Learning a language 2
FB And on the question of derivatives being perceived as risky – do you think that’s still a problem?
TC I think it is partly ignorance and partly lack of knowledge. I think that pension funds are loath to use derivatives in a way that increases risk. But, they can certainly be educated to use them to reduce risk because properly used they can be a great benefit to funds. Somehow or other the education has got to get across to funds and I’m not sure we’re making huge progress there yet.
KR I think one of the issues is that derivatives is such a broad term. There are certain types of derivatives like swaps and futures that are just a means to an end and here I feel that there isn’t a widespread perception of risk. These are the sorts of derivatives that companies tend to use for themselves and when we talk about these derivatives with our clients there’s almost always a company representative who says that they are already very active in the swaps market and that they see it as just a different type of fixed income investment. We’re finding that when we talk about those sorts of derivatives we’re pushing against an open door where there are few worries about risk. The other types of derivative, which we have talked about as ‘asymmetric’, is where you have the insurance element present and that is, in my view, a completely different thing because it is not just about a means to an end but a question of changing the nature of the pay-off and the risk/return profile. I am slightly more sceptical about the use of these sorts of derivatives and this is where we have much more detailed and in-depth conversations with trustees.
MP I guess people consider derivatives to be risky as they allow the potential to leverage a portfolio. But I certainly believe that with proper risk controls, derivatives are no more risky than the underlying asset classes. What does ‘derivative’ really mean? It means it is ‘derived’ from the underlying assets, so the exposure is the same as the underlying assets.
It’s right that you can change the return profile of an asset such that the return becomes asymmetric, but the position is not necessarily more risky. So in answer to the question, are derivatives considered risky? I ‘d say yes. Is this justified? I’d say no if there are adequate controls and limits on leverage.
AG Looking at the leverage question, are derivatives risky in that respect? Yes they are. The whole point of leverage is you can put your one pound on the table and the exposure you can buy with that one pound is considerably greater.
As a practitioner Mako traded some 82m exchange-traded options last year and were going to trade 120m this year. There is no greater user of options around this table. The interesting thing though is that there are eight managing partners running a business of 250 people, which means that Mako has to efficiently manage its own risk. We have 190 traders based all over the world trading on leverage, and trading aggressively, all of whom are actively risk managed. We’ve been in the business for 15 years and are aware that it is our own capital that we stand to lose. So yes, I am very aware of risk.
But Mako doesn’t need a big operation to manage this risk. Our operation is pretty lean, with a risk management team consisting of three people. We can do that because we are a fully integrated company. There is nothing an individual trader can do without risk management having visibility. As 99% of our business, with the exception of the US, is on electronic exchanges like Eurex, as soon as we transact we know exactly what our risk profile is. We then use sophisticated models to understand that risk and to offset it. We may do a large trade in one asset class and then use technology to migrate the risk out of that particular product into another. We also continuously stress test the whole scenario to look at the ‘what if’ questions. Addressing the point raised earlier, we were informed by a large European insurance company last year, which before the market moved down was utilising an option structure for protection that they would have had balance sheet problems without the use of derivatives.
RL You’ve raised a very interesting point actually, which is whether the insurance company you mention had the right exposure in the first place. There’s a pretty common pattern of people who have adopted entirely inappropriate asset structures and then dressed up some sort of a policy to ensure themselves against disaster, rather than going to the heart of the problem, which is having the right asset structure in the first place and then perhaps more explicitly saying, okay I’ve got the right structure, I now want to take a gamble on equities and I’ll try a call option.
In addition, I think the derivatives industry can appear intellectually arrogant when it comes to these risk questions. No doubt there is a great deal of expertise within the industry, but I think it is a very brave person who says they understand derivatives full stop. I think there’s a lot of self-referential behaviour in the derivatives arena. There’s a danger in creating an air of expertise, which defines the terms on which risk is managed. One has to be very wary of the idea that the rest of the world is somehow ignorant but that we know the truth.
KM I also think we have to be very careful in the use of some of these words like risk. What exactly is risk? In my view derivatives are ‘risky’, but in a sense that is their reason for existence. A major reason people trade derivatives is to reduce the risks that may already be embedded in their portfolios, and derivatives provide a cheap and efficient access to offsetting ‘risk bundles’. However, their use is not limited to hedging. They can also be used to focus and target risk in the areas that you wish to have it. Every asset manager, mutual fund manager and pension fund manager tends to have an index to which they are comparing themselves. A passive manager will try to replicate that index, whereas an active manager will try to trade around that index, and to the extent that he takes positions different from the benchmark index he will incur risk.
