The World According to Stan Jonas
An interview with one of the savviest derivatives users
on Wall Street.
By Joe Kolman
Stan Jonas, 48, is a minor legend on Wall Street. Currently a managing
director at Societe Generale/FIMAT, Jonas runs a desk of about 20 people
whose clients are mostly proprietary traders at other dealers and institutions.
He first traded in 1979 for Acli, a government securities firm specializing
in cash/futures arbitrages. In 1987 he headed the derivatives group at Shearson
Lehman, where he directed proprietary arb trading and institutional business.
He joined Societe Generale/FIMAT in 1991.
Jonas is recognized as one of the savviest users of exchange-traded and
OTC derivatives, particularly internationally. "He's an unusual combination
of trader and thinker," says Vince Bailey Jr., a portfolio manager
at New York-based BEA Associates. "He understands the big picture and
has a knack for translating economic issues into trading profits."
A typical Jonas arbitrage spread trade might be based on the difference
in the volatilities between Eurodollar options with different maturities.
In conversation, Jonas leaps easily between trading ideas, global historical
events and options theory with a breathless machine-gun delivery. He spoke
recently with editor Joe Kolman.
Q:You've lived through a lot of different markets over the years. What
happened in February 1994 and how have things changed?
A:February 1994 was the end of the euphoric bubble.
The huge pump priming exercise by the Fed turned this market into a speculative
free-for-all. The Fed perceived that the banking system was in terrible
shape. So they kept the yield curve very steep and didn't raise rates in
order to give banks a chance to rebuild their capital. Bankers were attentive.
They got the signal that the government was giving out a free put. They
figured: We'll buy the two year notes and make money on the capital gain
and then on the carry profits.
So all through 1993, and particularly towards the end, we had this huge
rally. When bonds broke at the end of '93, everybody was long bonds. As
the Fed tightened, the market recognized how closely concentrated liquidity
had been. Everybody was in the same trade. Everybody was long - US bonds,
German bunds. And nobody imagined that so many people could be long in such
Q:What do you think was responsible for the huge capital movements we
A:Think about what went on in the mind of a typical equity oriented hedge
fund manager in 1992. In 1992, he's got $3 billion in stocks. The Fed has
given the signal to the banking system and somebody says he should be long
bonds. So he figures, "OK, bonds are one third as volatile as stocks
so I should be long $10 billion bonds."
A little later on, the yield curve is steepening, so he figures he doesn't
want to be long $10 billion bonds, he should be long two-year notes. How
many notes? On a duration weighted basis his quant tells him that he should
be long about seven times as much, so he figures he should be long $70 billion
in two-year notes. That's more than exist.
In 1992, the value-at-risk guys, looking at past correlations and volatilities,
were telling them that French bonds and two-year notes were a comparable
exposure to their current U.S. fixed income positions: Why not move to Europe,
where the easing cycle had not yet caught up to that in the United States?
Many of the hedge funds made that kind of decision. It all happened very
quickly. All the equity guys decided to get into fixed income. And the "worst"
thing is...they made a lot of money. The Fed eased 24 times and kept on
Hedge funds were terrifically leveraged. Guys like Moore Capital perhaps
had $3 to $4 billion of hot money at times leveraged 100 to 1. Michael Steinhardt
had so many Canadian bonds that we thought he was going to have to file
Q:...to take over Canada...
A: Right, to take over the country. Hedge funds had more investment
capital than any major bank. When the Fed began to ease aggressively in
1992, the financial world was completely different than it had ever been.
With derivatives, you could make bets that were impossible to make three
or four years earlier. You could buy French bonds at the MATIF, or gilts
at LIFFE or do structured products with pay-offs based on the difference
between Spanish and German rates. The whole world essentially became a futures
If a Martian came to the U.S. and looked at the universe of hedge fund
managers, he'd see the same person. Many of these managers are interrelated
by blood, by hobbies, by education. They're all competing, checking what
the other one's doing.
Q: So when it came time to sell...
A:...There was nobody to sell to. You owned everything. Or somebody
like you did. So all of the statistical notions of diversification didn't
make sense because diversification assumes there's somebody else, a truly
"significant other." 1994 was the first year in history when all
global bond markets moved in the same direction and I don't think that's
coincidental. When it came time to liquidate, it was just impossible.
Q: But why were the selloffs so sudden?
