In Saul Bellow's 1956 novella Seize the Day, the hero uses his last $700 to buy lard futures on the advice of a seedy acquaintance. The unfortunate fellow's agony, as he watches lard prices plummet and a steely-eyed broker close out his account, is enough to scare a reader away from such markets for life.
But derivatives--financial instruments that, like futures, are derived from an underlying transaction in goods, currencies, stocks, bonds, or money itself--have come a long way. Originally invented for commodities providers as a hedge against price fluctuations, futures and options also gave speculators like Bellow's poor slob the chance to make a fortune or lose their shirts. Now, financial engineers are designing derivatives that ideally meet very specific investment needs. Caution is in order. Some of these products are being peddled by the same firms that brought you REITs, limited partnerships, and portfolio insurance. But for investors who do their homework, derivatives can help make the most of market conditions.
SPLICE JOB. For example, Nikkei put warrants were introduced in 1990 when the tumbling Japanese stock market excited international options speculators. The warrants, which trade on the American Stock Exchange, give holders a right to sell a certain amount of Japanese stock at a locked-in price. So the worse the 225 stocks that make up the Nikkei do, the more the put warrants are worth.
Derivatives are sometimes called synthetic securities because different kinds of investment instruments are artificially spliced together. Thus, PERCS, or Preferred Equity Redemption Cumulative Stocks, act like bonds for two or three years, paying an interest rate usually above-market for investment-grade corporate debt. Then they automatically turn into the underlying common stock at a preset ratio.
That's an attractive proposition if the issuing company prospers, though the conversion formula means there's a cap on the appreciation holders can realize. PERCS are finding favor with investors now because their coupons are about two percentage points higher than those of ordinary corporate bonds. The trade-off is if the issuing company's stock takes a beating, you're forced to own it anyway--or to sell your PERCS, whose value is likely to sink too. Such trade-offs are typical of derivatives, though they may look as if they offer the best of several worlds.
Similarly, synthetics like collateralized mortgage obligations, or CMOs, have made a hit with individuals because they appear to beat the going rate on alternative fixed-income investments. Yet it is almost impossible to calculate your actual yield to maturity on any particular CMO--again the trade-off for a good-looking initial return.
Does the average investor need such instruments in a reasonably diversified portfolio? Synthetics makers believe they do--not as devices for hedging or speculation but as a new and prudent form of asset allocation. "Investors are nervous about stocks, they're sick of short-term money market rates, and they don't want to lock in a long bond at 7.3%," says Joshua A. Weinreich, a managing director at Bankers Trust. Weinreich believes that Bankers Trust's market-linked CDs correct a mistake that investors make out of fear: getting in and out of the market rather than the tried-and-true strategy of buy and hold.
The CDs, sold in denominations as low as $2,000 and maturing in 5 1/2 years, are linked to the S&P 500 and promise to deliver 100% of any gain in the index at maturity. If the S&P rises 100%, you get double your deposit back. If the index stays flat or falls, your principal is guaranteed. A slightly riskier version offers 110% of the S&P's return over 5 1/2 years, and your principal cannot decline more than 10%. The deposits are FDIC-insured.
POOR PROMISE. Merrill Lynch's MITTS, or Market Index Target Term Securities, are issued at just $10 a share and work the same way, promising 115% of any S&P 500 rise after 5 years, with no downside risk. And future MITTS may be linked to other markets or even specific stock sectors. "Versions can be custom-made," says Michael R. Feigeles, first vice-president for equity marketing. "We can link them to the Nikkei or the NASDAQ, biotech stocks, whatever."
On the surface, such deposits seem to let investors bet on the stock market fearlessly. But giving up yield for five years is no joke: Your money will steadily lose purchasing power. And if there's a stock-market scare right before your CD matures, any interim upticks will be lost opportunities--your money was tied up. "Over a five-year period, to promise your money back is pretty poor," says John Markese, president of the American Association of Individual Investors.
