Their profits are yours too
Alex Kiam explains what financial institutions really do with all the money we invest with them
Wednesday 09 July 1997
So when they get a bloody nose from their own activities, a smile is hard to hide. The temptation seems even harder to resist when the money is lost through incomprehensible futures and options trading, as happened recently with the pounds 130m black hole at NatWest. But should we display such schadenfreude? If you have a pension plan, an endowment mortgage or life policy, the answer is no. Like it or not, financial institutions all invest huge sums on our behalf.
Take your pension, for example. If you are in a company scheme, the pension fund managers will choose which markets, which companies and which financial instruments they are going to plough the cash into. Each of these financial institutions will be making a series of complex deals with your money. It is worth understanding what they are up to.
Individuals, companies and institutions can increase the value of their portfolios only by taking on financial risk. One way of increasing risk would be to invest in smaller companies. But understanding what makes these companies and markets tick is difficult. Instead, the modern trend is to trade in derivatives.
A derivative is nothing more than a financial instrument derived from an underlying asset. So, rather than trading in an equity such as British Petroleum shares, you trade in an instrument derived from the shares. The most common derivative is the "option".
Buying a "call option" gives the investor the right, but not the obligation, to buy a certain number of shares at a predetermined price on a specific day (a "put option" is the right to sell). The price is known as the "exercise price" and the specific day is called the "expiry date".
For example, you could buy the right to buy British Petroleum shares at a price of 700p in October. Depending on the current price of the underlying shares, say, 730p, the option to buy the shares may cost something like 50p per contract (one contract is 1,000 shares). If you believed the shares were going to rise, you could buy 5,000 shares at 730p, which would cost you pounds 36,500. Should the shares rise to 770p, you would realise a profit of 40p per share, giving you a total of pounds 2,000, ignoring dealing costs - a gain of 5.4 per cent.
However, if you'd bought the same value of call options you would have received 73 contracts (73 contracts x 1,000 shares x 50p = pounds 36,500). When the value of the underlying share increased to 770p, the value of the options would increase to, say, 75p. This time your profit would be pounds 18,250 - a gain of 50 per cent.
The problem with large risks is that they can lead to equally large losses. If the BP share price, above, had fallen until October, your options would expire worthless. So a careful portfolio manager would attempt to manage the risk.
One way of doing this would be to buy a "put option" with the same exercise price and expiry date. This option would increase in value as the underlying share price falls. This strategy of holding equal and opposite options is known as a "straddle" and produces profits so long as the underlying shares show a large change in price in either direction.
Other ways of managing risks are known as "futures", "forwards" and "swaps". These are predominantly used to hedge against changes in interest rates and currency exchange rates, rather than share price movements. One of the most difficult aspects of managing the financial risk of a large portfolio is knowing the extent of the risks you face - and hence which instruments to use to hedge against those risks.
Many models exist to help quantify the risks. Some incorporate the assessment of factors such as interest rate sensitivity, price to earnings ratios and dividend yields. Others assess macroeconomic factors such as changes in inflation, general investor confidence and overall industrial production. The final set of models looks purely at statistics, and an assessment of a portfolio's risk is made based on the past movement of prices. One of these statistical factors is known as "volatility". It is a measure of how often an instrument's price varies from its mean value, and by how much.
The problem with any model, as in any walk of life, is that using the wrong one can lead to bigger problems than you started with. And even if you get the right model, you need to put in the correct values. Rubbish in equals rubbish out.
The writer's `Understand Financial Risk in a Day' and `Understand Derivatives in a Day' are available for pounds 6.95 (p&p included) from TTL, PO Box 200, Harrogate, HG1 2YR.
Q&A: What’s the best way to invest for our baby?
Crowd-to-let: How crowdfunding sites can give investors a slice of the property market for £500
Simon Read: 'Seven Families campaign offers an escape from financial and emotional distress'
After the election: What will Britain's financial future look like on 8 May?
General Election 2015: How you vote next week could affect your finances
- 2 The man who filmed the Freddie Gray video has been arrested at gunpoint
- 3 How the language you speak changes your view of the world
Over 50,000 families shipped out of London boroughs in the past three years due to welfare cuts and soaring rents
EU asylum policy is 'a direct threat to our civilisation', says Nigel Farage
The Rothschild Libel: Why has it taken 200 years for an anti-Semitic slur that emerged from the Battle of Waterloo to be dismissed?
General Election 2015: SNP and its activists 'openly racist' towards the English, Farage says
General Election 2015: UK will be 'run for the wealthy and powerful' if Tories retain power, Labour warns
Schools forced to act as 'miniature welfare states' with teachers buying underwear and even haircuts for poor pupils
iJobs Money & Business
£16000 - £18500 per annum: Recruitment Genius: This is an excellent opportunit...
£24000 - £28000 per annum: Recruitment Genius: A Senior SEO Executive is requi...
£16000 - £18000 per annum: Recruitment Genius: An Online customer Service Admi...
£18000 - £22000 per annum: Recruitment Genius: This global, industry leading, ...
Day In a Page
This detached four-bedroom home in Middleyard is arranged over two floors, with features that include a wood-burning stove and bespoke oak staircase.
In a row of eight detached Georgian residences, this five-bedroom home offers views of The Sound, Mount Edgcumbe and Cornwall from its impressive veranda and full-length balcony.
If you love cooking for friends this two-bedroom flat - complete with views of the iconic Battersea Power Station and an open-plan kitchen/dining area - will go down a treat.
