The idle ramblings of a Jack of some trades, Master of none

Apr 23, 2007

Risk the Spread

Is the increasing use of financial derivatives resulting in a less risky world? It is often said that the wider distribution of risk is a good thing to be encouraged. But consider this argument by Raghuram Rajan.

The emergence of a new class of intermediaries, coupled with large leveraged positions and that ever elusive search of benchmark outperformance, accentuates real fluctuations, [and] can also leave themselves exposed to certain small probability risks that their own collective behavior makes more likely...Some economies, therefore, may be at a greater risk of a market induced turmoil than used to be the case.

In this current world of low bond yields and excess liquidity, what's a money-hungry financier to do? The arcane and incestuous world of credit derivatives is one way to leverage the risk premium of an admittedly low probability of a corporate default. Yet this packaging and repackaging of risky investments and distributing them across the financial system leads to the potential of a cascade of failures, margin calls and dried up liquidity just when it is required the most. This article explains how that could happen.

Scary stuff, indeed. Luckily, we in the world of currency trading are all fiscally conservative, above board, and morally upright.


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