WASHINGTON -- Securities firms that buy derivatives face a tough challenge in understanding the products and the tools available in pricing them, industry sources said. George Hall, president of the Clinton Group, said firms need to be capable of designing their own pricing models. His remarks were made at a conference in New York City on pricing and valuation of fixed-income securities and derivatives that was sponsored by Frank J. Fabozzi Associates and Information Management Network.
"If you don't know how to do this stuff, meaning you can't do this inhouse, and you have to rely on outside people, it's probably better to stay out of this stuff," Hall said Monday at the conference.
Hall noted that the standard pricing models, including an option-adjusted spread analysis, won't be enough when dealing with derivatives.
However, Dave Johnson, vice president at Van Kampen Merritt Investment Advisory Corp., maintained that many of these problems don't exist in the municipal derivatives arena.
"What we have in our markets is not rocket science," Johnson told the conferees. "Pricing, as far as [municipal] derivatives go, has not been a problem." Johnson said municipal derivatives are not as complex and probably won't become more complex very quickly because the market serves retail clients.
Meanwhile, Barry Miller, a vice president at Chase Manhattan's Global Securities Services, recommended that in addition to having expertise in-house to price derivatives, outside pricing sources should be used.
"I believe models work," Miller said Monday. "I do believe that there are some models better than others and we rely heavily on our investment managers to give us feedback as to whether they're in the ballpark or not," he said.
Miller said that he found his firm's vendors to be very responsive to issues like falling interest rates. "I do believe that whether the model works or doesn't work, if you give them the appropriate feedback, they will go out and research it," he said.
Carla Eyre, chief financial officer and chief operating officer of Harris Investment Management, said that the pricing of a derivative does not determine its value.
"Where you can get rid of [a derivative product], that's the ultimate value, as opposed to some of the model prices that you can get on illiquid securities," Eyre said.
Even so, Eyre said firms still have to be able to evaluate the products effectively.
Eyre said that average traders at her firm probably will not completely understand the pricing of derivatives and will need to have people in-house or a consultant to make sure they can understand what they are buying for their clients.
"The most important thing we do is that we have a group of professionals that have the capability to model and to evaluate each interest rate fixed-income investment," she said. "I think that a key component to our success today is that we have really beefed up our analytic capability and that seems to be the wave of the future."
Elizabeth Endrom, a Morgan Stanley Trust Co. principal, stressed the importance of knowing what risks customers can take.
"You must know your customer and you must know their tolerance for risks," Endrom said. "If you make a decision to buy and you don't appropriately appreciate the complexities of the product, you can find yourself in something that you can't sell."
Endrom said that the cost of analyzing overly complex derivatives may be too much of a burden to customers.
To the extent that a firm has pooled vehicles, including mutual funds and pension plans, the costs of these services are applied directly to the return that has been earned on a portfolio.
"If you have a break-even situation, it may not be worth the effort that you put into it," Endrom said.