Harold Kim Managing Director, Head of Structured Products Citigroup, Hong Kong Jan 20, 2007

Team Latte's Rahul Bhattacharya recently caught up with Harold Kim to have a chat. Harold is an economist at heart and a great intuitive thinker. He runs the Equity Structured Products team for Citigroup in Hong Kong and is responsible for pan-Asian coverage. We would like to point out that while doing training for Harold's team in Hong Kong recently, out of which in many of the sessions Harold himself was present to supervise us, we learned a thing or two of great importance from him about pricing exotics. And we have also learned that payoffs derived from partial differential equations are meaningless if investors cannot understand how to make money from them and if the banker cannot understand the investment rationale behind them. Here is an excerpt from our conversation with him.

Team Latte :
You encourage a lot of hands-on quantitative modelling and analysis of exotic structured products amongst your team members. Every day we have new products coming out and every day a new math model becomes the lingua franca of the quant community. To what extent does this focus on math help? I mean, do you believe that throwing more and more math at a problem makes it easier to solve and understand?

Harold Kim :
Math is useful for understanding product behavior up to a point, after which it may provide a false sense of security. For example, take the course that your team did for our desk here in Hong Kong . If you recall, throughout the course while we were working with math and computer models, we kept emphasizing the importance of intuitive understanding of the products and methodologies…what might work, what might not….In terms of a tradeoff between math and common sense, you do need a certain amount of math to get going but after that common sense prevails.

Team Latte:
Do you think that as a result of this preponderance of math models in our workplace, we are faced with some sort of a gigantic "model risk"?

Harold Kim :
Very possibly - that's what I meant by pushing the reliance on mathematics too far and perhaps deriving too much comfort from it. We have recently seen losses in the market, though the structures that were traded are considered vanilla within the exotic world, because either liquidity hedging considerations or other issues were not properly considered when the trades were done.

Team Latte:
As the structured products market has grown, have products continued to become more complex?

Harold Kim :
In general, we are seeing a bit of a backlash against model complexity for complexity's sake. Two or three years ago, the market was developing structures that were extremely complex and exotic in terms of payoffs; there were structures that were very difficult to understand from an investment rationale point of view. If you look at the recent evolution of structures, say in the past year or two, you'll see the structures are simpler to understand and explain to investors in terms of risk and reward. The hedging of these products may still be a bit complex but the actual product itself is simple to understand.

Team Latte:
Does this mean that the demand for Ph.D.s will go down?

Harold Kim :
No, I don't think so. Even coming up with simple exotics requires a reasonable amount of academic training.

Team Latte:
Within the universe of mathematical and quantitative models we are witnessing the emergence of Monte Carlo simulation models, especially within the banks here.

Harold Kim :
I would call it a re-emergence rather than an emergence. Monte Carlo techniques aren't new …They have been popular for a while, given their usefulness;

Team Latte:
Yes, they have been in the U.S. or Europe, but I was referring to banks and financial institutions in Asia . There has been a clear preference for Monte Carlo type models. You are a big proponent of Monte Carlo simulation models. Do you think Monte Carlo models are appropriate for pricing today's exotic structures? In your opinion what is the single biggest advantage of Monte Carlo models over other type of models?

Harold Kim :
In Citigroup, we often do use Monte Carlo simulations as an important tool to price exotics, and it is certainly a part of our tool box. But I don't agree that we necessarily choose Monte Carlo over other types of models all the time. If other types of models, say tree models, finite difference methods or closed form models are available, relevant and robust for particular products, then we will use them. I think the reason that Monte Carlo models are so popular these days is their flexibility. As market participants come out with more types of payouts, they want to have the flexibility to price them quickly. With computers as powerful as they are, Monte Carlo models are now feasible for use on derivatives desks.

Team Latte:
Are you encouraging your quants and structurers to use Monte Carlo more and more?

Harold Kim :
For first cut pricing and depending on appropriateness of structure, yes, we would turn to Monte Carlo methods In terms of speed and flexibility, Monte Carlo is a very, very powerful tool.

Team Latte:
Are there any drawbacks to the Monte Carlo method?

