A Derivatives Tale… (and a word of warning)

in derivatives •  3 years ago 

 I joined the derivatives structuring desk of a European investment bank straight out of university.

I recall having to google search the term ‘derivatives’ the day before my interview.

That pretty much sums up my degree of expertise on the subject at the time.

At the end of a pretty grueling interview (which involved having someone come and interview me in Mandarin), I was offered a job.

They asked me what I expected as a monthly salary. 

I told my interviewer and future boss what an intern friend of mine at UBS was earning.

He offered me just under half that amount.

I accepted.

My first day was in August of 2004. 

There was no training program… no scheduled classes, presentations or anything like that. 

On that first day my boss put a stack of around a dozen financial textbooks on my desk and just said “learn those”.

As an area of finance, derivatives are seriously technical. I however, was not.

No matter. I persevered, and three months later, in November I structured and sold my first structured note.

I remember drafting the product term sheet. 

I christened it a “Bermudan Callable Three Times Leveraged Inverse HIBOR in-arrears Resettable Step-up Snowball Note.”

No, I’m not kidding…The notional value of the note was HKD100mn (around US$13mn), and we booked around EUR100k of profit. 

It was a relatively short-term note, hence the low profitability.

But it was my first trade so I was happy. My boss ceremoniously cut my tie off below the knot when the trade was done.

I still have the tie… or what’s left of it. It’s hideous. In retrospect my boss did me a favour.

 I won’t go through how the structured note coupon was calculated… but the only thing you need to know is that if Hong Kong interest rates rose, the note holder would be screwed.

You can probably guess what happened next (see chart below). 

 Okay, so that one didn’t quite work out as expected but live and learn… 

(The client did. As far as I know they never did another structured note with us. Although I should point out they didn’t lose any of their principal).

The thing is, even if rates had stayed low we’d probably call back the note after three months.

In that event the client would get a nice coupon for three months and then his money back (which he would now have to reinvest in a lower interest rate environment).

You get the picture… either way, perhaps there were better ways the capital could have been put to work…I went on to spend nearly 9 years on derivatives desks at investment banks (I got better!).

Anyway, I was reminded of this story recently when I read an article on Bloomberg entitled “Brexit Blows Up Currency Derivatives Sold to U.K. Businesses”.

The article describes how an increasing number of U.K. firms are facing massive losses after entering into leveraged derivative transactions to “hedge” their foreign exchange exposures following a sharp post-Brexit decline in the British pound.

The article states: “The derivatives subject to misselling claims have names like “seagull” and “two-times leveraged accelerated knock-out, knock-in forward.”

To many, this sounds like complete gibberish, but the story is a wearily familiar one by now…And it brings me to some very simple rules I learned in my time on the structuring desks which I want to share with you now. 

Beware of any derivative product with more than one adjective in its name.

I mean, in all honesty a “two-times leveraged accelerated knock-out, knock-in forward” is unlikely to be a ‘hedge’ against anything.

If it sounds ridiculous, it probably is.

Complexity = Profitability… for the banks and brokers.

This should be pretty straightforward. 

The less a client understands about what he’s buying, the more money you can make.

Of course, the fine print always has the disclaimer that the client knows all the risks etc…But unless you have the pricing model yourself (which, let’s face it, small businesses aren’t going to have), then you really don’t have any idea what you’re letting yourself in for.

Complex Structured Derivative Products don’t get bought… they get SOLD.

Believe it or not, there are relatively few corporate treasurers who wake up on any given morning with an urge to buy a “Bermudan Callable Three Times Leveraged Inverse HIBOR in-arrears Resettable Step-up Snowball Note.”

Likewise for your average retail or high net worth individual.

They get ‘sold’ to you because they are profitable for the seller!

Don’t confuse “hedging” with “speculating”.

The entire purpose of a hedge is to offset any potential gains or losses you might incur in another position.It’s not hard! It should be straightforward.

Done correctly, hedging provides certainty and reduces risk. 

 If you ‘hedge your bets’ and end up with more risk than when you started… chances are you’re not doing it right.

An example. 

If you know you are going to receive Japanese yen and buy U.S. dollars in 6 months’ time, you can enter into a simple FX forward.

This locks in your forward FX exchange rate and that’s it! 

You’re hedged!

Now, over the next 6 months that FX forward contract can gain or lose in value depending on what happens to the currency pair, but it’s irrelevant!

In 6 months’ time you receive your yen, buy the dollars and settle the forward contract.

Regardless of what happens, net-net you’ve gotten the FX rate you knew you would.

What’s more these kinds of ‘vanilla’ hedging products exist in every financial asset class…FX, equities, interest rates, commodities… and they are transparent and liquid.

Which is why banks and brokers won’t be rushing to sell you these… because transparency isn’t a word they associate with profitability!

Why sell an FX forward when you can sell a “two-times leveraged accelerated knock-out, knock-in forward”.

The bottom line is this: the vast majority of individuals and companies have absolutely no business whatsoever in doing anything more than the most vanilla derivative products… if those.

Maybe you sit on the board of a small business which is being sold these kinds of products… the kind of one the Bloomberg article talks about.

Or perhaps you have some financial advisor trying to sell you some kind of structured product.

My advice? Be warned!

And good investing, 


Authors get paid when people like you upvote their post.
If you enjoyed what you read here, create your account today and start earning FREE STEEM!
Sort Order:  

Hi! I am a content-detection robot. I found similar content that readers might be interested in:

Congratulations @churchouse! You have received a personal award!

Happy Birthday - 1 Year on Steemit
Click on the badge to view your own Board of Honor on SteemitBoard.

By upvoting this notification, you can help all Steemit users. Learn how here!

Congratulations @churchouse! You received a personal award!

2 Years on Steemit

Click here to view your Board of Honor

Do not miss the last post from @steemitboard:

Saint Nicholas challenge for good boys and girls

Support SteemitBoard's project! Vote for its witness and get one more award!

Congratulations @churchouse! You received a personal award!

Happy Birthday! - You are on the Steem blockchain for 3 years!

You can view your badges on your Steem Board and compare to others on the Steem Ranking

Vote for @Steemitboard as a witness to get one more award and increased upvotes!