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.