Much of what happens in finance goes beyond selecting the right stocks or funds for a portfolio—and at the professional level, this is in many ways the easiest and smallest part of the job. In reality, the bulk of finance has to do with managing cash flows—that is, making sure that everyone who has liquidity has it, and ensuring that reserves that aren’t earmarked to be liquid are put in the best performing assets possible and appropriate for the client, fund, or situation.
Creating liquidity isn’t achieved solely by liquidating a position—in many cases, derivatives can be used to manage cash flows and ensure that an account has enough liquidity to meet its obligations.
For instance, consider the interest rate swap, or IRS. This is a derivative that, like a futures or options contract, is an agreement between two parties where one party agrees to offer future interest rate payments to another party in exchange for a specific amount of principal.
Consider the following example: I have issued a fixed-rate bond to investors, meaning I have a liability to pay a certain cash flow at a fixed interest rate. At the same time, I think that the interest rates on floating-rate loans is going to rise considerably. Instead of paying that fixed-rate bond’s interest payments from cash reserves, I instead want to pay it from the cash flow that a creditor of a floating-rate receives.
There’s just one problem: I’m not a bank, so making a floating-rate loan out of thin air isn’t possible. Instead, I can go to a bank and explain my situation; the bank, which already has a floating-rate loan payout, can agree to “swap” my fixed-rate loan payments for the floating-rate loan payments for a fee. The bank gets a trading commission, I get the interest rate exposure I want, my bond buyers keep getting their interest payments, and the debtor who took out the floating-rate loan gets the loan she wanted. Everyone wins.
Usually, IRS’s are used to provide exposure between fixed-rate loans and floating-rate loans, and they are important especially for bond investors who want to hedge their exposure to or speculate on the future of the yield curve. The basic premise of an IRS involves simple algebraic math, and in corporate finance managing IRS’s is not terribly difficult. In bond funds, however, IRS’s can get very complex due to a combination of multiple inflow and outflow exposures and the difficulty of statistically estimating the probability of future changes to the yield curve as expressed in futures markets. This quickly becomes PhD-level math.
The basics of the IRS, and of other derivatives that manage cash flows, are the kind of thing that many newcomers to finance know little about. Interviewers at investment banks won’t expect first-year analyst interviewees or interns to know about these kinds of things. But the newcomers who are aware of these kinds of products will have a tremendous advantage when they get into the daily grind of finance and quickly discover that it is much, much more than Warren Buffett-style stock picking.