Friday, April 23, 2010

Parable of the day

Andrew Clavell teaches:
... I called my friendly investment banker and said, hey, I'd like to buy protection on a decline in value of a reference pool of equity securities of 20% or more of their present value. Actually, I'd like it to be a pool of 200 of the 500 of the largest stocks in the US by market capitalization. I liked researching these 500 stocks in detail, and felt that 200 was the right number. What could you do for me, mister banker?

So my banker went out and spoke to an assembler of reference pools of securities. As it happens, they knew an outfit called Standard and Poor's, and they had a handy list of 500 stocks which they had previously selected into a pool. They already sponsored this pool of securities so all was good, and they happily agreed to arbitrate the performance of my 200 stocks.

My banker, not wanting to assume my risk in the reference pool, decided to look for someone else to lay the risk off to. Lo, there were takers for this sort of risk. Embedding the risk into a bond issued by my bank's offshore conduit that if the securities fell by more than 20%, principal would not be fully repaid, this bond paid nicely above-market interest rates. Many investors wanted to bear this risk, but my bank did not tell them that I had an opposite view. Had they done, investors would not have cared, as the securities were market priced at the time of striking the deal and they were happy to bear the risk on offer. They bought the bonds, and I bought my protection. My banker called it a cash settled put option, but you know, whatever.

As luck would have it, the reference pool fell by 50%. The first 20% fall didn't do anyone any harm, as no-one had a side bet on this risk. Investors in my bankers' bonds lost 30% though, and that was paid to me.


Should my friendly banker or I be nervous about an SEC law suit for this despicably complex transaction?

No comments:

Post a Comment