Today I’m sharing an article written by my friend, Tama Churchouse, who with his father, Peter, runs Churchouse Publishing in Hong Kong. Peter spent decades as the Head of Asia Research and Regional Strategist at Morgan Stanley in Hong Kong, and is a fantastic source of stories and insight on investing in Asia. He’s a frequent guest on the major financial news networks, so you might have seen him or heard his market insights before.
Tama’s career began in the trenches of the banking world – and here he shares a story that will resonate with any investor who’s been tempted to buy something he or she doesn’t quite understand.
Peter and Tama write The Churchouse Letter, a monthly publication about investing in Asia, along with a free email called Peter’s Perspective, which you can sign up for here.
4 Lessons from the derivatives desk that “smart money” learned the hard way
By Tama Churchouse
I joined the derivatives structuring desk of a European investment bank straight out of university.
I recall having to google the term “derivatives” the day before my interview. The search result gave me something like this:
“A derivative is an arrangement or instrument (such as a future, option, or warrant) whose value derives from and is dependent on the value of an underlying asset.”
The fact that I had to look it up sums up my degree of expertise on the subject at the time.
Simply put, a derivative is an instrument, created by an investment firm, which is based on a security. Derivatives allow financial engineers (like I was interviewing to be) to create complex securities that (in theory, at least) offer better returns with less risk.
At the end of a grueling interview (which involved having someone interviewing me in Mandarin), I was offered a job.
They asked me what I expected as a monthly salary. I told my interviewer and future boss what an intern friend of mine at a different bank was earning.
That was my ballpark expectation…
He offered me just under half that amount.
I instantly accepted.
My first day was in August of 2004. There was no training program… no scheduled classes, presentations or anything like that. On that first day my boss put a stack of a dozen financial textbooks on my desk and just said, “learn those”.
Derivatives are seriously technical. They involve complicated math and calculus. I however, had spent my years at university studying economics, and knew as much about calculus as I did about nuclear physics.
No matter. I figured it out, and persevered. And three months later I created and sold my first structured note.
I remember drafting the product term sheet. I called it a “Bermudan Callable Three Times Leveraged Inverse HIBOR in-arrears Resettable Step-up Snowball Note.”
No, I’m not kidding…
This was a painfully complex instrument, the kind of thing that only people on derivative trading desks (and their customers) pretend to understand.
Just like a regular bond, structured notes have a notional (or “par”) value. The notional value of my note was about US$13 million. We booked around US$110,000 profit. Since it was a relatively short-term note, it wasn’t very profitable…
But it was my first trade, so I was happy. My boss ceremoniously cut my tie off below the knot when the trade was done and dusted.
I still have the tie… or what’s left of it. It was hideous anyway. In retrospect my boss did me a favour by destroying it.
I’ll spare you the details on how the price of the structured note coupon was determined. But the crucial thing is this: If Hong Kong interest rates rose, the investor who bought the instrument would be in big trouble.
You can probably guess what happened next (see chart below).Interest rates in Hong Kong skyrocketed. They went from nearly zero percent to over 4 percent in less than three years.
That investment didn’t work out as planned. The client had essentially “bet” on low interest rates. While he didn’t lose any principal, the investment was a dud. The guy who bought the note was not happy (and hey, that was the sales guy’s problem, not mine!). But he learned a hard lesson: Despite (or maybe because of) all the esoteric calculus, complex derivatives often don’t work.
The thing is, even if Hong Kong rates had stayed favourable, the client wasn’t going to make much money. The derivative instrument was intended to be closed out after three months.
So even in the best-case scenario, the client would get some decent interest for three months and then his money back.
Except now he would have to reinvest at rates lower than when he started… and no prizes for guessing who would be first in line to sell him another genius idea!
You get the picture: Complex doesn’t necessarily equal profitable. Perhaps there were other ways that capital could have been put to work…simpler, better….
Despite this early setback, I went on to spend nearly 9 years on derivatives desks at investment banks. (I learned to create, simpler, better structured products!)
Anyway, I was reminded of this story recently when I read an article on Bloomberg entitled “Brexit Blows Up Currency Derivatives Sold to U.K. Businesses”.
The article describes how many U.K. investment firms are facing massive losses from imploding derivative instruments aggressively sold to clients. The complex transactions were supposed to “hedge” (insure against losses) in clients’ currency positions.
However, following a sudden post-Brexit crash in the British pound, many of these complex instruments turned out to be useless as hedges – clients had big losses despite them. Clients are suing the banks, claiming the firms didn’t fully disclosure the risks of the derivatives.
Clients said they were cold-called by bank salesmen who were compensated with fat commissions for promoting the esoteric securities.
According to the article, the derivatives had names like “seagull” and “two-times leveraged accelerated knock-out, knock-in forward.”
After so many years in the derivatives business, this story had a wearily familiar ring to it….
And it motivated me to write some very simple rules I learned in my time on the structuring desks… rules I hope will prevent investors from losing money needlessly on derivatives:
Beware of any derivative product with more than one adjective in its name.
I mean, in all honesty, a “two-times leveraged accelerated knock-out, knock-in forward” is unlikely to be a “hedge” against anything.
If it sounds ridiculous, it probably is.
Complexity = profitability… for the banks and brokers.
This should be pretty straightforward. The less a client understands about what he or she’s buying, the more money an investment bank can make.
Complex Structured Derivative Products don’t get bought… they get SOLD.
Believe it or not, there are relatively few corporate treasurers who wake up on any given morning with an urge to buy a “Bermudan Callable Three Times Leveraged Inverse HIBOR in-arrears Resettable Step-up Snowball Note.”
They get “sold” to you because they are profitable for the seller!
Don’t confuse “hedging” with “speculating”.
The entire purpose of a hedge is to limit losses that may result from an investment.
It should be straightforward. Done correctly, hedging provides certainty and reduces risk.
If you “hedge your bets” and end up with more risk than when you started, chances are you’re speculating – and not investing.
For example, if you know that in 6 months you are going to receive Japanese yen then convert it into U.S. dollars, you can enter into a simple foreign exchange forward contract. Essentially, a forward contract lets you lock in the exchange rate so that you don’t lose money when if the rate moves sharply within the six month period.
That’s it! You’re hedged!
Now, over the next 6 months that FX forward contract can gain or lose in value depending on what happens to the currency pair, but it’s irrelevant!
Regardless of what happens, you know the FX rate you’ll get at the end of the contract.
What’s more is that these kinds of “vanilla” hedging products exist in every financial asset class…
FX, equities, interest rates, commodities… and they are transparent and liquid.
Which is why banks and brokers won’t be rushing to sell them to you… because transparency isn’t a word they associate with profitability!
Why sell a basic FX forward when you can sell a “two-times leveraged accelerated knock-out, knock-in forward”. And receive more fees….
The bottom line is this: The vast majority of individuals and companies have absolutely no business whatsoever buying anything more than the most vanilla derivative products… if those.
Maybe you sit on the board of a small business which is getting the hard sell on structured products from an investment bank… instruments that take pages to explain…and you still don’t understand them.
Next time, if a financial advisor is pitching you on a “hedged instrument” called a “Bermudan Callable Three Times Leveraged Inverse HIBOR in-arrears Resettable Step-up Snowball Note.”
My advice? Ask the salesperson for something with fewer adjectives in the name.