Derivatives IV: Profits

Derivatives trading is no stranger to other trading rule: buy low and sell high. The key is to know how much others are willing to pay because it is hard to know what the real cost is.

Derivatives earnings come from two sources: agency business and trading business. Agency business makes money by finding buyers and sellers. Trading business needs to find price difference in buy and sell. Agency business is a low-risk profitable model as long as there are trades can be tapped.

Dealers' value are from their firm value because clients deal with an entity not individual. Profits from traders and sales person are actually from the firm value. Thus, contributions from individuals are negotiable and dispensable. By contrast, dealers want to setup protections to their profits by maintaining the food chain.

Besides legal sources of profits, illegal inside information is also playing a role seeing profits. Larger banks can also use overwhelming force, i.e., capital, to blast off their competitors. Fundamental and technical analysis are used to predict price movement as a tool for trading business.

Profits can be reduced due to the need of credit reserve. Credit reserve is held against contingencies --- cover liabilities, future administration cost, hedging costs. Accountants want fewer reserve while regulators want more. Mark-to-market rule acts as the rule in between. It tells how much needs to be reserved or write off.

Traders are paid handsomely. Traders work for firms with hierarchy. First tier firms are Goldman, Morgan Stanley, JP Morgan, Deutche Bank, and UBS. Contract negotiating skills are critical in getting good contracts.

Derivatives III: the Buy Side

The buy side is investors and corporations who trade with banks. The buy side enters into trades to hedge risk, manage exposures and to speculate. Hedge fund is one of them, who is also a main client to banks.

Hedge funds have to post collateral when trading derivatives with banks. If the bank is owed money, the hedge fund must post cash or bonds to cover potential loss. This way protects the banks from on uncovered risk from hedge funds. Hedge funds are secretive, ruthless and arrogant due to their ability to make money and market movement.

The other client group is corporation who use derivatives to hedge their operational risks. Their operation can involve futures, forward/swap, and options to protect themselves from currency, market, and system risks. It has been well known from many cases, success or failure, such as Orange County. Corporations can trade foreign exchange, bonds, commodities, and equities. Due to complexities of some derivatives products, clients might have difficulties fully understanding the products so that lawsuits were brought up when losses incurred.

Investors are fund managers, who display more quantitative superiority and massive capital under management. Their principles are 1) diversification 2) efficient market 3) mean/variance for risk 4) risk/reward. Regardless fund managers' style, these principles are translated to 3 practical investment principles: 1) capital preservation 2) constant capital income 3) capital growth. Order matters in the 3 principles.

Fund managers are agent of investors. For a fee, fund managers agree to manage the investment, all losses and gains are for investors. The Agency theory explains why: all sorts of contracts are needed to balance fund managers' interest and investors', assuming the relationship would harm investment outcome.

Derivatives II: The Sell Side

Derivatives trading business cast consists of traders, sales staff, analyst, risk managers, product controllers, compliance officers and back-office staff. Among derivatives trading parties, banks and dealers are known as the "sell side" because they provide products and services to clients --- the "buy side". Salespeople on trading desks link the bank's traders to clients. Sales staff is to make clients do trades so that banks and traders make money.

Sales staff has the responsibility to bridge the knowledge gap between clients and their products. That is a requirement to know your clients. They need to constantly call clients to understand what they did and needed from financial products. The banks then market new products and trade with clients. A big hurdle is to find the right person for each client. Banks can figure it out eventually.

Sales person also give client market information, or market color daily. Clients may be cautious on what the sales person told them and verify everything because of the sensitive role. Sales person have lots of Powerpoints. Large amount than clients can read research reports is also another tool to lure customers. Along the path, sales person come up with everything investors need and clients outsource their intellectual power. Sometimes clients just can't differentiate what is good from what is available. That had caused many lawsuits. It seems crazy anyway: if the trades are good, why do the banks use it with their own money?

Traders take contracts and unbind them into smaller parts; each part has its risk; the traders then cover each risk separately in trading. There are market-makers, who support sales person, and proprietary traders, who take positions independent of clients. Despite the names, traders only follow money and make money. To achieve that, traders engage in various analysis tools, e.g., technical analysis and fundamental analysis. Success trading is simple: you must overwhelm others by having more money than others. How to find a good trader? It is hard because you need to find someone is, in a sense, really "lucky".

