There is no insurance against market crashes
The history of attempts to tame volatility risk is not a good portent for the current enthusiasm for investing in emerging market economies.
Bill Gross, who runs Pimco, the world's largest fixed income fund, is also a great salesman. So he caught the attention of his audience of financial advisers in Chicago recently when he told them he would reveal the secrets of Pimco's spectacular success.
"I'll be handing you the keys to the Pimco Mercedes," he said.
Pimco does not just trade bonds; it insures them. "Insurance": that's the secret. It's highly active in derivative markets and is now one of the biggest sellers of insurance against market volatility.
But the latest hot market is a reminder of previous episodes of this nature.
Before the 1987 crash, the asset du jour was portfolio insurance. Investors, keen to lock in profits from a bull market, created a boom in sales of software that triggered computerised sell orders at pre-set stop points.A
second more damaging market collapse occurred in 2008 when Lehman Brothers' collapse exposed the full extent of debt and counter-party risk in the financial system.
American International Group (AIG) was still boasting in 2007 that it was the fifth-largest business in the world. It had been amongst the heaviest players in the derivatives business. One popular product, credit
default swaps (CDS), dominated by AIG, was considered so bullet-proof the company believed it would never have to pay out on any claims that were insured by CDSs but simply collect premiums. The bailout of AIG
cost US taxpayers an estimated $180 billion.
Bull markets, notably in equities, preceded the crashes of 1987 and 2008. These markets, fuelled by easy money, created a powerful demand for insurance to lock in those bull market profits.
As it turned out, the "insurance" that was supposed to protect those profits actually exacerbated the crisis.
Last weekend the Bank of International Settlements, one of the few institutions to identify the risk and destructive power of the global financial crisis, warned that "euphoric" financial markets had become
detached from the reality of a lingering post-crisis malaise.
In its annual report, the BIS pointed out that while the global economy was still struggling to escape the shadow of the GFC capital markets were "extraordinarily buoyant." The BIS report states: "Overall, it is hard to avoid the sense of a puzzling disconnect between the markets' buoyancy and underlying economicdevelopments globally."
It notes that extraordinarily (a word which crops up often in the report) easy monetary conditions have spread to the rest of the world, encouraging financial booms there. They have done so directly because currencies
are used well beyond the borders of the country of issue. In particular, there is some $7 trillion in dollar-denominated credit outside the United States and it has been growing strongly post-crisis.Currency arbitrage
They have done so indirectly through arbitrage across currencies and assets.
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