Say it ain't so! Derivatives innovation, the giant oak that shot up from an acorn in a decade, dead? AAARRGGHHH!*#!*@!!

Chill, guys. The reports of death are greatly exaggerated. To be sure, financial innovation has changed emphasis and direction recently. It is also being driven by market forces as never before. Clearly, too, it is stronger in some market areas than others. But if there is one overriding message from the contributors to our Round Table it is that the giant oak will bear new fruit.

Ari Bergmann
Managing Director, Head of the Transaction Development Group Bankers Trust

Most of us have heard dire predictions that the dynamic pace of financial innovation achieved in the past decade cannot continue. Many of the most vocal doomsayers have suggested that risk management is yesterday's peacock (alluring and gaudy) but will become tomorrow's feather duster (good for windows). I disagree. As John Neff, the legendary mutual fund manager, pointed out in a 1994 Barron's interview, "If anybody believes people are going to stop buying derivatives, he's got his head in the sand."

There are, I believe, compelling reasons for this position. For starters, too much of the argument about the future of innovation seems focused on whether the underlying product itself must necessarily become more complex for there to be progress. That preoccupation ignores the fact that the pace of innovation on the application side, particularly as it relates to derivatives tools, is increasing tremendously. A useful analogy might be drawn between derivatives and information systems. Even if there were no foreseeable breakthrough in computers, it would be many years before people exhausted the realm of possible applications of the current technology.

Similarly, in derivatives there has been a hectic pace of development and proliferation of many derivative tools, but collectively the financial community has explored only a handful of the most practical applications. Most of their creative potential remains to be discovered and released in the future.

For example, people have known how to hedge stock market exposure for many years. But it was only in 1994 that we initiated, with France's Rhóne Poulenc, a structure that effectively applied the power of derivatives on a wide scale, enabling employees in a newly privatized company to own the company's shares with only limited downside risk. The employee doesn't have to know anything about derivatives to appreciate their value at work. Future applications of this use of derivatives to employee-share ownership could have a massive social impact.

Another firm that adopted a similar employee-share structure is looking to extend it to the firm's vast worldwide employee base. That application will require additional foreign exchange capabilities as well as multicountry tax and employee benefit plan expertise. Ironically, it is European countries that have embraced derivatives technology, although we now know of one US firm that is exploring the use of these concepts to improve its existing options plan.

Another important emerging application is the use of derivatives by small- and medium-sized companies to give them access to sectors of the M&A market from which they are currently excluded. My group has assisted several small companies in their attempts to take over much larger companies in deals that could not be contemplated with straight cash or stock as the tender. We have also developed companies' hedging strategies for various risks, such as the effects of weather on store sales.

There have been shifts in the dynamics of innovation in risk management. Previously, mathematical proficiency was the main driver. Today innovation also requires a thorough knowledge of tax, accounting, financing, mergers and acquisitions, employee benefits and other corporate issues. Mathematical geniuses have made an abundant contribution, but now they are at best secondary to the process.

I believe that, on a purely mathematical basis, the new products need to be much simpler and yet a lot more powerful than their predecessors. Dealers will require a greater understanding of the client's business, plus a greater ability to convey to the client an intuitive, easy-to-understand solution.

Many sectors of the economy have yet to appreciate the benefits existing financial engineering could deliver. In sum, the future of derivatives innovation looks more robust than ever.

Catherine Bartzos
Director, Corporate Derivative Origination & Structuring, Chase Securities

Financial innovation is far from dead. Over the past seven or eight years we have seen quantum leaps in the financial engineering of derivatives. Today many of these once "exotic" products have gained acceptance in the corporate end-user arena as part and parcel of their standard array of financial instruments.

For instance, many end-users have recently carried out hedging instruments selling digital options. By selling a digital option the end-user has significantly reduced the open-ended risk typically associated with selling options, since the digital has a fixed payout profile if and when it is effective. Not long ago digitals were considered "exotic" and selling options was viewed as a somewhat overly aggressive risk profile.

This industry continues to deliver new products, new twists on existing products and new applications for managing risks and monetizing views. The next significant trend will be the management of risk on an integrated basis. As a result we will see the emergence of the risk manager, who will perform centralized risk management for treasury, operational and geographic areas within a firm.

