More On Derivatives Regulation

Last week we derided David Corn's argument that deregulation of derivatives championed by McCain adviser Phil Gramm had led to all the problems of the current financial system.  One of the many problematic passages was this:

But the Enron loophole was small potatoes compared to the devastation that unregulated swaps would unleash. Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It's like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm's bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.

No.  The Federal Reserve regulates the money-center banks; if those banks are entering into credit derivative swaps, then the Fed will oversee their activities in that area.  However, it is fair to say that no one was empowered to watch hedge funds, and it was the SEC that regulated investment banks.

NY Federal Reserve President Timothy Geithner spoke in these topics yesterday.  This is from the WaPo:

Geithner, echoing an elaborate proposal by Treasury Secretary Henry M. Paulson Jr., said the nation's fragmented system for regulating banks and other financial institutions needs to be consolidated -- and in Geithner's vision, the Fed would take on new power. Currently the Fed can order commercial banks to adjust their exposures to a given type of asset or to improve their systems for measuring risk -- but has no such formal power for investment banks and a range of other financial institutions.

"At present the Federal Reserve has broad responsibility for financial stability not matched by direct authority," Geithner said, "and the consequences of the actions we have taken in this crisis make it more important that we close that gap."

He stopped short of proposing new regulation of hedge funds or private-equity firms.

The WSJ has more and better coverage:

"The conventional risk-management framework today focuses too much on the threat to a firm from its own mistakes and too little on the potential for mistakes to be correlated across firms," Mr. Geithner said in prepared remarks to the Economic Club of New York.

Mr. Geithner called the existing regulatory structure "an enormously complex web of rules that create perverse incentives and leave huge opportunities for arbitrage and evasion, and creates the risk of large gaps in our knowledge and authority."

A recent Treasury Department blueprint for regulatory overhaul, designed to address those problems, shifts some of the Fed's power to other agencies while giving the central bank overall responsibility for the financial system. Mr. Geithner appeared to take issues with that design, saying that major "globally active" banks and investment banks need to operate under a single framework with stronger consolidated supervision.

Geithner spoke about hedge funds and derivatives two years ago.

MORE:  Megan McArdle notes the absence of omniscient, prescient regulators and wonders what Barack has in mind on the regulatory front.

Comments

[Patrick R. Sullivan]

Well I'd rather get Barack's ideas on why they're not gay about lesbians:

Three islanders from Lesbos told a court Tuesday that gay women insult their home's identity by calling themselves lesbians.

The plaintiffs — two women and a man — are seeking to ban a Greek gay rights group from using the word "lesbian" in its name.

Can we talk?

[Jane]

The new name for "lesbian", is gayelle, or so I'm told.

[Sue]

Good grief. I don't know whether to laugh or cry.

[Sue]

Totally off topic, but have you guys seen the picture on Drudge of the scientist holding the rotten tomatoes? The headline is Red Scare. And someone had to have told the scientist to look as worried as possible.

[Forbes]

I repeat my question from an earlier thread, has David Corn ever been right about any of these lead balloons he launches? He doesn't even know what he's talking about.

Let us count the ways.

First, his assertion in support of regulating CDSs is based on interjecting Enron into the discussion, so let's call that bait 'n' switch. Interesting rhetoric, but not an argument.

Second, his analogies are entirely inapt. Bookies don't trade bets (as a bank might trade a portfolio of securities)--and bookies don't gamble on the outcomes of the bets they do accept. Bookies (like racetrack wagering) are middlemen that take a piece of all the action, while at-risk for none of it. Bookies aren't financial institutions, and of course, vice versa.

And finally, he claims "no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed" presupposes that civil and criminal penalties against fraud are insufficient prophylactics against the hazards Corn warns.

Perhaps, if rather than reading about mortgagees who inflated their income on mortgage applications, and Congresscritters and regulators who encouraged loans to the less-than-credit-worthy, and instead I was reading about hedge funds not meeting obligations assumed under credit default swaps, I might be swayed by Corn's narrative fantasy.

Sometimes the truth is not stranger than fiction.

[Rick Ballard]

Somewhere there must be an A x Y = C explanation of how hedge funds caused the Fed to ignore the massive abandonment of underwriting standards which underlies this rather peculiar financial non-crisis. The Fed forced mortgage holders to add their "magic junk" back onto the balance sheets in December, with the quite pleasing result that Idiots Central hotshots CITI and Bear Stearns either cost their shareholders more than 50% (CITI's 12 month range is 53 - 21) or 90% as B & S became an aperitif for JPM.

