tag:blogger.com,1999:blog-4039434.post7088400526317212608..comments2024-02-26T06:46:53.171-05:00Comments on Rajiv Sethi: Self-Fulfilling Prophecies and the Iowa CaucusRajivhttp://www.blogger.com/profile/13667685126282705505noreply@blogger.comBlogger3125tag:blogger.com,1999:blog-4039434.post-47141778663505272402012-01-02T18:26:04.023-05:002012-01-02T18:26:04.023-05:00Your point on why others did not mimic Magnetar is...Your point on why others did not mimic Magnetar is a fair one. My best guess is that this was still a trade not open to a lot of market participants. To buy the equity tranche for example, you pretty much had to be in the deal from its origination. <br /><br />And the banks were incentivised to take on exactly the inverse position due to the moral hazard and principal/agent dynamics incentivising them to take on the negatively skewed super-senior tranche in a levered form. Even more generally, the fixed income structured products market is dominated by negatively skewed payoffs as opposed to the equity structured products market which is largely dominated by positively skewed products. Investors essentially want "safe" bonds and lottery-like equity investments. <br /><br />On the CDS, I tend to agree. Again shows how difficult it is to reason from market price patterns. Does the leading movement of CDS prices show their increased accuracy or simply their primary position in this reflexive dynamic?Ashwinhttps://www.blogger.com/profile/12538605904825633269noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-92152151336253656422012-01-02T11:09:03.119-05:002012-01-02T11:09:03.119-05:00Thanks Ashwin. I've been following your blog c...Thanks Ashwin. I've been following your blog closely as usual.<br /><br />Regarding the Magnetar trade, I agree completely. They were betting against a middling outcome (equity tranche fails, senior tranche fine) and this may well be because they had such positive feedbacks in mind. But if more people had taken such positions then relative prices should have shifted to wipe out the opportunity. Why more firms didn't do the same thing is an interesting question in its own right. <br /><br />Regarding the wily investor placing the straw that breaks the camel's back, I suspect that this is much easier to do with naked CDS than by shorting bonds, which is one aspect of the debate over CDS that I think doesn't get enough attention. Just because CDS prices appear to move ahead of bond prices doesn't mean that they are always being driven by fundamental information.Rajivhttps://www.blogger.com/profile/13667685126282705505noreply@blogger.comtag:blogger.com,1999:blog-4039434.post-78865177944419154182012-01-02T09:25:05.778-05:002012-01-02T09:25:05.778-05:00Excellent post as are all your previous posts on t...Excellent post as are all your previous posts on this topic. <br /><br />Just a quick thought - the existence of a positive feedback reflexive connection between the market and the underlying results in a reduced probability of a middling outcome. In extreme cases we could have a sort of two-outcome distribution. These cases present some of the most compelling trading opportunities in financial markets. <br /><br />An example is the Magnetar trade where they bought the equity tranche and sold the senior tranche - the rationale being that either every tranche will be fine or none will be, because of positive-feedback induced selling, tightening of credit standards preventing refinancing and triggering foreclosure etc. <br /><br />This is true even without reflexivity but with reflexivity, we have the possibility than a wily trader can engineer the "straw that broke the camel's back" rather than having to wait for the disturbance that pushes the system into its alternative state.Ashwinhttps://www.blogger.com/profile/12538605904825633269noreply@blogger.com