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Momtchil Pojarliev
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Some Like It Hedged

BNP Asset Management's Pojarliev discusses a variety of options to address foreign currency exposures. Although there is no single best-practice solution for addressing foreign currency exposures, institutional investors have three main choices, he says.

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June 1, 2010

Market Madness

By Dan Mathisson

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By a week into the investigation, the convergence theory seemed to be winning. The theory held that unusual conditions combined to form a financial perfect storm capable of generating gale-force market winds. In short, the explanation went something like this: The Greek riots created nervousness, volatility spiked causing quants to reduce their maximum position sizes, and then an initial selling wave from a large money manager hit the S&P futures knocking it to a discount. As stocks followed futures down, the NYSE began to hit its "Liquidity Replenishment Points," removing its bids from the public quote, and simultaneously retail stop-loss orders began getting triggered, generating a fresh deluge of market orders. Electronic market makers began getting long tons of stock, and with futures at a discount, they couldn't hedge effectively, and therefore stopped buying. Bids then rapidly faded, and with no one left buying, the market collapsed.

Regardless of the explanation, the results of the day revealed a serious flaw in our market structure. We all saw the reality--that there are no mechanisms in the current market system to stop panicked sellers, or fat fingers, or just plain old stupid orders from whacking a stock all the way down to zero. While politicians reflexively blamed high-frequency trading, and some blamed any traders who pulled their bids in the midst of the maelstrom, no one pointed out the obvious: that a stock can only go as low as the lowest-priced sell order. The people at fault for driving stocks to a penny were not the traders who made a rational decision to avoid buying in a moment of great uncertainty. The true culprits were the sellers who were willing to pound these stocks down to any price by using a dangerous tool called a market order.

An order to sell "at the market" is a limit order with a price of zero, while a buy market order is even more frightening, being a buy order with a limit of infinity. The order type is based on faith that the other side will materialize at a reasonable price, which is unlike how people buy or sell almost everything else--no one bids for a house, or even for a pair of Yankees tickets without putting out some maximum price. Yet the majority of orders in the equities market from mom-and-pop investors are sent at the market. On normal days, this isn't a problem, since professionals are around to absorb this steady barrage. But if the pros momentarily step out, as happened on May 6, the constant flow of retail market orders guarantees that stocks will lurch to ludicrous levels.