Buying & Selling Derivatives - The Dentist and the Financial Engineer
June 12, 2007
Team Latte

We have been telling to all and sundry who came our way that the ultimate onus of risk taking was with the investor who bought a derivative product and not with the bank who sold it. In every training session, in every discussion forum, in all those pseudo-intellectual discussions in Starbucks around Central Hong Kong - where one does nothing but "sip lattes and talk about interest rates" (a borrowed phrase from the movie Blood Diamond ) - we've been putting forth the argument that it is the buy side guy who needs to know what he is buying and understand the product well. You cannot blame the smart and clever derivatives salesman who sold you LIBOR squared note because you are the one who should have looked at the presence of convexity or concavity (or both) in the product and analyzed it in pre-buying simulation tests. Surely, you cannot be the treasurer of a large multinational organization and not know "how to simulate convexity in an exotic derivative¨.

No sooner had we uttered the above phrase in one of our hyper-charged discussion sessions with a group of fund managers recently when one of them went into a state of fit. He said, "you know what, that's baloney!" "Utter simple nonsense.... and please don't ever be condescending with fund managers again, not with the real ones at least."

He asked: "What car do you drive?" One of us, probably Simon or Rahul, answered: "Ford Mondeo".

His quip: "Besides holding on to the steering while driving and adjusting the automatic transmission gear while easing out of the parking and pulling the brakes what else do you know about your car? Can you tell me how does a Ford Mondeo work? How does the car's fuel combustion system work? How does the coolant react inside the car? What do you know about the mechanical and the electrical system of the car that you are driving?

We were blank, a bit out of context, we thought. We said that in fact we didn't know anything about all this. And he said: "and yet you chose to buy a car and you put your life at risk every day by driving it to work. Why do you do that?" He was on fire and was in a mood to completely rip us apart. He went on: "you do that because your salesman, the car company, the authorized dealer has assured you of all these things... ...given you a guarantee card, whatever.......they have checked it all out before handing the car over to you and you have taken their word and a piece of paper as an assurance of safety. There is still a risk, though a small one - I hope - and it is a calculated risk that you have taken."

"C" mon guys, are you nuts to make that statement? You are telling me that the homeowner - me, you, the school teacher, our family dentist - needs to test the structural quality of the apartment building and run tests on electrical systems in the apartment before he buys the apartment? They need to run simulation on architectural design to test for seismic insulation? No mate, they don't have to do that. They need to simply take the architect's and the building contractor's and the real estate company's guarantee and move into the house. And of course, buy insurance."

He finished by saying: "And the same goes with the structured products and all your fancy, so called "exotic" derivatives. You need some kind of assurance, some form of guarantee, and a level of confidence from your seller when you buy these things."

One of us made a rather stupid and an unnecessary comment, something like gambling with life is different from gambling with your money . We regret making that comment very much, which of course, portrayed us in a very poor light; and rightly so.

Thus the questions are:

1. If our family dentist is buying an exotic structured product from his private banker which is designed by the best financial engineer from the bluest of the blue chip investment bank should he be worried about the risks of the product?
2.   Since he did not "simulate the architectural design plans of his house" or the "electrical and fuel combustion systems of his car" before buying them should he now "simulate the convexity of the exotic derivative" before buying it from his private banker?

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