2 views on derivatives

I follow the events in World Economic Forum in Devos closely to update myself on the economic happenings around the world. On 28 Jan 08, the newspaper reported an interesting exchange between a politician and an investment banker on derivatives.

During that exchange, the financial world was still recovering from the shock created by the SocGen's 4.9 billion euro trading fraud. Mr. P. Chidambaram, India's Finance Minister, held strong view that the current global credit crisis is the result of unscrupulous usage of complex financial products that "most people don't understand". He was referring to derivatives.

On the other side of the panel is Mr. Jerry del Missier, president of Barclays Capital. Mr. Missier held equally strong view that derivatives have their merits (primarily as a risk hedging tool), and we will continue to see growth in users and innovation and he thinks derivatives will be one of the key drivers of the next phase of economic growth cycle.

As a bystander of world economic and financial affairs for many years, I have to agree with Missier's view. Derivatives will play an important role, like it or not. My view is not so much based on the technical merits of derivatives, but rather on my observation of human nature. It is human nature that we tend to draw towards something that will magnify wealth with least effort. It is also in human nature that we are driven by greed. Derivatives nicely satisfy these two human natures (unfortunately).

I remembered in 2003, i attended a seminar on CDOs (a form of derivatives). The speakers were accomplished investment bankers and economists. CDOs then were described (and promoted) as the "perfect" product to achieve high yield and provide safe volatility relative to equities. Subsequently, in 2004 - 2006, I read that the amount of institutional funds that go into CDOs were mind boggling. In 2007, we know the story of CDO crisis.

Financial options and futures (common derivatives) allow corporations to hedge their risk against price volatility. Speculators have other ideas. They use the technical merits of options and futures to magnify their personal wealth. Some have treated the stock market as a gigantic casino.

More accomplished speculators went one step further. They use leverage (i.e. borrowed money) to run their derivatives operations. In 2008, we know the story of SocGen.

There will be more stories to come. However, instead of avoidance which is impossible because of human nature, it would be wiser to study and understand derivatives to put them under control.

SocGen and derivatives

I was having my afternoon coffee in T3 (Changi Airport), reading the Financial Times. The headline is of course the Euro 4.9 billion loss by one single trader (Mr. Jerome Kerviel, a harmless looking chap) in Societe Generale. I was curious to know how did this come about, and what lesson can be learnt from this case. First, what went wrong?

The problem came from equity derivatives. What exactly is equity derivatives?

In the world of investment, we have basically 3 groups of investment products. The first group is the traditional products such as shares and bonds. The second group is the non-traditional products such as hedge fund, REITs, commodities, currencies, arts and private equity. The thrid group consists of financial instruments such as futures, options and swaps. The third group is commonly known as derivatives.

A derivative is a financial contract between 2 or more parties, which is derived from the future value of the underlying asset. As in most financial products, it started life innocently. It is a way where manufacturers can hedge the volatile prices of raw materials or currencies, so that the production (and financial) process can be executed meaningfully in a predictable manner. As in most financial products, it loses its innocence fairly quickly when speculators step in.

Over the years, derivatives have become a way where people and institutions trade for big profit (and loss). I was flipping through the pages of Financial Times, I found that practical everything can form the underlying asset of a derivative. We have bond futures, interest rate futures, oil futures, commodities futures, Euorpean stock index futures, and the list go on and on.

In a future contract, the buyer and seller enter into a firm contractual agreement for a specified asset on a fixed date in the future. Usually the buyer need only come out a fraction of the contract price (call the margin), and when the fixed date is due, the full amount has to be settled. The problem is that one can never know what this future price will be. As a result, most traders are merely "betting" the price movement. The problem can be further magnified if the trader uses leverage (i.e. borrow money) to execute his bet.

In Societe Generale's case, the bet went way off in series, and the loss amounted to euro 4.9 billion, which essentially wipe out the entire pretax earning of the bank for the year!

Prior to this case, Societe Generale prides itself to have a world-class equity derivatives business under the leadership of its chairman, Mr. Daniel Bouton, since 2000 (SocGen hires most of the best mathematicians produced under the French education system). This case demonstrates that we have to respect the uncertainty nature of the economic market, and be very prudent when handling complex products. Otherwise, that very product can be a "weapon of mass destruction" inflicting huge pain onto the user, even if the user is first class.

Money have to be earned

At the beginning of new year is a good time to reflect upon what have been done last year, and prepare for what ought to be done in the coming year. In my work in advising people on wealth preservation matters, the core purpose has always been deepening the relationship with my core clients. There will always be economic issues that will cause sleepless nights; there will always be new innovative financial products that will grace the market; there will always be new kids on the block that claim to have the unique strategy to make you a (instant) millionaire. If one is not careful, it is very easy to feel overwhelm by such issues and feeling unsecure.

Most of my time is spent having dialogue with people. In the process, I have an appreciation on their life's goals, fear and love. To those who are clients, i will then see how can they deploy their financial assets to address these goals, fear and love. To those who are not yet to be clients, I will make mental notes, and allow myself to be available when they meet up with life transition events.

Through these dialogues, I also learn alot about issues in life and money from different people. One such wisdom is from a successful businessman in his 50s. He runs a travel agency and pioneered the Israel tours since the 1980s. The dialogue is as follows:

Me: "Mr Soh, how do you view money?"

Soh: "First, money have to be earned. Investment products will have their place, but it would be unwise to think that one can sit back and let investment products take on the money earning role for you. Investment products can compliment your finances, especially in retirement, but it cannot be rely upon to replace your earning role or capability. To do so is foolish.

Second, money still have to be earned. Money don't come from 4-D, ToTo, or how many goals David Beckham scores in a football match. To rely on investment products to replace your earning role is foolish; to rely on random probability on chances (i.e. gambling) to replace your earning role is deadly."

Back to my earlier paragraph where one feels overwhelm and unsecure by economic issues, new products or concepts. The response is simple: "Are you earning your money truthfully, and strengthening your capability in earning money in your current role, whether as a an employee or businessman?" The ball has always been in our own court.