More On Counterparty Risk

Michael Panzer of the book and blog, Financial Armageddon, was the first to touch upon this important risk in the system - two years ago.  He republished the article, that when read now seems genius in its scope and foresight.  To be honest it is quite spooky.  I urge you to check it out.  I have reposted some excerpts that play on some of the other themes I posted on recently.

Volatility, Negative Gamma, Insurance

Another other popular form of derivative is an option. Options are different from futures and forwards in that one party has a right, rather than a firm commitment, to initiate a transaction at some future date based on the established terms. Typically, the option is granted by the "writer," the one who is obligated if called upon, in exchange for a payment up front.

In a sense, these types of contracts resemble traditional insurance products. The writer of the option is like Allstate, Prudential, GEICO or any other company issuing a life or homeowner's policy, where the holder ends up receiving a predetermined amount if an event takes place (e.g., a fire ravages the property) in exchange for paying a premium or premiums beforehand.

Plus this might explain why volatility as an asset class is so popular right now.  In reinsurance, a major problem is that in a hard market there is no capacity, so a new asset class developed for capital markets - insurance linked securities.  Just as reinsurers who insured the property along the New Orleans gulf coast found out, fat tail losses need to be prepared for.   For the capital markets, volatility is the risk that needs to be insured.  Major banks need markets for this risk and more and more liquidity.  They are now looking for volatility "reinsurance"

Buybacks

Or maybe he believes market prices are headed higher, and wishes to have temporary control of the property with a relatively small outlay. In this way, options represent a form of leverage, similar in some respects to the margin on a futures contract, where the holder can potentially receive the upside benefit without having to pay the full cost up front

Isn't this the same thing.  Management "thinks" price going up, instead of investing in a dividend, buys back some stock and gets a few years worth of dividends discounted by the market up front - and a nice pay package.  Investors don't care because they can. 

Anyways, there's lots I would like to comment on but I am too tired and busy.  Go read that article!