Tuesday, 4 May 2010

Risk avoidance vs Risk spreading

By now there is every chance that you have heard of credit default swaps, the instruments at the heart of the financial crisis of a year and a bit ago. Unless you are like me and the Tamil movie scene, that is – surely I must be the only Tamil in the world who hadn’t heard of Asin (for non Indian readers, this lady seems to be the Tamil equivalent of Zhang Ziyi/ J Lo (?) ). So I can’t say that there you cannot, but, have heard of that silly acronym CDS.

All derivatives, like credit default swaps, spread risk around; they don’t reduce or eliminate it. Most derivatives are fiendishly complicated, so much so that the most simple and basic derivative, which would surely tax the intellectual powers of the aforementioned Asin, is called “plain vanilla” by the geeks. But all they do, for their incredible complexity is play pass the parcel – they simply pass the risk to somebody else. Or chop it into individual bits and toss the bits around. Or find all sorts of devilish ways to spread it. But its all just a form of pass the parcel.

There isn’t enough done to avoid or mitigate the original risk in the first place. The analogy is one of taking a fire insurance in your house, feeling very safe and secure and then stuffing it with propane and smoking next to it. What about fire avoidance; what about fire fighting equipment; what about safety measures; what about fire alarms ……

Derivatives bring a false sense of security to the people who take the risk in the first place. Just because they have passed the risk around, they feel safe. And since the original transaction has been decoupled from the derivative, the focus of risk avoidance on the original transaction seems to fall. Therein lies the great danger. Risk has actually increased because of a false sense of security of having passed it somewhere else. The risk has not gone away, its just floating in bits and bobs all over and if it bursts, its effect overall would be almost the same as if it hadn’t been spread around.

Having spread the risk, you are tempted to take more risks, on the security of being able to pass that around too. This creates a domino effect and the total risk in the system exponentially increases. Under normal circumstances , this doesn’t matter – some punter wins and some other loses. But if a tsunami starts, it becomes a massive destructive force that can almost destroy nations, as the crisis in 2008 demonstrated. Little wonder that the inimitable Warren Buffet called derivatives as weapons of mass destruction some years ago.

It’s a little bit like this. Lets assume the fabulous Asin decides to produce and star in a new movie – lets call it “Gilsa Zenova” – just for illustrative purposes, OK ? There’s a high probability that the movie will flop and that the two featured gentlemen will write a review in their blog praising her beauty but panning the movie. So what does the lady do ? She goes out and buys an Movie Flop Swap – a derivative that says RamMmm, Ravi, Kiwibloke and such other wealthy punters shall pay her $1m if the movie flops (added bonus; she’ll have dinner with these three before they write the cheque). Now that the damsel is safe (at least monetarily), it does not mean that she should not make some attempt at getting a decent story, some attempt at getting a passable hero (a slimmer version of Vijay, I am told, will fit the bill), put a little vigour in the dance, a little more speed in running around the tree, a little more rouge on the cheek, bat the eyelids a few more times, perhaps shed a few pounds despite the fondness for buxomness ……….

Get the picture (pun fully intended) ?


zeno said...

Pl pl do not insult J.Lo. J.Lo is J.Lo. Asin is no where near J.Lo.

On behalf of punters, more details on the dinner please ;)

running around the trees? oh that is more like 5" or 8" diskettes ;)
Nowadays ppl run around hong kong singapore!

I was in an understanding non business funny posts were meant only for sundays ;)
Were you talking about derivatives?
I thought you were explaining about how tamil movies work by correlating with CDS[the anology is so apt!]

zeno said...

It is time we should introduce you to Namitha ;) http://en.wikipedia.org/wiki/Namitha

Vishal said...

Ramesh - you made us understand the concept so beautifully and so "zenogilsfully", I am not going to forget CDS for rest of my life. :-D

Seems magic of "Asin" is working to its best. I hope these wealthy punters (would you mind entering into a swap with this lovely lady) would not mind if one of us (Gils or Zeno or May be I) go out for dinner.

Am not sure you will react to introduction of latest damsel by zeno.

@ Zeno - thanks for the introduction. ;-)

Ramesh said...

@zeno : I stand corrected. J Lo is J Lo. Then who is Asin ?? :)

This was a damn serious post on derivatives and risk. Where on earth did you get the idea that it was a funny post ? :) :D

Oh no; one more lady to become aware of ? This education drive is going rather too fast :P

@ Vishal - That's exactly how the market operates - you are free to approach any of the three punters and swap the main course for a date with the president of the CA Institute or whatever !!

Did I read your comment on the swap right ?? Of course you must have meant something else. Not even I would pass on an opportunity to dine with the star :)

Vishal said...

I thought she could even come to you for the movie flop swap. :)

On a second thought, the analogy was superb. Mind-blowing stuff! Absolutely makes great sense. Risk was never mitigated in the first place. You pass the risk to someone and someone passes it to someone else and so on. And in the process, underlying risk remains there - just like a volcano waiting to erupt!

Durga said...

Ramesh, you explained it nearly as similarly as an authority on Derivatives did sometime in February this year. The concerned person is based out of Mumbai and his knowledge in derivatives was so profound and his explanations so simple, that a dunderhead like me could actually understand the implications much better than read the complicated standards and write-ups on derivatives and not understanding a thing about it! That's when I realised that what Warren buffet said is 100% true. The Blog Professor at his best again! Hip Hip Hurray!

ambulisamma said...

