The Art of the Option
Back in 1982 I was in an unusual position. All of my peers at my bank aspired to be line division managers. That was the traditional path to glory and was the first really important middle-management job tier. I had been jammed up with all my peers as a team leader of an important group of clients. I had two junior bankers working for me and a stable of big multinational clients. Suddenly I was asked to consider an alternative path. I was offered the opportunity to take over a staff division called the Marketing Division. It was the unit that the brass wanted to spur the development of important new financial products and the cross-selling of bright ideas from one team or division to another. So it was intended as an area to foster deal communications and promote financial innovation. Besides being one of the more creative bankers in the bank, I had also taken a shine to the woman who headed that new division and spent a lot of time with her, trying to help her get her division off the ground.
When it was announced that I would be taking over from her (she was leaving to go to some big job at the Ford Foundation), some of my friends were impressed, but most used it as an opportunity to poke fun at me since I was taking over a staff function and was moving off the line. It’s like trading in your rifle for a typewriter if you were in the military. That didn’t bother me because I noticed they all came by my office (Division Heads were the first level of management with an office) and were all curious what I did all day long. Anyway, I was off and running and immediately hired a few youngsters from the next training class. One was a “Poindexter-like” financial sort that was short on interpersonal skills and the other one was a marketing-type that was light on finance and very personable. I figured with the two of them I was covering my bases since even I wasn’t altogether sure what we were going to do.
One of the first things that came across my desk was a proposal from a weird ex-international banker who knew a lot about foreign exchange. It was the early 1980’s and everyone was grappling with the new spiking in short term interest rates. It was unprecedented and very costly to many of our clients. It also undermined our credit risk since it was clear that exposure to short term rates was a serious added potential burden on the borrowers. This proposal was for the creation of a forward market in interest rate contracts, much like the over-the-counter (OTC) market that existed for FX forwards from banks. The rationale for this was clear and well-reasoned, but the modus operandi was unrealistic. Markets didn’t just spring up overnight for a new instrument like that. But it got us thinking.
On the trading side of the bank, several new markets had recently opened up in the Chicago commodity markets that were drawing some interest from financial market traders. They were called futures markets and there were new futures contracts being traded (lightly) in T-bills, Eurodollars and T-bonds. The commodities markets had their own protocol that didn’t match either the financial instrument markets or the FX markets. They were different enough that only the smarter, more enlightened traders were dabbling in these new instruments. The ones who did were not casual traders, but very committed traders who didn’t care what they traded, they just loved the action of the trade. The Chicago commodity markets were nothing if not exciting and energizing. They were open for shorter hours and the trading was far more physical than the bond (a virtual marketplace) or even the stock markets (a genteel open-outcry market). The pits in Chicago had earned their name because when you went into the pit you were in the thick of it.
The bank had decided (along with their brethren at JP Morgan) to open a Futures Commission Merchant (FCM) to do all their trading in the Chicago pits and the growing commodity markets around the world. The defining event was a Columbus Day after the infamous Paul Volker Saturday Night Massacre which crushed the bond market. Those traders who knew how to use Chicago traded it aggressively on Monday morning (they were open where the bond market was not) and made a killing at the expense of the old traders who were off for a last sail of the season in Sound. We had made such a killing and e would lead the way to Chicago. The bond jockeys picked a guy to build out the FCM, but he was not excited about not making hay on the bond desk like all his buddies. He recruited me to take his job since I was busy researching the whole forward interest rate market idea.
That was a seminal moment in my career akin to the line in The Graduate when the guy tells Dustin Hoffman, “Plastics!” Futures was really about futures and options, which were linked instruments. So I moved downtown and started to learn how to build and run an FCM. Along the way, I kept that forward market contract idea in the back of my head. As we built out the futures and options trading desks in Chicago, New York, Singapore and London I still believed that corporate clients were less likely to want to trade and more likely to want us to manufacture a hedging product for them. The capital markets arena already had interest rate swaps, which were growing like gangbusters, but there was nothing like an interest rate option.
We decided to create such a thing and called them Caps and Floors, trying to keep it simple. It was a novel idea and it really was complimentary to swaps, but the guys in the capital markets area were like the old traders, they knew what they knew and didn’t want to bother with new things like Caps and Floors.
Just then, the bank started working with this new shop called KKR, who had started this thing called a leveraged buyout. The concept was to buy a company and leverage it up with debt. Naturally, controlling the interest rate exposure was important. The first big deal we did was called Malone & Hyde, which was in Memphis. The head of that banking unit asked that the head of the Swaps Unit (a guy named Allen) and I (representing the new Cap and Floor products) go to Memphis to present. We did so and were literally set up as dueling product salesmen rather than colleagues looking for the best answer for the client (those were the roaring ‘80’s).
When we came out of the meeting, Allen and I found ourselves in the parking lot of a suburban office building (in the pre-Uber days of old). We didn’t know how to get to the airport. When a local came out of the building, I approached him and asked him if he would take us to the airport for $10. He agreed with not more than a moment’s thought (this was the polite south in those days).
Allen’s reaction was to suddenly say, “Would you do it for $7?”
I patched that up with the guy, gave him a $10 bill and we got to the airport. Now Allen was just being funny, but there was much truth to this vignette. Allen was as hard-charging a guy as our bank had ever seen. I even offered to merge my Cap and Floor business in with his and he politely declined. One of his guys with a Masters in Applied Math said the concept would never fly. Years later he became one the great options gurus on Wall Street. Allen went on to become Mr. Derivatives after he and I did indeed form a JV to construct swaps with futures. The new unit became known as The Derivatives Department. And to think he almost missed out on the opportunity for $3.