In order to stay competitive in the increasingly complex derivatives market, banks large and small are turning to hightech software to help them navigate the sometimes arcane waters of risk management.
As derivatives trading grows - the market currently is about $16 trillion globally - newer and more Complex instruments are constantly being introduced. Financial institutions have to be able to price instruments quickly and calculate risk measurements as accurately as possible. The number of types of derivative instruments currently is estimated at between 300 and 400.
And as some recent highly publicized losses have shown, users of derivatives need to know exactly what they are getting into before they leap into the market.
They need to know how possible fluctuations in interest rates and yield curves will affect their portfolios tomorrow, as well as five years down the road.
Dealers and end users now are turning to software manufacturers for programs that help them more accurately identify the risks of the financial instruments.
Earlier this week Chase Manhattan Bank said it will use Infinity Financial Technology Inc.'s Montage software for its global derivatives trading activities.
Neil Wright, vice president and division executive of global derivatives operations at Chase, said the bank selected the Mountain View, Calif.-based Infinity's software to help it better track the nuances of its exotic derivatives portfolio.
Mr. Wright said Chase's customers increasingly are asking for exotic derivatives products to help them hedge their risk.
While exotics make up only about 2% of the derivatives market, they are potentially very lucrative.
For instance, while a plain vanilla swap of $100 million may net a dealer only $100,000 over five years, exotic instruments of the same amount such as leveraged swaps and structured notes - could potentially net 10 times that amoun t.
The potential for disaster, however, also is extremely high. That's where the software comes in.
"We are using it to create a database of exotic derivatives," Mr. Wright said of Infinity's Montage software. "We already developed a mainframe system that handles the vanilla product quite well."
He noted that as Chase's customers demand more exotic products, the banks needs to know the possible trouble spots in the deals and have the capacity to react to any changes quickly.
"Exotics are where the interest rate business is headed," Mr. Wright said. "At the end of the day we need to be able to quickly process whatever products we've come up with to meet our clients' requirements."
According to Infinity, the Montage product family consists of applications for trading and risk management and provide an opportunity for further development by the customer.
The company's Montage Data Model is a data base of Treasury information and other financial indices.
Chase's Mr. Wright said the bank is customizing Infinity's Data Model to handle its exotic portfolio. It will not be used for pricing or risk management, however, he said.
The bank currently uses Berkeley, Calif.-based Financial Engineering Associates' Global risk management software for that purpose.
The software runs on various Unix-based platforms and is compatible with PC-based spreadsheets.
Infinity's Montage family consists of front-end applications that include products to help manage the trading of swaps, caps and floors, swaptions, bonds, forward-rate agreements, futures, futures options, foreign exchange, and money markets.
In addition to Chase, Infinity's clients include Chemical Bank, ABN Amro Bank, and Bank of Montreal, among others.
For banks that want software to help manage their derivatives portfolios that can be run on virtually any PC, Park City, Utah-based Theoretics Inc. earlier this week introduced two such products.
The company's Term Structure Analysis and Tier 1 software programs provide live data through links that are compatible with all of the major data stream vendors. The software also provides futures hedging factors, allows for custom designed curves and for the computation of theoretical spot yields, according to Theoretics.
Later this year, the company plans to introduce Tier 2 software, tailored to currency options and swaps, and Tier 3, which is tailored to interest-rate and currency options, as well as the more exotic derivatives.
K. Scott Robinson, Theoretics' vice-president, said banks and bond traders have shown a lot of interest in the software.
"The larger banks are interested in the Tier 3 software," he said. "For the smaller and regional banks who are end users of caps for asset-liability management, Tier 1 contains 99.9% of what they need."
Mr. Robinson said because Theoretics' software uses openarchitecture, it can be employed on nearly any PC and is extremely flexible.
"You can change any data point on the curve," he said. "It gives you a visibility you never had before. It helps determine the true risk."
Richard L. Sparks, Theoretics' marketing director, said that while using software to plan risk management strategies is nearly universal at corporations and financial institutions, there are a few that still insist on doing things the old-fashioned way.
He suggested that those companies will find the derivatives market rough going because their strategies did not take into account all the possible market variables.
"Some of the people that don't use software seem to be more and more in the headlines now," said Mr. Sparks. "They are finding that their models are not up to par. For people trading in markets that are illiquid, we can interpolate what that looks like. That's hard to do without software."
Another advantage to using software, said Mr. Robinson, is that it is much easier to mark to market with a computer.
"End users used to call up their dealer and tell them to mark their positions to market," he said. "They essentially were stock with that day' s price. Now they can do it m-house and don't have to rely on the dealer. They can see where the market is going themselves."