By Robert Hunter

All derivatives pros, at one time or another, have found themselves at a cocktail party trying to explain what they do for a living. In between crab puffs, they rush to define risk, options, futures and other financial concepts in the tiny window of opportunity before bored listeners' eyes glaze over and they excuse themselves one by one to refill their drinks.

Now there's help. When confronted with such questions, they can simply pop into the nearest VCR a copy of "Trillion Dollar Bet,” a program in the Nova series on PBS that aired last month. In less than 60 minutes, the show manages to explain thoughtfully the concept of risk, the Black-Scholes-Merton formula and the fall of Long-Term Capital Management. It's clear that the show's producers hadn't cut their teeth in financial journalism before tackling the subject—the narrator, for instance, claims that interest rate swaps are traded at the Chicago Mercantile Exchange and refers to the "Chicago Board of Options”—but they nevertheless managed to pull off a compelling, dramatic piece of television.

The producers tapped many of the industry's biggest stars to serve as talking heads, including Merton Miller, Leo Melamed, Myron Scholes, Robert Merton and Stan Jonas. While most of them were filmed unceremoniously in their normal working environments, Scholes and Merton appeared to be comfortable taking some stage direction.

In the show's first sequence, we see Scholes in a nearly pitch-black room writing the Black-Scholes-Merton formula on a white board, underneath a brilliant spotlight. Later, he appears on a golf course sizing up a putt, while the narrator talks of LTCM's fabulous early success. Merton, meanwhile, is introduced while driving in his calculatedly modest German car. Later, before LTCM is discussed, he proudly fingers his Nobel medal, saying it's the best thing that could happen to a person in several lifetimes.

Interspersed are dramatic shots of traders in slow motion, gold coins and bricks piling up, numbers on stock tickers and trading screens changing rapidly, and long, slow pans across dollar bills. WGBH has created a companion web site to the program, at www.pbs.org/wgbh/nova/stockmarket/, where viewers can learn more about the Black-Scholes-Merton formula and even try some simulated trading. For a copy of the program, call WGBH Boston video at 800-255-9424.

What follows are excerpts from the program.

Zvi Bodie, an economics professor at Boston University, on Robert Merton: "He was kind of a wunderkind. He was just recognized from the very beginning as an extraordinary intellectual talent. His creative powers, the power of the analytical techniques, mathematical techniques that he was bringing to bear on some age-old questions in economics. Savings behavior, investment behavior. It was just obvious that here was a guy who was going to make intellectual history in our field.”

Myron Scholes: "Bob phoned me up one Saturday morning and said that, you know, he had an alternative proof to our particular model and was very—he was convinced that it did work. He had used technology that I hadn't been aware of and Fischer hadn't been aware of, called Ito calculus, to actually solve the problem in a more elegant way and a more robust way, I think, than Fischer Black and I had done.”

Narrator: "The formula that Black, Scholes and Merton unleashed on the world in 1973 was sparse and deceptively simple, yet this lean mathematical shorthand was the fulfillment of a 50-year quest... Here was a formula that would enable investors, by dynamically hedging, to control risks by spreading them across individuals, financial markets and through time. Academics marveled at its elegance and sheer audacity.”

Stan Jonas: "It was as though the apostles had effectively come down to raise money in a bingo parlor. This was going to be the team of the century.”

Roger Lowenstein, of the Wall Street Journal: "What they did was study the relationships between various markets all around the world, bond markets, eventually equity markets, interest rates, the rate at which those prices change themselves. And when the relationships between these various markets got out of whack, which is to say became different than what had been their historical norm, LTCM would place bets, the bets being that the historical relationships would re-assert themselves. And they did this all over the world.”

Jonas: "It was as though the world was behaving exactly the way it had been writ on the blackboard. Long-Term Capital thought that they had discovered the path to Nirvana. Here they are doing their day-to-day activities, playing golf in lush Greenwich or attending hedge fund conferences in Bermuda, or raising funds in Cannes. And then slowly and totally unexpectedly, a change in the market dynamics began to become apparent.”

Scholes: "In August of 1998, after the Russian default, you know, all the relations that tended to exist in the recent past seemed to disappear.”

Peter Fisher, of the Federal Reserve Bank of New York: "What really was the shock for me when we went up to Long-Term Capital and the partners gave us an overview of their positions and the risks and the pressures they were under, was the extraordinary scope of the risks that they had taken on, the breadth of the portfolio, and yet how utterly their effort to diversify the portfolio had failed them—that this wide set of positions across all markets had all come in, were all behaving the same way. Everything had come up heads.”

Robert Merton: "It's like getting hit by a truck. I can't imagine anyone wouldn't feel very deep emotions of loss, of why? And I'm no different from that.”

Scholes: "Some people have asked me how I felt going through the LTCM experience, and obviously I felt quite bad—badly for, you know, investors, for others who had worked with us...because it was the case that we had a great idea and a great franchise, a great application of these ideas to problem-solving, and essentially realizing that that was very difficult to effect...Individuals suspect that the models were flawed and essentially that was the reason why LTCM ended up in its difficulties. I personally don't think that that's the reason. It could be inputs to the models, it could be the models themselves, it could be a combination of many things. And so just saying models were flawed is not necessarily the right answer.”

