of the derivatives.
You will see an increasing use of implied volatility as the markets' expectation of future risk vs. always looking at five-year historic, which is a very static measure of risk. I think you will see an increasing use of unbundling risks into risk buckets into the smallest common denominator rather than lumping a group of risks together as one asset class. And I think you will see an increasing probabilistic evaluation of risk vs. traditional securities, which are more what they return and what they don't. In derivatives you have that probabilistic evaluation of where the markets are going.
Mr. Shultz: Looking at portfolios in terms of buckets of risk and not thinking in terms of asset classes but risk exposure is in its infancy. We haven't even scratched the surface of really understanding risk in this particular context.
P&I: Is the education required to use derivatives more so than a traditional investor in the stock and bond markets?
Ms. Polsky: Yeah. The risks you look at through derivatives are bundled into traditional securities. So the traditional interest rate investment has credit risk, it has liquidity risk, it has directional interest rate risk, and depending on the structure of that security, may have gamma-type risks or convexity risks.
And the difference really is whether you take those risks and lump them altogether into one asset class called interest rates or whether you unbundle them and say, "How much of my exposure do I want to have to credit, how much of my exposure do I want to have to directional interest rate, etc."
The risk has been there all along in traditional securities. Derivatives didn't introduce the risk; derivatives provided a way of looking at the risks.
Mr. Lummer: There is a certain safety that you have when you bundle all the risks together, though.
Ms. Polsky: A lot of the risks existed in traditional securities pre-derivatives. I think of it as B.C. as "before creativity" and A.D. as "after derivatives."
Before derivatives were around, as we commonly define them, a lot of people had investments in convertible bonds and mortgages in putable bonds, but they didn't mark the put or the option in that convertible bond to market because people didn't look at risk probabilistically.
There wasn't a probabilistic mark-to-market concept. Now people mark derivatives to market and look at the value of the option. People are seeing risks they think weren't there before, but were.
P&I: Are derivatives the most challenging investment for you to handle as opposed to, say, emerging markets, venture capital, real estate?
Ms. Beder: It really depends on the type. I mean, for example, it's pretty easy to evaluate the cash flows of the zero-coupon Treasury strip. It's pretty hard to evaluate the cash flows of the corpus of a bankrupt corporate, determining what will ultimately be your path of returns.
Mr. Lummer: No more than the underlying asset class.
Mr. Service: Exactly.
Mr. Lummer: A swap is a very simple thing to understand. Just because it's a derivative doesn't make it more complex than investing in a venture capital fund or investing in an emerging markets fund.
P&I: What's your biggest concern in using derivatives?
Mr. Lummer: There are two things that worry me more than anything else. Number one is that the person making the decision really doesn't fully understand.
The second is that unlike anything else, there is a reliance on the person who is on the sell side to educate me about the process, and that's where I think things have fallen down. I would not in a million years expect somebody who is selling me a venture capital fund to tell me where all the skeletons are and where all the warts are in that fund. I have to do my own due diligence and investigate it myself. But with a derivative I listen wholeheartedly to that person (Continued)