At Chase we have been structuring integrated risk management instruments-hybrid and correlation products-for quite some time. However, most corporate end-users are typically not configured in a way that permits integrated risk management. Some of the obstacles are 1) an organizational structure inimical to integration, 2) a lack of specialized skills, 3) a benchmarking mind-set (i.e., "I'll do what my competitors do but no more"), 3) internal "turf" and compensation issues and 4) inadequate measurement tools. To be sure, this last-mentioned obstacle is diminishing, thanks to value-at-risk (VAR) methodologies that permit end-users to express all classes of risk in one unit of measure. This will permit management to test and employ tactics that take advantage of correlations across existing fixed income, commodity, foreign exchange and equity risks.

Over the last couple of years financial innovation has been subtler than in the past, operating at an entirely higher and broader level-a kind of quiet revolution. One of its thrusts has been toward the development of more extensive models for both the dealer and end-user. Great strides have been made in the quantification of risk. As a result we can structure and price more quickly and with significantly more flexibility. This upgrading has enabled us to deliver complex and tailored alternatives much more easily. For the end-user this means access to much more product at keener pricing, plus the ability to monitor risk positions.

Alex Dannenberg
Head of Swaps, Paribas Capital Markets

Innovation in finance is alive and well. The real question is: where will innovation crop up next? Will it be in foreign exchange or equities? In debt or commodities? Sliced a different way, will it show up in new securities or in new risk management practices? My own opinion is that innovation will be increasingly important to asset-liability management in the coming years.

Just as simple interest rate swaps originally bridged the previously disparate fixed and floating debt markets, new derivatives will continue to forge links between different asset classes and give corporate treasurers more efficient tools to manage their hodgepodge of separate but correlated risks-risks to interest rates, equity and commodity prices, foreign exchange rates and so on.

Granted, innovation will also continue to exist on the so-called asset side. When investors are yield hungry, they will continue to buy yield-enhanced securities with embedded options of all sorts. But I think that corporate America and institutional investors are more sensitive to the risks of these trades than they used to be and will find more use for financial engineering and innovation in their risk management efforts. Basically, the different asset types are somewhat correlated and that makes it cheaper to hedge a single, big, messy bundle of risks than to hedge them out separately.

One solution would be to buy an option to protect the Swiss franc proceeds of their dollar-denominated Yankee issue, giving them protection against a combination of interest rate risk and currency risk. You can sometimes achieve premium savings of 30 percent simply by not having to purchase the interest rate and currency rate protection separately.

Mark Garman
President, Financial Engineering Associates

Financial innovation is decidedly not dead. To be sure, the pace may be slower than in the past seven or eight years, but barring a complete financial meltdown of some sort, I believe innovation will continue to surge forward. I recall that in the mid-1970s it was prophesied that options theory was dead-after the breakthrough work of Black, Scholes and Merton. But since then I have encountered, almost weekly, one fascinating derivatives twist after another.

Innovation is driven by both market supply and demand. Derivatives customers are prompted by market situations to control their market risk and simultaneously exploit their perceived opportunities. Therefore they will look at such things as the slope of interest rate term structures, or disparities between various interest rates or prices, and position themselves accordingly. So there is a constant rotation of innovation, as the suppliers strive to produce derivatives strategies that meet shifting market demand. It's pretty easy to forecast that the appetite for new products and ideas will continue undiminished.

On the supply side, the financial engineering aspect, or state of the technology, is a key factor. Almost by definition, a derivative is something that can be hedged effectively. Unless the derivatives suppliers can work out the theoretical price and hedge ratios, and implement an actual and effective hedge program, they will decline to meet customer demand because it cannot be done safely.

If we look back at recent years, one of the most important strands of innovation is the emergence of the building-block derivatives. For instance, a ladder option can be described as a portfolio of simpler derivatives. The more basic knock-ins, knock-outs, digitals and such have been quite important as building-block components. In addition, continuous groups of building blocks can be assembled. For example, the "soft barrier" options can be seen as an infinite number of infinitesimal-sized barrier-option building blocks. This building-block approach has multiplied the possibilities enormously. For starters, with just the few hundred or so building-block spreadsheet add-in functions that my company supplies via its @GLOBAL product, we estimate that perhaps ten thousand reasonable derivatives structures could be evaluated. Obviously there is a powerful innovation multiplier at work here.

On the mathematical front I believe that alternative technologies like neural networks and chaos theory are unlikely to contribute many earth-shaking ideas. Most of the time they seem like techniques in search of problems. The more organic and productive approach, I'm convinced, is to start with the problem and find the techniques that best address it.