Either outcome should be quite satisfactory to any capitalist, although seeing CITI continue to drop until the board is replaced would be even more cheering. The Fed managed to change the rules sufficiently in December to precipitate the failure of Carlyle Capital, the disappearance of B & S and the substantially more than decimation of the value of CITI stock. All without a new regulatory framework.

Wouldn't a more proper question involve asking the Fed to explain the two year delay in imposing the December requirements? The sheer idiocy of the total abandonment of underwriting standards wasn't precisely a secret - why did Greenspan sit on his thumb for as long as he did?

[Steve]

Great site!

Would you like a Link Exchange with The Internet Radio Network? At the IRN you can listen to over 70 of America’s top Talk Shows via Free Streaming Audio! In addition you can email the President, VP and Congressional Leaders!!
http://netradionetwork.com

[Eugene Fama]

I hope the Dems make derivatives a big issue for November. I think once the impact of derivatives are brought to light to the public the people will rise up and say "Derivatives? That the hell are derivatives?"

[Eugene Fama]

Oops, the people meant to say "What the hell are derivatives?"

[Rev. Dr. E Buzz Miller]

"Arbitrage? what's that? Sounds delicious, get me some."

- Barry Obama

[MayBee]

The people just got so confused, Eugene.

[Jane]

Good grief. I don't know whether to laugh or cry

Sue,

Laugh!

[Rick Ballard]

BTW - If any insomniacs wander by, I would suggest that you peruse the Geithner Hong Kong speech linked above. Place a pillow on the keyboard before beginning to read - I wouldn't want anyone hurt by their head slamming into the keyboard or desk top.

[AT]

Wait a sec, are you the Eugene Fama, or just a Eugene Fama?

[cathyf]

Bookies (like racetrack wagering) are middlemen that take a piece of all the action, while at-risk for none of it. Bookies aren't financial institutions, and of course, vice versa.

Nah, bookies are financial institutions, and vice versa. It's just that bookies are unregulated financial institutions. But, notice that they manage to function fairly well and honestly, living and dying by their reputations. Pretty amazing considering that they are all crooks...

As for whether we have THE Eugene Fama or not. THE Fama should be grading finals about now, and is probably muttering despairingly under his breath something quite similar to "these people don't know what the hell derivatives are..."

[Publius]

You say arbitrage, I say Armitage.

[Rick Ballard]

Rich,

Another Petrobras tickler.

Much of the company's exploration efforts are focused on the so-called pre-salt area, located off Brazil's south-east coast. The firm has quantified reserves made at one large discovery there, Tupi, at between 5 billion and 8 billion barrels of oil equivalent. The firm has said subsequent wells drilled in the pre-salt area suggest there are many more large reserves.

Gabrielli said that, as a result, exploratory risk in this area is now "practically zero," which justifies changing the terms of the exploration block auctions to increase the government's share of revenues.

The 44 VLCCs mentioned at the top of the article can deliver 4.4 million bpd (based upon a 20 day round trip to the US or Europe). Current Brazilian production and consumption is running at 2-2.2 mbpd and VLCCs aren't really needed for the domestic market (unless there is some reason why pipelines won't work). Brazil is also almost at the decision point re two 1 mbpd domestic refineries.

I'd say the numbers suggest that Brazilian production in 2015 will be in the 5-7 mbpd range versus current EIA projections of 3.3 mbpd. That will shoot Brazil way past Venezuela. In fact 5-7 mbpd would put it in fourth place world wide.

[PMII]

Not that I'm down on government but when do they ever get it right? Seems they ignore until disaster strikes, then you blame others.

Why would anyone ever want more government?

[Patrick R. Sullivan]

We can add Jim Geraghty to the list of readers:

...Obama’s answer that Ayers was just a professor who lives in his neighborhood downplayed his long relationship with the man. Beyond the donations, early fundraiser, and service on boards together, blogger Tom Maguire notes Ayers was “instrumental in setting up the Chicago Annenberg Challenge, a project dedicated to public school reform which was launched in January 1995; Barack Obama was the first chairman of the group, and they worked together on it for years. Let’s add that the fundraiser hosted by Ayers was in 1995, at the same time Ayers and Obama were buddying up on the Chicago Annenberg Challenge; they were hardly casual acquaintances.” Noting that Obama’s campaign failed to disclose this connection, Maguire suggests the rule, “where there’s smoke and a guy with a fire extinguisher, there’s fire.”

