CMRA in the Press 1997

Former Citibankers Lisa Polsky and Leslie Rahl have walked and talked derivatives since the market's infancy in the early 1980s. William Falloon invites them to reminisce.

Derivatives pioneers

Lisa Polsky and Leslie Rahl, pioneers of the over-the-counter derivative markets, started their careers in the 1970s. Wall Street was then largely a man's world but was about to change dramatically. "Derivatives markets began to develop when women began coming out of universities with the appropriate credentials," remembers Rahl, principal of Capital Market Risk Advisors in New York. "We were becoming mathematicians and MBAs. In my class at the Massachusetts Institute of Technology (MIT), for example, there were 50 women and 950 men. That was the largest class of women that MIT had ever had up until that time."

After a spell as Citibank's traders, both women's careers at the bank continued on an upward path - and eventually coincided when they became joint heads of the risk management products group in the 1980s.

Rahl joined the bank in 1972 with a BS in computer science and an MBA from MIT. After managing the bank's growing back-office operation for 10 years, she began to trade a proprietary option portfolio in 1982 and went on to oversee the bank's push into interest rate options. Keen to trade, her entry into derivatives at Citibank was no fluke. in the early 1980s, she agreed to set up a team for the head of Citibank's investment bank in return for such an opportunity. It was around this time that the Chicago Board of Trade had started to trade interest rate options on futures. A door opened, and Rahl never let it shut. "My boss said: 'Well, you don't really know much about trading, but you went to MIT, so you can probably trade these options as well as anyone else'. It was really a situation of being in the right place at the right time," says Rahl. Through the 1980s, she oversaw the bank's interest rate risk management department.

...After the two women worked together in the risk management group, their career paths diverged. Rahl took maternity leave in 1990, and decided to raise her child without the pressures of the dealing room in the background. Her new life included running a part-time risk consultancy at home, Leslie Rahl Associates. Since then, Capital Market Risk Advisors, formed in July 1994, has become one of Wall Street's largest independent risk consultancies, with 25 professional staff. About half the firm's clients are commercial and investment banks, while the remainder are pension funds, mutual funds and corporates.

...Both women remember the first trades that launched their careers and the long list of Citibank alumni who made major contributions to the development of derivative markets, including Yves de Balmann, now vice chairman at Bankers Trust, David Pritchard, now with the UK's Securities and Investments Board, and Lee Wakeman, currently consulting for CIBC Wood Gundy, who is often credited with bringing a new level of sophistication to the study of term structure.

What made Citibank such a fertile environment for talent? Simple, says Rahl: the bank was a triple-A credit at the time, had a strong balance sheet, and a global client base that rivaled that of any bank in the world. "Citibank attracted a lot of smart people just for that reason," she explains. "Of course, circumstances changed with time and the bank ran into problems with loans later on. But, if you look at the alumni it spawned, it was a real powerhouse."

Rahl believes it was a dead heat between Citibank and Salomon Brothers as to who sold the first interest rate cap. But when it comes to interest rate collars, she is confident that Citibank edged out the competition with a blockbuster transaction in 1983. This inaugural trade, a 10-year, $100 million deal for a real estate concern, was prompted by business conversation at a cocktail reception.

"It was a sizable and long-term deal even by today's standards," notes Rahl. "Caps had been around for a couple of months. But the concept of the collar, or a "floor/ceiling" as it was called at the time, evolved when we learned that some clients didn't want to pay premiums. The collar was a way to eliminate the premium fee or at least to reduce significantly the upfront cash that needed to change hands. The client said, 'I love the idea of buying a cap, but I don't want to write a cheque. Is there something you can do?'."

Rahl's suggested solution was not zero-cost, but involved significantly reduced upfront fees. When asked to explain how the deal was priced, she laughs. Fortunately, she recalls, the spreads that could be charged on such a transaction were so large that pricing and hedging precision were not the critical factors they have come to be some 14 years later.

"The futures markets were clearly an invaluable tool for us," Rahl says. But the futures strip didn't go out that far back then, maybe two years. So you had to stack futures, which had its own series of inherent risks. Most banks used a blend of stacked futures and intermediate US Treasury instruments. If you just stacked futures, you had this huge curve bet. And if you hedged everything in Treasuries, you'd have a huge basis risk. So generally what was done was to use a combination to get some yield-curve protection and Treasury-Eurodollar (Ted) spread protection."

And what about a pricing model? "We priced options by drawing a forward yield curve, drawing the cap line, and saying: `If it never pierces the cap, it has zero value. If it pierces the cap, it has a value equal to a swap.' That was one of the methods we bandied about in those early days. In addition to using the Black-Scholes model, which we thought was pretty sophisticated, we had two normalized style yield curves. On any given day, we would pick either yield curve A or B, high or low, as our term structure of volatility. That's the way we priced and hedged.

