Derivatives used by Latin corporates and U.S. equity index investors are helping resurrect the Latin American capital markets.

By James Lacey

Reports of the death of the Latin American capital markets have been premature. Two years after the peso meltdown, there are new signs of life. And oddly enough, the resurrection is due in no small measure to the derivatives promoted by banks, investment banks and derivatives exchanges operating in the area.

The products have helped Latin American companies-not just Mexican ones-get access to funding in the most difficult financing environment imaginable. While the rates aren't what an American corporate would consider reasonable, at least funding is available. Other products have encouraged U.S. institutional investors to return to the region's bourses through a variety of relatively liquid indexed products that allow them to increase or decrease their exposure with unprecedented ease.

Innovative debt

For corporates, the region's most common type of derivative transaction is commonly known as a monetization play. It has allowed companies to use the equity positions to build funding structures with many of the characteristics of debt funding.

To date, two types of structures have dominated this field. The first is a simple straddle strategy, whereupon a company sells its stock to a bank and then buys a call option, while simultaneously selling a put to the bank for the same stock. Because of the limited risk to the bank, this market has been dominated by investment banks.

The second structure is a debt-equity swap that has almost the same payoff characteristics of the first structure. A company sells its stock to a counterparty and buys back the return on that stock through a swap deal usually at a cost of Libor plus a margin. The cost is substantially lower then the firm could have gotten by approaching the debt markets directly.

This is most directly a lending game and as such it is dominated by commercial banks, with European (particularly French) banks being big players in this market. The major risk is that there will be another massive downdraft in the market that will leave banks' Latin counterparties unable to met their payment obligations. It is this uncertain credit risk that is cited most often by investment banks that have tended to shy away from this type of deal structure.

Jean-Marie Barreau, head of equity derivative sales at Société Générale, says that most of the action that his firm is seeing consists of people or companies using derivatives to monetize positions so that they can make short-term loans to their companies without actually giving up equity control. He says that many of these companies are desperate for cash in order to finance operations and pay down some of their previously incurred debt. This seems to be especially true in Mexico where the economic environment has not yet stabilized and monetized positions are being continuously rolled over instead of reversed. Barreau says monetization trades were also common in Brazil and Argentina early in the peso crisis, but these economies had stabilized sufficiently by last July and there have been very few rollovers of positions in those countries.

James McNulty, a managing director of Swiss Bank, sees the same type of action taking place, but believes most of the crisis funding has vanished. "Companies are now making reasoned decisions based on how to achieve the lowest cost of funds. Rather than go offshore to borrow money at Libor plus 400 basis points, companies are doing liquidity deals. By using various combinations of stock sales, and the purchase and sale of options, companies have been creating synthetic debt instruments that generate cash at substantially reduced cost of funds."

Market experts claim that this type of trading amounts to little more than securitized loans, where the firm is actually putting up its own equity as collateral. Tom Clark, head international trader for Morgan Stanley, says his firm is doing a lot of cash-generating derivative trades and is worried about the growing credit risk these deals impose on the market. "Another downturn in the market will cause liquidity to dry up and will greatly reduce the valuations of the underlying equities in these positions."

Option spurt

Dealers report that there has also been a spurt of options use by locals to make speculative plays on their own markets. According to Clark, these plays are almost all short term and reflect no real conviction or commitment to the market. In fact, the most common play in the market is an up-and-out option. The option is based on the purchase of a one-year out-of-the-money call that will pay out the increase in market value if the index goes up 49 percent or less. However, if the index goes up over 50 percent the payout is limited to 15 percent. Obviously the locals are not expecting a massive surge in the markets. On the other hand, the trade is generally bullish and demonstrates that that local investors do not expect any further declines in the coming year.

David Neubert, a trader at Morgan Stanley, also sees an increase in options use throughout Latin America and attributes it to the reduced implied volatilities which have recently dropped from the mid 50s to low 30s. Other factors include a general rise in Latin American markets that has generated substantially greater levels of call writing and the need to hedge gains in portfolios. In fact, Neubert claims that the writing of over-the-counter puts against an entire portfolio is becoming a major force in the option markets.

A number of bullish local investors are willing to purchase one-year calls against the market or specific segments of the market. These deals are usually being done in the U.S. and for dollar values. Dollar-value options expose the investor to substantial currency risk but because they are priced using U.S. interest rates they are usually half the cost of options priced using local interest rates.

Public deals

Activity in the public markets is also increasing. Deals are being placed in the market that are only possible because of the embedded derivatives in the structure. In late March, for instance, Nortel, a 60 percent shareholder of Telecom Argentina, placed 5.95 million "MEDS" (Mandatorily Exchangeable Debt Securities) with a 10 percent coupon and a 15 percent conversion premium. The five-year structure from JP Morgan carries Nortel's credit and is convertible at maturity into ADSs. The issue, priced at $42, traded 1.9 million shares on it first day.

