Learning a language 4
FB Could I ask you to give me examples of striking uses that you are aware of regarding the use of derivatives in portfolios?
VM I brought here the ISDA statistics which show the notional exposure to derivative swaps and derivatives, which is currently past the $120trn mark, which I think gives an idea of the size of the market.
MP This raises an interesting point. Vincent uses the phrase ‘notional exposure to swaps’. Sometimes that can make derivatives seem a lot more risky than they actually are. To give you an example, if I went to my life fund board and said that our notional exposure to swaps was $3bn, that would probably scare them. But if I said we’ve got $3bn worth of corporate bonds, that wouldn’t scare them. The question of terminology and using it in the right context is very important.
I can think of three particular uses of derivatives, which are not striking but are useful. The first is tactical asset allocation. Listed futures are a very efficient and cheap way of getting exposure or changing your exposure to various asset classes. The second area is currency derivatives, when you have liabilities in one currency and you want to invest in overseas assets. If currency risk is a large part of your risk you can use currency derivative forward contracts in order to hedge that risk. The third area involves the use of swaps. In our annuities portfolio we have a number of liabilities linked to inflation, the UK RPI index, and there aren’t that many RPI linked assets available – index-linked gilts being the only ones. So, what we’ve done is create synthetic RPI assets by investing in fixed income corporate bonds and then entered into RPI swaps where we pay the fixed interest that we receive on the bonds and receive an RPI linked cash flow. That’s one particularly useful way of matching your assets to your liabilities much more closely.
RL We’ve found single stock futures to be particularly useful and have developed their use over the last year or two, and we’ve been pretty heavy users of those instruments for various reasons, so I think that’s one good use.
KM There’s so many examples, I don’t know which ones to consider striking. I’d just like to take up on a point mentioned already about hedging foreign exchange risk with forwards. This is a very broad point in our use of derivatives, which could be called risk disaggregation. For example, an investor might have a view on Japanese interest rates or bonds and they may wish to take a position on that, either long or short, but he or she might be a sterling, dollar or euro-based investor and not want to incur the underlying currency risk. One way to do this would be to trade the bonds and then trade FX forwards against it. Another way would be to trade bond futures, which are an implicitly funded position, and roughly equivalent to buying cash bonds and then borrowing the money in the same currency in order to fund that position. So you have an asset and a liability implicitly in the same currency, which to some extent, at least on a first-order basis, reduces your currency risk. You obviously have residual second-order risk on any profit or loss you might make on that position, but you have largely focused your risk on the particular area where you wish to have it, which is the on the bond yield and not directly on the currency.
A broader extension of that is, for example, in the use of futures for index replication, where investors replicate the duration risk of an index using futures and then have the free cash to invest in areas where they feel they have a particular advantage. Another example would be with pension or life funds that have long-term fixed interest liabilities where they’ve committed to pay out a certain rate of interest. Clearly as we’ve moved into a lower yield world this creates difficulties. One way that funds can deal with this is to hedge that risk by buying futures or receiving swaps, but that might generate losses if yields rise. Another way is through the purchase of receiver swaptions, which offer protection if yields go below a certain level.
CL Certainly there has been a significant increase in the use of derivatives. For example, we’ve seen quite a lot of activity in the equity options market. Fund managers, rather than just taking a view on the direction of a particular stock – ie, stock goes up, I buy more, stock goes down, I sell it, are now taking a view in terms of the volatility of a particular stock and trading options around that. In the life insurance market we’ve seen quite a lot of hedging activity going on with life insurance companies going out and putting in place zero-cost collars.
Also, we’re finding a lot of life companies and to a lesser extent, pension schemes using swaptions to hedge interest rate guarantees in their portfolios.
JA I don’t know if I’d describe any of our uses of derivatives as particularly striking. The majority of uses are now in swaps, in terms of both moving up and down the duration curve away from the fixed interest benchmark with the intention of creating alpha and in moving between fixed interest gilts and triple-A-rated swaps.
The main reason for that is purely the size of the fund. We’re using them in essence to provide speed and liquidity at a low cost. I think that’s where the advantage is for us.
FB What do investors need to do before they attempt to use derivatives, and where should they turn for expert, dispassionate advice? What are the key issues regarding the introduction of risk management systems and derivatives? Are there any specific accounting implications for institutional investors? Additionally, how can investors best manage and monitor the use of derivatives most effectively?
VM What we recommend for pension fund trustees is that the first person they could talk to is the chief financial officer of the sponsor, in a corporate environment - that’s one very good source of information in general. Obviously the providers of solutions are very passionate about the quality of the solutions, so they probably are not as impartial as you would want them to be. That said, there are lots of people that are involved in derivatives if you want to start talking about it: CFOs, auditors and consultants are good ports of call. Importantly, there are also ways in which you don’t have to be tied to one particular price that a provider gives you. There are ways you can get it checked and this is important not to rely on a single source of information before pricing on a recurring basis.
