U, that is. Uranium. According to this article, hedge funds have been buying up uranium.

Cue, of course, jokes from the Wall Street Journal about "a new nuclear arms race". But the story here isn't that, twelve months down the line, Citadel is going to be ending its press releases with the ominous sentence "Our words are backed by NUCLEAR WEAPONS!"

Instead, it's a way of getting in on a market that has been climbing dramatically over the last year or so.

The New York Fed's Tobias Adrian writes that, although it may look like 1998 out there, the high degree of correlation between hedge funds is no reason to be concerned.

Yes, hedge fund returns are currently highly correlated. Yes, the last time this happened was just before the 1998 crisis. But, Adrian says, this is a misleading consequence of the way correlation is calculated.
Correlation is calculated as covariance (the degree to which returns move together in dollar terms) divided by volatility (the overall movement in returns). Thus there are two things that can cause high correlation. Either everyone is following the same strategy, so covariance is high - this is a problem, and happened in the leadup to 1998. Or the markets are generally not moving much, so volatility is low - this, he says, is what is happening now.

There's an interesting second point too. As the crisis got going hedge fund volatility peaked (obviously) but the covariance between hedge funds dropped away; so some funds did well and some badly. But in the equity market at large, correlation in returns went high - returns on equities, for example, increased sharply, peaking at over 60%. In other words, the degree of contagion peaks just when there is a problem to be spread - not good news. (Sheep are most likely to run in the same direction when they're being chased.)

And, if you want more hedge fund reading for the long weekend, here's the Banque de France's 200-pager on the subject!

(via RGE)

The new issue of Risk is online now, here - subscribers can read all the articles online. The cover story this month, written by Jayne Jung, looks at the rise of products based on hedge funds - products which have immense appeal, but present real difficulties in the area of risk management.
Limited liquidity - caused by short and infrequent redemption windows - is one:

If a hedge fund has monthly or quarterly liquidity, the dealer cannot buy or sell shares in the fund on a regular basis. Instead, it has to hedge using proxies such as the HFR index - a composite index of 2,000 hedge funds created by Chicago-based Hedge Fund Research. However, using a proxy is imperfect - the returns on the hedge fund index may not mirror the performance of an individual fund of funds, meaning dealers are left with a large amount of basis risk.

Given this infrequent liquidity, the biggest exposure for dealers is gap risk - the risk that the value of the hedge fund will plummet following a massive widening of credit spreads, a large spike in volatility, a rapid reversal of equity or bond index trajectories or the implosion of the underlying hedge fund. In such an event, the delta-hedging of their exposures would require them to sell their holdings in the hedge fund - although the sharp drop in the NAV of the fund would mean the dealers are selling at a sizeable loss.

Read the rest at Risk.net.

Here is your quant homework for the weekend...

Damiano Brigo and IMI colleagues Andrea Pallavicini and Roberto Torresetti discuss the issue of modelling loss distributions in pools of credit names in this month's Risk. They produce a fairly straightforward GPL model, but the paper leaves some questions open: leave your thoughts in the comments.

More dubious news from Optionable, the NY brokerage involved in massive energy trading losses by Bank of Montreal. The story so far is here - now we learn that, according to the National Post, Optionable's management sold $27 million worth of stock just before the losses were discovered by BOM's auditors. (They sold it to Nymex. Bad move, Nymex; the stock has now fallen 88%).

The bank has also said David Lee, the trader believed to be responsible for the losses, is on leave, along with Bob Moore, the bank's executive head of commodity products.

Sources say Mr. Lee has a close personal relationship with executives at Optionable, including Kevin Cassidy, the chief executive, who made US$5-million out of the April 10 share transaction.

In the same deal, Mark Nordlicht, Optionable's former chairman, picked up almost US$19-million for seven million shares sold to Nymex.

Investigations continue...

When I spoke to the CFTC's Reuben Jeffery back in March, I asked him whether there was a prospect of a merger between CFTC and SEC to create a single regulator - he replied that, while there was "growing overlap" between the two, he didn't see them merging.
Since then I've been looking through back issues of Risk in preparation for our 20th anniversary issue later this year (of which more later) and found that the same issue was being discussed in 1999, and before that in 1988. Obviously one of those perennial arguments...

Another regulatory merger seems to be moving rather more quickly - the oversight arms of the NASD and the NYSE should be merged by this summer, according to NASD's chairman Mary Schapiro.

And, following up on the insider trading issue, a guilty verdict in the Morgan Stanley insider-network case. (But insider trading's still definitely on the increase.) And the FT reports on the SEC's new approach to investigation; it's extending its reach abroad, but that means that it may be producing less conclusive evidence.

Here's a futurist question for you: is better technology - such as increased use of real-time monitoring of exchanges by the SEC, or improved pattern-detection software to spot suspicious trades - going to make insider trading harder? Or will the growing size and complexity of the global financial markets give the criminals the advantage in the future?
Personally I'm a pessimist - it seems to me that "hard crimes" (such as murder, piracy and aggressive warfare) all seem to be becoming much more difficult as technology, especially communications technology, advances. Meanwhile "market crimes" (drug trafficking, people smuggling, gun running and copyright infringement) are growing apace. But perhaps this is too broad a view...

The FT spreads itself today on the subject of covenant-lite loans. Worth reading - the issue was brought into prominence yesterday by Anthony Bolton, Fidelity's Special Situations fund manager, in his valedictory speech from the firm.

Risk will be covering the subject in more detail in its next issue, but in the meantime a quote from one lawyer I spoke to today: "The people making these loans are like the people who were buying dot-com shares in March 2000 – they think the only risk is being excluded from the market. I am 100% certain that one or two years from now, we will look back on this as a turning point."