A: Most hedge funds make money as trend followers. The key to
trend following is that if the market goes up you keep buying more. If you're
right, you end up a big hero. Normally, if you make money, you're supposed
to take profits. But when they make money, they effectively double up on
their positions, so on any big move down, they're going to have a big loss.
Anthropologically, it is interesting to note how hedge funds attempt
to sell themselves to their potential investors. Many of the biggest ones
promise that they'll never lose serious amounts of money. They have developed
brute force stop loss systems, so that, hopefully, no matter what happens
they try never to lose more than say 3 to 5 percent of their value in any
So what happens? They're not in fact diversified, they're not hedged.
As they experience losses in one marketplace, they start shrinking their
positions in every marketplace because they don't want their portfolios
to lose more than 5 percent. So after the Fed tightened, the European markets
began to suffer. Then the Latin American markets. Those were all profitable
positions at the time. There was nothing wrong with them per se. But they
began selling because they had to shrink their entire position.
It becomes "global triage." The position is pared of the most
liquid securities first, leaving the fund with the most difficult move on
their books. It's very much like our mortgage funds that, when forced to,
sell their liquid securities, leaving them only with the "toxic waste,"
to the detriment of their shareholders. You begin to see the total market
move globally. You start to see strange corollaries. One day you're down
in Germany and the next day it spills over to Mexico and the Turkish markets
in rhythms tied to investors' preferences and risk aversion, not to macroeconomic
events in the marketplace. This is cheap relative to that, Mexico is cheap
relative to Spain. This shrinkage quickly becomes self-exacerbating.
Q: So what does all this teach us?
A: The lesson from the banking side is that the static notions
of risk and implied volatility are crazy. You can no longer provide infinite
liquidity to the marketplace based on theoretical models. You can have mathematical
structures that work on a very localized level, but in the real world they
will almost always break down.
How do you manage your risk if some firm like Quantum wants to buy volatility
on the Sterling/Mark cross, prior to Great Britain's leaving the ERM? They're
going to do so much of that trade that if they're right, the volatility
you've priced the trade at is not going to accurately reflect the realized
volatility. In many ways its like arguing with a 600 pound gorilla.
The guy who first had the opportunity to make a lot of money doing this
was Mark Rich. How did it work? I buy options. I go to this bright young
dealer. He's got his options pricing model, and I want to buy a call. He
gives me the price because he's got a model and he figures they're liquid
instruments, and he can always buy more and more to complete the hedge.
But I'm the gorilla. So I can buy a lot of options from him and from
other dealers just like him. I know one thing. Every time I buy more, it
sets off a signal to buy more. It's a positive feedback loop. I'm the gorilla.
I can control you. I can eventually make you buy a lot of it. If I can control
the marketplace to make you buy more of it, I can dominate you because I
know your recipe for replicating the options. As Nassim Taleb said in his
Dynamic Hedging, "The market will follow the path to thwart the highest
number of possible hedgers."
Q: OK, volatility can be affected by liquidity and can itself
be volatile. Do you have the same problems with correlation?
A: Absolutely. Dealers have provided us with the opportunity to
track a new type of risk embedded in the marketplace: correlation risk.
The pricing is based on relative movements of previously stable historical
relationships. All the hedging technologies based on those ideas are going
to break down.
Take a look at a value-at-risk system. What's its greatest weakness?
It says that we can historically identify certain probabilities of moves
in the market, and that we have a stable correlation matrix.
Here of course is where the VAR or any statistical approach is vulnerable.
When potential loss distributions are fat-tailed, simulation based critical
value estimates show significant biases and have standard errors of substantial
magnitude. This is particularly significant when a portfolio's positions
contain options. These distributions are a mixture of different distributions,
and it becomes virtually impossible to verify with any accuracy the potential
losses associated with extremely rare events.
Q: Ultimately it all comes down to a set of assumptions...
A: Maybe even a set of historically updated assumptions. But history
moves, and it doesn't move smoothly. By very definition, if everybody's
using the same assumptions, and you have everybody in these trades, the
correlation can't be appropriate, because things aren't going to move historically.
If everybody has to get out at once, the markets are so finite and the historical
parallels are so dynamic that you take on a tremendous amount of risk -
risk that is unquantifiable.
Ironically, it's the worst sort of empiricism. More to the point, it's
like the worst sort of technical trading. "I don't have to know anything
about the fundamentals, the charts tell me all...," that's the refrain
of the lazy technician, and it's been carried forward by many risk modelers.