A bit earlier in the year Morgan also put together a PERQ security to assist Brazil's Telebrás in raising funds for an expansion project. Without the derivative structures embedded in these deals, allowing for future equity participation, it is doubtful that these firms could have found funding even at rates approaching double what they are currently paying.

Warrant action

Swiss Bank's McNulty indicates that this may be the tip of the iceberg. He says there are few signs, as of yet, that the retail warrant market is returning to 1994 volume levels; current levels are less than 25 percent of the volume witnessed two years ago. He expects, however, to see more and more equity linked debt issues beginning in the second half of this year. His expectations are tempered by the fact that two $100 million plus warrant-linked deals that Swiss Bank was already working on, one in local currency and the other denominated in dollars, may be experiencing some delays.

No one is making any predictions as to how warrant-linked deals will be greeted when they do make their triumphant return to the market. However, the odds are that there will have to be some very favorable pricing to entice investors to return. "A lot of people that were long warrants got really screwed and volumes have dropped to nearly nothing," says one dealer. "They are not going to forget that beating quickly." He admits, however, that there has been growing interest in warrants based on equities in the key Mexican index, the Indice de Precios & Cotizaciones (IPC).

Morgan Stanley's Neubert sees this as a positive development. "Warrants," he says, "tend to really make their appearance at market tops. The time to get into the equity market is before warrants predominate and then get out when they begin to flood the market." He has detected no great interest in warrants with the exception of one-off deals usually structured for legal reasons by offshore subsidiaries and arranged in Luxembourg. For instance, an investor may desire exposure to all Latin American bottling companies. An investment bank would structure an index of these firms in a Channel Islands subsidiary and then sell the warrant/option on that index to the investor through the Luxembourg Exchange.

Allocation interest

Investors may continue to shun warrants, but they aren't completely adverse to investing in Latin America. Says Neubert: "We noticed a big rush of money in the beginning of the year, but it has slowed to a trickle now. All indications were that the rush was the result of global asset allocators rebalancing underweighted Latin American portfolios." Most active market participants attribute the latest run-up to the same cause and usually comment that most of these investors have now adopted a wait-and-see attitude.

For the most part these allocators have been basing their investment decisions almost entirely on the purchase of indices or their specially constructed surrogates. Peter Marber, head trader at Wasserstein & Perrella, sums up the case for the use of indices rather than a specific selection of stocks: "Research report after research report has stressed that when it comes to investing in emerging markets it is much more important to have the country or region right then it is to make the best selections within a region."

Indices, along with equity swaps, which were also very popular at the beginning of the year, provide the most efficient ways to enter a market or to rebalance portfolios. Passive investors are currently providing the bulk of new funds going into the Latin American markets today. Morgan Stanley's Clark sees this as very beneficial both for the derivatives industry and the markets in general. He says most of these investors did not sell out when Mexico collapsed, that "Mexico may have slowed down the rate of investment, but it did not make these investors sellers." This flies in the face of what has been generally assumed. Many governments in the region and other observers have worried over the growth of index investing, fearing that the efficiency with which indices let investors shift funds will lead to further troubles.

Currently meeting the demands of investors for emerging markets index products are Morgan Stanley, the International Finance Corp. (the private investment arm of the World Bank) and, lagging well behind in market penetration, the Financial Times/S&P Index. These indices are usually licensed to investors so that they can be used to establish usually passive investment funds. Morgan Stanley's Clark claims that his firms' indices have an advantage over the IFC's and that there have been 19 conversions in the first quarter alone. He attributes a good portion of this to the fact that many investors who use Morgan's indices for developed markets want to use the same methodology for their emerging markets investments. When asked about the 19 conversions an IFC representative asked, "Is Morgan Stanley selling an investment product or peddling a religion?" He added, "Of course you know we still have a 75 percent market share in emerging markets indices."

Steve Schonfeld, head of index and derivative products of the IFC, is expecting tremendous growth in the licensing of its indices and related products. He says that the IFC is in negotiations with a number of exchanges to create derivative products based on its emerging market indices. The IFC has recently created a Latin 50 index, and Schonfeld says that it is in the final stages of an agreement with a unnamed dealer that will create various over-the-counter swap and option products based on the index. "Latin America holds tremendous promise for us based on proximity, time zones, market transparency and increasing liquidity."

Exchange Explosion

The exchanges have not been slow to catch on to this trend. Both the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE) have already begun trading the Indice de Precios & Cotizaciones. According to Morgan's Clark, it has generated a lot of interest very quickly because of the wide range of OTC products already based on the index. To date volumes on the contract have been low, but Morgan's Neubert says that is due to regulatory restrictions in Mexico that prohibits local brokers from posting margins on the index in the U.S. When these restrictions are lifted, says Neubert, "The IPC futures and option trading in the U.S. will explode."

Joseph Rizzello, executive vice president of the Philadelphia Stock Exchange, says that: "In coming months, the exchange expects to list a wide variety of products based on futures, options on futures, currencies, interest rates and stock indexes from Latin America. This is in addition to contracts on the Mexican peso and Brazilian real that are already trading successfully."

