Thursday, July 5, 2007

Magical Markets, Enron and GE and a New Word

I was looking for Alt/Renewable energy ideas a couple nights ago when I found a story in a middle-market newspaper that had a sentence in it that is now the front-runner for funniest line of the month:
"We protect against all losses through hedging"

Here's the set-up. Some forex guys just bought a $3 mil. historic mansion to run their business out of. They're doing some smaller scale Yen carry-trade "arbitrage" (retail min. $50K). They borrow from the BOJ at 1/2 point and say they invest at 5%. Looking at the yield curve, you have to go out seven years to get 4.99%. Borrow short-term, lend long-term.

Then they gear it up 2.7 times and are showing their investors 12% risk free. At that point in the story I started laughing so hard my eyes were watering.

Right now the 30-day treasury yield is 4.51%. That is the risk-free rate of return. That's the number you plug into your slide-rule to do options pricing.

If someone is offering you greater than 4.51% at 1:00 pm EDT on 5Jul07 you are, by definition, taking on risk. Period.

Now don't get me wrong, risk is good. Risk allows you to die with a garage full of stuff. Like a helicopter. In the garage. On your yacht. There was one with a 3000 square foot master suite offered on ebay last year for $168 million.

The second problem with the story is: the minute you use leverage you no longer have an arbitrage. You might still have a really, really good hedge, a six-sigma hedge; but it's not an arbitrage. Remember that wonderful term of the eighties "Risk Arbitrage"?
Only one of the words was accurate.

There are three types of people who would say "We protect against all losses through hedging"

1. A fool-they don't even understand the game.

2. A moron-they may have some nifty swaps and other derivatives to hedge against the one and two standard deviation event risk, but what about the 3,4 and 5 SD risks? Last night I heard a farmer in Kansas say "We had our last once-in-a-hundred-year flood in '86". Now that guy understands, I'd bet he knows more about markets than the folks at LTCM.
I'm sure the forex guys have the currency risk covered, they may even have something to cover a magnitude 9.5 Tokyo earthquake. But what if your counter-party had physical exposure you didn't even think of? Maybe their bullion vault was on the fault-line. There's no Force Majeure, only insolvency.

3. A liar.

The guys I traded with as a pup would right now be figuring out how they'd like to furnish the historic mansion in a middle-market-newspaper town that they just took from the 1, 2 or 3 above, forex guys.

Andy Fastow of Enron fame said "I can strip out any risk"; well maybe, how'd you hedge the risk of doing six years hard time?

Speaking of yield curves Econbrowser had a post titled "The yield curve dis-inverts, sort of"
Dis-inverts was a new word for me. The post is possibly a sign-post.

Speaking of Enron, does anyone know if Congress has repealed the Enron exemption in the Commodity Futures Modernization Act of 2000, first enacted by Wendy Gramm (Republican) as a CFTC rule in 1993 and signed into law by Bill Clinton (Democrat) during his last month in office?
I bet General Electric knows.

Here's a 1998 article from The Arbitrageur:
Losing your tail on the repo market: The story of Robert Citron.

I forgot to mention the "journalist" who wrote the carry-trade story was touted as being "the author of more than 20 books on business and investing".