Monday, June 29, 2009

A nuclear weapon going off in your city centre

On 13 December 2001, there was a terrorist attack on the Indian Parliament. In the following days, there was a dramatic escalation of tension, complete with nuclear sabre-rattling.

I was in North Block at the time. I could not help think that my GPS coordinates were on the shortlist of any plan for nuclear attack against India. Vaporisation is not that bad, once you get to think about it, but one does think about it.

I tried to look at the fledgling Nifty options market, to see whether there was something one could read in the implied volatility. Then I started thinking that nuclear war is a unique problem on the options market. There are really two kinds of players in this situation. The first is a person in Bombay/Delhi who expects to be vaporised in the event of nuclear war. For him, it's efficient to sell protection, getting cash for free while he's around with no cash outgo if things go wrong (thanks to vaporisation). This should generate a lot of supply of protection and generate apparently low implied vols. Then there are investors at a safe distance -- e.g. foreign investors -- who might like to buy options as protection. But they'd have to worry about whether NSCC would remain aloft across the nuclear war; though they would expect that the Indian government would ensure that NSCC would not default at a time like this. So if nuclear war was a serious threat, options would be cheap but foreign buyers would be skittish about credit risk.

It was interesting, thinking of the tree of states of nature and option payoffs, some of them labelled `vaporisation', asking how to back out the probability of nuclear war from this information. Some of these thoughts came back to me today, when I saw this talk by Irwin Redlener. His big idea is that during the cold war, civil defence countermeasures against nuclear war were irrelevant, since nuclear war between superpowers would torch the sky and there would be no life on earth after that. But the genuine nuclear threats that we face today, such as a few Indian cities being targets, are qualitatively different. Civil defence countermeasures can help greatly reduce the toll, and there is something to live for because these small scale nuclear explosions do not imply the end of life on earth. He argues that modest efforts to prepare for this scenario could save a half million lives in the scenario of a modest 10 MT nuclear weapon targeted at a major city centre.

6 comments:

  1. Interesting post.

    If I "expect to be vaporised in the event of nuclear war", I'm leaving the country and stocking up on either gold or swiss francs.

    I'm not sure if that is rational!

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  2. The credit risk issue would be similar to previous less dire events with sovereign risk? The common counterparty credit risk example: some US funds lost money while being on the right side of the Russia 1998 default trade because they bought protection from Russian banks and never got paid!

    Which is why most of the US sovereign CDS market is quoted and settled in Euros (with no US entity involved) and similarly for other countries.

    Instead of buying options in the Indian market, foreigners could buy options on the ADRs or Indian ETFs or funds listed in the US. eg: EPI/PIN/ICN/IFN/IIF all have option markets on them.

    It would be interesting to see implied vol changes on these ETFs vs. NIFTY options before various events in the future.. hopefully less dire events like the upcoming budget release.

    Duke Nukem: Not sure the Swissie is a good idea for a safe bet:
    Short Term Bank Liabilities by Country
    Swiss Franc Devaluation?

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  3. "Vaporisation is not that bad, once you get to think about it, but one does think about it.

    I tried to look at the fledgling Nifty options market, to see whether there was something one could read in the implied volatility. Then I started thinking that nuclear war is a unique problem on the options market. "

    Apologies, but I still can't stop laughing and giggling at the apparent chain of thoughts. Not to really sound dismissive, in fact its a good thought experiment, but in the wider range of things, it looks so inconsequential.:D

    Well, as for me.. I refuse to predict. :D with the options market, if I survive, I will short the options with the highest IV :D

    I think, I will be buying Uranium futures in NYMEX :D

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  4. We are the six blind men and the elephant. I'm the blind man who thinks in terms of economics and finance when he encounters the elephant.

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  5. "For him, it's efficient to sell protection, getting cash for free while he's around with no cash outgo if things go wrong (thanks to vaporisation)."

    The pricing of options is predicated on this. But I don't understand why this is rational and will come to pass. Shouldn't there be a rational basis when defining a plausible scenario?

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  6. Dr. Shah,Analyse the budget.

    No talk of Pension Reforms, Education Reforms, Disinvestment this time.

    But, I dont really blame Mr. Mukh. for today's massacre.

    ReplyDelete

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