MR Beyond the usual educational material; brochures, computer based training, web-based training and academic studies, which Eurex has developed over the last few years, and which I would say is almost basic for most professionals, what we also do is partner up with our own clients – investment banks, liquidity providers and market makers such as Mako – to bundle our knowledge for a specific product user group. We might take four of our clients and discuss a topic that’s hot. As an exchange, we are a neutral platform and such forums are a great opportunity for users to meet a number of experts at one time. For the end-user it’s a tremendous opportunity to ask questions without feeling pressured to do business as a follow-up. At the same time I think it’s a great platform for the asset management community, as well as for investment banks and market makers, to raise their profile in a dispassionate way. Beyond that what we can do is increasingly try and educate our clients as well as the asset managers on questions beyond ‘what is an option’ or ‘what is a future’ into questions like the difference between OTC and exchange-traded, the role of the clearing house and counterparty protection. We discuss how we as an exchange can help to minimise the associated counter party risk with an integrated clearing house.
TC If I can interpret the question as looking at what pension funds need as investors, then we need education. Where are pension funds going to get it? Well, they’re going to get it from their investment managers, from the exchanges and their consultants and from magazines and conferences too. In terms of conferences, for example, in the last couple of years we’ve seen a big increase in demand for our risk management events. It is an area that people now realise that they have to take seriously. Partly, it’s down to the type of manager they have, and pension funds seem more comfortable with investment managers where derivatives are used within a fund. When they have a segregated account, they feel a little more exposed because obviously with a view on short-term events there’s a feeling that this can produce unlimited costs. At least if you go into a fund where the manager is using derivatives you know this is where your exposure is – it’s once removed and it doesn’t feel as close. I’m not quite sure though if this is a logical feeling of comfort.
In terms of the monitoring, pension funds are going to look to the people who do their accounting. I think they’re asking for a shake-up in the way in which accounting performance is being handled at the moment. It’s quite clear in terms of calculation of performance statistics that there is going to be a greater input from global custodians in the future. I think there are big changes taking place in this area and I think that we’re going to see changes in the way in which derivative use is included in performance statistics. Some education is going to be needed to ensure that the accounting takes place properly and pension funds understand the information that is being presented.
MP I second the point made about education. A lot of users of derivatives need this before they feel comfortable using them. What I find is that a lot of the fear associated with derivatives is to do with the terminology. Quite frankly, it can sound like a foreign language, but then once you’ve learnt that foreign language it’s a lot simpler to understand, and you feel a lot more comfortable using derivatives. So, that’s the first step in using derivatives. When it comes to actually using derivatives, we have a very rigorous new product approval process. This covers various aspects including - understanding the exposure created; understanding the risk profile of the instrument; ensuring that the operations departments can settle and monitor the position; ensuring that a suitable valuation model exists to price the instrument; ensuring that the instrument can be accounted for correctly; ensuring that any regulatory guidelines are met. Post trade an independent risk management function monitors what the fund manager does. Senior managers also have a duty to perform independent oversight of any derivatives activity.
AG I’ll leave aside the issue of expert advice and look at just risk management, accounting implications and monitoring.
In terms of risk management you can buy excellent off-the-peg risk management tools for all sorts of derivatives. The weakness again comes back to the issue of volatility. In almost all the risk management systems volatility is your one undefined component. What do we see in terms of the general trend? Well we have made markets in both exchange-traded and OTC products and we’ve seen a massive move in the last two years away from OTC. I can understand this because if you’re trying to account for an OTC transaction, especially if it is quite complex and it’s provided by one end-user then it’s actually extremely difficult to value. What we’ve seen is companies heading toward exchanges where there’s more than one quote for an option, where it’s transparent and there are good after market and risk management systems. Our own risk management department is totally independent and we rigorously make sure they have nothing to do with the trade. They have a pre-defined set of criteria and systems which can be tested against the market place, with access to volatility quotes from all sorts of sources to verify what we think is going on as traders. They also have pre-defined limits because we know that volatility can gap on opening and closing of markets, we take that into account. That gives us, and has thus far given us, a rigorous risk management system that has enabled us to grow our business.
RL I think, in the UK, there’s been an increasingly healthy dialogue between consultants and brokers. It’s partly born out of brokers’ frustration with getting what they believe to be the right solutions out to the market place via the asset managers. I think it’s right that pension funds do turn to their consultants in this regard. At State Street we are organised in a way that means we don’t have a derivative desk as such. I expect portfolio managers who work in our outfit to have a reasonable level of knowledge and to have pockets of expertise in each department, be it equities, bonds or currency. So I think we could provide advice on derivatives also. The question, in a way, is whether this is a commercial proposition for us. I can recall spending a lot of time with clients and it not being terribly obvious how we’d ever get paid for the advice, even in an environment where they actually executed a transaction at the end. Equally there are many houses where there is a derivatives department whose sole raison d’être is to generate revenue, and they obviously have a financial interest in the outcome. I think that’s a difficulty as well.
