If you want to understand the mind-boggling complexity of the world of derivatives-a world inhabited by such fierce creatures as swaps, diffs, quantos, and inverse floating-rate notes-Charles W. Smithson suggests you start by thinking about puppies.
"Think what you're doing when you agree to buy a puppy when it is weaned for a certain price," he said. "If you can understand that concept, you'll have a basic understanding of foreign exchange derivatives, commodity derivatives, just about the whole bit.
"Really, this stuff is not so hard as some people would have you believe."
Unlike most people who populate the peculiar world of derivatives, Mr. Smithson is not a salesman-although he thinks derivatives are pretty terrific risk management tools. Nor is he a trader-although, after he thinks about it a little, he can translate the technical jargon traders use.
Rather, he is a former college economics professor who 13 years ago swapped tenure for a job of explaining derivatives to uninitiated bankers, corporate treasurers, and boards of directors across the world.
He now serves as head of CIBC Wood Gundy School of Financial Products, a school whose mission is to attract customers to CIBC's derivatives desk by explaining the instruments in language free of techno-gibberish.
"People in the business don't have the incentive to tell you 'This is easy,'" Mr. Smithson said. "They maximize their pay by telling you 'This is hard and if you want to do one of them, you had best come and see me.'"
In addition to his teaching work, Mr. Smithson is also treasurer and a member of the board of the International Swaps and Derivatives Association, a trade group made up of representatives from the big trading banks. He has also authored several books about derivatives and is working on an update of his 1993 book, "Managing Financial Risk," due out next year.
"Charles' ability to express complex ideas in clear terms makes him a particularly welcome member of the ISDA board," said Mark C. Brickell, ISDA board member and managing director at J.P. Morgan & Co.
Mr. Smithson happened upon the world of derivatives quite by accident. Until 1984 he was a professor of economics at Texas A&M University, where he specialized in natural resource economics and wrote such books as "The Economics of Mineral Extraction."
When it came time for him to apply for his department's chairmanship, he wrote to a former teacher seeking a recommendation. That former teacher happened to be chief economist at Chase Manhattan Bank. Rather than write a recommendation, the economist arranged for Mr. Smithson to come to Chase to teach derivatives to the sales team of the bank's new swaps group.
"I told my teacher, 'I don't know anything about corporate finance, and I certainly don't know anything about commercial banks,'" Mr. Smithson recalled. "He said, 'Great, you'll have less to unlearn.'"
It didn't take long to figure out what a brave new world he had entered.
"At my first lunch at Chase, we were eating up on the 60th floor and people there started talking about Libor (the London interbank offered rate)," he said. "I had no idea what they were talking about. I was thinking, 'What kind of ore is this? Are we going to crush it? Smelt it?'"
But Mr. Smithson, who has a doctorate from Tulane University, proved a quick study. With the help of Clifford W. Smith, professor at the University of Rochester, he read whatever was available on the burgeoning world of financial engineering.
As he cultivated his own education, he figured out how to explain the complexity of derivatives to people who were as inexperienced as he once was. He developed what he calls the "building blocks" approach, which begins by thinking of derivatives as agreements to buy puppies at a certain date for a certain price.
"I can get you 85% there without any math; teach you 93% with just algebra. Above that, it gets difficult. But you don't really need the really advanced level of knowledge unless your job is to price derivatives," he said.
In his 13 years as a student and teacher of derivatives, Mr. Smithson has become a recognized expert. He worked on the Group of 30 recommendations on derivatives regulation made in 1993 following the debacles that rocked the industry. His articles appear in several trade magazines, and his annual yearbooks comprehensively and candidly sum up the year that was.
His survey, co-sponsored with the Wharton School, asking companies why and how they use derivatives is one of the most revealing in the business. For example, no derivatives users questioned would acknowledge buying them for speculation. But plenty admitted they adjust their positions as market conditions change. The difference between that and speculation, accountants observe, is purely intent.
He joined the Canadian Imperial Bank of Commerce's securities unit in 1995. The bank was hoping to build its new business by offering free seminars where buyers of derivatives could get the same kinds of lessons Mr. Smithson once gave sellers.
CIBC Wood Gundy's six teachers, who are supported by three other staff members, lectured in 20 countries last year before approximately 3,000 students.
Most attendees, Mr. Smithson said, are new junior employees in treasury departments or people in charge of formulating risk management policy at corporations. Every now and then he and others appear before a board of directors.
The key to the seminar's popularity, participants say, is not only their clarity and informativeness, but the lack of pressure from CIBC Wood Gundy.
The school has total independence in what it teaches and how it teaches it, Mr. Smithson said. But it has no control over who attends-that is decided by the marketing department.
"It's the only way a program like this could work," he said. "By the time there's a closing party, we're long gone."
Chris Grubb, product manager for risk management trading at Wachovia Corp., said he attended a course on Value-at-Risk, an important risk management technique that many vendors are pushing as the primary way to avoid huge trading losses.
"They showed us the framework and what we could do with it," Mr. Grubb said, "but it didn't seem like they were pushing us in any one direction to do it any one way, or to even consult them in doing it."
To Mr. Smithson, Value-at-Risk is a useful tool whose applications are limited and not well understood.
"I think the way to look at it is not as a risk management tool, but as a risk governance tool. It's a tool that can be used to communicate with boards and shareholders.
"For example, VAR might be very useful for Acme Securities, but not Acme Pharmaceuticals. Why? Because the value of Acme Pharmaceuticals can't just be measured in profits, losses, and share value like Acme Securities could be. You must look at the likelihood of future earnings, what they're spending on research and development. So Acme Pharmaceuticals might use derivatives, but VAR wouldn't give an appropriate view of the company."
Obviously, Mr. Smithson and his colleagues hope the good will they generate through their school will help CIBC's nascent derivatives business. And the firm, which is one of the most active marketers of credit derivatives, no doubt hopes the efforts of Mr. Smithson will help build the relationships with companies that the Morgans, Chases, and Citibanks enjoy.
"We want to be not just on companies' Rolodex, but their speed-dial list," he said.