Located above Grasmere village, this five-bedroom home is arranged over three floors and offers countryside views across Grasmere Lake towards Silver Howe.
Surrounded by the Western fells, this five-bedroom Georgian home retains many original features including panel-plastered ceilings, sash windows and fireplaces.
This six-bedroom home is set amongst three acres of grounds. Currently a large family home, Clift Hill has potential to make a B&B, subject to change of use permissions.
A former period coach house, Glebe Farm Stable is now a three-bedroom cottage with a double car barn, office, kennels and an outbuilding that's currently used as a gym.
Set sail for this four-bedroom farmhouse in Cowes. With five acres of land and an indoor pool, this home oozes character. There is even potential to let a one-bedroom annexe.
Surrounded by woodland, this five-bedroom manor house has plenty of outdoor storage space in the form of three converted loose boxes, two smaller outhouses and a woodstore.
This four-bedroom detached home comes with a double carport, useful workshop, garden and two walkways that offer views of the adjacent countryside.
With space for an equestrian business, a greenhouse for growing your own veg, a wine store and a gym; this five-bedroom home has all the ingredients for a country retreat.
This four-bedroom home has exposed brick chimneys and a vaulted ceiling in a breakfast room that's ideal for summer entertaining - the doors open to the patio and garden.
The decked roof terrace of this two-bedroom flat is perfect for summer drinks while large windows and ample storage space make for a light and spacious interior.
Surrounded by approximately 15 acres of grounds, this six-bedroom grade II-listed home has been extensively refurbished yet retains many period features.
This four-bedroom home comes with a two-bedroom cottage and commercial office, with planning to extend, in a stunning courtyard setting.
In a pretty Norfolk village, this four-bedroom family home is surrounded by landscaped gardens, with even a self-contained annex for guests.
A few miles from the seaside at Perranporth, this four-bedroom farmhouse sits amongst nine acres of idyllic grounds - including a lake and two barns used as holiday lets.
This five-bedroom home is arranged over three floors of a converted Victorian hospital, offering spectacular views of the Pentland Hills - only three miles from the city centre.
This four-bedroom detached home comes with grounds that span to approximately 2.5 acres, as well as two large patio areas and a double garage.
This four-bedroom cottage is a Grade II-listed town house, well-located for the thriving market town of Nailsworth.
A four-bedroom apartment on the ground floor of a stunning period property in North Yorkshire, with two kitchens and a large south-west facing garden.
This high-spec two-bedroom home is part of a smart collection of new flats at Beaufort Park and has a large decked balcony that's perfect for summer drinks.
Capitalise on the fabulous views of Trevone Bay by taking two homes and creating one spacious boutique B&B. Just a cliff-top walk from Padstow.
Overlooking a golf course, this six-bedroom Edwardian detached home spans four storeys and retains many period features including the original, operational servants' bells...
On the edge of the city, this six-bedroom home comes with an outdoor swimming pool and a large garage block that has annexe potential.
In a Grade II-listed manor just outside of Bath, this three-bedroom home is arranged on two floors with a skylight in a vaulted roof line.
Open the living room's bi-fold wooden doors to reveal a retro-style kitchen, and a conservatory leading to a paved garden at this three-bedroom home.
A Grade II-listed, four-bedroom home, in a charming Somerset village, with a two-storey studio that could be converted into a holiday cottage
A modern four-bedroom Victorian home, within walking distance to the high street
A luxury apartment in the Gothic mansion of Wyfold Court in Kingwood, offers six bedrooms spread over three floors and a turret
This school conversion, near Stockwell Tube, oozes New York loft style. The one-bedroom flat features double height ceilings and exposed brick work
This six-bedroom Georgian home is on three floors with open fireplaces, a two-oven Aga, an annexe, and cottage gardens with outbuildings and a car barn
High Crest House covers an impressive 9384sq ft, with almost three acres of grounds including a tennis court and summer house enclosed by electric gates
A six-bedroom farmhouse with separate accommodation in converted stables. Situated in the village of Church Aston, within walking distance to the market town
A two-bedroom flat with under-heated walnut floors and bespoke built-in storage. The Tube and Clapham Common are a short stroll away
A refurbished seven-bedroom townhouse with staff quarters, cinema room, superb gym, steam room and plunge pool
A minimnalist four-bedroom home designed to the highest spec, featuring glass walls and a kitchen space lit by a glass roof
Hibernate during winter and make your living during the summer at this busy guesthouse with panoramic sea views, in the village of Lynton
A four-bedroom penthouse next to the Tate with direct views of St Paul's from two floors of luxurious living space
A four-bedroom detached home surrounded by spacious gardens and woodland, close to New Pudsey
An 18th-century, three-bedroom home near Langstone Harbour built from ships beams with vaulted ceilings and wood burning stoves
A five-bedroom semi-detached home with a mix of period and modern features in a popular and convenient location
This five-bedroom red-brick beauty overlooks the village green and sits in just under two acres of land
A three-bedroom villa with self-contained flat, minutes from Lake Windermere
A five-bedroom Victorian home with four receptions, superb gardens and paddock in Pembury
An eight-bedroom house on the south side of the The Green with cinema, wine cellars and summer house
This 17th century beauty is full of rustic cosiness, while the detached home office means you can also run a business
Four exclusive apartments in a Grade II-listed former medical school with 2,275 sq ft of living space and 18ft ceilings
A five-bedroom terraced house on the popular Peterborough Estate, ideally located for both Eel Brook Common and South Park