The Arthur Andersen Hall of Fame ROUNDTABLE
New members of the Derivatives Hall of Fame joined past honorees for a roundtable discussion moderated by Arthur Andersen's Michael Onak and Derivatives Strategy's Joe Kolman.
|Myron Scholes, professor emeritus, Stanford University, and principal, Long Term Capital Management|
Robert Merton, George Fisher Baker professor of business administration, Harvard University, and principal, Long Term Capital Management
Richard Sandor, chairman, Hedge Financial
Conrad Voldstad, cohead of global debt markets, Merrill Lynch
Edson Mitchell, head of global markets, Deutsche Morgan Grenfell
|Joe Kolman, editor, Derivatives Strategy|
Michael Onak, America's director of Arthur Andersen's Derivatives and Treasury Risk Management Consulting Group
Joe Kolman: I'd like to give the three honorees a chance to talk about the past, the present and the future. Let's start with the two dealers, because you've had a similar history and a similar career path. When you started out in your careers, derivatives were off the beaten track of traditional investment banking. What did the derivatives business look like to you when you were starting your careers, and how does that view compare with what's going on now?
Conrad Voldstad: Well, it really wasn't the start of a career for me. I had been a banker for eight or nine years before really getting involved with derivatives. I was in capital markets coverage at JP Morgan in London in 1983 and we were doing bond deals and secondary market swaps. At Morgan, we actually started feeling that we were losing a little bit of our edge. It became clear that we had to get some more specialization. So in 1984, I told my boss, "We've really got to set up a group that's only doing derivatives. And if nobody else will do it, I'll give it a try.”
I really didn't give it a lot of thought. I knew it was something that I would probably be pretty good at. I'm a pretty quantitative person. I happened to have a banking background rather than a trading background. But I was looking at it as sort of a two- or three-year stint. Now, 15 years later, I'm still involved in derivatives.
Edson Mitchell: Initially, I saw it as a supplement and as an additional weapon rather than as a standalone business. In '84 and '85, I was in the capital markets syndicate desk at Merrill. At that point, Merrill was not really in the top tier in terms of the new-issue debt market. As the derivatives market began to develop, I saw derivatives as a way for us to catch up to the Salomons and the rest and enhance our ability to compete on the new issues and the capital markets side.
Michael Onak: When did your ideas about the derivatives market change? When did you realize it was more than just a supplement to something else?
Mitchell: It was 1987 before I fully grasped the enormity of what this business could be. In 1988 while at Merrill, I hired Martin Loat and a team from Bankers Trust to develop an equity derivatives business. At that time, Bankers Trust was pioneering the development of the equity derivatives market. Once I began seeing the applications for equities and corporate finance, in addition to the fixed-income applications that were becoming fairly commonplace, I began to realize that this was an instrument that could pervade all aspects of what we did as a financial intermeidiary, and that eventually it would lead to property derivatives and commodities and so forth.
Voldstad: When we set up the swap group, everybody at JP Morgan said, "Oh boy, this is great. Now we can do all these bond issues and then swap the proceeds into floating rate.” But it soon became quite clear that there was no margin in that.
|"I was in capital markets coverage at JP Morgan in London in 1983 and we were doing bond deals and secondary market swaps.
It became clear that we had to get some more specialization. So in 1984,
I told my boss, We've really got to set up a group that's only doing derivatives.
And if nobody else will do it, I'll give it a try.”
So we started trying to manipulate cash flows and understand how cash flows worked, and eventually did the same thing with options. We developed a business immunizing people against risk, designing products that would meet our clients' requirements exactly. Then, of course, we found we could make a lot of money doing it.
Onak: Both of you [Voldstad and Mitchell] have graduated to larger roles in your institutions. You must have thought about how a derivatives group should fit into the general capital markets group. Should derivatives be a standalone group? What is the right way to integrate the derivatives technology with the rest of the bank?
Mitchell: I don't think there's any one model that necessarily is correct—I think you've got to differentiate between the different types of derivatives. From my perspective, the more prosaic the derivatives are, the more they have to be integrated into the rest of the cash markets. There are some derivatives that I think need to be run on a vertically integrated basis. The big challenge is trying to strike the proper balance between specialization on the marketing side and having a generalist marketing effort.
|"I knew there had to be something wrong with [Black and Scholes'] argument that said that you could use simple portfolio mixes to hedge. That was my first and second instinct. But with the passage of time and looking at it,
I became a convert and I knew they were right.”
