Interview by Joe Kolman

Ezra Zask has long been one of the most active voices in the derivatives market.

A former assistant professor of finance and economics at Columbia and Fordham Universities, he spent most of the 1980s managing currency trading and marketing for Manufacturer's Hanover and Mellon Bank. He was in the forefront of developing the corporate marketplace for currency options both here and abroad.

In 1990, he formed his own money management firm, Ezra Zask Associates. As a registered Commodities Trading Advisor, he speculates in interest rate and currency derivatives on behalf of institutional clients. His firm works out of a historic landmark renovated train station in rustic Norfolk, Connecticut.

Two years ago, in response to increasing derivatives-related scandals, he started offering advisory services to corporations and institutional investors, including training, consulting and expert witness and litigation work.

Zask spoke with Editor Joe Kolman.

Derivatives Strategy: People have been backing away from derivatives recently. Do you think that's causing a new set of problems?

Ezra Zask: Yes, I do. One of the main reasons derivatives have grown so rapidly is because there's been a rapid increase in market exposure on the part of companies and institutional investors. The growth has been spurred by a real need to control the risk they're increasingly taking on. So by reducing the use of derivatives, they're going to be exposed to market risks that are not being managed in the marketplace.

DS: What's responsible for the increase in market risk?

EZ: A number of factors. Emerging markets are being continuously integrated into the world financial community both for multinationals and investors. An increasing proportion of capital is moving into places like South America, Southeast Asia and China, and Eastern Europe. And all these investments clearly have large risks associated with them.

Secondly, a lot of new risk comes from the increase in volatility that we've been seeing in most financial marketplaces. Previously regulated stock and interest rate markets have been allowed to deregulate almost everywhere, from Vietnam to the United States. With less government regulation and interference, and a dramatic increase in the number of players, there's been a tendency for increased volatility, especially for equities and interest rates. The rise in volatility is less true in foreign exchange, because we had our huge volatilities in the mid- to late 1980s.

Market risk is also increasing because the correlation between the movements of global markets has increased dramatically. That's added to the risk of investing for both corporates and institutional investors.

DS: So there's increasing volatility, but there's also increasing correlation between markets. We certainly got a big surprise in February 1993 in the fixed income markets. Do you think that we're due for the same kind of correlation surprise in the global equity markets?

EZ: I think there's a good chance of it. Almost everyone would agree that one of the main factors behind the worldwide equity market boom has been the decline in interest rates. This is clear in cases like Japan, where the correlation is very close. So you have two major markets-interest rates and equities-that are very closely linked with each other all around the world. And if interest rates start to bottom out or come up again, then the probability is that the stock markets around the world would all come down at the same time.

DS: That sort of destroys all sorts of notions about risk management through diversification.

EZ: Absolutely. If we go back to the fundamental rationale for portfolio management, the first principle everyone recognizes is that diversification is the best way to manage risk. This is the thinking behind everything from multinationals building factories in many countries to individual investors putting money into a variety of different instruments.

It's about the closest you can get to a free lunch. It's a very attractive principle, because you don't have to pay much money to diversify, you just go out and buy a whole series of mutual funds or invest in a whole variety of country funds, and voilá, you're diversified.

DS: But it's not working like it used to.

EZ: Yes, and if it doesn't work, it's going to lead to real problems because the first principle of risk management is undermined. We saw that with the stock market crash of 1987. Until that time, most people felt that if they had a portfolio of consumer stocks, growth stocks, high-tech stocks and so on, the chances that all of them would fall at the same time were very slim. Huge funds and investment houses built a multi-billion-dollar business around diversified stock market portfolios. What 1987 showed us was that in point of fact, all the stocks were very closely correlated and when the stock market collapsed, diversification failed-failed miserably. The same thing happened in the ERM breakup in 1992. There were many billions of dollars resting on certain correlations between those currencies and when it fell apart it led to some really big losses.

DS: And you think the same thing is happening globally.

