The Strange World of Derivatives

A violent meeting

I was shown into the conference room. A small room with a round table carved out of wood, walls white washed with rough textures, I was asked to be seated for a while, the thickly padded leather chairs were comfortable. It was, I feared, going to be a long meeting.

The boss walked in with a deceived look on his face followed by the so called treasury manager Mr. S. He knew nothing about treasury except for its spelling in english, though he boasted of being a Chartered accountant and had an earlier stint in a broking firm that actively traded on futures and options on stock exchange, always felt that he knew the whole derivative business inside out. A lot of painstaking efforts in explaining him that derivatives in currencies is a different ball game altogather, several times, went in vain.

" what the F*** has happened? I was told that nothing could go wrong and now my firm has a Negative MTM ( Mark to market - loss/profit if the deal was to be unwound at that particular point of time) of 2.7 million and you are here for a margin of another 1.2 million, I need to know why am I being whipped" screamed the boss. The boss (Mr.R) was a man in his late thirties, about 5 feet 8 inches tall and had a fair complextion with a medium personality. He was the man behind an IT firm which did software development for clients in US and UK. Generally very soft spoken, but now he had every reason to be furious.

I had to speak, " I think it would be helpful to go over the chronology of the transaction," I began. It took me over 10 minutes to explain the whole deal in detail after which the debate began. In order to save myself from being blamed, I started off in a very assertive tone " all the possible options to hedge the firm's flows were explained detailing the pros and cons for each one of them," " thats fine , but tell me how did this whole thing go wrong?" beamed Mr. R, " you are locked on the sell side at 40.04 and the rupee today is at 40.94 after paying a year's forward premium, hence you have an obligation to deliver at 40.04 when the market is at 40.94 - an opportunity loss, an unexpected depreciation in rupee being the major cause sir" I said. " So?? I am going to deliver, and it bloody makes no sense in you asking me another 1.2 million when u already hold 2.7 million of my money as deposit against this trade," It took me great courage to explain him the whole concept of MTM and the risk that bank carried for holding the firm's position. " you think I am going to F*** off without delivering?? are you questioning the credibility of my company???" he barked at me. After great deal of explaination and blame taking business, I could successfully convince Mr.R that it was purely a call of the company ( rather Mr. S) to get into a forward, heedlessly putting at stake the entire revenue stream of the frim for an year and that we had suggested plain vanilla at all the meets prior to the closure of the deal, and now it was not the bank's call to collect money, but an RBI directive.

Derivatives - WMD

On the face of it, derivatives are to hedge one's risk on a particular asset. the word 'hedge' is to be taken in its pure sense - to protect / to reduce the risk, more often we find companies 'gambling' thier chances with luck, having thier revenues at stake - thats one side of it, which I am ok with ( I am, afterall, a banker!!), the other dangerous side is the one I am currently living with, firms have no idea what derivatives are for, they get sold to what the bankers/brokers/consultants say, only to be blamed later that every thing was executed at the sole discretion of the firm. The case mentioned above has a little exception though, to thank my stars, the so called treasury manager who lived with a conception that he mastered the art, made my job safe and easy to fool him and make money.

Derivatives if understood properly can be a boon to the guy buying them, else its a disaster for the entire company eventually leading to death. The guys buying and selling these financial weapons must be masters in reading the market and its moves, and at the same time act very witty when required, more importantly they must be leveraged enough to escape when the markets turn against them. Every morning, I get up only to realize the gruesome cruelty with which I sell structures to clients and sometimes push them into trading which they, hardly, are aware of. Thats my job and thats what I am paid for........

Derivatives or trading comes into picture when a firm has cross currency exposures, liability in other currencies and domestic loans in their portfolios. Firms generally use derivatives as an instrument to protect their exposures to foreign currencies, to reduce the interest rates on domestic and international liabilities. However, there is a catch to it, nothing in this world comes at free of cost, the firm either diversifies its risk to something else or pays a cost upfront to stay safe. The greed with which most managers think, does not allow them to pay upfront premiums, instead, put thier head into something that they hardly know, on the name of diversification.

Donald rumsfeld once quoted "As we know, there are known knowns. There are things we know we know. We also know there are known unknowns. That is to say we know there are some things we do not know. But there are also unknown unknowns, the ones we don't know we don't know."

- The world of derivatives is full of known unknowns and unknown unknowns.

I still remember the days of my MBA at college, we had a subject by name Risk Management (cant help my self but laugh the moment I read this word, for the sheer exploitation that bankers/brokers/consultants use this word to make millions). I used to ponder over all these concepts like options, fowards, swaps....I mean, why the F*** would some take a loan in rupee at 10% and then swap it to Japanese Yen for a 9% arbitrage when you can F****** borrow in yen directly, which fool would dare to sell an option which is like crocheting a rope to hang yourself, all by yourself. I felt all these concepts are sheer nonsense, only If I had known then, that I would be making smart money selling the same nonsense for all my life!!!

Trading........

Trading is straightforward, you just need to buy at a cheaper price than you sell. If you expect the price to go up, you buy it; then you sell it when it has gone up and you are sure that it is not going to go up any more; you bank the profits. If you want to be fancier, then you use derivatives: you use a forward to gain leverage; you buy a call option to limit your risk to the premium paid if the price doesn't go up. you can sell a put option and bank the premium; if the price goes up then the option won't be exercised and you get to keep the premium; if the price goes down, then you leave the country. (you leave the country because the guy to whom you sold, would come to you with a bazooka in his hand forcing you to buy at the agreed price which is galaxies away from the market price.)

Epilogue

After coming up with proofs of all the conformations and underlyings signed and submitted by the firm ( done by Mr. S, which he had no powers of doing so), Mr.R had no choice but to cancel the deal ( otherwise he would have to sell himself along with the company to pay for any further loss) and take a loss of 4 million ( which he thought was better than keeping the trade alive, paying margin money to keep the MTM low) and kick Mr. S out of the firm for his reckless pretentious behaviour. All Mr.S aimed at, was a smart bonus for protecting the revenue streams of the firm and that too at no cost. Greed paid!!!!