Shake and Quake

• Posted by Adam Warner
• on July 23rd, 2010

Big news from the people that brought us Bill Gross’s moustache (via Bloomberg).

Wall Street’s hottest new product is fear.

Almost two years after Lehman Brothers Holdings Inc.’s failure caused world markets to seize up, Pacific Investment Management Co. is planning a fund that will offer protection to investors against market declines of more than 15 percent. Morgan Stanley strategists estimate demand for hedges against such cataclysms helped drive as much as a fivefold increase last quarter in trading of credit derivatives that speculate on market volatility.

…….For much of the year before Lehman’s collapse, Nassim Nicholas Taleb warned bankers that they relied too much on probability models and had become blind to potential catastrophes, which he labeled black swans, a reference to the widely held belief that only white swans existed — until black ones were discovered in Australia in 1697. His 2007 book, “The Black Swan,” contends tail risks are becoming more severe.

To hedge against tail risks, investors usually look for the cheapest insurance against a cataclysmic market sell-off, mainly through derivatives that are expected to multiply in value as prices plummet for everything from stocks to the Australian dollar.

The Indiana Public Employees Retirement Fund, with $14.1 billion of assets, asked financial institutions in January to send information on a tail-risk management program that would protect it against “an extreme market downturn,” according to a request for information on the manager’s website.

As they state in the article, the desire for this sort of insurance is growing by leaps and bounds. Have heard odds and ends about the volatility world’s versions of CDS that they sell hedgies off market. The them’s are the same; disaster protection.

You know those way OTM VIX calls we alway see trading in size? Has to be a byproduct of this. Someone’s selling the insurance, i.e. shorting the tail risk exposure i.e. taking the tail risk itself. They in turn need to lay off that risk. It eventually has to translate to the steep skew curve we note periodically. And I have to think the steep premiums in Sep/Oct/Nov VIX futures.

I think Behavioral Finance gets it right, you want to buy this sort of insurance when it’s cheap, not pumped like this. The issue is of course the lightning-in-a-bottle nature of being exposed to “tails”.

 

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