The overriding problem in derivatives is to solve the supply-side requirement, the creation of effective pricing and hedging methodologies for new instruments. Neither neural nets nor chaos theory addresses this problem very well. Neural nets may have some application in predicting price movements, and chaos theory provides an alternative to classic random walk ideas, while also proposing subtle patterns of price predictability. But predictable prices have only a loose connection to derivatives. You don't need derivatives, other than for their possible leverage, to exploit your superior forecasts of future price directions.

In sum, I predict that the big engines of derivative innovation will be the more established technologies of trees or risk-neutral Monte Carlo-plus plain old mathematical hard-slogging.

John F. Marshall
Professor of Financial Engineering, Brooklyn Polytechnic University

Historically, innovation occurs in spurts: an extended period of rapid innovation is usually followed by a period of consolidation, in which the novel becomes routine. The financial markets have similarly experienced spurts of innovation followed by periods of settling. In the near term I do not believe that financial innovation will continue with quite the vigor of the recent past. The coming period of settling will be characterized by an extension of the techniques of financial engineering to the emerging markets of the world. Futures contracts, options contracts, novel debt instruments and a host of OTC products commonly traded in the West will revolutionize the financial markets of developing nations. This process is in fact well underway. Stock index futures, for example, are scheduled to begin trading in Korea this year. While some innovation is driven by dealers who create products they hope will yield wider profit margins, the bulk of innovation is end-user driven. Markets test new ideas and quickly reject those of little or no value.

In the context of financial innovation, the last 20 years have unquestionably been the age of derivatives. In a world with complete derivatives markets, all assets become fungible: dollars become deutsche marks, floating rates become fixed, equity becomes debt, short-term debt becomes long-term, commodities become interchangeable and so forth. The advent of global asset fungibility shattered the old comfortable world where equity was equity, debt was debt, and dollars were dollars. Suddenly the logic of the tax and accounting rules, market regulations and all the other little cubbyholes and mind-sets-which mankind had so painstakingly constructed over the course of a century to organize the financial environment-crumbled. In this new world the old anchorages simply fail to hold. The resulting disorientation and insecurity are the seeds of the paranoia that seems to beset so many media discussions involving derivatives.

While I am not prescient enough to predict the next wave of financial innovation, I do believe that one day derivatives may be used to manage variation in the business cycle. Although there are obvious political obstacles in the short term, futures, options and swaps tied to GDP could be used by procyclical and countercyclical entities to hedge business-cycle risk. One way this might be done is to replace a portion of Treasury debt with securities that pay a floating rate indexed to GDP. This would in reality be a kind of structured note-no different from issuing fixed-rate debt coupled with a macroeconomic swap. When the economy expands, the GDP-linked Treasury notes would pay a higher coupon-thus offsetting the revenue gains from windfall tax collections. And in a contracting economy, the GDP-linked securities would pay a lower coupon-offsetting the tax shortfall. Thus, financial engineers have already developed the conceptual tools for the management of business-cycle risk by both private firms and national governments. In time they will be tried out in the real world.

Harrison Roth
Senior Vice President and Senior Options Strategist, Cowen & Co.

Financial innovation today is alive and well, particularly on the US exchanges, which have done a brilliant job of new product creation, making considerable inroads into OTC markets. I'd single out for special mention the Philadelphia exchange's aggressive expansion of its listed currency options and the development on many exchanges of LEAPS (Long-term Equity Anticipation Securities). Philosophically, LEAPS have probably been the most important new idea in a very long time. LEAPS have a different time-decay profile from other options and retain more of their intrinsic value even as the option comes close to maturity. A close second in the "best of innovation" category are FLEX options at the Chicago Board Options Exchange (CBOE).

The CBOE in particular has taken a leadership position with regard to innovation. Its FLEX options product line will very likely be expanded to include options on individual equities as well as indices. The American Stock Exchange has also made a considerable recent contribution to listed market innovation with its introduction of SPDRs (S&P Depository Receipts), which imitate the behavior of the S&P 500 indices. Thanks to them, broad market index investments are now more readily available to smaller institutional investors and high-net-worth individuals.

Nick Waltner
Vice President, Manager, Global Equity Derivatives Products, Salomon Brothers

Looking back over the last year, we see a significant amount of innovation in three areas: capital market issuance, such as PERCs, ELKs, DECs and PEPs; merger-related securities, including CVRs, VCRs, VSRs and warrants; and such investor-driven strategies as exotic double-barrier options and compound puts. Let's examine each in turn.