Analyst conduct research. Derivatives research has become increasingly quantitative, complex math techniques are employed to obtain trading ideas and convince clients.

The above can be called the "front-end office". On the other hand, risk managers, compliance, lawyers, technology, accounting and operations are the back-end office components. The existence of the back-end office is ensure the front-end office does what they can do within all sorts of boundaries, legally and commercially. The back-office is paid less and their pay is from revenue the front-office generates. Frequently, there are fights between them. Trading failures are hard to tell if they are because of the front- or back-office's operations.

Leaders of this structure is the senior management, whose contribution is strictly strategy or business model. But sometimes it is hard to outline the strategy physically. Managers are sometimes promoted due to Peters' Principle --- everyone is put to their highest level of incompetence. That is the reason of having management consultant.

Derivatives I: overview

Financial derivates are used to bet on changes in prices of forward underlying. It usually is cash settled. This is good because now everyone, including the ones who are not living on the underlying but purely traders, can trade it.

Derivative contracts are based on an agreed price, which should match to the forward price. If not, there is "basis risk". Basis risk needs to be hedged too. A common assumption is that basis risk is too small or trivial to be considered.

Derivatives are powerful or efficient, depending on your angle, because of its leverage power. Traders speculate the market by using smaller needed capital. Why does it have leverage? Because derivatives are based on future or expectation of the underlying.

Derivatives use a lot of swaps. Swaps, in a sense, establish a bridge between investment banks and commercial banks. There are equity swap, currency swap, and interest rate swap as the mainstay.

Swap can really lower borrowing costs. For example, a company has US$ debt linking to LIBOR would like to lower its borrowing cost. It can find a European country to issue a dollar bond through a bank. The bank arranges a swap between the fixed rate bond and floating rate borrowing rate. The bank gets fees, the company gets lower rate money, and the issuer gets US$ from the company lower than LIBOR. Everyone is happy.

Derivatives can also manage liabilities.

Derivate failure law suits

A series litigation acts follow after credit failure. Such law suits had no seemingly meaningful content except lawyers try to convince others that his client, investors, didn't know what he was doing when he signed a contract. Besides, investors normally sue investment banks for insufficient information before investing. The claim may be true as the complexity of some credit derivatives products leaves some risks are not hedged. For example, an interest swap has no hedge for opposite interest movement so that investors get burned badly.

Such losses bring in a string of law suits. No one wants to be in such situation. But what would it be if it does occur?

First, both sides would sue each other. Investment banks or whatever would sue investor for they are behind payment. Investor sues the banks that they are duped. Then lawyers are involved with so called "experts" are called in for professional judgement. The first option is to have case settled with the two parties, privately. It may settle if the banks think the case would hurt their relationship with other customers. If not, the case advances to a summary judgement.

A summary judge is to ask a judge in court to enforce the written contract. Thick expert reports are submitted after experts from both sides meet independently. Then a joint report, if the experts can reach it, is turned to the judge. Costly counsels are hired, the senior (who commands) and junior (who follows orders). Along the path, arbitration is also tried. When arbitration fails by a retired judge or senior lawyer, the judge intervenes.

Main job of the judge is to moderate or ask both parties to settle. It is still possible to settle this case at this stage. There is no other case than proving the investor didn't know what he was doing. It is hard so it is better to settle between them. But there are cases the judge has no favorite statement to the investor, such as the Lehman case in HongKong.

Unofficial emerging market investment cycles

Phase one, growth. Lots of influx capital. Many manufacturing facilities are relocated to the region. Labors are cheap and infrastructures are laid down. Government controls are relexed as foreign investors tell them so.

Phase two, prosper. Living standards improve. A middle class with cars, homes, and club memberships is established and flourish. Property prices hike. More money comes in and loans are even cheaper.

Phase three, high costs cause uncompetitive. Things aren't cheap enough and are started overpriced. Government are more keen to have tallest building in the world, longest bridges, fastest trains, etc. No one contents that the nation is a developing nation. Greed awaits larger fool to come.

At last, everything collapses and deem another cycle.