Tag Archives: interest rates

Derivatives as a mechanism to hedge

9 Apr

Stephenson (1967) conducted a monkey experiment aptly narrated by another blogger Safetynut:

Four monkeys were put into an observation room with one banana on the floor. The monkeys were wired so that the researchers could give each monkey a mild shock. When the first monkey approached the banana and tried to pick it up, he received a mild shock.

When the second monkey approached the banana, the first monkey became very agitated and attempted to stop the second monkey from touching the banana. Any monkey who touched the banana received a mild shock. Suffice it to say that the monkeys learned very quickly that touching the banana was an unpleasant experience.

Now for the most interesting part of the story. One of the four original monkeys was then replaced with a new monkey. As this new monkey approached the banana, the other three became extremely agitated, and succeeded in stopping the new monkey from touching the banana. A short while later, one of the remaining three original monkeys was replaced with a new monkey.

As this new monkey approached the banana, the other three monkeys, including the one who had just replaced the first monkey, became extremely agitated and stopped the new monkey from touching the banana. This replacement process continued until all of the original four monkeys had been replaced with new monkeys.

None of these new monkeys would touch the banana, and whenever a new monkey came into the observation room, he was quickly taught not to touch the banana. In effect, none of the remaining monkeys understood what would happen if they touched the banana — they just knew that they should never touch it. These monkeys were immersed in this culture and were completely unaware of the reasons for their behaviour.

This is a great real-life example of repeated behaviours that are learned / acquired without understanding cause and effect. This is very similar to the ways in which governments operate. They lack effective controls and insight; the vast majority of interest rate derivatives, credit default swaps, fixed income and equity options are not to hedge farmers output or to hedge fuel costs for airlines; they are purely an instrument for speculators. Enforcing margins of 30 or 70 basis points on deal structures is insufficient; sales are wrongly incentivised to push deal quantity including 30 year durations. Current PV’s are extrapolated into the stratosphere to determine future PV’s; it’s mostly imagination.

For those working within the investment banking community you will be well aware that the majority of the deal volume in derivative and esoteric financial products are heavily weighted towards the hedge fund community. Hedging fuel costs or agricultural produce is not the main function of derivatives; derivatives like Warren Buffet has stated are: “financial weapons of mass destruction” that could harm the whole financial and wider system.

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