Investing in derivatives without losing your shirt

By Martha Myron –
Oil prices this week after the destructive path of Katrina spiked to over $70 a barrel. Gold prices are around $431 after climbing over the past five year from a low of $275 per ounce. Real estate prices in the US are still fairly strong; the UK housing market is still of interest as well. With all this activity in natural resources (otherwise known as commodities), clients often express sentiments of regret. What if, I had bought oil futures way back when? What if I had bought some gold? What if?
The truth is that single commodity choices are not easy for the average investor to work with.


A further truth is that investors are still skittish after the last bear market. No one likes losses with far more people far more concerned about the risk of loss in capital markets than they used to be. Clients getting close to life style changes have become permanently conservative, and that is probably a good thing. This is the way investor thinking will be until we have another huge bull run in the markets, and then watch the thinking change!
In the meantime, we’d all like to have our cake and eat it, too; that is, take some big risks, but have an assurance that your principal will be there when you need it.
Ask people about stocks. Most everyone has some idea what they are and how they work. Who hasn’t seen Jim Cramer on “Mad Money”?
But talk about bond laddering to a party gathering, and everyone’s eyes glaze over. Bonds are so, well, safe, but so boring and still they may fluctuate, particularly in a rising interest rate market. But they provide much needed diversity.
Mention the word derivative to most people, and you are likely to be met with a blank stare and the comment, “I have enough trouble figuring out what stocks do – those things are perfect for those esoteric aggressive broker types.” Use alternative wording to describe derivatives such as commodities or futures, and the reaction is more of the same. Yet, it is a little known fact that futures trading (in grain and agricultural natural resources) started thousands of years ago, historians say, with Greek civilisation. In the accelerated way that free markets evolve, the futures markets now represent trillion dollar diversified investment strategies every day. No longer an old joke on investments about pork bellies, commodities are comprised of livestock, precious metals, petroleum, natural gas, industrial metals, grains, and even vegetable oils, along with more esoteric instruments such as currency plays, interest rate and credit default swaps.
Every investor wants to have some elements of aggressiveness, low volatility, safety, and diversification in a balanced portfolio. Split those wants into separate asset holdings and you can become victim to the market watching game. At every up tick in your stock valuations, you feel rich. No need to discuss how you feel when the market has a bad day.
Investment professionals understand only too well the emotional factors that affect investor decisions. Constantly alert to changes in investor moods more recently reflected in net redemptions (or simply lack of participation in) of investments, they have launched innovative new products to meet the new conservatism: market-linked structured certificates of deposit.
Structured Notes
So the reasoning went, why not combine the safety of a certificate of deposit (CD) with a fixed time frame but link it in some way to equity (or other indexes) that may fluctuate short-term, but tend to appreciate over the long term, or to indexes that are not correlated to either stocks or bonds, such as futures contract indexes on real physical commodities, energy, oil, gold, silver, wheat, sugar, coffee, soybean products, etc. Why not hedge the CD in your domestic currency by linking to the changes in a basket of foreign currencies. If your currency holds steady, you haven’t lost anything; if it depreciates, you pick up the gains on the foreign currency appreciation.
Combining the elements of safety and principal protection with exposure and linkage to major capital markets, forward thinking investment industry specialists have managed to provide the critical elements to buffer both major investor emotions – the desire to see assets appreciate faster than inflation, and the mitigation of the fear that they will lose their entire asset base.
How do they really work?
The basic premise is quite simple. Certificates of deposit have existed for many years, offered in various maturities and compounding terms. The client is actually loaning his money to his bank. These deposits are listed as liabilities on the bank’s balance sheet, representing an implicit promise to repay the money. In all geographical commerce, it is imperatively important that your bank have a very strong publicly stated credit rating. AAA represents the highest grade attainable, usually granted by credit agencies to strong country governments and massive global corporations. AA is almost as desirable. These ratings are not easy to attain and are not granted to privately held businesses such as credit unions and small privately owned groups.
The certificate of deposit is issued for a certain time frame and may pay a standard rate of interest, but the real value is its market-linkage to a selected index or multiple indexes. While indexes track the underlying asset class, for many investors purchasing them alone just feels too risky. At the end of the time frame, the appreciation in the index is attributed to the certificate of deposit and the total is returned to the investor. Regardless of market direction, if the index should track downward, the investor’s principal is protected. Exposure to diversified passive indexes is an increasingly popular method for investors to achieve transparency, cost effectiveness, if needed, use of collateral for loans.

Martha Harris Myron CPA/PFS CFP® is a VP and Senior Private Banker, Private Client Services, Bank of Bermuda Member HSBC Group. She can be reached at 299-5578. Send e-mail to marthamyron@northrock.bm. The article expresses the opinion of the author alone and the content of this article should not be taken as specific individual investment advice, nor as a recommendation to buy a specific investment product.

Source: The Royal Gazette

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