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Derivatives

March 13, 2003

There has been a lot of attention paid by some sectors of the investment community regarding the "time bomb" represented by the open derivatives position, and the size of the JP Morgan derivatives book in particular.

Recently, even Mr Warren Buffet saw fit to comment on the risks inherent in the derivatives market and, given that Berkshire Hathaway happens to own one of the largest re-insurers in the world, I would imagine that he knows what he is talking about when it comes to risk.

Nevertheless, I have been applying my mind to the question of derivatives - from a purely conceptual perspective - and I find myself wondering about two factors on which few people seem to focus:

  • All derivative contracts have an expiry date. When the expiry date is reached, the contract is either rolled over, or is allowed to lapse.
  • Not all derivatives contracts are "one way". Some are bets that a market will rise, and some are hedges against a fall in that same market.

Logic dictates that most contracts that are "out of the money" at expiry date are allowed to lapse, whilst many that are "in the money" are likely to be rolled over (but only if this is mutually acceptable to BOTH parties to the transaction).

Take a "call option" on the gold price as an example. If - when the gold price was trading at $300/ounce - I bought a six month option to purchase physical gold at $350 an ounce, the "loss" to the option writer (if he did not cover his risk by buying forward production of some gold mine) would be the difference between the market price (currently $350) and the $350 strike price less the premium I was charged for risk. (ie At present, the seller of the option described would have zero loss). Of course, if the seller of the option thought that the gold price would rise even FURTHER following expiry, he would almost certainly be predisposed NOT to roll the contract over.

Now let's assume that JP Morgan was the ultimate seller of the option, and let's assume that their "Investment Committee" was focussed on the risks inherent in the original call option transaction; would they not seek to cover the bank's risk by buying forward production at current market price? My common sense tells me that it is drawing a long bow to assume that JP Morgan would be totally bereft of any propensity to manage their risks and so the probability of a totally "naked" exposure is open to question.

Let's assume that they did decide to buy forward. How would that contract be shown on their Balance Sheet?

From an auditing perspective it could be argued that a contract to purchase a future delivery of gold is an out and out liability - which should be reflected on the Balance Sheet. However, the Bank for International Settlements happens to have a guideline regarding "Capital Adequacy" which states that a bank's equity should never fall below a certain minimum percentage of its liabilities. In this context, ALL banks (which are populated by human beings possessed of the same frailty as you or I) will be predisposed to want to minimise their liabilities as shown on the Balance Sheet.

So what would I be arguing if I was the banker in question? Well, it should be recognised that a future contract to purchase anything will be 100% attributable to "the bank's" capital. I would therefore be highly motivated to ensure that as the forward purchase contract was really a risk management tool to offset the "contingent" liability of the call option I had sold, a risk of a "fall" in the gold price was just as high as the risk of a "rise" in the gold price. I would therefore be arguing forcefully against characterising the forward contract as a liability because of the implication that any loss would be 100% leveraged against my equity base if the auditors were ever to focus on this issue.

My argument to the auditors might be that if the gold price rose, I would deliver the forward purchase against the option and would experience no loss, and so there was no real liability that would need to be reflected. I could also argue that if the gold price fell, the call option would expire and at that time I might elect to buy (and hold) the gold which I could put on my Balance Sheet as an asset and hold it for an unrealised loss, or I could choose to sell the gold. And given that I would have the option to hold, and given that we cannot tell now what the "loss" might be, this should also be regarded as a "contingent" liability.

So, in this context, I might be predisposed to try to convince my auditors that NEITHER contract would need to be put onto the Balance Sheet itself, and that BOTH transactions should be treated as derivative contracts.

Let's keep assuming that I was employed by JP Morgan and I had the view that gold has now entered a long term (Primary) bull market. What would I do? Here are some decisions I might take:

  • Significantly increase the price that I charge for the call options that I sell going forward, thereby reducing the number of call options that I sold.
  • Let a higher proportion of "wrong way" bets (from my perspective) lapse on expiry.
  • Try to manage the risk (buy time) until such time that as many as possible derivatives contracts expired - and thereby attempt to minimise the loss
  • Try to offset my risks by taking bets the other way

Whilst I am no closer to understanding the "real" exposure that JP Morgan may have to its derivatives book, I am reasonably convinced that it cannot be as stark as some people are pre-disposed to want to argue. To argue that JP Morgan is TOTALLY exposed to its derivative book is to assume that its Senior Management is both negligent and stupid. At face value that argument seems to be a bit extreme.