Q: In the last few months, I think we've all noticed an enormous
new interest in risk management. Why?
A: What's really moving the marketplace now is that more things
are getting marked to market. And that's moving the marketplace dramatically
toward risk management. When you have more and more liquid securities...
Q:...and accounting that supports mark to market...
A:...and accounting or technology that supports the ability and
necessity of mark to market. All of a sudden, risk management becomes the
only thing that counts. Because before, if you could value things at book
value, what do you care? "The thing's a ten-year hold." The thing's
eventually going to pay off. You didn't care about intermediate risk.
Q: Do you have any basic rules risk managers should follow through
A: Well, risk management has got to start at the top. The first
thing you have to ask is: What is my goal? How much risk do I want to take?
What risks am I interested in pursuing? The calculus is relatively straightforward
if you can develop the goal. Is my goal to replicate a T-bill? I may decide
that my job is not to minimize risk, but to take on a given amount of risk
for a given amount of reward. If I have a speculative component, I have
to be careful how much speculative risk I'm willing to take.
Then you have to find a way to limit the risk you're going to take on.
You could say, I never want to see more than x amount of variance in my
positions on a given day... say three percent. Once you have that as your
goal, then you can develop the tools and instruments to measure and control
In a way, risk management systems are only valuable if they can handle
the "wings" of distribution. The outliers, those fat-tails, where
somebody, unfortunately, has to live.
Q: How do you make sure traders abide by a particular risk management
system? How should you pay them?
A: You have to devise a system that rewards the types of risks
you want to pursue. You shouldn't try to overlay a value-at-risk system
on top of a traditional payout system. If you tell a trader, "I don't
care how much money you make, but I care how you make it," if you compensate
people for the quality of the risk they take, not the absolute magnitudes,
then the people who are working for you are not going to have an incentive
to sell all these crazy options, literally and figuratively.
The flip side is that you should understand what your risk goals ultimately
mean and have those goals supported politically throughout the institution.
Let's look at a corporate treasurer. You have to determine: When is he doing
a good job? The first rule is that if he hedges he's going to lose. Is the
corporation willing to understand that by diminishing risk, it'll have losses
on its books? Because if interest rates go down and he hedges against a
rise in rates, somebody will always come back and say, "Interest rates
went down and you hedged. Didn't you know interest rates would go down?"
Here's rule number two: Deal only with instruments that are liquid and
where you can find a tradeable price from several different sources at the
end of every day. Or even sooner, with live prices. Value-at-risk depends
on being invested in structures with prices you can apply. Your value-at-risk
system won't matter if you can't say what a particular thing is worth. You
should be able to see price history, to be able to estimate volatility.
That enables you to provide the feedback into your risk management system
so your positions are easily understandable.
Rule number three: If you can't simulate the characteristics of more
complicated instruments on an Excel spreadsheet, don't do it. You, not somebody
else in your office. If you can't sit down and simulate what will happen
in different scenarios, if you can't do that by yourself, you shouldn't
be in the instrument.
Q: Now, of course, you can buy models that...
A: No, that's not enough. You have to be able to replicate it
on your own. You have to understand the dynamics of the model, what the
ultimate payoff is in that security. But good modeling programs are very
helpful because they can help you see the risk in a security, and that's
critical to being able to understand more complicated securities.
The fourth rule, the most important one in risk management, is making
sure your portfolios are marked to market. When you don't have portfolios
that are capable of being marked to market, risk management is irrelevant,
a Platonic ideal.
Q: What is it that people like about derivatives? What's made
derivatives so popular in the US?
A: A lot of it is the regulatory benefit. Derivatives have achieved
such a rapid growth for reasons beyond their ability to compete in the marketplace.
If we can replicate the payoffs of derivatives with a combination of linear
securities and borrowings, why then is there a market for prepackaged derivatives?
From a cynical point of view, there are three reasons, not in any particular
order of priority: 1) regulatory; 2) the ability to disguise leverage; and,
of course, 3) the recognition of economies of scale on the part of dealers
willing to price and offer derivative securities.
Q: The capital requirements certainly encourage you to move all
this stuff off balance sheet.
A: Yeah, but if your positions are not marked to market, you're
not going to care about value-at-risk. When you understand that the market
has a real impact on your positions - that's when you start to look at value-at-risk.