A heavy subject in a lighter way,you rock ramesh.

Ramesh said...

@Vishal - ahhh ; I'm honoured at the swap idea.

@Durga - Is there a link to that expert's explanations. Or was it a talk ?? Would be very interested to read if I can.

@ambulisamma - Thank you; you are very kind.

Ravi Rajagopalan said...

Another gem from the same Scottish chappie I referred to in an earlier response to an earlier post. Commenting on the relentless sales efforts of a fellow banker who was selling CDOs to anyone who was mug enough to spend five minutes in his company: "A man comes to mr x (the banker) and says - My wife is dead, my children are druggies, i have just lost my job and i have lost all my savings. what do i do?. Mr X replies - thats all very well but have you tried a CDO?" :)

Deepa said...

I am on a lookout for the pirated CD of 'Gilsu Zenova'!!! jujubi.. :D

Btw comparing Asin to JLo was a sacrilege. I knew it one of the boys would get spurned, but right on the first line of the first comment!?!? No wonder, they are sending u links in frenzy for 'asinful education'.

You've explained it so well! Me and my husband almost had a fight when I was explaining debt- securitization to him! These CDSs look like contracted wagers to me!

RamMmm said...

What shall I say, sire, what shall I?

You made a awesome dish with your skillet of the concept with the analogy, and what an analogy it is :) :)

As an honoured wealthy(!) punter, I'll be damned by missus if I dine out (alone) with Asin and the swap is available for a derived consideration. :)

And wouldn't Asin be 'asin'ine if she did all this? :)

gils said...

aaaha....thalaivar is surely smitten with asin :D :D intha postla kannula patta edam ellam asin puranamavay iruku :D :D wiki link vera!!! avvvvvvvvvv chaancela...u shd've chkd ur hit counter before this post and now :D

Ramesh said...

@Dada - Oh, the boor bankers ....

@Deepa - My knowledge of Hollywood ladies is only slightly better than the knowledge of Kollywood ladies. So simply picked one of the two or three names which at least I wouldn't ask Who's she if mentioned !!
CDSs are certainly useful to get the risk off your books, but the punter who takes them on is no different from the Las Vegas or Macau types.

@RamMmmm - Superb comment full of intended puns. Have you ever considered a career in writing movie scripts ?? They write such horrible stuff and you write such brilliant stuff - Can visualise as the credits roll - kadhai, vasanam, direction - RamMmm

@gils - Totally smitten !! I was hoping for a considered review of the said lady's star appeal from THE expert. Maybe a post in your blog .......

Sandhya Sriram said...


you should seriously consider writing a book ..... finance demystified! I second all the nice comments which have been written on the absolutely inimitable simplfication of such a deep concept!!

there is no concept of risk avoidance! the very reason someone takes up a risky proposition is to make more money. there is no business if there is no risk taking. now the question here is that whether the risk spread is a business risk or a speculative risk. in these instruments, due to the complexity of the deals, the end buyer has no idea on what risk he is investing in. and if one have invested in a speculative risk then he must be ready to face the outcome as well

thanks Ramesh for such a wonderful post!!

zeno said...

and you should also do an analysis of search keywords that direct traffic to this post. am sure you would be surprised

RamMmm said...

Incidentally I heard this song on radio today. Very funny.


kiwibloke said...

What contradictions - Kiwibloke, wealthy, punter are three words that do'nt go together! I figured out Asin about a couple of months back so you are not alone. Reminds me of an interesting episode way back in the 90s. Was flying BLR-MAA and a pretty young thing was sitting next to me. Lots of people craning their necks towards my seat (Felt flattered that every one in the plane was looking at me) Then realized it was the PYT they were looking at. I looked as well, could'nt figure out, but face looked kinda familiar. Curiosity killed the cat, yours truly turns to her and sayz "gee, excuzes, but you look kinda familiar, did we go to school together, or somethin?" Blank cold stare from PYT. Later I figured out when one of my mates who was on the back of the plane was all excited about the fact I was sittin next to one Meena who was the leading light of the day in Tamil/Telugu movies!

Ramesh said...

@Sandhya - As always, a great angle from you. I completely missed the fact that without risk there is no business ; so you can't truly avoid risk. Totally agree that if somebody takes blind risks, he should bear the outcome as well and not moan about it.

@Zeno - Oh; I don't do traffic monitoring; its enough for me if the wonderful people who comment here, come to this blog often.

@RamMmm - Darn; that's blocked too by my wonderful nanny. Will find a way to duck under.

@kiwi - Kiwi ? certainly, punter ? sometimes, wealthy ? reasonably so :):) Delighted to hear that i am not alone in ignorance of the charms of many PYTs !!

05 May, 2010

zeno said...

Just an enlightenment fact!
I think back in 90's she would have been a PYT ;)[meena]
Recently she got married to a S/W guy. She is one of a very rare females cause she acted as [almost] daughter to rajnikanth and paired with him as heroine and many are hoping she might even act as mom to him ;)[hoping and praying you wont ask who is rajnikanth]
@kiwibloke, i think, she may have never seriously considered that you couldnt recognize her and highly probable that she felt you were pulling a trick to impress her.

Ramesh said...

@zeno - You are truly a walking encyclopaedia. How come you know PYTs of the 90s when you would have been in your cradle :):)

Btw, R is at least one name I can say I know. Have even sat in the front row on a night show and whistled to his charms in some bygone days :)

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