Harold Kim :
Monte Carlo is computing intensive relative to some other methods, certainly versus closed form solutions. Yes, there has been tremendous growth in computing power, but at the same time the product space has also increased immensely. If you have a very large number of products on the books and use Monte Carlo for every one of them then you could experience significant slow downs in your computational speed.
In addition, Monte Carlo methods often are not appropriate or efficient for American-style options where early exercise decisions could be relevant.

Team Latte:
How do you structure products for your customers? What important parameters go into your decision making when you come up with new structures for your customers? How much of it is a financial engineering exercise and in what way?

Harold Kim :
There isn't one answer to this question. Sometimes product ideas come from customers, sometimes they come from us. And quite often product ideas are developed through iteration of ideas between customers and the desk. In general, there are two areas of product development –the payout of the product, and the underlying of the product. In both these areas, dialogue with customers is very important for us. One of our most popular products embeds a call overwriting strategy in a capital protected note. The original spark for the idea came from a customer question; we worked on the idea and developed the product. A simple idea triggered by a simple client question, resulting in the development of a multi-billion dollar product.

Team Latte:
You also have a lot of internal brainstorming amongst your team members, a lot of searching for good ideas?

Harold Kim:
Oh yes, all the time. Still, more than 50% of the ideas come from the customers, and even our internal brainstorming is driven by new ideas or requirements from customers. We try to establish what customers want in terms of investment exposure and risk/reward profile; we then go ahead and do the financial engineering. This is a fundamental process that all bankers should keep in mind. Ultimately, it is the customer who should drive the process. The customer has specific needs; he has specific risk-return expectations or targets;he has certain payouts and exposures he wants. Our job is to engineer the best solution for the customer.

Team Latte:
Of late, what products do you find challenging to structure and trade? Perhaps, you could name one or two exotic structures that you truly find challenging. With regard to risk analysis how are these products unique?

Harold Kim :
Over the last few years, the biggest challenge in terms of structuring and trading exotics has not been structure-specific - that is, that certain structures have been ‘truly challenging' to trade in and of themselves. Rather, the biggest challenge facing the Street is the imbalance in the market with regard to demand and supply of volatility and correlation. This imbalance has made trading exotics, even "commoditized" exotics like autocalls whose risk profiles are generally understood, very tricky, due to the hedging and liquidity dynamics in the market. The imbalance has meant that the Street has been long volatility and short correlation, which has been generally difficult to hedge out. So when volatility declines dramatically, the Street is sometimes caught out, causing trauma for some desks.

Team Latte:
There has been some talk about knock-in auto call structures recently and it is rumoured that the trading desk of a bank in Asia has recently faced some losses with this product. Why is this product so challenging to manage? How is the risk profile different from other products?

Harold Kim :
It is not that different from other barrier products. Again the fundamental problem is that of a volatility and correlation imbalance. For example, take Korea ...an estimated US$20 billion worth of equity linked structures hit the market in 2006. This represents a lot of volatility for the Street to absorb. The Korean warrant market is now 10% of stock market turnover, but the amount of vega that can be sold is still small relative to the vega generated by the equity linked structures. If you are a market leading ELS player and have not been able to offload your vega, the declines in volatility can hurt.

Team Latte:
Correlation has become an important dimension of risk in the last five years or so. How do we go about managing correlation risk in today's world? How important are correlation products in your portfolio and what parameters are considered when you design a correlation product for a customer?

Harold Kim:
As I mentioned before, there is a discrepancy between the Street's ability to buy correlation and sell correlation. Many of the products sold by the Street have correlation risk, allowing investors to squeeze extra yield from the structures. However, the ways to hedge this risk are still developing. End of the conversation.........It was a real pleasure talking to Harold and we really appreciate the time he took out from his busy schedule to talk to us.

Personal Profile of Harold Kim :
Harold holds an A.B. in economics from Harvard University, magna cum laude (1986) and a Ph.D. in economics from Princeton University (1993) specializing in finance, macroeconomics and econometrics. He was a Lecturer at Princeton from, 1990 to 1993 and then joined Salomon Brothers in 1993; he subsequently moved to Hong Kong with Salomon in 1995. (Salomon has since merged into Citigroup.)
With five young boys aged 8, 6, 4, 2 and newborn, he unfortunately has very little leisure time to pursue other interests currently.

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