Like the innocent-sounding CDs, familiar old zero-coupon bonds have been packaged with stock options to give investors a hybrid that seems to do more than one thing well. LYONs (Liquid Yield Option Notes) and LYNX (Liquid Yield Exchangeable Notes), also Merrill Lynch creations, are convertible bonds that turn into a predetermined amount of the issuer's common stock.
These "liquid notes" are longer-term bets than the CD-stock combinations, typically maturing in 15 to 20 years. That's fine if your goal is to lock in today's interest rate. But the notes' appreciation potential is questionable. Because they sell at a premium to their conversion value in common stock and you get a fixed number of shares, the underlying stock has to rise steeply to make the conversion worthwhile. Eric Ryback, manager of Lindner Dividend Fund, thinks investors are much better off with ordinary convertible bonds. "Anything that requires you to watch the security intensely from day to day, we tend to stay away from," he says.
Possibly the sexiest derivatives are LEAPS (Long-term Equity AnticiPation Securities) and BOUNDs (Buy-write Option Unitary Derivatives). Long-term stock options, these expire in years rather than months and cost a fraction of the underlying stock price.
For example, 10 IBM LEAPS expiring in January, 1994, with a strike price of $105 give you the right to buy 1,000 shares of IBM that month at $105 a share and cost you $3,250, minus commissions. If IBM stock hits 120 at that time, the 10 LEAPS will be worth $15,000: 1,000 shares times the difference between 120 and 105. If IBM closes below 105, the LEAPS expire worthless. Of course, if IBM is on an upswing, you can make money selling the LEAPS before they expire.
Such a bet is more comfortable over two years than over several months. "People find LEAPS attractive because they can take a longer-term view, away from the daily whipsaw of the market," says Harrison Roth, senior options strategist at Cowen & Co. As of now, 108 LEAPS are listed on the Chicago Board Options Exchange.
MURKY STATUS. Will the bigger time frame make options palatable to the prudent investor? Some advisers say that no derivative, let alone an option, belongs in an individual's portfolio. Derivatives "require acute timing skills," observes Michael Metz, chief investment strategist at Oppenheimer & Co. "That hardly categorizes professionals, let alone amateurs."
Most derivatives have other built-in problems. Regulators argue over who should oversee them, because no one is sure whether they should be classified as securities or options. Their tax status is often murky, since many defer payoff until maturity and then don't call it "interest." And the newer products tend to be dangerously illiquid, because the more specialized they are, the smaller the market.
Yet there's a future for the descendants of lard futures, says Richard Kleinberg, a derivatives consultant in New York. "The man in the street has no hedging need to trade soybeans," he says. "But he does have a hedging need to trade interest-rate and stock investments. We're in a new environment where there's a very conservative reason to use derivatives." He may be right. But not with your last $700.
UNDERSTANDING AN ARCANE WORLD OF INVESTING LEAPS, BOUNDs Long-term stock options, with expirations of two, three, or five years. Investors have a longer time frame in which to make a correct guess on equities. Like ordinary options, LEAPS (calls) and BOUNDs (buy-write options) let you play the market more cheaply than if you bought the underlying stocks. Also like their short-term counterparts, they leave you with 0% of your investment if you bet wrong `LINKED DEPOSITS,' MITTS These state-of-the-art CDs guarantee your principal and offer potential appreciation based on price changes in some underlying market or index, such as the S&P 500. When banks issue them, they are FDIC-insured up to $100,000. When brokerage houses issue them, they are guaranteed by the firm. Terms are usually about five years. Although they are relatively low-risk, the opportunity cost of parking interest-free money for five years may be high if the underlying investment doesn't pay off LYONs, LYNX Fancy zero-coupon bonds with a conversion feature. These bonds, usually with 15- to 20-year maturities, separate their interest-paying component from their principal, which is then linked to the issuing company's common stock. Yields are relatively good, but the so-called appreciation potential of your principal is very limited. Also, as with zeros, you may pay taxes on deferred interest DATA: BW