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Key Financial Instruments : Understanding and Innovating in the World of Derivatives Warren Edwardes/ Hardcover / Published 4 February 2000 Financial Times Prentice Hall ISBN 0273 63300 7
Instrumentos Financieros Fundamentales
Warren Edwardes Hardcover (October 2001)
Prentice Hall; ISBN: 8420531952
Warren Edwardes is CEO of Delphi Risk Management, the London-based financial product creativity, communication and control consultancy. He is founder of the schoolofbanking.com at the London School of Banking and Finance.
Edwardes was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives. Edwardes can be contacted via firstname.lastname@example.org
Updates to the first edition of:
Key financial instruments: understanding and innovating in the world of derivatives
4 Feb 2000, Commissioned by Financial Times Prentice Hall ISBN 0273 63300 7 link
Extracts from the first edition of "Key financial instruments"
18 August 2001 Warren Edwardes' best-seller Key Financial Instruments, launched in Spanish as "Instrumentos financieros fundamentales" "Profesionalmente, un espléndido trabajo." , "Para aquellos que deseen descubrir el delicioso mundo de los derivados sin la desalentadora tarea de tener que comprender su jerga. Instrumentos Financieros Fundamentales es la lectura deslumbrante y decisiva de la década." "Las breves y claras explicaciones de Edwardes muestran cómo la ingeniería financiera puede ser utilizada para reducir la incertidumbre y mejorar los resultados de una manera sencilla." details
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The Big Why
In Holland in the 1630’s there was a lively options market in Tulip bulbs – until the wife of a trader cooked a bulb thinking it was an onion. Has much changed?Well the 1760's saw the founding of two eminent British financial institutions. The Equitable Life was founded in 1762 and Barings was founded in 1763. Nearly a quarter of a millennium later, the latter came crashing down through the misuse of derivatives and the former was as a result of the failure by the insurance company to use derivatives to manage interest rate risk. On 10th April 1999 The Financial Times reported that "Assurers may face GBP14 billion bill for pension guarantees". The losses at the Equitable alone estimated at GBP 1.5 billion could have been mitigated through using derivatives and dwarf those that arose through using derivatives. This led to questions in the British parliament about the role of the insurance companies' supervisor - "Brown Faces Equitable grilling" Financial Times 1st March 2001.
Part I: Introduction
chapter 1: introduction to the world of financial instruments and derivatives
chapter 2: how to capture the big new IDEA?
change Edward Land to Edwin Land, inventor of Polaroid cameras.
Don't forget that whilst Christopher Columbus was right in looking for a Westerly route to India on landing in America he thought he had actually landed in India. That disaster turned into an opportunity for Spain. And the next time you open a bottle of Champagne think of its origins. It too was a disaster in its day. A still wine that over-fermented and went fizzy. But it proved popular and the rest is history.
So disasters can provide sparkling results.
.... By the time she got off at King's Cross many of the characters in the books had already been invented.
Or did it? On the 16th March 2000, a US author sued the writer and publishers of the Harry Potter books, claiming that plots and characters in the wildly popular children's series originated with her. But Nancy K. Stouffer of Camp Hill argued in her federal lawsuit that ideas for J.K. Rowling's Potter series were lifted from her 1984 book "The Legend of Rah and Muggles," which included a character named Larry Potter. There were a number of other coincidences. J.K. Rowling won the case on September 19, 2002.
Beware in bars, trains and planes
Given that genuine new ideas .......
...... in 32-point type.
The laptop was invented to allow computers to be used on trains and planes. But now because of the increasing number of leakages of sensitive information many major companies are insisting that their staff keep their laptops firmly closed in public. In November 2000, after one of their executives had reported that he had read sensitive information from the laptop of the person sitting next to him on an aeroplane Aerobus introduced such a closed-in-public laptop policy.
The increasing amount of vital product information contained in portable computers and Palm Pilots, and the ease of theft is causing real concern, and not only amongst the spies of MI5 who often leave theirs in taxis or London tapas bars. Many companies are insisting that those travelling with such portables only stay in hotels that have room safes capable of accommodating them. Others are insisting that their employees save work-in-progress information to floppy disks, or to e-mail files back to the office, and then delete the data from their computer, carrying the disk on their person always. Robust password protection systems to protect data in the event of the computer being stolen is also an important precaution. Sometimes old technology is better than the modern equivalent. TFT screens can be read from any angle; but old-fashioned and cheaper DSTN screens can be read from ahead only and so are a better bet from a security standpoint.
It looks like not much has changed since 1985 when I read the notes of Lloyds Bank's Head of Product Development on a London train. Nowadays one reads others notebook computer screens rather than paper notes.
Beware of "friends" and potential employers.
There is a bank, ....... , no job on offer!
The Times of 21st April 2000 reported on Liz Jones, who dreamt up an advertisement for Maltesers chocolates. The Sussex University Media Studies student sent in a story board to the advertising agency describing the idea but it was rejected by the advertisers as "it would be dangerous if young children tried to copy it." Not long afterwards, however, amazingly similar press and television advertisements were launched by Mars.