Mark to market forces you to reevaluate your opinions. If Bob Citron had
been long the equivalent amount of Eurodollar futures instead of these structured
notes - if he was long 40,000 Euros and every day he got a margin call -
that would force a different type of confrontation of the issues. It no
longer becomes an intellectual/analytical debate, whether the losses were
paper or real.
If you let a guy take on a position to sell OTC options without a mark
to market component, that can lead to the greatest of human weaknesses,
hope. "It can still come back. Maybe it'll come back." The irony
is that net net, someone like Citron would be flat to up today but it doesn't
matter - when you're leveraged, hope is the worst thing in the world because
"eventually being right" doesn't count.
Q: You'd like everybody to trade futures...
A: Futures are not the only instrument. I'd like them to trade
options, too. Here's a proposal originally developed by Sanford Grossman
I'd like to see implemented. I'd like to arrange things so that all the
major trades that take place over the counter are effectively known in the
marketplace. Not the participants, not who and not why, but the price and
Then the trade must be broken down so that we could determine somebody
today traded this correlation at say .80. He bought a Deutsche mark/Spanish
peseta option at x price. Then you'd analyze that x price. What implied
correlation is that? What volatility is that?
Q: What would that do for you?
A: Rather than using some historical estimate of volatility and
correlation, one would have the market's current estimate of those values.
In times of stress, the market's judgment of implied volatilities will enable
you to gauge your current risk as well as to price your derivatives portfolio
Well, now if you had a value-at-risk system, and you had a similar instrument
that you didn't know how to value, every day it would go on the books and
you could mark it to market every day. Then it becomes public domain.
Q: But why would the OTC market ever agree to do that?
A: It would or could be mandated. I told you this was hypothetical.
From their point of view, nobody would care. Or they could contribute to
a generalized clearing function. This is where the world's going to go in
It seems that the world is progressing to this point anyhow on a piecemeal
basis. The current environment makes it imperative that firms provide this
data to their customers, and there are literally dozens of risk management
groups that collectively try to gather this data and provide pricing. Rather
than having dozens of people all doing the same thing, let's economize.
Real values will eventually be disseminated in the marketplace.
Q: It sounds sort of like FLEX options.
A: Yeah. I have a similar arrangement with swap shops right now.
When we sign a contract to do a particular transaction - a swap, a cap,
whatever - it stipulates that I get a tear-up value every night. They tell
me the price every night. We'll argue about it, but we'll agree upon a price
every night. If one transaction moves in my favor, they send me money. If
it moves in their favor, I send them money. Eventually most transactions
will be commoditized.
Q: You do that with everyone?
A: We do it with everyone.
Q: That's pretty unusual.
A: No, more and more people are doing it. It's to everybody's
benefit because it cuts the credit risk down. We're turning OTC dealers
into futures markets. The only people who don't relish it are the top credits.
Because it diminishes the benefit of your triple-A. But the market is becoming
so competitive now...
Q: You'd recommend that everyone do this.
A: Absolutely. It's imperative from a risk management point of
view. One of the most important things that risk management people don't
take into account are the problems of liquidity.
From an arbitrage perspective a totally balanced position could put me
out of business. In principle, its not much different than MetalGesellschaft...
My two positions are ostensibly identical, separated only by a difference
in time, but at the margin that is a critical difference.
Take a typical trade we might do. I buy a cash bond, which is effectively
receiving fixed from the Government, and I enter into an interest rate swap,
in which I'm paying fixed. It's a simple asset swap. The bond begins to
drop in price, so I have to give $100 million to my bond dealer because
my government collateral is marked to market. How do I get money out of
I've got to go to that swap dealer and say I want to reprice that swap,
which is worth more. We mark it to market, the swap dealer sends me money
that I send to the bond dealer. That's what's going to happen.
Q: The Chicago exchanges are trying to set up something like that.
A: The dealers will effectively do it themselves. That's because
we're arbitrageurs. We can't trade without liquidity.
Take the example of a $200 million fund I'm familiar with. We trade only
these arbitrage relationships with 15 to 1 leverage. The trading is "risk-free,"
but if the market levels or moves 20 percent, we don't have enough money.
So we develop tear-up arrangements with swap dealers. We say, "Listen,
we're big customers, we're in every day, you want to do it or not?"
They say, "No," we say, "OK, I'm sorry. We'll still come
to you eventually. Because we'll go to a place that will do the trade, which
is a place like General RE, which will do tear-ups, and later on we can
transfer the position between you two guys. But we're not going to do business
with you directly unless we can do tear-ups." That's going to be the
uniform way and that's the way we're going to have the components of a value-at-management
Q: What do you think of RiskMetrics?
