Monday, October 11, 2010

Mayer’s Laws of Derivatives

From a 1999 interview with Martin Mayer in Derivatives Strategy

The first is that when the whole is valued at less than the sum of the prices of its parts, some of the parts are overpriced. What this usually means is that you’ve separated out and sold the toxic waste, and you’ve found customers for the Z tranche.

The second law states that when you segment value, you also segment liquidity. The second law is absolute. The very factors that allow you to sell the part for more mean that you’ve tailored the instrument to the needs of specific customers. And that means that in the end you have a smaller market for these parts than you might have for the instrument as a whole. That’s demonstrably true.

The third law involves the deconstruction of credit judgment. The rule holds that risk-shifting instruments will tend over time to shift risks to those less able to bear them, because “them as got want to keep and hedge, and them as ain’t got want to get and speculate.” It always turns out that you do business with firms that are B-rated and worse, because you can get the best prices out of them. So there’s an inherent instability in the tendency of credit judgment to deteriorate as you make money going down the credit scale.

I’ve worked on a fourth law, but haven’t come up with the right aphorism. That law will hold that the more abstract the instrument, the less it depends on real developments in real economies, and the more likely it is to be a vector of contagion.

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