A great post from Andrew Clavell today, which can be distilled down to one simple piece of advice: Just Say No to Derivatives. If you’re buying derivatives and you’re not a banker, or if you’re buying a derivatives product which was a banker’s idea and not your idea, then, well, you probably shouldn’t be.
Let’s assume you work at a Pennsylvania school board, or a Swiss private bank, an Australian life insurance company, a German corporate treasury, a UK Pension administrator or any one of thousands of other buyside entities, supposedly with sufficient expertise that an investment bank can classify you as a non-retail customer.
The more complex the structured product, the more opportunity for agents to extract fees at your expense…
Admitting you don’t know is pure alpha; you will not claim to have any edge and this may put you off involvement in the product. If you claim you do know where the fees are, banks want you as a customer. You don’t know. Really, you don’t. Hang on, I hear you shouting that you’re actually smarter than that, so you do know. Read carefully: Listen. Buster. You. Don’t. Know.
Still, the risk/reward profile of a particular structure might actually be useful to you, provided you are rewarded appropriately for the risk. Let’s use a CPDO as an example. There are always more efficient ways of assuming a similar risk profile than entering into a nicely packaged transaction – simply buying a solid vanilla floater and selling enough iTraxx/CDX OTC protection for your target yield enhancement would get you close enough not to worry much…
If this alternative is unavailable to you, for example, because your trustee documentation forbids trading derivatives, why on earth should it be OK for you to access those derivatives just becuse they were wrapped up in a funded structure with a pretty rating?
Clavell’s a former derivatives whizz: chances are, he knows what he’s talking about. Have you ever wondered how investment bank derivatives desks make so much money in a zero-sum game? It’s because, in Clavell’s words, they’re the Masterminds, and the buy side, in toto, is the Patsy. If you’re buying derivatives to hedge some risk, that’s great. If you’re using them as a profit center, not so much. Holger Härter, pay attention!