In less than 60 minutes, the show explains the concept of risk, the Black-Scholes-Merton formula and the fall of Long-Term Capital Management.

Jonas: "When do you admit that you're wrong, start all over again, or when do you hang on and assume that the markets will turn around in your way? That's the biggest decision we all have to make. However, there's one thing that's clear. Over the last several hundred years, we've been able to identify some people that can do it better than others. They don't necessarily go to MIT; they don't necessarily have degrees in mathematics, though that doesn't automatically rule them out. They're the kind of people that can make that judgment that says, something's different here, I'm going back to harbor until I figure it out. Those are the kind of people you want running your money.”

The day when you can get full-strength trading and risk management applications over the Internet may not be here just yet, but it's certainly right around the corner.

The latest entrant into the race to provide trading and risk management services via an application service provider (ASP) framework is Cygnifi, an independent derivatives services company being developed jointly by JP Morgan, NumeriX, Bridge and Sybase.

The new company grew out of JP Morgan—not unlike the RiskMetrics Group, which was spun off in 1998. JP Morgan is donating a large number of its internal, proprietary trading systems to Cygnifi, as well as some 25 employees, including the global derivatives systems development team and a couple of senior people.

To create a truer feeling of independence, Morgan actively courted an information technology partner, a provider of data, a provider of analytics and an Internet connectivity provider. After talking with a number of parties, Morgan reached agreements with Sybase as the IT partner, NumeriX for analytics and Bridge for data and connectivity.

The underlying intellectual property comes from JP Morgan. It includes various risk management systems (although not its equity derivatives system) as well as its collateral management systems. Morgan will be the firm's first customer. Although JP Morgan is no slouch when it comes to analytics, the architects of Cygnifi preferred outsourcing a large measure of the analytics to a third party. "NumeriX fits in by providing a large software library that performs pricing on derivatives, on portfolios, stress testing and some proprietary algorithms to do Monte Carlo faster than anyone in the world,” says Craig Bouchard, president and CEO of NumeriX.

The company expects to have a product to sell by midyear. The target audience will include the dealer side—small, medium and large—but Cygnifi will also offer a suite of different products tailored to the needs of corporates and other institutional investors. "Cygnifi will be able to price derivatives across interest rates, commodities, equities—all the main derivatives product lines—as well as perform analytics, stress testing and all manner of portfolio valuation at the dealer level as well as on-desk applications,” says Bouchard.

The Monte Carlo engine that goes on behind the portfolio in the VASP project will be very, very fast, allowing dealers to run portfolios intraday.

The first company offering will be an on-line subscription service to derivatives technology for post-execution market and credit risk management. One of its biggest selling points: it runs a large Monte Carlo simulation that tells desks how much money they have made, gives them the value-at-risk on their portfolio and provides a large set of analytics to show management how they did.

Later next year, the company will serve as a "value-added service provider” (VASP), offering a service called Advice on Demand, which "will focus on independent appraisal and analysis of portfolios across market risk and credit risk, focusing on a wide range of clients across financial institutions, asset managers and corporations,” says Vlad Torgovnik, president and COO of Cygnifi.

"The VASP function will provide risk management consulting services and address large global portfolio types of issues, such as ‘How do you take all of your portfolio and manage it better and run it more quickly and accurately?'” says Bouchard. "NumeriX will contribute the Monte Carlo engine that goes on behind the portfolio in the VASP project. It will be very, very fast, allowing dealers to run portfolios intraday.”

At the beginning, "customers will be able to price all of their instruments and their Greeks, with a fairly incredible set of sensitivity tools. We may help them organize their database so the trades are formatted correctly in the FPML language or even have an off-site databank,” he notes.

In later stages, he adds, "we may then run their portfolio for them, and do valuation of the portfolio at speeds not available today. If they can do it in an hour's time, they could in essence plug a trade into their portfolio and allow them to get real-time Monte Carlo. If you knew, for instance, that by adding a trade it would increase the risk, you would price it more conservatively. But if you knew that adding it to a different portfolio would allow you to price it very thinly, you'd have a big advantage.”

The benefits to trading desks could be enormous, says Bouchard. "Clients would have to enter trades, but they wouldn't need middle-office staffing, or a big quant staff to model trades. They would need less oversight, because of the tremendous amount of oversight via the VASP portion. It will lower the cost of trading operations substantially and lower the mushrooming cost of trading derivatives.”

Electronic trading has always promised to disintermediate interdealer brokers from the derivatives trading scene. Now, two leading brokers have decided that, since they can't beat the electronic crossing networks, they might as well join them.

GFI, a leading New York-based broker, has announced that it's beta-testing GFInet, a web-based, real-time trading system for the professional trading community. The GFInet platform will be used for the brokerage of global financial products, including stocks, bonds, currencies and derivatives, as well as for telecommunications and some other volatile corporate assets. The system has been in live operation on GFI's Latin American equities desk for a while, and the company plans to roll out derivatives functionality soon. It is beta-testing derivatives products at existing GFI customer sites, which, the company says, include four of the top-ten banks and brokerage firms in the United States.

