Article – Derivatives activity linked to share falls

As a follow up to yesterday’s CROX and Cubes Comments posting, here’s an article from today’s Financial Times that will help you understand the derivatives hedging process and how it can feed on itself and amplify moves at inopportune times. Remember Long Term Capital Management, When Genius Failed? Yes, Virginia, the probability distribution of market movements is not normal and it has huge tails. Have a great weekend and check out those headlines and feature stories. Cheers!

Derivatives activity linked to share falls
By Gillian Tett
Financial Times
Published: May 19 2006 03:00

The recent sharp falls in stock markets appear to have been exacerbated by an unusual wave of derivatives activity on the part of hedge funds and big banks, traders yesterday indicated.

In particular, some banks and big investors appear to have been forced into selling large amounts of equity futures because they have been acting as counter-parties to large, leveraged bets on the direction of stock market volatility in recent months – and these bets are now unraveling because volatility has increased sharply.

This forced selling has hurt equity futures index prices on markets such as the London International Futures Exchange – and depressed the value of cash equities as well, some observers suggest.

“This is an incredibly sensitive topic but it looks as if some big investors are being forced into big moves because they need to hedge these [derivatives] positions,” one senior trader said yesterday.

It is impossible to track this type of derivatives trading with accuracy, since the investors and banks engaged in these markets are extremely anxious to keep their positions private.

However, one factor that suggests the market is experiencing some unusual dislocations is that in recent days there have been large price gyrations in European equity futures market after 4pm each day.

This is the time when many banks and other large investors reassess their trading positions – and then rebalance their books by buying or selling assets, if necessary, to ensure that their exposure to risk complies with their internal rules.

“These market movements could just be programme selling, but the timing suggests that something else is going on,” said a senior derivatives trader at a leading bank.

The issue that is believed to be triggering this turmoil is an instrument called a “variance swap”. This is a type of derivative that has become very popular among hedge funds in recent months, since it allows them to place bets on the direction of stock market volatility in a leveraged manner.

The banks that have been writing the derivatives contracts with these hedge funds have apparently been trying to hedge these positions by making large trades in conventional equity options.

During the past year, while equity markets have been stable, it has been relatively easy for the banks to manage these positions, without exposing themselves to large levels of risk. However, now stock markets are becoming more volatile again, they are suddenly being forced to readjust these positions to comply with their internal risk management rules.

What makes this process particularly pernicious is that the speed at which they need to adjust their books increases as equity market volatility rises.

Moreover, the sheer fact of selling makes the markets more volatile – and thus increases the need to adjust positions, in a potentially self-reinforcing pattern.

Some observers believe that these movements are temporary, and will quickly correct themselves after a few days.

However, others argue that the self-reinforcing nature of these trends could create serious market problems in the coming days, particularly since there are relatively few investors willing to take the other side of these positions at present.