A Demon of Our Own Design by Richard Bookstaber
A Demon of Our Own Design by Richard Bookstaber
Bookstaber worked as a risk manager for Salomon Brothers, Morgan Stanley, and Moore Capital Management. After walking us through his career he calls for self-regulation, for people to not buy products where the value can change drastically.
The fact that the total risk of the financial markets has grown in spite of a marked decline in exogenous economic risk to the country is a key symptom of the design flaws within the system. Risk should be diminishing, but it isn't.
Aaron Brown would probably argue that people have just gotten better at unlocking value faster and that financial shiftiness will be with us for as long as people find new values to unlock.
But (Peter) Palmedo's argument extended beyond a simple comparison of the market of the day with that leading to Black Monday in 1929. He knew about portfolio insurance, and had run through a simple thought experiment with me. "If the S&P drops, what are you going to do? And what will LOR, JP Morgan, and every other portfolio insurer do?"...
"You have $3 billion of positions you need to hedge. Between you and LOR and everyone else who is doing this -- not counting some places that have started doing this sort of hedging in-house -- there must be 20 times that amount. What do you think the effect will be on the market when you all go into the futures market to hedge?...
Palmedo walked the talk; he bought $60,000 of out-of-the-money put options...
When the dust settled at the end of the week, Palmedo, at age 27, made his farewells and retired to Sun Valley, Idaho, with his family and $7 million in profits.
As the market moves into crisis, the absolute value of the correlation of assets approaches one. The problem is you cannot always predict ahead of time if the correlation will be positive or negative.