Gmike2000
Senior Member
Posts: 797
Joined: Sep 2003
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Fri Apr 25, 08 08:53 AM
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Quote
Originally posted by: zxem
About those long dated exotics(5-10Y), who is the customer, how to manage the risk. Bonus is still based on the P&L?
Many customers are constrained and unsophisticated (meaning low tech, not meaning stupid) investors who (as pointed out below) want exposure to a single payoff and let a bank's desk manage the strategy. They tend to not be able to compute the price or the greeks themselves, so very likely they use accrual accounting for their P&L (in fact, many customers are ALM departments, insurance funds, pension funds, etc). No daily MTM, otherwise they would quickly see that exotics are inefficient from risk/return point of view (this is mostly due to the embedded fees, and high bid-offer which makes unwinding mid-way impractical).
Most exotics are designed to produce high cash flows which are achieved by selling embedded optionality. This comes at a cost, of course, but to an accrual accounting driven firm, 8% coupons look like an arbitrage (the real cost often comes down the road, when the product has blown up and the customer needs to "restructure"....).
Having said that, the most sophisticated alpha seeking buy side shops stick to vanillas for very good reasons.
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