MARKETS & THE BLACK SWAN EVENT

Nassim Nicholas Taleb in his famous book – THE BLACK SWAN writes about the extremely low probability and high impact event .On Monday 18th May 2009 markets got a taste of just that. The surprising election results on Saturday and a stable congress led UPA government led to complete frenzy, Nifty went from 3671 (on Friday) to 4323(on Monday) a jump of 20% and stopped trading due to upper circuit (a circuit gets triggered at various levels both up and down on Monday’s case Nifty went up 15% (first circuit breaker and later up to 20% second circuit breaker).

Markets going up should be good news. Hang on, it was not so for everyone.

Traders (especially in foreign banks) had bet big-time on a weak government and market falling. Such a big upswing was never expected and the quant models had never factored it in .They had written call options at Nifty 4000 and pocketed the premium. (A call option is a derivative contract where the buyer has the right, but not the obligation to buy the underlying instrument from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The buyer pays the seller a premium. Nifty moved upwards above 4000 in a day and all the options got exercised. The models had betrayed them. Hedging was not perfect and they suffered big losses.

Option writers have suffered such losses in the past (in January 2008 when the market fell). The interesting thing is that these events have extremely low probability according to the models and should happen once in hundreds of years. But they seem to happen quite often regularly these days.

THE ILLUSION OF HEDGING

When we start reading the basics of hedging we read the case of the poor humble farmer. The professor explains that the poor farmer grows wheat and has no control of the market prices. When he actually sells it the price can either increase-he makes a profit or falls - he books a loss. To protect his interests we have a process called hedging. Here the farmer has already gone into a long term contract at a fixed price. This saves the poor farmer from price fluctuations of the market and his risk is eliminated.

But is it really so? Is there no risk? Have we transferred the risk completely?

Contrast the case with a Steel company. Suppose the company hedges the cost of iron ore (my raw material) and fix it(by a long term contract ofcourse) . What happens now? Suppose the iron ore price goes up the company wins.

But wait a second. Suppose it goes down now I loose. But it’s not as simple. What about other companies, my competitors? If they have not hedged the raw material cost they can cut the prices of steel. So either I need to cut my prices of steel or wont be competitive. I can only choose my way of death. But just hang on. I hedged to negate this very risk which I am still facing now. So we see that hedging doesn’t really eliminate the risks. It can bring forth new ones. Many companies in the past have hedged and lost big-time. Airlines industry is a great example.

Hedging has its own share of risks. We need to understand them before we make a decision. Often the problem is the companies go by the bank’s advice and do not understand the risk’s involved. More on the banks next time.

COLD STEEL

Well i just finished this heck of a thriller(although I knew the ending, whats the big deal.everybody knows)COLD STEEL the multi billion dollar fight for Arcelor by Laxmi Mittal. I really enjoyed the novel and its like an outside view of what an investment banker's role is.

I always thought that I want to be one of them but after going through i now begin to understand what kind of life it is.

However the best thing about the novel is that illustrates the importance of communication and listening in life. Mittal's skills as a communicator and listener are greatly highlighted. More often than not we tend to look at the hype surrounding big M & As. But we really surprised to know that more than the hype and media its the small things that matter. And people like Mr Mittal take care of the smallest details.......

Surprizingly we all know this and yet get swayed by the brand names!!!!! and foolisly believe that they can do no wrong. They forget to ask the basic questions. The moment you

see a big brand name you tend to think its correct.Take care of the smallest details wether u deal with big brands or small. Bcoz u never know????????