How Buy-Side Investors Use Exotic Derivatives for Views and Hedging
Summary
The document illustrates why buy-side firms and corporate issuers may use complex derivatives for both investment views and risk management. One example is a structured note whose coupon depends on the relative performance of two indices, purchased because the investor believes the note is attractively priced. Another is an insurer using a credit-linked note to obtain a GBP fixed-rate exposure while taking credit risk on an investment-grade borrower that does not issue GBP debt.
A corporation preparing to issue bonds in a developing market may use out-of-the-money options to offset the risk that market or credit conditions deteriorate before issuance, reducing the proceeds available at its preannounced coupon. These examples show that derivatives can combine exposures or target specific risks, and that the buyer’s market view may influence the choice. They are illustrative cases rather than a taxonomy of users or a pricing analysis; the document does not quantify payoff, costs, or suitability.
Key ideas
- Buy-side investors may purchase structured notes when they judge their pricing attractive.
- Credit-linked notes can combine a desired currency and interest-rate exposure with credit risk.
- Issuers can use options to protect against adverse bond-market conditions before issuance.
- A derivative may serve both a hedging purpose and an investment view.
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# What kind of entities use exotic derivatives, and do they serve any purpose other than hedging risk?
# What kind of entities use exotic derivatives, and do they serve any purpose other than hedging risk?
I work in a sell-side bank in derivatives modeling. My work involves modeling and pricing of exotic derivatives and I often wonder who are the buyers of these products.
From my research, I found that its generally hedge funds or entities on the buy-side that want to buy these exotic derivatives. However I don't understand it in depth in the sense that are derivatives used to speculate or take a position, or they are used to hedge a certain position.
For example, I have questions like, is it reasonable to assume that funds that employ systematic strategies wouldn't use exotic or complex derivatives while it would only be the discretionary funds that would use such exotics.
Could someone take an example of a derivative and explain how a buy-side entity would lets say take a position and how using a derivative would make sense for them in that context. Or you could point me towards some online reading material or resource where I can learn about this.
## Answer by Dimitri Vulis (score 2, accepted)
https://quant.stackexchange.com/a/55105
Example 1. Buy-side buys notes whose coupon is $\min(\max(\rm{gearing}*(\rm{index}_1-\rm{index}_2),\rm{maximum}),\rm{minimum})$. Their motivation is often their view that the sell side is pricing these too cheap.
Example 2. An insurance company wants to buy 20-year fixed-coupon GBP bonds. However they want higher yield than GUK, and they are willing to take a little credit risk. They buy a credit-linked note that repackages the debt of some investment-grade reference entity that does not issue GBP debt. The notes are a GBP inerest rate hedge, but they also increase the credit exposure to the reference entity.
Example 3. A corporation needs to issue bonds to finance a project in a developing country, whose (stupid) local regulations require that they announce and lock in the fixed coupon that the bonds will pay several months before the bonds are actually issued. The issuer is worried that the market/credit conditions will change in the meantime, and they will have to sell the bonds with this coupon substantially below par, and will not get all the capital that they need to raise. The bond issuer often tries to buy some kind of out of the money options that would compensate them if the bonds have to be sold far below par, but usually include also the issuer's views on what will actually happen.
As a "career advice", you should try to hang out with the salespeople and talk about what problems the clients are trying to solve, and what tools would help the salespeople.Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.