Now, just to round off the argument: Assume that JP Morgan also employs people who understand the concept of a "Primary" trend, and assume that their Senior Management is now aware that selling call options going forward is a highly risky proposition (and that their auditors are now behaving with greater vigilance, and are therefore more difficult to convince).

Would it not be reasonable to assume that JPM will do everything it can to keep the gold price from "exploding" upwards until the majority of the open "wrong way" derivative book had expired?

In this context, the recent consolidation of the gold price should not be coming as a surprise to anyone who might stop to think about it. Further, an assumption that the gold price will "explode" upwards is predicated on the assumption that there will be a dislocation in the markets, flowing from some form of panic. Again, it seems to me that thinking in terms of only one side of the equation is a predisposition of those who think only in terms of extremes.

For example, if there was indeed to be a "dislocation" in the markets, why should it be assumed that this dislocation would be confined to only one market? Clearly, a "panic" would more than likely manifest in several markets at once.

Under circumstances of panic, what are the authorities likely to do? By way of example, in Argentina, when there was a run on the banks, the banks stopped paying out depositors. The rules of the game were changed to ensure that the markets were allowed to continue functioning, albeit in a crippled state.

So let's not lose sight of the fact that the authorities ultimately have the ability to change the rules of the game, and in the case of the derivatives market, the probability of this approach seems quite high to me. By way of example, if the gold price were to "explode" to $3,000 it is virtually certain that any contractual option to purchase gold at $350 would not be honoured. The counterparty risk of derivatives contracts should not be ignored, and there are TWO counterparties to any contract. In this context, it seems highly unlikely to me that the counterparties who are "short" gold will be the same people who push up the price of gold to $3,000/ounce. They will merely elect to seek protection under Chapter 11.

So who will be the people who "panic" into gold?

Certainly not the Indians, who are the largest consumers of gold, and who have demonstrated a high sensitivity to price rises. When the gold price rises only a few dollars the Indian market seems to shrink dramatically.

Certainly not any Central Banks, who are all predisposed to want to maintain order in the markets.

Arab Oil Sheik's? Possibly, but then they would forego significant oil revenues going forward as other markets became dislocated.

The moms and dads? With what? The money they lost on the Nasdaq?

Mutual Funds? With what? There is likely to be net disinvestment at that point and they will not have cash.

High net worth individuals? Possibly, but look at Newmont's capacity only. That company produces 7.5 million ounces a year. That's $22.5 billion dollars that the high net worth individuals would have to find, and most don't have cash lying around. It is typically tied up in other assets such as real estate or government bonds. I haven't taken the trouble to add up the net worth of the world's top 100 wealthiests persons as published by Forbes Magazine, but assuming an average of (say) $15 billion each, that's around only $1500 billion.

It seems to me that holders of Government Bonds represent the highest probability source of funds to drive the gold price higher, but this begs the question regarding what will happen to interest rates if people started to "sell" government bonds in favour of gold. Certainly, interest rates would rise strongly.

Ultimately, this is why I have been focussing with such laser like attention on interest rates. There is no sign yet that they want to rise at all, and I find this a very disconcerting fact, because it implies that we might be headed into a period of deflation.

Conclusion

It seems to me that there is no logical connection between the state of the derivatives market and the propensity of the gold market to "explode" upwards. Whilst I am personally convinced that - because of the imbalance of supply and demand - the gold price will indeed rise over time, it seems more logical to expect the rise to be of an orderly nature over the long term - as is being reflected currently on the monthly charts. Finally, it seems to me that if/when the rise begins in earnest, there might be an initial burst through $400 to around $550 per ounce (as is already being anticipated by some share prices) following which the rising trend will assume an orderly "angle of incline". This breakup may not occur for a year or more, except if there is a market dislocation.

Notwithstanding this conclusion, it also seems sensible to take out some form of insurance policy against a dislocation in the markets, and therefore gold bullion should be bought as an insurance policy.

Silver, on the other hand, is a different proposition. For reasons that have been fully explored by others on the GOLD-EAGLE web site, it seems to me that the angle of incline of silver's Primary Bull Trend is likely to be steeper than that of gold when taking a long term view. Furthermore, the public as a whole would be able to participate in a market where the price of the commodity is currently only 1.4% that of gold. Even (say) 2.8% of $3,000 ($84/ounce) would be affordable by the average person.


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