EZ: Yes, and it can be shown empirically. The correlation between stock markets around the world, for example, has been going up very dramatically to the point where there is more than a 50 percent correlation between the world stock markets. In the world bond markets it's even more pronounced: about 60 percent. So the principle of diversifying risk in different stock markets and bond markets may not be valid if there's a massive turnaround in the markets in general.

DS: Pension funds, of course, have dedicated up to 10 percent of their assets in international stocks in order to get the benefits of diversification. Are you suggesting that strategy is wrong?

EZ: It probably won't afford the level of protection they think it will-and the level it might have afforded them in the past. Correlation is going up dramatically. But that's not to say they shouldn't pursue international diversification because the returns from some of these markets are higher-or will be higher over the same period-than, say, from the US market. The idea is not to throw out the baby with the bath water, but to point out that in pursuing higher returns, they are exposed to higher risk.

This is where a case for derivatives can be made. If diversification doesn't work, it makes a lot of sense to use derivatives such as stock market index futures or options, or interest rate futures or options-

DS: -or swaps based on those indices-

EZ: Absolutely, or asset-based swaps based on portfolios of equities or fixed income. It would allow you to earn a higher return while smoothing out or reducing the risk of holding the underlying assets. If you simply hold the underlying stocks or bonds, you have no overall portfolio protection in the case of a downturn in the stock market. But if you have derivatives in place, you're giving yourself a buffer on the other side.

DS: You can set up a short position.

EZ: Yes. As an investor, you're always long, whether it's equities or interest rates, and by doing a futures contract or a swap, which is just a string of futures, or an option, you get a buffer in case of a market downturn. That allows you to suffer the down period without having to liquidate your portfolio, which can be a very expensive proposition in the secondary markets. As a pension fund, you don't want to be constantly turning your portfolio over. It's much easier to turn over a futures contract.

DS: The dollar has been declining for years, in spite of warnings from many people about an imminent rise. But to a lot of pension funds, the people who have been calling for protection have been crying wolf for too long and their cries are falling on deaf ears.

EZ: There's absolutely no common agreement on currencies and their relative role in portfolio management. The literature goes back and forth about whether currencies are an asset class or not and whether, over the long term, one should or shouldn't hedge currencies. One school says currency risk should not be hedged because it reaches an equilibrium level, and another school says it should be hedged because currencies deviate from equilibrium levels to such an extent that there are profit opportunities. Pension funds like San Diego have increased their allocation to currencies as an asset class to 5 percent while other pension funds have a strict no-hedge policy.

DS: You're a currency manager. You believe in managing currencies.

EZ: When you look at returns from overseas investments, currencies account for about 35 percent of the returns of overseas equity portfolios, and they account for almost 70 percent of the return of overseas interest rate portfolios. In other words, pension funds and mutual funds that are invested in overseas interest rates are in effect making a currency play. This applies to both pension funds and mutual funds that have overseas funds.

DS: That statistic is familiar to some people in the derivatives world but unfamiliar to most people in the plan sponsor world. It's sort of the dirty little secret of international investing.

EZ: One investment manager who manages money for pension funds once told me that although he trades interest rates, what he really does is currency speculation. His mandate won't allow him to go directly into currencies, so he has to use bonds as a surrogate. But at the end of the day, his decision on whether to buy Swedish bonds is entirely based on where he thinks the krona is going.

DS: But managing an international bond portfolio is more complex than that. You've got duration and interest rate levels.

EZ: Of course. But at the end of the day, they only account for less than a third of the return of these portfolios. We saw that in the performance of mutual funds that invested in overseas interest rates. They were first marketed in 1992 and 1993 as low-risk propositions. They were able to pay a higher interest rate by investing in higher-yielding currencies, including the Mexican peso and the currencies of some smaller European economies. Many of these funds got hurt as those currencies devalued in 1992 and 1993.

Then in 1994, everyone expected a higher dollar, so all the mutual funds went out and hedged their dollar exposure. In reality, the dollar came off some more, so they made fairly meager returns. Then everyone went unhedged in 1995 because they got burned in 1994. And just when they did, the dollar started to rally from its low, particularly against the yen and against some of the European currencies. So they turned in a very poor performance.

