Arnold Kling  

Make them take Basis Risk

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Eric Falkenstein writes,

because financial contracts have virtually zero marginal costs, sometimes an inflated 'face value' arises because it is easier to keep adding offsetting ones, rather than extinguishing some and starting over, the way a futures open interest works. The reason why derivatives are not transparent is that they come in some many different flavors they escape any reasonably finite taxonomy--they are 'over the counter' and thus have idiosyncratic terms.

He argues that this makes simple-minded regulatory schemes, such as setting capital requirements, untenable. Read his whole post, and for additional context, Tyler Cowen's reply.

I want to elaborate on the distinction between contracts traded over-the-counter (OTC) and futures contracts. Futures contracts are safer for a variety of reasons.

Futures contracts are more liquid. They are traded constantly, and there are many potential buyers and sellers. The OTC market has to be made privately, by a few firms, such as Bear Stearns.

With futures markets, there is insurance against counterparty risk. When I close out my position on the futures market, the central clearing house is responsible for settling my account. I am not dependent on the particular party that took the opposite position.

OTC derivatives have two possible advantages to financial institutions. First, they may allow risks to be hidden from regulators. That is not a good thing.

The other advantage is that they provide a more precise hedge. Futures contracts only exist for specific financial instruments and specific dates. When you hedge using futures markets, there is often a slight mismatch between the futures contract and the instrument that you are hedging. This mismatch is called basis risk.

For example, consider a mortgage originator offering an interest rate "lock" to a borrower, meaning that the borrower can decide any time in the next few weeks whether to close on, say, a 6 percent mortgage, regardless of what happens to market rates during that time. If the originator hedges by going short in the futures market on ten-year Treasuries, the contract may have a delivery date that is a few weeks after the expiration of the "lock." Moreover, ten-year treasuries and fixed-rate mortgages are not perfectly correlated. All of that leads to basis risk.

I think that if I were a regulator, I would rather see financial institutions using futures markets than OTC derivatives. I would want to tilt the incentives in that direction. That would mean increasing the incentive to take basis risk, in exchange for lowering the incentive to take liquidity risk and counterparty risk.

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COMMENTS (3 to date)
Different River writes:

The example of a mortgage lock is not really the best example, because the mortgage originator is -- believe it or not -- not actually obligated to delivery the funds at the locked rate, or even at any rate. Less-than-honest mortgage brokers often use this to squeeze a few points out of home buyers by adding points or raising the rate the day of the closing, and then pointing out to the buyers that if they don't accept the new terms, they forfeit their deposit to the seller.

This actually happened to me, and to many other people -- and things like this exacerbated the current mortgage problems

Snark writes:
Futures contracts are more liquid.

And cattle futures contracts are more lucrative.

David Harper writes:

Great distinction. Some other examples related to basis risk:

1. one culprit in the subprime (sythetic CDOs): CDS basis. CDS didn't often hedge the super-senior CDO tranche

2. cat bonds are interesting examples. Indemnity triggers have little basis risk but moral hazard. Versus indexed/parametric notes: no moral hazard but grave basis risk

3. credit derivatives linked to credit indices are analogous: index is transparent (liquid) but basis risk

David Harper

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