Miss Jones said that "getting a really good job in advertising is what I want and getting some credit for this idea might help. "The advertiser and Mars both deny plagiarism. Joe Boyd, director of the DMB&M, now called D'Arcy, dismissed Miss Jones' claims saying "It was entirely coincidental that we came up with an idea that bore some similarity to her idea."
So make sure all proposals are in writing - and with a watertight confidentiality agreement or not at all. Beware.
... Mr Y
In UK Prime Minister Tony Blair's leaked email memo "Touchstone issues" (Sunday Times 16th July 2000) he wrote of new initiatives "I should be personally associated with as much of this as possible." And he is not alone in this as these words could have been written or spoken by almost every CEO of a major corporation. Leadership is not about grabbing glory. It is about encouraging creativity and will only be effective if credit is given where it is due.
But coming up with a great idea and turning it into a successful product just is not good enough. Polaroid was used as a case study into how to think like a child - think innocently. But you have to keep on doing it. But don't just rest on your laurels. A combination of one-hour photo labs and multi mega pixel digital cameras resulted in Polaroid’s demise. On 12th October 2001, Polaroid Corporation filed for bankruptcy protection sealing the fate of one of the best-recognised brands in the world. As the Financial Times wrote on the day. "Polaroid, founded by one of the greatest inventors in US history, Edwin Land, proved incapable of making the transformation into a consumer products group. Products such as a Barbie camera, sunglasses and a flashlight fell flat. The popularity of the I-zone faded quickly, as adolescents turned to other fads."
chapter 3: what drives innovation?
"No one can long make a profit producing anything unless the customer makes a profit using it." Samuel Pettengill, US congressman
Part II: Key Financial Instruments
chapter 4: Key financial risks
Because of the appreciation of the Pound versus the Euro, Honda UK is reported to be turning their attention to exporting to the US market instead of the rest of the EU. ("Honda delay blamed on strong Pound" BBC online Business news. 31 October 2000 and "Currency worries force Honda to change plans" Financial Times, 1 November 2000)
The strategy sounds really ingenious but they could be in for a nasty surprise. If production costs of British made cars are now, say, 20 % more than European made cars when sold in Europe, selling to the US or elsewhere does not help. On the same assumption of a 20% Sterling uncompetitiveness versus the Euro, production costs do not change. They are now also exactly 20 % more in the UK than in Euroland for cars sold to the US, Japan, South Africa or South America. There is no refuge from an overvalued currency if the UK produces directly comparable products in a competitive market. Changing models and "strategy quickly if currency conditions change" to the CR-V for the US only makes sense if there is no similar Euroland made product also sold in the US.
Nevertheless, considering purely the foreign exchange exposure angle, it makes sense for the likes of Honda to continue to invest in the UK as a means of long-run currency diversification. It could, of course, hedge itself by paying its employees partly in Euros and organise regular employee shopping trips to France not just to Auchan for beer but also to Ikea for furniture!
chapter 5: key financial instruments
chapter 6: derivatives for the retail client (name change to Retail financial innovation)
I am currently working on a case where the London branch of an international bank sold USD 1m of distressed debt on a margin basis to a Latin American investor with net assets of USD 200,000. Whilst the initial margin was a mere USD 80,000 a variation margin call was triggered a week after the deal was struck making the client insolvent. And this deal was sold via the bank's New York branch through an agent based in the investor's home Latin American country.
I believe that raw financial derivatives should not be actively marketed to individuals. However, financial institutions should make use of the variety of options, futures and swaps available to satisfy their customers' investment and financing requirements. It is incumbent on these institutions, however, to ensure that their customers have absolutely no doubt as to what they are entering into and the risks inherent - including in the case of fixed rate mortgages, any early repayment penalties or with respect to investments, premature encashment terms.
In the mid-1990's the UK's Britannia Building Society launched inflation-indexed deposits. I am not aware of how Britannia hedged the inflation-risk in its liabilities but I do not believe that they used internal asset/liability management. No inflation-linked mortgage product was publicised by Britannia at the time. The key to successfully managed financial instruments is to create structured asset or liability instruments. But then instead of going into the market to hedge such structures, savings banks should engineer liability or asset structures that have equal and opposite properties. This not only increases the margins but enhances liquidity.
And many of the most successful retail financial products have not used derivatives at all. Paying interest on current accounts was deemed to be revolutionary not so long ago. And being prepared to provide flexible "one accounts", combining current accounts and mortgages with monthly salary income being used to temporarily reduce the client's mortgage, was deemed to be uneconomic. Now such flexible mortgages are commonplace. And some retail banks have introduced cash prizes in lieu of interest or "cash back" on taking out loans. These structures do not require derivatives. The most successful products are those that can be explained in a 30-second television sound-bite. These have the inherent difficulty of being easy to replicate by competitors. Anything much more complicated could lead to complaints years down the line over mis-selling and misrepresentation.