[Hoosierhoops]

OT:
But has anyone informed AL Gore about this?

Geophysicist Phil Chapman, the first Australian to become an astronaut with NASA, said pictures from the US Solar and Heliospheric Observatory also show that there are currently no spots on the sun. He also noted that the world cooled quickly between January last year and January this year, by about 0.7C.

"This is the fastest temperature change in the instrumental record, and it puts us back to where we were in 1930," Dr Chapman noted in The Australian today.

If the world does face another mini Ice Age, it could come without warning. Evidence for abrupt climate change is readily found in ice cores taken from Greenland and Antarctica.

-Daily galaxy web site

[Neo]

His Democratic friends are saying ..

No oil to invest in. They know ExxonMobil is making a filthy killing in this energy crisis, but what galls them even more is the knowledge that ExxonMobil can’t spend any of its $40 billion in profits to find American oil in the most obvious places.

Maybe they should contact their Democratic friends on Capitol Hill and tell them.
They want it all spent on alternative fuels so their friends can make a bundle.

[Patrick R. Sullivan]

Meanwhile, back at the asylum:

Labor union officials and some liberal activists were seething Tuesday over Barack Obama's choice of centrist economist Jason Furman as the top economic advisor for the campaign. The critics say Furman, who was appointed to the post Monday, has overstated the potential benefits of globalization, Social Security private accounts and the low prices offered by Wal-Mart -- considered a corporate pariah by the labor movement.

....Lori Wallach, a lawyer and leading opponent of free-trade policies, said the appointment was jarring from a policy and a political perspective.

"Furman seems like a liability, given his anti-worker writings and statements about Wal-Mart, fair trade and other middle-class issues," said Wallach, director of Public Citizen's global trade watch division.

....[Furman] was also quoted in a transcript from a CNBC interview in 2006 as suggesting openness to changes in Social Security that might include private accounts and benefit cuts.

However, other members of the Obama economics team said, don't worry, we won't pay any attention to him:

In naming Furman as economic policy director, Obama also announced that other economists, including some from the left, would informally become part of the Obama economics team.

One economist from the left-leaning Economic Policy Institute, Jared Bernstein, offered praise for Furman, saying he understood why some critics were unhappy, though he thought their fears were misplaced.

"I understand the concerns, given positions he has taken" on some issues, Bernstein said. "But I am 110% certain that it will be Barack Obama -- not Jason Furman or Robert Rubin -- who will be setting the policies for the Obama administration."

[JM Hanes]

Patrick R. Sullivan:

I remember hearing folks say that Obama would make up for his inexperience by being smart enough to select top drawer advisors and make first rate appointments. Hope they've been paying attention. The claim that Johnson is not working for Obama is twice as bizarre as the claim that advisors won't actually influence Obama policy. The definition of "work" notwithstanding, Johnson certainly should be working for Obama. One shudders to think of the alternatives, should Johnson be working for someone else, especially in light of his business connection to Geo. Soros, no?

[MayBee]

JMH- I missed his Soros connection.

[Neo]

Robert Rubin ? He managed to head Citibank for all of 3 or 4 months before he decided that the mess was even too big for him, so he went back to the "corporate dole."

[glasater]

It seems that Soros was for Hillary before he was against her.
Pehaps he found Obama more maleable.

[jimmyk]

If any insomniacs wander by, I would suggest that you peruse the Geithner Hong Kong speech linked above.

What makes it such a snoozer is that it's so full of platitudes and generalities, I wonder if Obama had a hand in writing it. Big punchlines like "we must continue to explore ways for supervisors and regulators to cooperate more closely together"; "As the structure of markets change, we need to continue to review whether the overall framework of supervision over the core banks and investment banks provides the right balance of efficiency and resilience for the system as a whole."

The idea that this whole episode should lead to an expanded role for the Fed strikes me as ludicrous. As this speech makes clear, the Fed invariably fights the last war, and is incredibly slow-moving and stodgy. The players on the street will run circles around them.