The system will provide professional traders with the ability to monitor real-time market activity, post bids and offers, execute transactions electronically, while still linking with GFI's professional brokerage staff.

Prebon, meanwhile, has joined forces with CreditTrade, an on-line credit-trading exchange launched last July, to provide traders with greater access to real-time data, improved trading information and enhanced liquidity via the Internet.

Prebon will move its global credit derivatives team and historical default swap database to CreditTrade in return for a substantial equity stake. Prebon's Americas chief executive officer, Harry Fry, will join the CreditTrade board, working with the existing management team to expand and develop their financial exchange.

In all, 13 credit derivatives brokers in London, New York and Singapore are expected to join CreditTrade's existing on-line credit sales desk to form a single global team that will serve all major counterparties under the CreditTrade name.

Prebon has been active in the credit markets—which the British Bankers' Association estimates will grow from $450 billion to $740 billion by the end of the year—for several years, working with clients to resolve documentation issues and maintaining a database of historical default swap data, including bids and offers for credits by tenor, maturity, country and industry, dating back to 1997.

For more information, see www.gfinet.com and www.credittrade.com.

By Nina Mehta

A few years ago, Nomura Securities Co. and other large Japanese securities firms were forced to pull back from the swaps business when their credit was downgraded in the wake of losses relating to Japanese real estate, mortgages and the Russian debt crises.

The downgrade prevented Japanese financial firms and banks from doing business with sovereigns and other counterparties that require a triple-A credit rating. To recapture some of that business, Nomura did what other financial institutions in similar positions have done over the last decade: It took out its checkbook and created a triple-A subsidiary to book derivatives transactions.

Nomura's newest entity, Nomura Derivative Products Inc., received its triple-A rating from Standard & Poor's in late January and is expecting Moody's Investors Service to give it the nod at the end of this month. The subsidiary is organized as a termination structure. This means that if certain trigger events occur, such as the bankruptcy of the parent, NDPI is terminated and its transactions are immediately unwound at the midmarket price, freeing—or forcing, as the case may be—counterparties to retransact in the marketplace.

Going the triple-A route, of course, isn't cheap. Enhanced derivative products companies (DPCs) are expensive precisely because they are "enhanced”—that is, their credit rating is not contingent on the lesser-rated parent's guarantee. This segregates the DPC from what S&P's reports gently refer to as "credit sensitivity.” Trading with a non-triple-A entity, for instance, generally involves a higher capital charge for counterparties and requires the posting of more collateral.

NDPI's capitalization consists of $100 million in cash and a $25 million subordinated loan from its parent. Another $25 million in capital and a $50 million credit facility is currently being negotiated with Ambac Assurance Corp., a triple-A insurer, should additional funds be necessary. The subsidiary's capital base is designed to "prove to the rating agencies that NDPI will always have enough capital on hand to be able to make all of the counterparties whole and satisfy all of its obligations if the structure terminates,” says Wendy Brewer, NDPI's COO.

So what's unusual about NDPI? "Nomura has innovated in terms of the types of products it wants to offer and the potential use of Japanese government bonds as collateral,” according to Jim Vinci, co-lead partner for the financial risk management practice in the Americas at Pricewaterhouse-

"Nomura has innovated in the potential use of Japanese government bonds as collateral.” —Jim Vinci PricewaterhouseCoopers

Coopers, who in 1994 helped form Lehman Brothers Financial Products. DPCs established in the United States have so far relied on U.S. Treasury bonds as collateral, so Nomura's negotiations with the rating agencies, law firms and regulatory bodies could allow other foreign institutions to expand their use of Japanese government bonds.

For S&P, rating NDPI is different, natch, from rating a straight securitization, since it's an operating entity and has the possibility of evolving and offering new products. "We looked at NDPI's capital model,” says Jack Frishberg, director of derivatives ratings at S&P, "and we looked at its ability to mark-to-market all of its products. We reviewed NDPI's operations to make sure all of the systems are in place. The subsidiary eliminates market risk by doing mirror transactions with Nomura Global Financial Products, and the credit exposure from that subsidiary is minimized by collateral posted to NDPI. All of these things give us triple-A confidence in NDPI's ability to meet its obligations—either as an ongoing entity or in termination.”

NDPI's product mix is geared toward the exotic. "We don't want only plain-vanilla transactions that could be booked in one of the other Nomura entities such as Nomura Global Financial Products,” says Brewer. "We want to do structured deals that complement the expansion of the Nomura global business environment. We will do a lot of structured combinations of foreign exchange options, caps, floors and swaptions, but no equity or commodity swaps since that's a whole different type of risk.”

Brewer, who first dipped her toes in the swaps business at Chase Manhattan Bank in 1985, later switched over to Bank of Tokyo-Mitsubishi and launched its swaps subsidiary, Mitsubishi Capital Markets, which she ran as executive vice president and CFO from 1991 to 1997. Last September, when she joined Nomura, she went from being the highest-ranked woman at Bank of Tokyo-Mitsubishi to being the highest-ranked woman at Nomura.