IF.com, Halifax Bank of the UK's internet banking standalone subsidiary, has attempted to patent its flexible mortgage structures. I would be surprised if the proves to be successful as there seems to be little different in IF.com's structure to what has been available elsewhere for several years. However, the very process of attempting a patent has provided the impression of innovation and it has generated favourable publicity. Even if an innovative product proves to be unsuccessful, the market need not become aware of the lack of success. The publicity generated during the launch in the media will probably more than cover the development costs. In any case the innovative reputation of the firm will be enhanced and the publicity will generate normal business as it will be seen to be an institution that cared for its customers' needs.
Part III: Cases in innovation: from creativity to closing
chapter 7: the break forward
chapter 8: perpetual swaps
Part IV: Risk Management
chapter 9: hedge choice and performance measurement (name change to Who wants to be a millionaire?)
This chapter examines hedge choice and performance management. Important lessons are learnt from popular game shows such as " Who wants to be a millionaire?"
Who wants to be a millionaire?
In a casino's Roulette Table a zero and often a double zero are acceptable to gamblers. A player can walk away from the game (usually!) with, at most, the funds brought to the table lost. He puts up limited capital. The casino has an unlimited capital exposure and cannot, other than through bankruptcy, turn clients away.
"Who wants to be a millionaire?" is now a world-wide television game. You are in the hot seat. The host hands you a cheque for half a million Pounds (or Dollars or Euros or ..) but snatches it away saying "But we don't want to give you that!". You now have the final question ahead of you for a million. You have already used up your lifelines. You've asked the audience; you've phoned a friend and you've had the computer take away two of the choices under the 50-50 lifeline. In short, with no lifelines left, you are no more than 60% certain of which of the remaining 2 possibilities is the right answer. Do you take a guess? If you are right you win a £1million. If you are wrong (40% probability) you go home with £16,000. So the expected outcome if you guess is £606,400. But you take the money and go home as you can leave with a substantial £500,000 albeit less than the £606,400 expected if you play. Many contestants often, quite rationally, will take the money and stop playing the game - even if on a simplistic probability calculation they should continue. The value of the certain substantial gain in-hand outweighs the possible benefit through a chance win of a larger sum. The decision all depends on the value of the £500,000 in hand. Bill Gates might well take a chance if he is 60% sure he is right. The consequences if he is proved wrong are trifling. But most people would focus on the loss of £484,000 rather than the possible gain of £500,000 and be reluctant to gamble it away even if they are almost confident. This is rational behaviour that has applications to treasury and funds management. Most people and most firms are risk averse.
Watching Bobby Robson and Terry Venables discuss Brazil's World Cup victory over Germany, I am reminded that both once coached Barcelona Football Club. What is the Utility Function of the coach of F.C. Barcelona? Bobby Robson, as coach in 1997 won the European Cup Winners Cup as well as two domestic Spanish cups. He was still fired! Why? Real Madrid won the Spanish league title that year. But his successor, Louis Van Gaal, did win the league and in particular finished ahead of rival Real Madrid. But he was still vilified for not using enough Catalans and forced out. As it happens Van Gaal has just returned to Barca after failing as Holland’s coach. So a poor track record is not necessarily a hindrance in football or indeed as the CEO of a Billion Pound losing firm. Just as in the case of individual investors in Premium Bonds or gamblers in lotteries and casinos or football team presidents, corporations do not have linear relationships between profit & loss and benefit to the firm.
And finally ..
Before deciding on a performance management methodology carefully examine your objectives. And before choosing a hedging strategy examine your performance management system. If the resulting strategy seems strange then re-examine your performance management methodology and reappraise your objectives.
chapter 10: legal risk management (by Iona Levine)
chapter 11: taxation aspects of derivatives and risk management
Part V: Back to the Future?: Current Developments and Trends
chapter 12: credit and insurance derivatives
chapter 13: dangers and disasters; profits and principles
It has often been suggested that companies providing employee options should hedge and crystallise their value through hedging in the market. This at face value sounds pretty good advice. However, it relies on the company in question buying an appropriate hedge.
Marconi appears to have "hedged" its employee share option scheme using forward contracts rather than options ("Marconi faces Pounds 200m loss on option hedge", Financial Times October 7, 2001). Remember that options grant the right but not the obligation to buy or sell something at a predetermined price. But forward contracts incorporate the right and the obligation to exchange at the agreed rate. Hence Marconi's loss.
Elsewhere in this book I have stated the obvious: "There is an enormous difference between something being cheaper and costing less money!" Forward contracts do not involve the payment of an up-front insurance premium and appear to be zero-cost or free. But adverse movements can lead to a substantial cost under a forward contract. Things that appear to be free can end up costing more than other things at an apparently higher price.
chapter 14: the financial future
Part VI: Appendices
Appendix 1: a list of financial risk types or "50 ways to lose your money"
See Morbidity Risk ... key-man insurance. I once worked in a bank where key-man insurance was seriously considered for a junior but key member of a project. For me, a sure sign of a badly run firm or team is when such insurance is even muted. It may be good for the ego of the person in question, but the solution is not the purchase of insurance but internal hedging; just make sure that at least two people can do the job.
Appendix 2: a list of financial risk management instruments
Appendix 3: a list of risk management terms
Appendix 4: Islamic financial products
Appendix 5: authors publications and bibliography