A: I think what JP Morgan has done is brilliant, a tremendous
job. And they keep on doing it. The work is technologically very sound.
It doesn't solve all the problems, but they address all the problems in
a very clear way, and anybody who wants a good education in risk management
should read the technical document that JP Morgan publishes. It's well written,
it goes through all the math, it's not overly complicated, and it outlines
what they're up to. And then as people talk about it and complain to them
about the assumptions, they actually go back and they rebut and they argue.
It's the best thing I've ever seen any institution do in this field.
They're very clever. If you have these positions, they give you the pricing
for everything. One place, one stop. Maybe the exchanges do it, maybe Bankers
Trust does it. You have everything. Interest rate swaps, French bonds. I've
got currency positions. I've got Turkish lira forwards, and at 3:00 New
York time you tell me how much the thing is worth and how much it's moved
from yesterday and what my potential risk is. The first thing it tells you
is how much you made or lost. But you also have some historical data to
say exactly what your positions are, what the historical risk is. In a large
number of these markets where we have options, there's all this information:
what the implied valuation of your positions are. Then the risk management
is basically arithmetic.
Q: What's going to happen when the market becomes more sophisticated
about risk management? How is that going to change things?
A: You have to understand an important thing: Most financial engineering
is a simply a technique of burying the cost and taking advantage of human
nature. With derivatives products and options you can pick any point of
the payoff distribution and sell off all the others.
The problem is not that people buy derivatives, it's that people tend
to sell them. It can be very deceptive, and you have to understand what
you're selling. Because implicitly what happens is that in order to pay
for a high yield, they're truncating some part of distribution. They offer
you high yield today in exchange for giving up something in the future,
something that may seem very outlandish or realistic. But human nature is
such that we always believe somebody else is going to get the tail of the
distribution. People tend to look at things nearby as much more probable
and they discount the probability of outside events much too much.
The sales pitch for some of these securities is that in the worst case
you're going to get your money back. "You may lose the 6 percent return,
but you're going to get your capital back." But that's deceptive. Because
return of capital in our world is, of course, investing at no interest.
Value-at-risk is very critical because that kind of structure would show
up as a very risky transaction. If you have a VAR mentality and you use
the proper software vendors, you will eliminate in the next generation that
ability to bury the risk in the books. You're not going to be able to bury
those risks. They're going to show up, and that's going to change the way
we look at what we're doing. It's going to stop 80 percent of the intellectual
Q: But is it going to stop trading losses?
A: No. The trading floors on Wall Street have much more sophisticated
risk management systems than anything a corporation could invent. But you
have the same problems. The same losses. There's no panacea.
Of course, it's those extremely rare events that either make or break
us, and that's when we truly need a risk management system.
In the meantime, as more and more institutions adopt the VAR framework,
which is not too different from what the Street has been doing for nearly
a decade, we'll find traders becoming experts at arbitraging the failures
of the VAR they are subjected to.
Q: So the conclusion seems to be that all the risk management
modeling in the world isn't in itself going to protect you from the vicissitudes
of the market.
A: George Santayana talks about the fallacy of misplaced concreteness.
Look at all these option-adjusted spread models. They look so real and palpable
and they produce real numbers. But people take them so seriously. The real
issue is that over the past five years, risk management systems were in
place and we still had disastrous consequences throughout the Street.
Look at mortgage-backed securities. There's been no area of the marketplace
in which more analytical and computer work has been done. But it's all been
to no avail. All these smart people, models, all of the risk control measures
they thought they could do, the second-largest fixed income market in the
world next to the government market - and you nevertheless had disastrous
You have to be aware that there are certain basic risks that can only
be handled on a very simple level. How much money am I willing to commit
to any strategy, and when the strategy goes wrong, am I willing to stop
myself out and to look at it again? That's one thing value-at-risk doesn't
let you do. The risk is not always continuous. You have to know when to
decide if you're really wrong.
After all, one of the premises of trading is that there are driving fundamental
factors in the marketplace. Life really isn't a draw from a random distribution
with or without drift. When circumstances change, stable correlations disappear.
When the Fed tightens, and my positions are long duration, it's not the
volatility of the position that will worry me. A slow steady increase in
rates will destroy me as well if I sit and wait for the conclusion. The
speed of my demise is of less consequence than its certainty.