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It seems that the term "hedge-fund" is now totally disgraced. For
managers like Meriwether these hedge-funds were a one-way bet:
If they got it right they would get huge incentive fees. When they
blow-up they just loose their job. The risks being nil because the
funds indeminify them against possible legal proceedings against
them.
It will get really interesting when one of the large investment
houses fails and the liquidators try to unravel millions of OTC
transactions in derivatives.
The Russian bank failures already gives a taste of things to come.
Virtual all reputable investment banks sold OTC derivatives to their
clients which represented Russian government debt hedged into US
dollars. The investment banks hedged their rouble exposure with
Russian banks. After the Russian banks failed they were stuck with
huge unhedged positions.
In Malaysia something similar happend. The government outlawed
offshore currency trading. This in turn forced the international
banks to settle all their Ringit forward contracts against each
other. The question is only which price they should take after the
the market has disappeared.
The OTC market is a huge unsolved problem because it is built upon
the assumption that all participants are guaranteed to pay when the
contracts are due. If this chain breaks we can see chains of cross
defaults.
There are some very interesting problems related to this. For example
if a contract involves instruments which are dominated in different
time-zones. Then one side of the deal might get settled but the other
side doesn't because the company has become bankrupt at the end of
its time-zone.
Furthermore many of the instruments which investment banks sold are
nearly unhedgeable unless you are running a large book. If the OTC
market dries up then many companies might be stuck with
highly-leveraged, illiquid instruments which they cannot hedge.
I guess we just have to wait for more surprises to come.
Gerrit
Gerrit Jacobsen
http://www.tickscape.com
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