I’d be interested to know how much money you think an asset manager should spend on risk management systems, because I think to do this properly requires really quite a substantial investment.
AG I think the real issue is training and having a risk manager who is absolutely independent and who knows how to utilise the software to check against the known variables and to work within their given set of criteria. That’s the key point. As to how expensive is it? In Mako’s business, as I said earlier we have approximately 250 people worldwide, and there’s only three in risk management. That’s because the systems are good and we have the ability to link into an electronic exchange. I couldn’t tell you outright how much this has costs us, but I can tell you, without it we would not have grown into the company we are today.
KM One thing is clear, you need to make a serious investment in systems – not just software systems, but also control systems and management structures, and when you trade derivatives – risk monitoring. Training of all involved staff is also critical, and these can come from a variety of sources. Ultimately, though, I think the person who is responsible is the investor. You have to feel comfortable that you understand the issues. One of the things that we recommend strongly for derivatives is that people start with small positions or even start trading via simulated positions. You do this paper trading for a while to see how it goes, monitor the risks and monitor the P&L. Then you gradually build up the size of the positions – the real positions – only as expertise spreads within the institution.
GS I agree that you have to understand these things yourself. This means you have to know the basics about the theory, implementation and operation of derivatives. You need to know where and how to place an order and it’s very important that the handling – the pure transaction operation side – is something that you and your bosses understand. We have the principle that our board of directors must understand every product that we use, and if not, then we will not use the product. This applies generally to all the financial products that we use, including derivatives. We need to get regular pricing, which with exchange-traded derivatives is nothing that proves too complicated. If we buy structured products that have embedded options or other derivative features then we require regular pricing from those that supply us these products.
On top of this there is the difference between reality and theory. If you buy a structured product everybody will tell you that you get regular pricing. But once you have the product you have to make phone calls so that you do really get the pricing every Monday or Friday or when you need it. For systems, I do not think that every pension fund has risk management systems as sophisticated as the banks and the asset managers. Therefore it’s important to start with a Bloomberg or a Reuters screen and to understand what they tell you.
Another lesson we have learnt is that all the people in the organisation need to understand what to do with the derivative product before you proceed. If you have not spent the time speaking to the bookkeeping department, then when they produce the first monthly balance sheet you will have to toss around with them on marked-to-market issues. You really have to think about the full value change this implies in your company.
CL I think it’s important for trustees to obtain impartial advice, which would tend to come from consultants. The issue with that though is that unfortunately consultants aren’t always in the best position to provide the advice and don’t necessarily have the same level of understanding as other parties. Dedicated teams working for asset managers or investment banks have the knowledge and experience in the area but quite often they have vested interests. It’s difficult to obtain impartial advice for derivatives and structured products and this is something pension scheme trustees will have to grapple with.
FB Have you been battling with this, John?
JA Yes, we have and we have made efforts to understand and educate right through the system. I like the idea that the board have to understand every product you use. I also think the advances made by some of the exchanges and even some brokers in this area have been helpful. The one area where we’ve spent an inordinate amount of time has been getting performance measurement right, which is a shame really, because you shouldn’t have to worry about it.
FB Do investors need specialist staff to use derivatives and if so what specialist staff do they need. Can they train up people in the organisation to do this job?
VM If they’re the end client – say a pension scheme or a corporate or life insurance company then I wouldn’t think that’s necessary. There’s one point that I would like to emphasise, which we haven’t talked about, is the legal risk when you use non-listed derivative contracts. You really want lawyers that understand the ISDA framework and how to negotiate a term sheet, confirmation and collateral agreements.
MR I can only say yes. Without specialist staff you do not have a chance to understand and evaluate the risk that’s associated with the use of derivatives. You can’t capture the small differences between two more or less identical products. Take index futures and ETFs, for example. Many people say it’s pretty much the same thing, but if you take a closer look there’s a huge optionality embedded. If you don’t have the people who understand what that optionality is about, you can’t make use of it. You actually may end up adding more risk to your portfolio than you thought you would take out of your portfolio.
TC Pension funds don’t need specialist staff but the people who do the investment need staff, not necessarily specialists, but people who know what they are doing. Given that derivatives cover such a wide area, you can’t just say you have to have a derivatives person. You need staff who know what they’re doing before they invest in whatever it is they invest in. That’s just a natural conclusion.
AG I’d say yes, I know it’s expensive, but if you are investing in derivatives then you need to have somebody who has prerequisite experience otherwise you’re going to suffer.
CL I think it’s important that the staff have a broad understanding of derivatives because what we tend to find is you can have someone that understands the equity derivatives market but has no real understanding of the fixed interest or credit market. I think it’s important because a lot of derivatives today span different markets.