Capital Market Issuance: over the last several years, the market has witnessed tremendous growth in the area of structured listed equity derivative products. This development started with the original Morgan Stanley PERC product, which was in essence a packaged buy-write (long the stock and short the call). This product became so popular that investment banks issued large amounts of these types of structures. These equity-linked notes (ELKs) were done against their own balance sheets in order to provide the PERC product tied to growth stocks that paid little or no dividends. Soon thereafter Salomon Brothers introduced DECs, another instrument that modified stock returns in exchange for an enhanced dividend. DECs, ACEs, PRIDEs and PEPs also offered the issuing corporation the ability to monetize or spin off stock holdings of another corporation. The market saw this trend in equity-linked issuance continue strongly this year with four PERCs and 15 DECs. Currently, there are 20 PERC and 30 DEC securities traded in the marketplace.

Merger-Related Securities: 1995 may have been the most active year ever in the trading of securities that were created by merger or restructuring considerations. Acquiring corporations, such as Federated Stores and Laboratory America, frequently used innovative derivatives to sweeten tender/restriction offers. The prime examples of this type of tender were the acquisitions of Paramount Communications and Blockbuster Video by Viacom. In each case Viacom issued a number of complicated securities to existing shareholders, including warrants, put-spreads (CVRs, for contingent value rights, and VCRs, for variable common rights) and subordinated/convertible debt. The range of Viacom's merger-related securities allowed investors a variety of investment strategies, sparking strong interest in these securities. In 1995 Viacom-related securities accounted for 20­30 percent of daily AMEX trading volume.

The Viacom merger derivatives were arguably the most complicated listed equity derivatives ever seen. The CVRs used to sweeten the Paramount acquisition carried maturity extension features, payment-in-kind features and a complicated settlement value based on the median of 41 different 20-day closing price averages. The VCRs it used in connection with the Blockbuster acquisition were even more complicated, carrying 30-day average-price knock-outs, payment in a ratio of Class B shares, S&P 400 MidCap strike price adjustment features and a settlement value pegged to the highest of 61 30-day closing price averages. These highly innovative instruments added considerable value to the tender packages and in the end, thanks to favorable stock price moves, cost Viacom relatively little. Few market participants were able to correctly value the CVRs and VCRs, and hence a discount of 30­40 percent to fair value often persisted. These pieces of paper became one of the most profitable volatility arbitrage trades of the year. CVRs and VCRs also surfaced in a number of smaller transactions, including Abex, Cytogen and Gensia. In the future the market is likely to see other aggressive acquirers use innovative equity derivative instruments.

Investor-Driven Products: these innovations primarily fell into two groups: 1) tailoring market views (cross-asset correlation) and 2) cheapening protection strategies. As portfolio managers continued to focus on cross-asset relationships, many turned to the exotic options arena as the optimal way to capitalize on their views. For example, at the end of 1994, 30-year interest rates were heading toward 8 percent. Many equity portfolio managers were looking to buy S&P 500 puts that became activated if and only if the yield of the long-bond were to trade over a particular level. The inclusion of this feature, commonly referred to as a double-barrier knock-in, lowered the premium cost 25­50 percent compared to the plain vanilla option premium. Here's another example of this innovative strategy: in the Japanese equity market, when the yen/US dollar was trading near 80.00, portfolio managers bought calls on the Nikkei 225 when it was trading in the 15,000 range. These calls knocked-out if and only if the yen/US dollar renewed its low, in this case in the 79.00 range. Again, the embedding of the knock-out feature significantly cheapened the long Japanese equity exposure. This structure also took full advantage of the US dollar sensitivity of the Japanese equity market, since a stronger dollar is likely to fuel a recovery in equities of Japanese exporter stocks that would likely drive the overall market higher. Finally, portfolio managers were also busy taking views on the bond/stock relationship, again especially in Japan, where one-month deposit rates fell to a low of 0.15 percent. In this case investors bought outperformance call options on the total rate of return of the Nikkei 225 over the JGB 10-year benchmark.

As the S&P 500 racked up gains of roughly 6­8 percent per quarter in 1995, many portfolio managers looked for better methods of locking in gains. Traditional methods of using no-cost collars resulted in disaster in the second half of 1995. Some of the more aggressive portfolio managers once again borrowed from the field of exotics to do the job. Compound options-to wit, the purchase of an option on an option-proved to be one efficient strategy. Last October a portfolio manager could have bought a compound put option, expiring at year-end, struck at-the-money on the S&P 500 for 80 basis points, versus a plain vanilla cost of 175 basis points.