[JM Hanes]

MayBee:

A commenter noted the Soros connection tangent over at Hot Air:

Jim Johnson is also vice Chairman of Perseus, LLC, a giant investment fund that, among other things, owns the company that published Scott McClellan’s book and is collaborator in a biotech fund with George Soros. Its other vice chairman is our good buddy Richard Holbrooke.
Johnson also attended the Bilderberg conference last week in Virginia.

I can't vouch for the author's reliability, but the info would probably be easy enough to check if someone wanted to follow up on it.

[Patrick R. Sullivan]

The gentleman prefers the blonde:

The actress Scarlett Johansson has revealed that she has regular email contact with presidential hopeful Barack Obama in which she offers advice and consoles him after difficult debates.

The Hollywood starlet said she had been communicating with the Democratic candidate for months and was "amazed" that he always found the time to reply.

[Oremus]

One of the big disappointments in this discussion of economics is that we have, at the NYT, an economist (Krugman) who could actually bring some meaningful insights to the issues, except for the fact that he's a certifiable idiot, as demonstrated by his recently published piece dismissing 'speculation' as a prime cause for high crude oil prices. Those of us who actually trade in the commodities futures markets (35 yrs for me) understand the role of speculators, such as index funds, and their recent 'investments' ($260B) in these markets.

[sbw]

The Hollywood starlet said she had been communicating with the Democratic candidate for months and was "amazed" that he always found the time to reply.

Funny, Hillary was amazed that Bill had time to reply, too. I can't wait to see if Michelle has time to reply. ;-)

[Eugene Fama]

From AT: "Wait a sec, are you the Eugene Fama, or just a Eugene Fama?"

Sorry, I am not "the" or "a" Eugene Fama. I'm too stupid. But I did have to struggle through one of his textbooks. I wasn't even sure if he was still alive.

[Stephen W. Stanton]

"Nobody" watches out for these risks?

How about "everybody" watches out for them. That's more accurate. People are betting their own money.

Often, everybody is wrong... As they were with dot-coms, subprime mortgages, Dutch Tulips, etc.

It is true that systemic risk is a problem. There is a herd mentality. Some quantitative analysis should be in the mix when exposures are studied. But using a 100 day history is a joke. We need to be ready for once-in-three-decades events.

We'll never catch everything, and we'll choke off innovation if we try. But it's possible for someone to look at total notional contracts in the market ($62t), run a worst-case scenario, and figure out that there is a potential trillion dollar problem hiding in the economy.

(Note... There are definite upsides to such risk sharing. My concern is mainly with the systemic risk of failure when a firm that is both long and short several $B disappears... ala Bear.)

[Rick Ballard]

"Some quantitative analysis should be in the mix when exposures are studied."

It's my understanding that quants were rather heavily involved in the risk analysis for the subprime market. It just seems as if their weighting of probaility of occurrence for the worst case scenarios within their models might have been just a tad optimistic.

I don't believe we'll hit a trillion even in write downs (prior to recovery through REO sales) but I suppose it's possible.

[Robert Arvanitis]

Let us first stipulate that Krugman lacks merit (though not for the reasons offered by Oremus).

Let us then do some math. World oil supply c. 90 million barrels a day, at c. $130 a barrel. Daily trade c. $12 billion.

Total "speculative" interest is thus 22 days worth of supply. That may nudge markets, but can't change supply/demand for long.

And if speculators lever up, then their downside will be that much more "educational."

Markets are not all that efficient, but don't bet against'em.

[Mitch]

May I make a proposal? No congressman should vote on what he does not understand. Let someone in the press ask one of these tribunes of the people to explain swap contracts. Then hand him a printout of a yield curve and ask him to price a simple interest rate swap, using the implied forward rates on the yield curve.

As a follow-up, ask him how these derivatives are regulated already: futures, currency forwards, and options. (Hint: one is always traded on a regulated exchange, one can be traded on an exchange or in a private transaction, and one cannot be traded on an exchange.) When he is through hemming and hawing, ask him WTF he thinks he is doing.

[Rick Ballard]

"Then hand him a printout of a yield curve and ask him to price a simple interest rate swap, using the implied forward rates on the yield curve."

To hell with the congressman, Mitch, we know the probable outcome there. Make that an unannounced test at the next Fed meeting.

On a simple Pass/Fail basis.

[glasater]

Oremus--I am sincerely asking for your opinion--as a commodity trader--on how raising the margin requirements would affect trading.

