Saturday, November 15, 2008

Brave new questions but not as Brave!

Ajit Balakrishnan writes in BS “Greenspan never saw how derivatives would make the housing crisis a global one”. 

But other questions are equally important but not so plausible;

 Why did, then, Warren Buffett, whose financial acumen is legendary, describe them recently as “weapons of mass destruction”? Where did they come from and how did they become such objects of veneration as well as hate? 

The mathematical model they came up with, the Black-Scholes model, did its job of pricing options so well that Gladstein made tons of money using it, Merton and Scholes won the Nobel Prize in Economics for it, and started the rush of mathematicians to the stock market. 

Derivatives are a way to “hedge” against these risks. For example, a housing loan to a borrower in, say, Cochin can be combined with a housing loan in Mumbai and another one in Bangalore under one common instrument and this combined “derivative” can be sold to an investor. This combination reduces the risk of disparate housing markets such as Cochin, Mumbai and Bangalore all suffering downturns at the same time. The investor in this derivative rightly believes that the instrument he holds has a balanced risk.    

If derivatives can diversify risk, as just described, what can go wrong? 

When Greenspan, who was Chairman of the US Federal Reserve Board, was told about similar issues developing in the US mortgage securities market he believed that such problems in the housing sector would be restricted to a city and could never become a national, let alone an international problem.” 

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