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The Risks of Hedging Risk

Satyajit Das wrote my 2006 summer holiday reading Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).  I can’t remember much else of that trip, it was so gripping.  He is highly sceptical of the many, many financial inventions to hedge or pass on financial risk.  His latest post in the the RG Monitor describes the unintended consequences of Credit Default Swaps that are actually exacerbating the problems of unwinding defaulting debt.

“The CDS market is also complicating restructuring of distressed loans as all lenders do not have the same interest in ensuring the survival of the firm. A lender with purchased protection may seek to use the restructuring to trigger its CDS contracts.

CDS investors influenced the financing or restructuring of VNU, the multinational media business, GUS, the UK retail group, and Cablecom, a Dutch communications company. In February 2009, the US unit of LyondellBasell, the world’s third-largest petrochemicals group that is in Chapter 11, secured a temporary restraining order and preliminary injunction against a group of creditors looking to enforce claims in a bid to trigger protection payments under their CDS contracts.”

It is not necessary to understand every nuance of this article to get the message that another, entirely different approach to managing risk is overdue.  One way that might be considered is to accept risk and prepare for the downside i.e. build resilience.  While costly, this approach can have other beneficial, also difficult to model, upsides.  Another approach to managing risk is to align all interests in the deal to share the risk equally in a partnership structure such as advocated by Chris Cook in his ‘Open Capital’ LLP model.  That way no-one participant gets to be the fall guy when bad times hit.

The single message Das expounds is – if you don’t understand the risk instrument being sold to you, it ialmost certain  that no one else does either, including the seller.   Link to full article

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