[Oremus]

In re Robt Arvantis math.....most specs and other futures traders don't put up 100% margin. More typical is 10%. Thus $200B in the hands of fund managers can control $2T in contracts. And it is not just index funds trading futures.....also 'commodity pools' and most of the big investment banks. Also a lot of European money is in commodity futures. Some estimates put it at $100B. Raising margin requirements would dampen speculation somewhat, but how much is anybody's guess.

[glasater]

Thank you Oremus for responding.
Have heard many folks say that "if the dollar were stronger"....but don't think that really would cure all the ills of the speculation mode.
In my former life I was a gambler. And all this "bubble" stuff sure reminds me of that "gambler rush" I used to be involved with.
Best:-)

[glasater]

Thank you Oremus for responding.
Have heard many folks say that "if the dollar were stronger"....but don't think that really would cure all the ills of the speculation mode.
In my former life I was a gambler. And all this "bubble" stuff sure reminds me of that "gambler rush" I used to be involved with.
Best:-)

[arhooley]

>>The gentleman prefers the blonde

"She described how after a particularly tough debate earlier this year, she sent an email congratulating him for 'holding his ground.'

"He responded that the questioning was 'difficult' and he was being pounded on 'one silly question after another.'"

Ooooh, Senator. Can I wash your feet with my hair?

Now there's a smart question. Yes, you can!

[Pink Pig]

I have no problem with some bureaucracy regulating the financial markets. Maybe that's an appropriate role for the Federal Reserve. But they shouldn't also be trading. Which they do.

There is in fact a great deal of corruption in the financial markets, but almost all of it is political. Scratch a senator and find a thief.

[Pink Pig]

>Oremus said:
>More typical is 10%.
Actually the margin for futures trading is about 0.25%, which is to say that to trade a Eurodollar contract on the CME, whose face value is $1,000,000, you only have to put up a margin of $2,500. I don't know what the requirements are in other markets.

[glasater]

Semi-related to the topic is this article by Tom Wolfe on people running hedge funds.

[Pink Pig]

Rick Ballard: B & S. I've never in my life seen this as an abbreviation for Bear Stearns. The usual abbreviation is BEST, which is/was their stock symbol.

[Rick Ballard]

"B & S. I've never in my life seen this as an abbreviation for Bear Stearns."

See? That's why it's a good reason to read JOM every day - always something new. Sometimes I use exchange symbols but a lot of the readers here aren't all that familiar with them. I was using "C" for Citicorp (hiss) for a bit but switched to CITI as being more recognizable. Note that I first used Bear Stern above and then used B & S - just laziness on my part.

Apart from niggling detail - what do you think of the Feds desire to buy a new farm and build a breeding and training complex acccording to current OSHA/ADA/EPA standards using only labor paid according to the Davis-Bacon Act based upon their discovery that the horses are loose - again?

Personally, I believe that they ought to demonstrate the level of knowledge implied by the test Mitch proposed prior to allowing them to go to the restroom unaccompanied. Layering additional regulation on the financial business increases costs and drives business to friendlier markets - ask the new millionaires in London.

They didn't require any new regs to force CITI to put its junk back on the balance sheet in December and there is no reason why the thrift regulators couldn't have stepped in when Countrywide opened its vaults to any liar willing to sign his name and grab the money.

[Oremus]

For Pink Pig.....TYPICAL margin requirements set by the exchanges are larger than 0.25%. And no trader uses his entire account balance as margin. That leaves no headroom for margin calls. So, as a practical matter, the $ allocated for margin by traders is greater than the actual exchange minimums. Light sweet crude margin requirred by NYMEX is currently 7%. Full listing can be found at www.tradingcharts.com.

[GMax]

May I make a proposal? No congressman should vote on what he does not understand.

 Good thought, but if that were the requirement for attending a session, quorem calls would be exceedingly difficult to pass. 

Some of these ninnies would not find their way to work and back but for a lackey staffer driving in both directions.

 

[GMax]

It's my understanding that quants were rather heavily involved in the risk analysis for the subprime market.

Sure but when you use your Cray computer to the point its literally smoking, you can come up with assumption scenario upon assumption scenario of rather far off events and thus impossible to fully refute, some of which allow you to book a much bigger profit today. When year end bonuses are tied to profits, or stock incentives are tied to stock prices which drive off rising profits, there will be plenty of temptation to pick the assumptions that yield a fat bonus.

[GMax]

May I make a proposal? No congressman should vote on what he does not understand.

