Rediff.com  » Business » When PCs take buy & sell decisions

When PCs take buy & sell decisions

By A V Rajwade
September 19, 2006 09:30 IST
Get Rediff News in your Inbox:
Yield-hungry investors are lapping them up, whether they understand the complexities is another matter.

The other day, I read media reports about how an increasing proportion of equity funds are being "quantitatively managed", with computers taking the buy and sell decisions; and about another, and latest, "quant" strategy, the so-called "dispersion trade" -  that is, betting on the volatility of individual stocks within an index (say you sell the index option and buy the option on the individual stock), to exploit minute anomalies in the prices of the two options.

That night, I had a pleasant dream about nirvana: each one of us would own a PC, get it to trade in financial markets, making millions, so that all of us could go on a permanent and luxurious holiday. On waking up, one question nagged me: would there be anybody left to serve us with food and drink when on a holiday, with everybody becoming so rich through financial market trading?

Complexity has now invaded the credit markets as well. Complex, structured financial instruments are the rage, and yield-hungry investors are lapping them up - whether they understand all the complexities is another matter. Remember, the good old housing loan which you and I might take to finance the purchase of a place to live? See how many  avatars it passes through in the "advanced" markets.

First, the loan portfolio may be securitised in the form of asset backed or mortgage backed securities (ABS and MBS). Then a series of ABS and credit derivatives are structured into highly complex, multi-tranche collateralised debt or mortgage obligations (CDOs or CMOs), with each tranche having a different risk reward combination. (Indeed, CDOs and CMOs need not be backed by an actual debt portfolio; in their synthetic variety, the backing is credit default swaps, which are derivatives).

And then, there are funds, which invest in CDOs and CMOs. Indeed, some of these Residential Mortgage Backed Securities have become so complex that the structurers themselves, often reputed investment banks, are making mistakes in their valuations! A recent report from Fitch, the rating company, highlighted many such errors.

Recently, ABN Amro, the Dutch bank launched a new instrument to give to investors "leveraged exposure to the main credit derivatives indices". The instrument is said to be a combination of synthetic CDOs and credit CPPI (Constant Proportion Portfolio Insurance - whatever it means). If you are not totally confused so far, consider another "product" -  leveraged loan. I grew up, and indeed became old, under the naïve believe that loan itself is leverage - for the borrower. But, it seems, leveraged loans are syndicated loans to below-investment grade borrowers.

Another part of the alphabet soup is PIK (payment in kind) loans, where the borrower has a right to delay payments of principal and interest - this is clearly a mix of features of debt and equity funding. Structures are getting so complicated that, a few months back, the Gulf Investment Bank withdrew an issue of a "specialist investment fund", after road shows had been conducted, because it could not find enough investors who "fully understood this kind of fixed income investment".

And you thought that fixed income investment was the simplest asset class? Clearly, life was so much simpler when credit came in only two forms - loans or overdrafts.

Most of these "innovations" are being driven by a combination of:

  • Extremely talented, and highly qualified, professionals, attracted through sky-high compensation packages
  • Ultra cheap computing power

Since no innovation in the financial market can be patented, today's New, New Thing (the title of a book by Michael Lewis about the dotcom craze of the late 1990s) becomes a plain vanilla commodity very shortly. The margins become thin and some more complex new instrument needs to be devised to protect margins and bonuses.

The risk and reward for the trader/innovator and her employer are asymmetric (the expression "playing fields not being level", is now so … old fashioned!), with the trader entitled to upfront bonuses on a profit, but not sharing the losses should the bet go wrong.

Tailpiece: I find something bizarre in the current Champions Trophy being played in Kuala Lumpur. It seems our esteemed Board of Cricket Control, under the chairmanship of Sharad Pawar, is bearing all expenses and paying the Australian and West Indian cricket teams a million dollars per match to participate, but hopes to make a profit in excess of $22 million from it. Clearly, cricket seems to have lost all characteristics of a competitive sport and has degenerated  into a purely money-making business (the Australians openly admitted that they are there only for the money). Travel companies are announcing special tour packages, including tickets for the matches. India, West Indies and Australia playing in Malaysia, watched by Indian spectators live or on TV, and financed by Indian advertisers! And, we are supposed to be a poor country, with one of the lowest per capita incomes in the world! Is it the televised version of gladiator combat to keep the Romans amused - damn the plebeians? 

Get Rediff News in your Inbox:
A V Rajwade
Source: source
 

Moneywiz Live!