The time-portal fallacy

In analyzing a particular trade, investors should consider all paths that the trade could take regardless of their opinion of the outcome. Realistically, this task is extremely complex, and most investors use rules of thumb or just skip the whole process entirely because the task might include calculating the scenarios over small windows of the entire trade’s timeframe which would be fairly taxing.
In reality the trade might take several paths and some of them may prove to be bumpy with M2M volatility, which may be fine to ignore in some cases, but not in others.

Consider the case in which certain investors are tempted by certain winners if held to maturity and will certainly produce results if some events trigger. Take for example the Greece debt crisis; an investor who is shorting Greek debt might take such a position because he believes that the event will happen but doesn’t know when and what paths the trade might take.

Similarly, people who are selling credit protection on US government debt (a possible end of world scenario?) which will result in a loss only if the US government defaults on its debt obligations. Given this scenario, the trader might argue that, “if that sh*t happens, we’re all screwed anyways, so who cares?”
The problem with such trades isn’t the ultimate hypothesis, but the fact that there might be several paths to it. The US government defaulting might surely be difficult to imagine, but it’s not too hard to imagine the market temporarily implying a significant chance of it happening and that being built into the pricing of the CDS tranche and thus demanding high premia because of the noise traders make which would impact the PnL of the trade and squeeze some people out. This behavior isn’t new though, Keynes noted back in 1932 that “the market can stay irrational longer than you can stay solvent”.

Another possible scenario is companies selling put options on their own credit ratings (You’re probably thinking who the hell would do that?). Companies might do this based on the reasoning that if they go bankrupt, their credit ratings won’t mean anything anyways, so might as well make some money along the way.
AIG was widely publicized a few years ago for selling protection on CDOs. AIG repeatedly claimed that the portfolio of CDS was safe on a held-to-maturity basis, but it never mentioned the impact of variances in the fair value of the CDOs which eventually pushed it to the brink of bankruptcy.

The proper prescription for combating such thinking might be to force oneself to consider the different scenarios over short time frames, and not just to maturity of the trade. But the irony in this is that, investors treat the small windows (let’s say three month windows of a trade which is suppose to last one year) as time portals yet again and forget the paths. While the ultimate outcome of trades might be apparent, the rational calculations to analyze it might be more nuanced.

Analyze well.