Complex Financial Products

World’s most successful investor billionaire Warren Buffet, in the year 2002 in his letters to shareholders said-

“Highly complex financial instruments are time bombs and financial weapons of mass destruction that could harm not only their buyers and sellers, but the whole economic system”

If we talk about the derivatives market we see it is showing a steep rise after 2002, from 100 trillion to 500 trillion US dollars. An unprecedented optimism about such complex products was seen amongst the banks and the major financial institutions including the investor community and market participants. However at the end, Buffet’s words came true and were exactly replicated in the financial market by Mass destruction of the whole economic system.

Investment in Complex Securities

Financial engineering led to an unprecedented rise in the usage of complex financial instruments. The growth of these products was earlier driven by economic reasons which included hedging of risk, but with gradual change in the sentiments these  products are almost entirely used for the purpose of speculation by financial institutions as well as the retail investors. As a result of which the volumes in these instruments (because of the leverage used) exceeded the GDP of many nations.

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Issues that need to be addressed by the Various Participants

1) Underwriters/Structuring Agents

It is important to ensure that the products developed by Investment Bank have proper logic associated with it. Also the banks should not just be pushing the products to the clients in order to increase their top line.

2) Credit Rating Agencies

Rating agencies should be unbiased and be funded by the government to a certain extent. A separate arm of the credit rating agency catering to the rating of highly complex instruments should be established which should be sufficiently funded by the government.

3) Regulators

Stress on Qualitative Factors

Traditionally it is seen that the risk management has been associated only with the quantification of risk. This resulted in neglecting the qualitative factors. In order to ensure proper investment environment to be established, the regulators should stress more on the qualitative aspects of risk management. The qualitative judgments may create soft   risk management boundaries and would help in detecting the irrational and subjective elements in market behavior.

Other factors which should be considered are:

• Only credit risk with proper economic logic should be retained
• Investing in complex securities purely on speculative motives should not be encouraged by the investors
• Implementation of stringent capital requirements should be there for investment in complex securities on speculation basis.

It is important that the credit rating takes the long term approach rather than using “At the point” approach. This will enable the market get a long term vision and the investor sentiments towards long term investment will take a new direction.

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Issues to consider while investing in Complex Securities

It is suggested that when an investor plans to invest in a complex securities, he/she should carefully asses the pros and cons of investing in the security. Following are the three key areas which need to be evaluated before an individual/organization invests in complex securities:

1) Valuation Issues

The lack of proper valuation standards for complex securities resulted in the recent financial crisis. Being new in the market the instruments did not have any historical prices. Thus the level of risk associated with the instrument was not known even to the sophisticated investors. It is important that the investor be very clear about the value of the financial instrument so that they can pay the right amount for the investment and make well informed decisions accordingly.

2) Behavioral Theory Perspective

It is needless to say that the decision making is a complex activity. Decisions are not just made upon personal resources. Most of the decisions taken generally depend on the psychology of the individual.

For example: When the Indian markets went down, the disbelief in the minds of people about the strong fundamental of the demand driven Indian market pulled the market down further as the selling spree continued to a great extent. Thus it is important to analyze the investment process from a behavioral finance perspective.

i) Loss Aversion: It won’t be wrong if we say that an investor is a risk-seeker when faced with the prospect of losses, but is risk-averse when faced with the prospect of enjoying gains. Given the fact that the complex instruments can create unforeseen risks, it is important for the investor to be mentally strong enough to take the losses at an earlier stage and exit out of the investment?

ii) Regret Aversion: It arises from the investors‘desire to avoid pain/sense of regret arising from a poor investment decision. This encourages investors to hold poorly performing shares as they are keen on avoiding the loss associated with the sale of the securities.

iii) Mental Accounting: It is the set of cognitive operations used by the investors to organize, evaluate and keep track of investment activities. Following are the three components which receive the most attention:

• How outcomes are perceived and experienced, and  how decisions are made and subsequently evaluated
• Assignment of  activities  to specific accounts
• Frequency with which accounts are evaluated and ‘choice  bracketing‘

iv) Self Control: It is necessary that the investors evaluate their self control before they invest in highly complex securities. Understanding the amount of risk borne by investing in a particular investment is important as it helps the investor plan accordingly for investment in other securities of the portfolio. It also helps the investor in assessing the need of future financial need which might arise due any unforeseen circumstances or known situations.

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3) Shareholder approval

An organization/individual who invest(s) in the complex securities should have a clear rational for doing so. Rationale behind investing in such securities should be clearly explained to the shareholder to seek their approval. Also clear mention about the kind of risk involved in the investment should be brought onto the table of discussion with the share holder. In case of an individual, he/she has to discuss the investment objective with his immediate stakeholders which include family members. Clarity in terms of the future financing needs be it education of  children or medical expense or wedding, it should be clearly stated so that further problem of liquidity in future could be tackled with ease.

Thus it can be concluded that an investment is subjected to market risk and if any investment is made after due diligence of risks and return involved, it leads to growth early than any investment made for speculation purpose.