I've yet to find anyone who can explain why this time it will all be different and the unsustainable will somehow be sustained - no doubt they exist, though.

The plot thickens at Optionable, the NY broker involved in trades that lost Bank of Montreal a huge amount - now estimated at $680 million. We are rapidly heading into Brian Hunter numbers here. Actually, the whole business is starting to look a lot like Amaranth, as the National Post has noticed. We have a high-performing trader - the now-fired David Lee (his boss, Bob Moore, has also been sacked) - whose impressive returns led management to loosen their oversight, the Post says. And it even happened in the natural gas market!

But there are also suggestions of something darker. While Amaranth was simply an example of what happens when a highly directional trade goes wrong, the bank has now suggested that there might have been "irregularities" in the BMO trades with Optionable. Nymex, which owns 19% of Optionable, has pulled its directors off the board. And CEO Kevin Cassidy has resigned after it turned out that he had been sent Up The River for three years for fraud and tax evasion in the 1990s. In a moment of inspired dishonesty, it seems he resigned a few months before the IPO in 2005, and then rejoined after it was completed - thus apparently avoiding the tedious necessity of admitting to potential investors that they were about to put their money into a company run by a convicted felon.

Other shareholders are suing the brokerage, alleging that it concealed its dependence on business from the bank, and concealed the losses that the bank was making on its trades (which led the bank to sever the Optionable connection, thus effectively dooming the brokerage). The suit also alleges that the bank's natural gas trades were being systematically mismarked - presumably in order to cover up the losses.

"This story just gets better and better," as Greg Newton comments.

Sean Park notices the Economist picking up on the possibility of hedging sports risk - specifically, pricing advertising slots during a match depending on the score and the time, both of which affect the number of viewers...

Broadcasters can capture some of this variation by charging advertisers on the basis of viewing figures. But ratings-based fees are retrospective and advertisers have to decide where to spend money ahead of time. Tanaka’s Stefan Szymanski thinks there is an argument for “contingent” pricing, whereby advertising slots for sporting events would be pre-auctioned, with bids depending on the score at each point in the game.

New research from S&P hints that the "junk bond" category could be a thing of the past. The spreads on both investment-grade and junk bonds (sorry, speculative-grade bonds) are at record lows, thanks to, basically, huge amounts of capital looking for a home. Almost half the corporate world is now junk grade, driven down by growing leverage and growing tolerance from lenders.
CFO.com:

For example, wrote S&P, from 2003 to 2005 investment-grade spreads slid close to 100 basis points; during the past 12 months, they have averaged 133 basis points.
The spread for speculative-grade debt has also contracted sharply, from 800 basis points in January 2003 to about 340 basis points during the past 12 months.

And the takehome quote:

"With spreads compressed across all rating categories, the cost of maintaining an investment-grade rating no longer affords firms a significant cost advantage," said Diane Vazza, head of Standard & Poor's Global Fixed Income Research Group.

It's another angle on the same story - high liquidity makes debt a borrower's market, and lenders' confidence is boosted further by the secondary debt market, which allows them to resell risky debt rapidly and reliably.

One of these days - maybe this year or maybe next year - a major leveraged loan deal is going to flop, embarrassingly and publicly. What happens then? Well, that'll be an interesting time for everyone, won't it?

Jason Ruspini at Risk Markets and Politics has thought of an answer to this question: what is the biggest uncovered risk category, and how would you hedge it? He suggests that the time is right for policy futures. For example, if your brewing business stands to lose from an increase in the tax on alcoholic drinks, then you should be able to hedge that risk by buying futures that will pay off if the tax goes up.

It's an interesting idea - but I can't help but be suspicious. In the example above, who takes the other side of the trade? "Speculators", says Ruspini, but that's no substitute for a naturally exposed counterparty. Who'd stand to gain from an increase in the beer duty? Apart from the treasury, of course - and I suspect that might be regarded as insider trading.

Ruspini invokes the special interest problem of concentrated benefits and diffuse costs, but it's difficult to see how a market would represent the diffuse costs well, if those who are bearing them are insufficiently interested to get involved.

But I'm open to conviction on this one. Comments? Will we soon see the end of the lobbyist and his replacement by the political futures trader?

Tim Weithers at the University of Chicago, writing for the Atlanta Fed:

The probability of systemic risk in the banking industry attributable to credit derivatives stemming from macroeconomic events is probably much lower than in the past – due to the dissemination of default risk among a broader investor base. This may not be true, though, of the insurance industry (“insurance companies account for only 1% of protection buyers versus 20% of protection sellers.”). The distribution of risk has its downside, though, in terms of control. Some may recall the days in which the Fed targeted the money supply. Because banks were so clever at creating money substitutes... eventually the Fed simply gave up attempting to control or target the monetary aggregates. One wonders whether there is an analogue at work with the control of credit risk (through credit derivatives).

The whole thing is worth a read.

Also, conflicting views on the European emissions trading scheme: a couple of environmental economists says it's been a success. Alea is not so sure, pointing to the embarrassing price crash from over €30 to under €0.50 since the start of 2006.

Taking the issue raised in the previous post a little further...
Risk covered the election markets previously here and the use of prediction markets here - though, of course, there is a difference between prediction markets, which are financially insignificant, and an event futures market big enough to be used for hedging purposes.
And Jason Ruspini points out in comments that there is significant basis risk between political event risk and election prediction; even if you hedge against a certain party being elected, there's no guarantee that they will follow the policies you're worried about (or vice versa).

Is there potential for abuse? If a company goes long on Policy X on the event futures markets, and then lobbies the government to follow Policy X, is it market manipulation?