Trading and Speculation

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  • Topic: Hedge fund, Short, Arbitrage
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  • Published : May 31, 2013
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Intro

Abuse

Risk

Activities

Policy

Chapter 9 Trading and Speculation
Jon Danielsson © 2009, 2010, 2011, 2012 LSE

Michaelmas Term 2012

Intro

Abuse

Risk

Activities

Policy

Introduction

Intro

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Risk

Activities

Policy

Speculation
Force for good and force for bad

• Speculators help farmers to plan production • And traders to threaten the financial system • There is no clear definition • But generally investment is long–term, speculation

short–term (buy and hold vs. buy and sell) • It is often impossible to distinguish between “ legitimate” and “illegitimate” speculation • It cannot be eliminated, even though many political leaders have expressed the desire to do so

Intro

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Terminology (Appendix)

• Party and counterparty • Orders, clearing (clearing house), settlement • Exchange vs. over–the–counter (OTC) • Market maker (quotes both sides) • Broker arranges transaction and charges commission • Netting • Central counterparty (CCP)

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scandals and abuse

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London whale and JP Morgan
• Chief investment office (CIO) at JP Morgan lost perhaps

$5.8 billion in London • Part of adjustment to Basel III, thought to lower risk–weighted assets • But became a speculative bet on the shape of the yield curve “flawed, complex, poorly reviewed, poorly executed, and poorly monitored. The portfolio has proven to be riskier, more volatile and less effective as a hedge than we thought,”

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LIBOR scandal
• LIBOR/EURIBOR benchmark interest rate (average • • • •

reported rate) Very costly because many contracts (e.g. derivatives and mortgages) have the rates set by LIBOR ($ 800 billion) Some banks manipulated is (Barclays admitted to, but others are investigated and even prosecuted) Happened before/after crisis And also to manipulate Barclays’s reported borrowing costs

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Ponzi scheme

• An entity promises very high returns, collects money, pays

handsome returns to early investors, which attracts more investors, in a pyramid scheme • Named after Charles Ponzi in 1920 in US • Best known recent is Bernie Madoff ($ 18 billion paper losses) • Happen all the time

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Rogue traders

• A bank employee manipulates the system to take very

high risk • Nick Leeson and Barings (£824 million) • J´rˆme Kerviels liberal interpretation of “low–risk eo arbitrage” causing a e4.91 billion loss to his employer, Soci´t´ G´n´rale (world record) ee e e • (Kerviel did not really get bonuses)

• Happens frequently

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Trading and Risk

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Where is risk

• Newspapers report equity markets (S&P 500, FT100,

DAX, CAC40, NIKKEI, etc.) • But the fixed income markets are much larger

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Market participants
• General term referring to those who engage in trading • Proprietary trading (prop trading) buying and selling for a

financial institution, using its money, in order to profit • This is the target of the Volcker rule, UK Independent

Commission on Banking (Vickers report), EU Liikannen report • Institutionalization, outsource investment decisions,

perhaps use a benchmark to evaluate performance
• Plenty of scope for abuse (e.g. underperformance and

fraud)
• Hence highly regulated (micro–prudential regulations)

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Hedge funds (HFs)
Lightly but not unregulated

• Lightly regulated funds that only sell to sophisticated and • • • • • •

wealthy investors (accredited) Who consequentially should be able to take care of themselves (No need for micro–prudential protection) Still subject to...
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