Unfortunately, in the cash or cash securities world, there is a relatively limited universe of instruments to choose from, and they come with risk profiles that have some elements that may be desirable and others that are perhaps less desirable.
In an ideal world a fund manager will use derivatives to neutralise those elements of risk they do not wish to have, and to leave exposed areas of risk they do wish to have or even amplify them according to their conviction in that area. So, ultimately a major purpose of derivatives is to tailor risk in a portfolio. The other question is whether the use of derivates within portfolios inherently makes those portfolios more risky on an aggregate basis? This should not be the case if the derivatives are used appropriately.
If you look at some of the examples of past incidents already mentioned, a number of them were due to lack of controls, such as Barings and AIB. However, I think the 1998 emerging markets case was less a control issue than, to some extent, a liquidity issue. If you remember what happened during that time there was a general sell-off in the credit and emerging markets and many people had positions in these markets, which were hedged by being short in government bond futures with the idea of reducing the risk in those areas. Unfortunately what happened is that the credit markets were selling off, the government bond markets were rallying, which led funds to lose money both on their assets and on their supposed hedges. What’s happened since then is that people have been using more appropriate hedge instruments for credits, such as swaps, which are much better correlated to the asset they are hedging.
You can go back further and you can talk about other crises such as Orange County or Hammersmith and Fulham, the latter being an actual credit issue in the swaps market. Or you can go back and talk about the crash of 1987, which was blamed in part on the put options which were used to protect portfolio insurance programme trading, the hedging of which exacerbated the fall-off in the markets. These again are valid concerns and a lot of them deal with the inappropriate use of derivatives, from which a great deal has been learned.
One thing that’s been raised several times here is the distinction between so called symmetric and asymmetric derivatives. I think that while there is a distinction, it’s not as black and white as we might make it. If we look at a lot of so-called symmetric instruments there is clearly an asymmetric risk component to them. For example, with the most basic 10-year Treasury note future in the US, there is a significant embedded option value in that. The best way to appropriately hedge this sort of convexity risk is through the use of options or asymmetric instruments.
Perhaps a more current example is the mortgage-backed security market in the US. Given that the mortgage is the underlying asset, which is itself callable, then there is an embedded optionality in there, requiring the use of some offsetting option or asymmetric instrument to hedge it.
To summarise all of that, I would say that, yes, derivatives are by definition intended to have an element of risk. The challenge, however, is to understand the risk of derivatives and also to understand the risk in the portfolios that they are going to fit into and make sure that the combination of the two is either less risky or has the risk targeted in the right areas.
GS I think derivatives are not necessarily dangerous, but they are efficient instruments. They are like a sports car in that you can drive faster around the corners. I believe that if anybody wishes to bring a better understanding of the use of derivatives to pension funds, one has to speak much more about how the risk and return profile of a plan can be changed. That should not be done with too much technical language.
The other important thing is that everybody providing derivative products to pension funds has to develop an understanding of pension funds’ investment horizons and their return and risk targets. I would stress that derivatives are not only for risk management they are also for return management, ie, suitable for securing a certain return target or providing a return corridor.
The use of derivatives depends on expectations and decision processes. What’s the difference between derivatives and long-term investment instruments like stock? If I buy a stock I have a belief that the company is good and the stock price will go up. If I buy an option, then there is a limited amount of time within which my expectation can materialise – otherwise the option premium will be lost. So, what is the good thing about derivatives? They force people to explicitly lay down their expectations. Unless an investor can do this it is very dangerous to use derivatives.
Let me give you another example. In my opinion we have a very successful new instrument these days – the exchange-traded fund. Why is this? Well, it is basically because it is a future but you can trade it within the framework of a fund. A lot of institutional investors that cannot use futures, or can only use them to a limited extent, can use exchange-traded funds for short-term opportunistic trading.
I am not saying that ETFs are derivatives, but they can be used like futures. I think their success shows that pension funds wish to do this. When a product is understood and accessible by institutional investors then it is successful.
