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How Derivatives are Changing the World

Matthew Crabbe

Incisive Media

15 November 2005

In June 1999, Risk magazine held its annual summer conference for the derivatives industry in Boston. The keynote speaker was Robert Merton, the Harvard professor and Nobel laureate who was featuring in headlines around the world because of his involvement in Long Term Capital Management, the hedge fund that had spectacularly imploded just a few months earlier. A co-creator of the Black Scholes option pricing model in the early Seventies, Mr Merton’s theoretical work had helped to lay the foundations for modern financial markets. The LTCM hedge fund was about turning big ideas into very big bets in the real world. When it ran into trouble in September 1998 LTCM had borrowed some $125 billion to play the markets with enormous leverage and complex arbitrage based on what its models told it were mis-priced investments. But when the markets moved against LTCM the theory simply didn’t work and its collapse required a $3.6 billion bail-out by investment banks that had supported it. The shockwaves of LTCM were echoing around Wall Street as the Risk conference opened. But Mr Merton wasn’t about to launch into a mea culpa. Instead, for an hour or so, he described his vision of how financial derivatives, packaged into retail products he called “life options”, would one day be used by ordinary people to regulate the ups and downs of their ordinary lives. Most of us face the same key financial events and risks in our lives, he explained - sickness, marriage, divorce, college fees, unemployment, inheritance. What makes us unique in a financial sense is that we each face a different bundle of those risks. Some of us get married at 23 and some at 33. Some of us get really sick; others don’t. A life option would be your bespoke derivative product, tailored by your broker and regularly refitted, to hedge you against your own particular combination of upside and downside. The internet would be the enabler in this: millions of us could simply type in the smallest details of our lives and - presto - a computer would assemble and price our life option at the other end. All very interesting. But frankly, it sounded at the time like pie in the sky. Six years on, though, what strikes me is how far wealth management has moved closer to that technocratic vision. Derivative products are now truly in the investment mainstream, and private investors are buying increasingly complex products that deliver leveraged returns with bets on correlation between markets and assets. You can have a 9 per cent coupon if you are prepared to take on the risk that the oil price does not fall by 20 per cent or more over the next 12 months. You can choose your own stock index basket and fine tune the level of risk you are prepared to accept on that index; how much upside you will sacrifice in exchange for downside protection on your principal investment. And the great thing is that a lot of these structured investment products make sound sense. Say you want exposure to the property market but you don’t want to invest more than, say £100,000 (a sum which would not buy you a garage for your Mercedes in central London) then why not instead buy a bond with a payout linked to a house price index? You don’t pay property transaction tax (stamp duty in the UK) and you don’t have to raise a mortgage to turn your £100,000 into realistic purchasing power. Small investors can buy these products in the high street. If you are a wealthy customer, your advisor will help you to precisely define your investment according to your objectives. It could be a European property index or a South of England index. And of course you can also have a product that pays more if property prices fall. What’s new in the structured product world? Products structured around emerging markets and commodities are hot now and are likely to stay hot in 2006. Among wealth managers, there’s a debate about whether products structured on indexes of hedge fund performance are better than investments in fund of hedge funds. And in the laboratory, analysts at investment banks are working on ways to turn options on market volatility into a structured product. This is not a description of a financial paradise. European market regulators, including the Financial Services Authority in the United Kingdom, are concerned about two things. First, they worry that investors do not understand the products they buy. Second, they say there is not enough transparency in the pricing of structured products. Both these concerns are especially relevant in Europe because investors are buying structured product investments that typically lock them in for five years, or even longer. There’s also a lingering suspicion that financial derivatives, offering exposure to assets you do not actually own, are toxic by nature. In defence of the structured products business, I would say first of all that it’s not only high-end investment products that are complex. How does the average homebuyer choose a mortgage or an insurance policy? Do we really believe there is any kind of real pricing transparency in how those products are priced? The key thing is the general level of financial sophistication of the purchaser. And in that, we have some reason to be optimistic. Consob, the Italian securities markets regulator, has taken a leading role in educating and informing investors about structured products. Often, it has criticised specific products, sometimes calculating and publicising a true market value on them well below the price they have been sold at. However, Consob says that the number of complaints it has had from investors about structured products has been falling, evidence perhaps that as they have learned more about them they have been able to choose more carefully. I do believe regulators are right to highlight concerns about the illiquidity of structured investment products. Larger private banks will say they will buy back products from clients who want to get out of an investment earlier than its agreed term. But that’s not the same as a liquid market that will reveal the value of your investment. The next big development in the structured products business will be the creation of such a secondary market – a market supported perhaps by the global investment banks that manufacture the raw derivatives material for the wealth managers to sell on to their clients. Such a market would probably only work for the more standardised products, five-year guaranteed bonds paying 60 per cent upside on the FSTE-100 for example. If it comes about, it might well be a market that mitigates against the more complex products. As the partners in the Long Term Capital Management hedge fund discovered in 1998 to their personal expense, it’s all very well having a great investment opportunity that very few other people have seen, but when things go against you a liquid market in which to escape is required. So our ability to manufacture complex products has to be tempered by our ability to trade them. But I believe there’s a fundamental trend we have to factor into this equation. Surely it is inevitable that investment opportunities are going to proliferate and that investment markets are inevitably going to become more complex. Just as we can buy twice as much computer processing power for a dollar than we could 18 months ago, structured investment products offer a sometimes bewildering range of options without our necessarily knowing exactly what to do with them. The investor selling a put option on the oil price in exchange for a high coupon would not necessarily be able to price that option himself unless he had a PhD in quantitative finance. More to the point, neither would his wealth advisor. Whatever the asset allocation process he’s gone through, the investor ends up making a bet; perhaps with the comfort of principal protection built into the deal, but a bet nonetheless. We all have to take risks and we owe it to ourselves to be as financially sophisticated about them as we possibly can be. There is some evidence that retail investors are more savvy than they were even five years ago. I’d bet the same was true of high net worth investors in Europe, the US and Asia. But of course I couldn’t prove it. Incisive Media publishes Risk and Structured Products magazines. See www.Risk.net and www.StructuredProductsOnline.com