December 24, 2009

A Demon of our Design

My first book after an extended study vacation that probably served no purpose to me. The book essentially tries to answer a simple question: Why is every new crash create larger impacts given that markets attempt to become more complex and strive to become efficient in its attempt to reduce impacts? To answer this, the author discusses many things mentioned below and the role played by hedge funds. He argues that merely blaming these funds as a cause for all disasters do not serve any purpose.

First, He does argue beautifully albeit in an elaborate manner, why added complexity serves no purpose: the possibilities of a mistake, as minor as it can seem, can lead to a big disaster. Adding layers to reduce disasters serves no purpose. The steps that preceded the disaster of Chernobyl and Valujet. I was really wondering why the author was spending such a large amount of time discussing the obvious point. It was an important point anyways.

Second, he argues for simple financial structures given that they have non-linear payoffs, the complexities that gets added due to globalization. He correctly assesses the risks of having MTM instruments, something that we saw in the current crisis.

Third, he advocates low leverage and consequently lower liquidity leading to lesser crash impact

The definition and importance of hedge funds was explained in a fair detail but one can clearly sense a bias on that one. Discussion on reducing inefficiency in the market, playing a vital role of providing liquidity to the market, transferring risk etc.

There is a good discussion on the functioning of a good fund: how much money can be played when information hits the market, importance of understanding how money is moving, continuous flow of information and how they are absorbed in the market, driving factors for investing in a specific stock and more.

There are some discussions for people who are interested in derivatives. However, I found that segment relatively unexciting. Overall I don’t think one really misses too much if one does not read this book. Hence, I would say…read it when you are really short of books on hand.

One of the good lines to take from the book: John Merriweather, “The hurricane is not more or less likely to hit because more insurance has been written. In financial markets, this is not true. The more people write financial insurance, the more likely it is that the disaster will happen because the people who know you have sold the insurance can make it happen.”

1 comment:

Mrunalini said...

what study leave? did you do cfa too ?