I work in a sell-side bank in derivatives modeling. My work involves modeling and pricing of exotic derivatives and I often wonder who are the buyers of these products.

From my research, I found that its generally hedge funds or entities on the buy-side that want to buy these exotic derivatives. However I don't understand it in depth in the sense that are derivatives used to speculate or take a position, or they are used to hedge a certain position.

For example, I have questions like, is it reasonable to assume that funds that employ systematic strategies wouldn't use exotic or complex derivatives while it would only be the discretionary funds that would use such exotics.

Could someone take an example of a derivative and explain how a buy-side entity would lets say take a position and how using a derivative would make sense for them in that context. Or you could point me towards some online reading material or resource where I can learn about this.

  • $\begingroup$ Honestly it’s such a broad question, given that you haven’t even defined an asset class or geography. A good start would be to ask the business people who are using your models. $\endgroup$ – dm63 Jun 21 at 12:28
  • $\begingroup$ @dm63 Lets say we are talking about interest rate exotics in the US markets. I dont get to interact a lot with the business end but I can try. $\endgroup$ – qwerty_uiop Jun 21 at 12:30
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    $\begingroup$ Therein lies an issue - there ought to be healthy interaction between those building models and those using them. If you can name a few types of exotics I can give you an answer. $\endgroup$ – dm63 Jun 21 at 12:40

Example 1. Buy-side buys notes whose coupon is $\min(\max(\rm{gearing}*(\rm{index}_1-\rm{index}_2),\rm{maximum}),\rm{minimum})$. Their motivation is often their view that the sell side is pricing these too cheap.

Example 2. An insurance company wants to buy 20-year fixed-coupon GBP bonds. However they want higher yield than GUK, and they are willing to take a little credit risk. They buy a credit-linked note that repackages the debt of some investment-grade reference entity that does not issue GBP debt. The notes are a GBP inerest rate hedge, but they also increase the credit exposure to the reference entity.

Example 3. A corporation needs to issue bonds to finance a project in a developing country, whose (stupid) local regulations require that they announce and lock in the fixed coupon that the bonds will pay several months before the bonds are actually issued. The issuer is worried that the market/credit conditions will change in the meantime, and they will have to sell the bonds with this coupon substantially below par, and will not get all the capital that they need to raise. The bond issuer often tries to buy some kind of out of the money options that would compensate them if the bonds have to be sold far below par, but usually include also the issuer's views on what will actually happen.

As a "career advice", you should try to hang out with the salespeople and talk about what problems the clients are trying to solve, and what tools would help the salespeople.

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    $\begingroup$ My impression as an outsider is that often regulatory and tax issues are important (as in Example 3). $\endgroup$ – noob2 Jun 21 at 16:39
  • $\begingroup$ yes, that theme comes up a lot. $\endgroup$ – Dimitri Vulis Jun 21 at 17:13

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