknowns and uses them to good effect.

Concepts I have yet to follow up on include

  • agency theory

1 comment:

  1. Derivatives are financial weapons of mass destruction. Warren Buffett. I gues he's entitled to an opinion on these matters:-)