Voldstad: I think a lot will also depend on the organization. I think Credit Suisse Financial Products, which runs itself as a vertically integrated operation without a tremendous amount of interaction with the rest of the organization, is very, very successful. I think you can run it that way or try to integrate it more with the rest of the firm. Sometimes when you depend on the rest of the firm to sell derivatives, you'll find that they are unable to close deals that add a lot of extra value. You have to make sure the account doesn't have half a dozen different product specialists working on particular problems. And you have to strike the right balance between that and having a generalist who understands interest rates but very little more. We've found that having one or two specialists working with generalists on client problems generally makes sense, but no more than that.
Onak: Both of you have been very interested in trying to get a handle on your firm-wide risk. A lot of people said that this is an impossible challenge, that it's almost impossible to get a handle on the myriad risks the firm was exposed to. How close are you, or have you arrived there?
|"If your risk systems are showing you're a billion dollars long or short, I think we're probably pretty close to being right and more or less under control. It doesn't matter if we're at $1.1 billion or $900 million, because the amount of extra risk that we're taking is insignificant relative to whether we're right or wrong.”
Mitchell: We haven't arrived—at least, at our firm. I'm sure Connie has at Merrill. (Laughter.)
I think we are probably similar to most big financial intermediaries. We're getting better at defining risk and putting it in the right buckets, but we're a long way from having a complete, all-encompassing model. I think there's another layer of risk that we feel pretty comfortable with, and that's general market risk. We look at things on a one-year equivalent basis. If your risk systems are showing you're a billion dollars long or short, or X amount of foreign exchange long or short, I think we're probably pretty close to being right and more or less under control. It doesn't matter if we're at $1.1 billion or $900 million, because the amount of extra risk that we're taking is insignificant relative to whether we're right or wrong.
As we get into more complicated derivatives and more complicated credit risk scenarios, we find we have a long way to go. We're in the process of trying to get a much better handle on credit risks. If you have a loan to a Turkish bank and it provides General Motors collateral, do you have credit exposure to the Turkish bank, to General Motors or to both? And if so, how much? We're in the process of getting our arms around that. It gets complicated as you look at the amounts of risk with different degrees of confidence.
It's actually a very exciting and interesting sort of thing for an old guy to look at. We're also looking at what happens to your risk after violent shocks to the portfolio. That's something else that we are spending a lot of time on. But we're not there on any of this.
Kolman: Now I'd like to turn Bob Merton. How you did first get to know this guy to your left and how did you get involved with the work he was doing?
Robert Merton: When I first met Myron at MIT, I was a graduate student looking for a job. Then Franco Modigliani suggested there may be something open right there at MIT. He said, "I want you to meet this young professor from Chicago. If it works out, he could be your colleague.” And that's when we first met, and it's been a blast since.
Kolman: What was your first impression of what the work that [Fischer] Black and he were doing, and where did you think it would go?
Merton: Well, my first reaction was that it had to be wrong. (Laughter.) That was also my second reaction.
Kolman: Why was that?
Merton: Well, Myron and Fischer had this brilliant insight. It's so commonplace now because we take it for granted—a dynamic strategy hedging the exposure of the options. I had done a little bit of work on warrants and other kinds of convertibles. I knew they were nonlinear functions, so I knew there had to be something wrong with an argument that said that you could use simple portfolio mixes to hedge. That was my first and second instinct. But with the passage of time and looking at it, I became a convert and I knew they were right.
|"Today, almost anyone with models or some credibility can get an audience with someone, and they'll listen. But at that time, the notion of partial differential equations was very, very strange on Wall Street.”
Kolman: Do you recall a moment when you actually thought, Eureka, and it all came together?
Merton: I don't know if Eureka was quite the word. I think it happened on a weekend, actually, but I couldn't put a date on it...I was working on it and I looked at it in terms of portfolio theory, and I did certain limits and I said, "Yeah, it works. It's right.”
Kolman: Myron, does he have the story right?
Myron Sholes: Yes, he always does. (Laughter.)
Kolman: What happened then?
Merton: Myron and I continued to work together, not in the sense of [writing] a paper but in terms of interchanging ideas. Where we really came together was in actually putting this stuff into practice. Our first big job on Wall Street was at Donaldson, Lufkin & Jenrette. This was before the beginning of the Chicago Board Options Exchange. Things were very different then. Today, almost anyone with models or some credibility can get an audience with someone, and they'll listen. But at that time, the notion of partial differential equations was very, very strange on Wall Street.
We worked on some option problems at DLJ and implemented them, and they supported them. In fact, the paper that I wrote was published at the same time as Myron and Fischer's. I had a special example of a down-and-out option, which was, as you know, one of the early exotics. After we worked together on some applications, we got ready for the launch of the Chicago Board Options Exchange. And the next thing we knew, everybody was running around with a little calculator and their formula was being used everywhere.