The use of ETFs illustrates the increased willingness and readiness of institutional investors to actively trade and manage market risk.
This has to do with a change in investment horizons and risk capacities because balance sheet issues have become more immediate. It also reflects unchanged return requirements: if you compare the consensus estimates for future returns in stocks and bonds with a return target of, let’s say, 7%, then you cannot achieve this comfortably through the use of traditional instruments. There is too much risk in bonds, too much risk in equity and if you do the traditional optimisation then you’re going to end up with 10% in equities and 90% in bonds. This gives you a total return expectation of about 4.5%, but your target is 7%. So what do you do? Do you end the game before you’ve even started playing it, or do you think about using what is available to achieve these returns and then build up the right infrastructure, knowledge and people to manage the accompanying risk? If one takes a pragmatic look at the market, then one is more or less forced to use derivatives.
We can use derivatives at the individual plan level, the external fund manager level and in the form of structured products. I expect more use of the latter. And the responsibility of the product provider is to really tailor products to the investment horizon and to the return and risk requirements of institutional investors.
FB Does anyone want to pick up on the points that have been made here?
AG One thing I want to touch on is the distinction being drawn between derivatives that have a symmetric pay-off and derivatives that have a non-symmetric pay-off. Certainly the use of derivatives with a symmetric pay-off is much greater than for non-symmetric pay-offs. I don’t think that is because derivatives with a symmetric pay-off are less risky. In fact, I would argue that derivatives with a non-symmetric pay-off are less risky because the gearing inherent in those sorts of structure is generally less and your losses tend to be limited.
I think the main reason why people tend to like symmetric-type instruments is because they are much easier to understand. If you have a long futures position and equity markets go up you make money, and if equity markets go down you lose money. With a non-symmetric position, like a call option, whether or not you make money from the position is less certain because you pay a premium for that option. If the market goes up you may still actually lose money on the position. I think the lack of understanding in terms of the pay-off profiles explains why a lot of investors are reluctant to trade non-symmetric-type products.
One good reason why I think derivatives aren’t being used as much as they could be is because the derivatives market doesn’t always provide the instruments that pension funds and insurance companies are looking for. If you look at the liabilities of a life insurance company they can go to 20 or 30 years. I think you’ll be struggling to find an investment bank willing to sell you a FTSE call or put option of that duration for a realistic price. The derivatives market doesn’t always provide the instruments that clients are interested in.
JA I think that is an interesting point actually and just as applicable for pensions funds and their liabilities. I would like to pick up what was said earlier about the need to be aware of what you are hedging if you are indeed hedging a risk. The question is whether it is appropriate to have taken the risk in the first place? For pension funds there is obviously the liability risk and if you’re asking pension fund managers to start hedging that risk then you get into the whole issue of benchmarking and how pension funds are run by fund managers. As to why derivatives are not commonly used, well I think a lot of it is due to the fact that you need to be able to have an informed discussion throughout the pension fund on products – right down from the specialist to the generalist, the manager and the trustee – and to decide whether these products are relevant to the fund. Everyone has to understand the product, at least to a sufficient degree, and to this end we work very closely with our trustees. Frequently the best questions come from the non-investment professionals in terms of understanding the area you’re working in. The straightforward, common-sense question is quite often the one that makes you stop and think and that’s very useful!
TC Can I just take up the point that was raised about the right asset structure for a pension fund. The problem of course is there isn’t a right asset structure. There is a right answer for specific questions, but the trouble is that pension funds are trying to cope with multiple-choice questions all at the same time. Pension funds have a very long time horizon and if one didn’t have short-term considerations then you would simply invest for the long term and not worry about the short term.
The problem is that pension funds also have very short-term considerations and a number of stakeholders who are very interested in short term problems. Therefore the pension fund has got a problem of always trying to marry long-term and short-term interests. Therefore it may well decide to invest with a long-term strategy whilst seeking protection against short-term problems.
For instance, it may decide to increase insurance in particular market situations or reduce insurance in others. It may decide alternatively to go for a short-term solution and decide what structure is right for this different scenario and then try to capture a little bit of extra alpha. At the end of the day most funds should include some derivative use in some form or another in any strategy. But I think the whole question as to what the right structure for a pension fund or an insurance company is one that’s going to be debated for a long time.