Their profits are yours too

Alex Kiam explains what financial institutions really do with all the money we invest with them

Banks and other financial institutions rank somewhere between second-hand car salesmen and estate agents in many people's estimation. Every year, it seems, they announce new, increased, telephone-digit profits.

So when they get a bloody nose from their own activities, a smile is hard to hide. The temptation seems even harder to resist when the money is lost through incomprehensible futures and options trading, as happened recently with the pounds 130m black hole at NatWest. But should we display such schadenfreude? If you have a pension plan, an endowment mortgage or life policy, the answer is no. Like it or not, financial institutions all invest huge sums on our behalf.

Take your pension, for example. If you are in a company scheme, the pension fund managers will choose which markets, which companies and which financial instruments they are going to plough the cash into. Each of these financial institutions will be making a series of complex deals with your money. It is worth understanding what they are up to.

Individuals, companies and institutions can increase the value of their portfolios only by taking on financial risk. One way of increasing risk would be to invest in smaller companies. But understanding what makes these companies and markets tick is difficult. Instead, the modern trend is to trade in derivatives.

A derivative is nothing more than a financial instrument derived from an underlying asset. So, rather than trading in an equity such as British Petroleum shares, you trade in an instrument derived from the shares. The most common derivative is the "option".

Buying a "call option" gives the investor the right, but not the obligation, to buy a certain number of shares at a predetermined price on a specific day (a "put option" is the right to sell). The price is known as the "exercise price" and the specific day is called the "expiry date".

For example, you could buy the right to buy British Petroleum shares at a price of 700p in October. Depending on the current price of the underlying shares, say, 730p, the option to buy the shares may cost something like 50p per contract (one contract is 1,000 shares). If you believed the shares were going to rise, you could buy 5,000 shares at 730p, which would cost you pounds 36,500. Should the shares rise to 770p, you would realise a profit of 40p per share, giving you a total of pounds 2,000, ignoring dealing costs - a gain of 5.4 per cent.

However, if you'd bought the same value of call options you would have received 73 contracts (73 contracts x 1,000 shares x 50p = pounds 36,500). When the value of the underlying share increased to 770p, the value of the options would increase to, say, 75p. This time your profit would be pounds 18,250 - a gain of 50 per cent.

The problem with large risks is that they can lead to equally large losses. If the BP share price, above, had fallen until October, your options would expire worthless. So a careful portfolio manager would attempt to manage the risk.

One way of doing this would be to buy a "put option" with the same exercise price and expiry date. This option would increase in value as the underlying share price falls. This strategy of holding equal and opposite options is known as a "straddle" and produces profits so long as the underlying shares show a large change in price in either direction.

Other ways of managing risks are known as "futures", "forwards" and "swaps". These are predominantly used to hedge against changes in interest rates and currency exchange rates, rather than share price movements. One of the most difficult aspects of managing the financial risk of a large portfolio is knowing the extent of the risks you face - and hence which instruments to use to hedge against those risks.

Many models exist to help quantify the risks. Some incorporate the assessment of factors such as interest rate sensitivity, price to earnings ratios and dividend yields. Others assess macroeconomic factors such as changes in inflation, general investor confidence and overall industrial production. The final set of models looks purely at statistics, and an assessment of a portfolio's risk is made based on the past movement of prices. One of these statistical factors is known as "volatility". It is a measure of how often an instrument's price varies from its mean value, and by how much.

The problem with any model, as in any walk of life, is that using the wrong one can lead to bigger problems than you started with. And even if you get the right model, you need to put in the correct values. Rubbish in equals rubbish out.

The writer's `Understand Financial Risk in a Day' and `Understand Derivatives in a Day' are available for pounds 6.95 (p&p included) from TTL, PO Box 200, Harrogate, HG1 2YR.