Leveraged Bets

Posted on October 11, 2006 by David Laidlaw 

An article in the New York Times a couple of weeks ago gave us a jolt:

The International Swaps and Derivatives Association, a trade group, reported this week that the outstanding nominal value of swaps and derivatives at the end of June was $283.2 trillion.  Compare that with the combined gross domestic product of the United States , the European Union, Canada , Japan and China , which is about $34 trillion. The total value of all homes in the United States is about the same amount.

We were aware of the growth of these exotic markets, but to have them exceed the combined GDPs of the worlds major trading partners by a factor of eight staggers the imagination.

In theory, these swaps and derivatives markets allow the trading of risk and the more efficient allocation of capital. Those entities that want to reduce their level of exposure to a future outcome can sell the risk to someone else who is willing assume it. For example, an American exporter that sells in Europe can buy currency futures contracts that would appreciate if the Euro weakened against the dollar. This strategy protects against a decline in sales revenue if the dollar strengthened compared to the Euro.

In practice, however, many market participants are making large bets with borrowed money. Amaranth Advisors guessed wrong in predicting the spread between near and distant month natural gas prices via derivatives and lost $6 billion or two-thirds of its assets. In this situation, the hedge fund’s aggressive trader assumed greater and greater amounts of risk as the price for natural gas declined. These wagers, which often produce stupendous gains or dramatic losses, represent speculation rather than investment.