The Canary Correction - Part 1

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Matt Blackman

09 Jul, 2006

in Indices and 2 more


caption: Figure 3 – An interest rate swap is an agreement between parties to exchange interest rate flows at intervals over the life of the contract. Currency options and futures contracts are examples of a currency derivative. Their use has increased dramatically in the last two decades
Chart provided by www.TradingEducation.com.

Credit default swaps, which protect the buyer against default of a bond, have grown even faster, doubling in size every 1.67 years since 2001. Even the slowest growing of the group, equity derivatives, have doubled every 2.53 years since their inception, nearly as fast as the Nasdaq during the Internet bubble. As Figure 4 illustrates, equity derivatives have been dwarfed by the popularity of credit default swaps.

Never before in history had so much money flowed into a market so rapidly. Was it sustainable? And what happens to the markets into which this money has been pouring when the flow inevitably slows?

Another concern was the unusual spike in volatility as global markets came unglued. When the Chicago Board Options Exchange (CBOE) Market Volatility Index (VIX) hit a 38-month high on June 13, stock watchers saw that as a sign of a possible bottom, but those institutional and professional fund and money managers on the wrong side of the trade got hit hard. Only in time will the world know the total size and impact of the losses.


caption: Figure 4 – Credit default swaps are in effect insurance policies against default by an individual, corporation, institution or nation. One party (buyer) pays a fee to another party (seller) in return for compensation in the event of default of a bond, for example, or other instrument by a reference entity. 
Chart provided by www.TradingEducation.com.

Although it is too early to gauge the damage this recent multi-market meltdown has inflicted on the global financial fabric and whether the incredible growth in derivatives is sustainable, let’s look at the rate funds have flowed into them. The most recent data for the annual rate of change of interest rate and currency derivative show the fund flows continue to decline and have been doing so since 2002 (see Figure 5).

Each time fund flows have hit relatively low levels, a bear market or emerging market crisis followed. In 1994 it was the Tequila Crisis in which the Mexican peso lost more than 30%, decimating the Mexican economy with shockwaves felt around the world. In 1997 is was the meltdown in the Thai baht that spread to global markets in the “Asian flu.” In 2000, it was a bear market in which the Nasdaq Composite was to drop more than 80% with fallout spreading to nearly all asset classes.



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Rookie (5 posts)

Where's Part 2 ??? did the canary die ?

Aug 06, 2006

Senior Member (461 posts)

I have two concerns about derivatives.
1) The speed at which funds have flowed into them in the last few years. Normally this rate of inflow has been followed by a major correction in other markets that have experienced this rapid an increase.
2) The rate of change of inflows is now declining and this has been associated with corrections or at least emerging market meltdowns in the past. I don't believe that derivates will end the world. They are here to stay. But as they are relatively new and have experienced irrational exhuberance of late, gives me reason for concern, especially given excesses in other asset classes. Matt Blackman

Jul 12, 2006

Rookie (5 posts)

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