Sam Sez

Date: September 25, 1998

Question: "Heads I Win, Tails You Lose!?"

Answer: That apparently is how the Russian Sovereign and Currency Markets operate.

First, induce investors such as hedge funds, mutual funds, banks and brokerage houses to purchase the equivalent of treasury bills. Effectively, these are obligations of the state or government. So far, the government wins by obtaining hard currency such as U.S. Dollars. Then the officials assure the investors that their currency hedges will be honored via the Russian Banks. Here, a hedge fund would purchase the debt of a government and expect the foreign banking system to honor the short forward contracts in rubles. Essentially, one position would offset the other and still provide a profit. But this did not happen. The Russian banks and treasury won when their government effectively "restructured" the terms of the open commitments.

By doing so, the banks did not pay off the forward short ruble contracts. If they did, the hedged positions would have worked. By unilaterally breaking the contracts, the Russian financial institutions profiteered.

Why do it this way? In one desperate act, hard currency such as dollars entered the coffers, without lengthy negotiating and constraints.

In recent weeks, there has been considerable interest in the financial community in terms such as Heteroskedasticity, Fat Tails, Nonstationary, and Standard Deviations. The upshot of this is that they are statistical terms which define the limitations of ordinary Value at Risk (VAR) methodologies.

As mentioned previously on this site, the methodology breaks down when times are turbulent. Can you afford to continue to rely on VAR by itself? Doesn't it make sense to get an independent evaluation of your existing exposures? Remeber that in a default, your clients' positions are your positions. Also, the regulatory haircuts become 100 percent.

For assistance in this area or other consulting services click here.