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New Software Figures Risks of ‘Exotic’ Derivatives

from Bloomberg Business News , August 16, 1995

by Matt Rees

A former research head at Bankers Trust Co., one of the biggest firms in the derivatives business, is selling computer software designed to help money managers and corporations figure the value of the trickiest of these financial contracts.

The software, sold by a Princeton, New Jersey, firm called Savvysoft, is aimed at the derivatives traders that don’t have the money to hire teams of Ph.D.’s to write programs that can accurately value their holdings of so-called "exotic" derivatives, said Rich Tanenbaum, Savvysoft’s president.

"Corporations don’t really have the expertise to look at exotics and figure out what price they should be buying or selling them at," said Tanenbaum, who spent eight years at the unit of Bankers Trust New York Corp. and was head of derivatives research when he left in 1989.

Without the enormous resources of big Wall Street forms and banks, "it’s very hard to build that up from scratch," said Tanenbaum, who founded Savvysoft when he left Bankers Trust.

Corporations use derivatives mostly to guard against the risk of swings in currencies or interest rates that can eat into their bottom line. Money managers use them to leverage their bets - and potentially boost their profits.

Difficult To Assess

Many of these derivatives users bought the most complicated kinds of derivatives, known as exotics, in the last several years. Exotics often are composed of several different kinds of options, which makes their payoffs hard to predict without intricate computer technology. One type of exotic derivative, for example, is a quanto option, in which payments might be based on U.S. interest rates, but actual payouts are in Swiss francs.

Their risks are just as difficult to assess. That’s particularly worrisome for corporations and money managers concerned about the big losses suffered on derivatives over the last 18 months. Investors from Proctor & Gamble Co. to Barings Plc lost out when the value of their derivatives plunged.

Those losses spurred a boom at the software firms that sell programs for pricing derivatives, as corporations scampered to figure the value of their portfolios. Few of these firms, though, offer software that can price the most complicated derivatives, which makes Tanenbaum think he’s onto a winner.

"Dealers’ business has slowed down, because people are scared of the losses," Tanenbaum said. But for the software firms, "the risk business is booming."

There are more than 40 companies in the $250 million-a-year derivatives software business, mostly in the U.S. or Britain. Though most are small operations with commensurately modest revenues, several firms have built multi-million dollar businesses catering to the biggest Wall Street firms and banks.

‘Biggest Problem’

While some of these outfits sell programs that can be used to calculate the value of exotic options, none are cheap enough for most of the corporations and money managers that use derivatives, said Charles Wurtz, managing director of Xticket Systems.

"The biggest problem that end-users have is they don’t have 50 P.D.’s in physics working for them, figuring out what this stuff should be worth," said Wurtz, whose own company recently began selling software that big firms can use to figure prices for exotic derivatives.

"If this software really does what (Tanenbaum) says it does, it’ll allow buyers to assess what the Street is telling them," Wurtz said, "and there’s nothing out there like that right now."

Savvysoft’s program costs between $1,125 and $2,225 as a flat fee for each user at a corporation or money manager, though the price drops as the number of copies ordered rises. That compares with prices that sometimes rise into the millions of dollars for high-end systems bought by the big derivative firms from Renaissance Software and Infinity International Financial Technology.

Unlike many of the more expensive computer programs, Savvysoft’s system is designed to handle the thousands of contingencies that must be assessed to get an accurate price for an exotic option, Tanenbaum said.

Limited Resources

Banks that use the more expensive programs can add Savvysoft’s program for specialized options. It’s compatible with Renaissance, Infinity and CATS Software Inc.’s programs, Tanenbaum said.

Even some banks have limited resources for writing their own programs. Though Societe Generale is one of the biggest banks in France, it’s a relatively minor trader in the U.S. markets. It used Savvysoft’s new system as part of a year-long test, as did other derivatives users including Union Carbide Corp.

That saved months of work for the bank, which would have had to write its own programs otherwise, said Catherine Willis, a financial engineer at Societe Generale in New York.

"We’re a small group," Willis said, "so we can’t really afford to have a huge systems group."
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