DS: At the start of 1996, then, we have a multi-billion-dollar US pension fund investment in European and Asian markets that is increasingly unhedged.

EZ: Yes, and they're unhedged along three axes that are fairly closely correlated. They're unhedged in their equity investments, in their interest rates and in their currency investments. More and more these investments have become one-way. Because of the sustained rally in the stock and bond markets and the continued fall of the dollar, portfolios have become very heavily weighted toward stocks and bonds and very heavily weighted short dollars, which makes them very exposed to any shift.

DS: What market scenarios do you think might contribute to the dollar rising 10 percent?

EZ: The whole world is already so short dollars that just prudent portfolio diversification would dictate a move toward dollar buying. That's what we're seeing out of Japan, where the dollar is more than 30 percent off its low. That represents a dramatic strengthening of the dollar because of a combination of very low Japanese interest rates and the Japanese desire to diversify their portfolio and move into US dollars.

DS: What about in Europe?

EZ: The central scenario for a sharp strengthening of the dollar would be if European interest rates went down at a faster rate than US interest rates. That would make US dollar more attractive. To me this is a very likely scenario, given that US interest rates have declined very sharply and European interest rates are behind us in the cycle. It would be very easy for me to see a scenario where the dollar strengthens by 10 percent over the next year.

DS: What would that mean for US pension portfolios?

EZ: Assuming they're unhedged, the equity markets would move against them, and so would the fixed income and currency markets. Even a moderate correction might cost them as much as $20 billion.

DS: It would be a closely correlated triple whammy.

EZ: Absolutely.

DS: What are the most glaring problems you find in your work as a consultant to pension funds?

EZ: Very often the core problem is the lack of a clear definition of what they are trying to achieve in risk management and the use of derivatives. The decisions may very well be made on the line in an ad hoc fashion: for example, "We'll hedge this month, but we won't hedge next month." Almost always, the first step we take is to help them think through what it is that defines risk for them-and what steps they're willing to take to hedge those risks.

The second problem is very often a lack of a consistent policy toward derivatives. A lot of them make blanket statements like, "We won't use derivatives" or "We'll only use one or two types of derivatives." But the great majority of pension fund money is managed by third-party fund managers. This opens up a problem with pension funds because very few have a clear-cut policy of what they look for in managers and what they allow their managers to do. It's almost like passing the buck. They say, "We can't control what our fund managers do." They may have very large derivatives exposures through their fund managers without even knowing it.

DS: They may also have set up some arbitrary derivatives policy that may shackle their managers and prevent them from doing their best.

EZ: Some of the public funds that are managed by legislators tend to be much more conservative. The Wisconsin legislature took apart that state's derivatives program. The same thing happened with the Alaska Permanent Fund. It basically left the pension fund with a no-derivatives policy.

DS: Do you think those policies make those funds more vulnerable than others?

EZ: I definitely think so. It's not to say that derivatives are always the right answer. But it closes off an option to them-it closes off the possibility of using this additional tool-and to that extent it creates problems for them.

DS: What other strategies do you recommend to your clients?

EZ: I see the proper application of value-at-risk as an important step. It's already started to move from the bank sector to the pension fund and mutual fund sector, which I think is very good for the industry. It's a systematic way of thinking about risk in portfolios, although it has some limitations. If you say something has a 95 percent confidence level, it can give you a false sense of security. You really have to apply stress testing. What happens if there is another 1987, or what happens if currencies or the dollar moves up 10 percent, or the stock markets of the world all decline by 10 percent? What does that do to my portfolio?

DS: Where do you think the derivatives market is going?

EZ: One of the heartening things is the incredible depth of the market. Derivatives are more than here to stay. It's developing like a parallel market to the cash market. The depth and the number of participants and the range over the last decade have just been spectacular, and make me feel comfortable and confident that there's not going to be any major threat to derivatives no matter what legislative initiatives are in place.

The derivatives market keeps growing because of the commercial and financial need for it. Look at the success of the Merc's peso contract. If the need is there, some exchange or dealer somewhere will find a mechanism to satisfy it.