"Thank goodness interest rates kept coming down and it didn't really matter," she chuckles. "These were the go-go years for caps and collars. It was a great period for option sellers because interest rates and market volatilities just kept coming down after the big interest rate spike in the early 1980s. Everything was working in the seller's favour, except the relatively primitive nature of option price modeling. But it was not as hard to make money in those early days."

Documentation was a thorny issue at the time. Rahl recalls that caps were sometimes categorized as swaps in which one counterparty never pays anything and the other counterparty pays out "if Libor is greater than X. "It took a few years for the industry to reach a common ground on documentation," she admits. "The market was fortunate not to run into problems before that. Improved documentation made a enormous difference in the ability of the market to grow and prosper thereafter. It was 1989, I believe, when ISDA came up with the cap and collar addendum to the standard master agreement."

...Meanwhile, on Rahl's desk, interest rate options-caps, collars, floors and swaptions were becoming significant, providing alternative risk management products for floating-rate or fixed-rate borrowers. Interest rate caps and collars provided interest rate protection without fixing rates, allowing many borrowers to fund at the short end of the yield curve with limited risk as rates fell. Citibank was soon taking a 10-25% market share in each product. Then it began warehousing option positions - and interest rate and currency swaps - to accommodate its customer base and to manage the enormous derivatives book it was building up.

By 1985, caps and collars were "established business", says Rahl. Interest rate swaptions followed in late 1987 and early 1988. These allowed for the monetisation of embedded options in callable bonds and gave Citibank a hedge. Soon the bank controlled as much as 50% of the market in swaptions, which brought risk management to the top of the agenda.

"Our risk in the cap and collar deals was structural," says Rahl. "Basically, clients wanted to buy caps so everything was one way. Dealers would sell, clients would buy, so dealers tend to have a short position on volatility. After the 1987 crash, interest rates plummeted. Although most made quite a bit of money by benefiting from the fall in rates rather than the increase in volatility, the Street decided it wasn't such a nifty position to be in. Not that there weren't times that you wanted to be short volatility, but you didn't want a business where you always had a structural position. So there was a lot of research and financial engineering effort put into figuring out option products where the Street could be a buyer."

To solve this problem, Citibank and others looked to the covered call writers in the institutional investment community. Their options tended to be short term and so did not cover the kind of longer-dated risk dealers were assuming in their cap and collar books. The only place where long-dated options were in great supply was the callable bond market, as longer-dated options were embedded in the bonds. Citibank soon switched on to the idea of using the swaption concept as a natural hedge. Rahl says that Chip Carver, now with Goldman Sachs, played a key role in the development of the swaption market. "There was a very large supply of those embedded options and it gave dealers a natural hedge," she says.

In early 1989, ISDA estimated the size of the cap/collar/swaption market at $325 billion. It wasn't long before Citibank broadened the concept to include non-dollar interest rates, equities, precious metals, energy and emerging markets, says Polsky. "You had a cap, you had a collar, you had a floor, you had a swap and swaption," adds Rahl. "Whatever a client who needed hedge protection wanted, you had the tools to meet his needs. This helped take away some of the clients' excuses for not hedging."

But it wasn't all plain sailing. Rahl recalls that in the mid-to-late 1980s, the success of the derivatives markets was creating competitive tension within the bank over who deserved credit for deals - the relationship managers responsible for traditional corporate lending or the "upstart" derivatives marketers.

There were also some painful lessons from the market. "The [1987] stock market crash had some indirect effects on the swap market that people hadn't really thought about, and that made them very nervous about dealer credit," she recalls. "It became very hard to repo your securities, and you had all these short positions because you had all these clients that wanted to pay you a fixed rate, but you couldn't repo them very effectively. Spreads really widened out in the swap market because of what was going on in the repo market. That was really a wake-up call about the interdependence of some of these markets. Clearly when you have that kind of turmoil, you worry about credit risk, because you don't know who's going to be burned."

"Lisa and I often laugh about what's happened to us," says Rahl. "We believe it's largely because many bankers in charge never thought derivatives were going to be all that big and important, so it seemed safe to give them up."
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TOP 50
LESLIE LYNN RAHL
Capital Market Risk Advisors
"The impossible we do right away. The more difficult takes a little longer." A founder of the swaps business and an innovator in interest rate caps, collars and floors, Leslie Lynn Rahl had certainly taken this adage to heart by the time she founded CMRA in 1994.

Before setting up her company, she worked at Citibank, where she was at the forefront of the swaps and derivatives team for nine years and responsible for market-making, hedging and proprietary trading for books in excess of $100 billion. She left to run Leslie Rahl Associates, a consulting firm specializing in swaps, options and derivatives. Rahl has also been active on a number of boards and presently sits on the board of directors of the International Association of Financial Engineers ((IAFE). She is a graduate of the MBA programme at the Sloan School of Management at MIT and is looking forward to the day when she finally gets some sleep.

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