Investing in products you do not understand….

By: ispeculatornew
Date posted: 05.25.2009 (5:00 am) | Write a Comment  (0 Comments)

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crocodile_marin_thoiry_19801I was recently reading “The Economist” and two articles caught my attention. Firstly, an article about a major scandal right now in Italy as it turns out that many banks and brokers sold products to investors that clearly did not read the fine lines before signing the papers as they did not buy. They either were not told or did not understand the downside risks of the contracts that they signed. While the recent market downturn and volatility in the markets (including FX) had not been predicted by many, it was a risk that clearly was not understood. I’ve read a similar article about similar things that happened in South Korea, on a much bigger scale. There are clearly many elements at stake here:

-Obviously, there should be regulation that explains clearly the risks involved before taking such contracts. Often, companies that want to hedge are clearly not specialised in finance and so understanding these contracts can prove to be quite a challenge.

-But also, how is it possible that these companies or individuals have signed contracts without understanding them completely

And to a certain extent, it is easy to imagine how companies can be fooled. Think about a fisherman that is costs in CAD$ and sells his inventory in the US. He will have a FX risk and might meet with his banker to offset this risk. Chances are that this fisherman does not have a deep knowledge of derivative products and that he might sign a contract that he is told will resolve his problem… and who could blame him?

That was bad but I figured that it was at least partially the investors fault for they signed up for these contracts.

But you might have heard about P2P, in this case Peer to Peer lending. This offers the possibility of investors and lenders doing business with less participants in the middle. And when a group of small visitors lend 5000$ to a student that has provided his credit history, motivations and plan for a business idea or for grad school, you can imagine that they have a good idea what the creditors are going up for. But now, with credit markets somewhat frozen, some banks are starting to unload these frozen assets through such P2P networks. This to me, sounds dangerous. If multi-billion banks have been saying for months now how difficult (i.e. impossible) it is to value such loans, that are often a group of loans on hundreds and thousands of lenders grouped together. There just seems to be no way for investors to know who they are lending to, and then how could you possibly sign up for that? But as these are geared towards mainstream investors, I have no doubt they will find a few people that will be more than happy to offer money since they will be receiving higer interest rates…doesn’t that sound almost criminal???

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