Sell Side: Other Derivative Securities

Stocks belong to equity markets because they derive their value from the equity (value) of the issuing firm. Other securities, whose value is primarily determined by interest rates, are said to be part of fixed-income markets. We discuss here a class of fixed-income derivative securities that has appeared just since the 1980s, the so-called mortgage-backed securities.

Since the 1980s there has been a fundamental change in the way the U.S. mortgage market is financed. Prior to that time, individual investors deposited money with banks, particularly with a type of bank called a "Savings and Loan." These banks would in turn loan their deposits in the form of a mortgage to persons buying real estate. But many investors, particularly those with large net worth, sought investment opportunities other than those provided by Savings and Loans, and their money was therefore unavailable to persons wanting mortgages. In the 1980s this changed as major investment banks and the quasi-governmental agencies Fannie Mae and Freddie Mac began buying mortgages from Savings and Loans and other mortgage originators and selling off pieces of the pool of mortgages they collected to investors. The pieces of the pool of mortgages were structured to appeal to the risk/return appetites of the individual investors. One investor might buy the right to receive only the interest payments received by the pool, whereas another might receive the interest and principal on the first 10% of the mortgages to be repaid. The determination of the prices of these pieces is much more than an accounting exercise. One needs to know statistics in order to estimate how many people will pay off their mortgages early, one needs a good sense of finance and mathematics to model the effect of changes in the interest rate on these pre-payments and the value of the mortgages, and one needs the ability to write efficient computer programs to perform the necessary large-scale computations to actually get numerical results.

In addition to stock options and mortgage-backed securities, there are derivitive securities on commodities, energy, currencies, credit, and even weather. The set of opportunities for people who understand these securities is large and growing steadily.

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