 Good thought, but if that were the requirement for attending a session, quorem calls would be exceedingly difficult to pass. 

Some of these ninnies would not find their way to work and back but for a lackey staffer driving in both directions.

 

[Rick Ballard]

"When year end bonuses are tied to profits, or stock incentives are tied to stock prices which drive off rising profits, there will be plenty of temptation to pick the assumptions that yield a fat bonus."

Yeah. I noticed that. I think it was in '74 but it might have been as late as '76. The mismatch between "rational economic models" and "human nature" is quite glaring at times.

I really appreciate the Feds efforts to restore misplaced faith in the shell game but I don't believe that it's actually necessary. The indoctrination system is doing a damn fine job of guaranteeing the economic illiteracy and innumeracy of the customer base as it is.

[Rick Ballard]

Chuckleworthy

I'd say that the musical chairs routine at CITI doesn't quite cover the core rot. Same with Lehman.

Long ago, in a galaxy far away, corporations had boards of directors which focused on a strange belief that the bottom line had some importance and that a firm grasp of operational fundamentals was a requisite that top managers were required to have demonstrated through profitable practice prior to being elevated to positions of great responsibilty.

[cathyf]

Actually the margin for futures trading is about 0.25%, which is to say that to trade a Eurodollar contract on the CME, whose face value is $1,000,000, you only have to put up a margin of $2,500. I don't know what the requirements are in other markets.

I'm sorry, that's just fatuous. That would be like calculating the margin percentage for a stock by dividing the margin by the total revenues of the company.

Here's the definition of what that "$1,000,000" means:

Each CME Eurodollar futures contract has a principal value of $1,000,000 with a three-month maturity. CME Eurodollar futures move in one point increments, or .01, equaling $25. The CME Eurodollar tick reflects the dollar value of a 1/100 of one percent change in a $1 million, 90-day deposit, determined by the following equation:

$1,000,000 notional value x .0001 x 90/360 = $25

Here's the ED Sep 08 Futures closings for the last 3 days:

Jun 09: 96.8850
Jun 10: 96.8050
Jun 11: 96.8800

The interest rates are 100%-futures price, so the interest rates are 3.115%, 3.195% and 3.12%. And the usual sense of "long" and "short" is reversed.

Let's look at the cashflow. The Sep 08 coupon which is the underlying instrument is

$1,000,000 * interestRate * 90/360, so the futures prices of the coupon are:

Jun 09: $7787.50
Jun 10: $7987.50
Jun 11: $7800.00

Since futures contract pay/collect every day, the $2500 margin only needs to serve as collateral for one day's profit/loss -- which over these 3 days is like $200/day. Historical volatilities are on the order of ~12%, which gives a daily volatility of like ~3/4 of 1%. The margin is like 30% of the price, so in round numbers, the margin is 40 daily standard deviations.

If interest rates move 40 standard deviations in a day, then we've got a lot more to worry about than whether margins will cover losses...

[Tom]

I think its important to note that much of the new money flowing into commodities from the large pension funds are decidedly not levered. They are using fully collateralized positions such that $1 invested buys $1 in a commodity index exposure.

[Oremus]

to Cathyf.......doing a volatility calculation as you did it is theoretically correct, i.e., divide the yearly volatility by the square root of the ratio 256/1. And its a great way to go broke because, in real markets, daily volatility often runs MUCH greater than that ratio predicts. I assume you don't actually trade Eurodollars.

[cathyf]

Ok, so it's leptokurtotic and so it's not the probability of 40 std's but instead 20 std's. It's like the difference between the probability of winning the lotto if you buy one ticket vs buying 10 tickets -- 1 * epsilon or 10*epsilon, you're not going to win...

The point is that in the pay/collect regime with daily settlement if you get into trouble the exchange knows immediately and takes off your positions. Since you never have unrealized profits or losses (or at least they are realized within about 18 hours) the margin just needs to cover the risk of a 1-day move, rather than the entire value of the position.

And the underlying is NOT a future on $1,000,000. It is a futures contract on a 3-month interest coupon on $1,000,000 principal. For dollars, three months of interest is 2 orders of magnitude smaller than the principal. Even during the Carter administration a 3-month coupon would only be about 4-5% of principal.

(And no, I haven't worked for eurodollar traders in 18 years...)

[sophy]

Please do not hesitate to have Hellgate London Palladium . It is funny.