Hedging is often an illusion, with "portfolio insurance" during the 1987 Crash being my favorite example. The trick is that there is almost always an assumption hidden somewhere, and that is the one that will crack.


Why? Because something has to. This is because hedging is often nothing more than the sale of something without pricing it in, without actually locating a counter-party. In other words, a hedge delivers to the seller the illusion of buyers whether or not any actually materialize, while at the same time it delivers to buyers the illusion of the absence of sellers. Let's use the example of crude oil.


The demand for oil at various prices is basically fixed in the short term. If it is cheaper, people may buy bigger cars, and so on. But nobody can be sure what the demand for oil will be. So, if you have borrowed money to build oil wells, and you have to pay a bond coupon each month, and oil costs a fortune to store once you pull it out of the ground, you might buy crude oil puts for each delivery month.


So someone sells you these puts based on the idea that either - and this is important - 1) they know better than you that there will be a strong demand for oil, or 2) they will dynamically hedge, by selling oil futures as your put strike price is approached. Notice, in neither case do they actually sell oil in the cash or futures market - sellers who think the price could go up and buyers who think the price could go down never do - and so the true supply of oil is not priced into the market.


Only one of two things can happen. Either 1) the out seller they will find the expected buy-side liquidity into to which to dynamically hegde on the way down - meaning the oil producer never needed to buy a put - or 2) the put seller will blow out and go broke. But whatever the number of buyers, they will be LESS THAN the number of buyes there would have been had the crude producer sold immediately - because consumers evolve and adjust infrastructure and lifestyles around prevailing prices!


Frankly, when I look at Enron or electricity in California, I cannot tell you exactly what happened, only that true demand wasn't priced into the market. The week before Enron collapsed, an old friend actually stopped by my house trying to sell Enron-counterparty electricity calls and futures to local businesses door-to-door! They actually had this girl out on the street selling electricity futures!


More abstract example. Suppose corporate bonds have a default rate such that 10 corporate bonds will deliver the same cash-flow portfolio as 8 government bonds. If government bonds sell for $1.00, corporates should sell at 80 cents, right? So, you can construct a portfolio that is contingent on the correlation of corporates to governments.


But what happens if corporates drop to 79 cents? I mean, the correlation is useless unless you actually intend to exploit some type of arbitrage, right? Everyone will buy corporates and sell treasuries. But then, how could corporates ever fall to 79 cents in the first place??? Ultimately, it becomes a duration problem.


The only timeframe in which a portfolio of corporates can actually fulfill a correlation to governments is in the duration of the actual coupons. But people who bet on the correlation may be betting for a normalization of relationships in a year or less. Meaning, the counter-party to their transactions is the coupons themselves. Meanwhile, demand to atcually buy these coupon streams today may be utterly non-existent, except the to the extent people trading on the correlation propped up the illusion of demand.


Okay, I'm lost, I forgot the point. Oh, but who will buy the bonds?


So that is what we saw in 30-year treasuries last November. On the one hand, all these people were getting short squeezed for whatever reasons while, on the other hand, interest rates based on true demand and expectations were actually way up here - as they found out a week later! Derivatives camouflage supply and demand, because it is difficult to trace what people are buying and selling back to actual conditions.


Derivatives rely on the construction of assumptions rather than the actual location of counter-parties. Meanwhile, the assumptions are only accurate so long as nobody tries to exploit them. Hedges and correlations don't spawn counter-parties, rather the opposite is true, they spawn company on the same side. As in 1987, or in Erin's example, the tipoff to mispricing in the underlying is the supposed mispricing of the derivative, or something.


Going back to Renaud's option example, which I don't entirely understand, you had a situation where one group of banks was buying all these calls, and another group was probably selling them, saying "What are these idiots doing?" Meanwhile, those call purchases were probably the only tipoff to a potential avalanche if the exotic derivatives they were hedging ever became due, the music stopped, and everybody was forced to find a chair or an actual counter-party.


Derivatives can be used to mask the absence of counter-parties. If you can sniff this out, you can make a fortune. But, since it is usually buried so deeply, this brings us back to Brownian motion. The only way to see the washout emerging is when the tip of it starts surfacing on the tape. At first, people trade against it, they say "This can't be happening, these two things are correlated."


A moment later, it becomes self-fulfilling, and everyone - everyone except the Turtles that is - gets swept away. Because nobody understands what I just wrote, and I don't know what I'm talking abotu either. And, in a world of people who have no idea what is going on, prices rule, and trend-trading - which is a cost in itself to the extent it creates chop and masks prices - is still the only safe way to go.


Anyway, there is actually a financial-engineering innovation to solve this, a sort of mine-clearing tehcnology which could make the world about a trillion dollars richer overnight. But I won't bore you with it


eLROY