Besides index products, dealers report that there has been an uptick in option and ADR activity in the past several months (see box on page 23). The reasons are simple. Dealers report a lot of interest from locals who find that ADRs are the easiest way to invest offshore money. ADRs provide a lot of other benefits, including tax advantages, ease of settlement and favorable transaction costs. Non-locals have been primarily using ADRs for hedging purposes. Through the ADR pink sheets they can gain access to over 75 percent of the markets. It is much more cost-efficient to realign correlations on a daily basis with a 3 cent commission than with the 40­50 cent commission required on local markets.

So what does the future hold? Swiss Bank's McNulty says, "All of what has happened in Latin America has been part of a predictable boom­bust cycle." In the first part of the cycle, after a bust, the type of activity outlined above predominates. McNulty see some evidence that the first part of the cycle has run its course. "In the second phase of the cycle come the IPOs and the return of the retail investor. This is followed by a considerable growth in hedging activity to protect all of the gains from the second phase." Most other participants agree that the Latin American markets have returned to the familiar boom­bust pattern of yesteryear, but are very reluctant to look out in a market and make predictions. As one participant says, "Two years ago everyone got caught with their pants down. You would have to be a fool to predict what the market will look like in a year. On the other hand, I am bullish."

''Mañana" has till very recently been the story in Latin American equity derivatives-understandable in an environment prone to hyperinflation, robust interest rates, financial immaturity and fragility. Not so in Brazil. No country has striven harder to create equity derivatives products. Options volume on the Bolsa de Valores de São Paulo, or Bovespa, has risen from 12 to 19 percent of a steeply rising turnover-much of it in covered calls. Although technically contract periods can run out to a year, one or two months is the norm.

São Paulo's derivatives-specific Bolsa de Mercadorias e Futuros experienced a 150 percent annual growth rate between 1990 and 1994. In part because its contract sizes are teensy, BM&F counts itself the third-largest futures exchange in the world. Most of its derivatives are based on gold, U.S. dollar/Brazilian real (the biggest contract), the Bovespa index and interest rates. An interbank deposit index option is the biggest contract at the Bovespa's smaller rival, Rio de Janeiro's Bolsa Brazileira de Futuros (BBF), which has no equity products. All in all the total annual volume of listed and unlisted equity derivatives in Brazil this year probably has a notional value of less than $1 billion.

Viewed from New York or London, this is certainly pequenha cervesa, or small beer. And although the OTC market is clearly the bigger of the two, there are clearly impediments to progress there, too-not the least being the high cost of hedging. Most of the recent demand, in fact, has come from investors seeking exposure, not protection.

Recently fund managers have been using equity swaps as cheap access vehicles to these markets, for instance where the return on an equity index is swapped for interest on the nominal value at some discount to LIBOR. These swaps eliminate share dealing costs and withholding taxes and sidestep foreign investment and capital repatriation rules. Yet while this market is fast-growing, the most generous guestimates are in the $500 million range for Latin American markets, a minuscule fraction of these equity market capitalizations (See chart.)

Derivative usage might be far more evolved had it not been for the peso crash of late 1994, whose hangover has yet to clear. But the good news is that the climate is fast improving. For one thing, governments have become more active and more skilled in fixed income and commodity derivatives markets and are encouraging local financial institutions to do likewise. Then, too, the Buenos Aires Stock Market (Bolsa de Comercio) is working on an agreement with the CBOT to develop a futures and options exchange.

Last June Brazil's Commissão de Valores Mobiliarios became a signatory to a declaration signed by 14 other international futures exchanges to enhance market supervision and the international safety net. Also last June the Mexican Stock Exchange declared itself ready to launch a derivatives market. The first product is likely to be futures-based on the key Mexican index, the Indice de Precios & Cotizaciones (IPC). Manuel Robleda, the bolsa president, says that this will be "a transcendent step" for the local markets and the economy as well.

In many respects events south of the border are being driven by puppet masters in Chicago and other financial centers, forcing local exchanges to improve procedures and innovate. Which is one reason that early last July Bovespa introduced a power sector index of mostly state-owned companies and began options trading on it; a private sector index will be launched later this year. A few days later the BM&F added stock indices-the IBOVESPA and the private sector Getúlio Vargas Foundation Stock Index, or FGV-100-to its OTC transaction booking and clearing registry.

And there is no better instance of the globalization of listed derivatives markets than the listing last May of Mexico's Indice de Precios & Cotizaciones on the CBOE (cash settled options) and the CME (of futures and futures options).

As this struggle continues, it is by no means clear that the Latin exchanges will not lose heavily against both listed and unlisted markets. For instance, last May Crédit Lyonnais issued 750,000 American-style call spread warrants on a basket of four leading Venezuelan shares. "This unusual issue," said a bank spokesman, "came in response to a surge of recent interest in Venezuela, especially among those investors who don't want to get involved in local details." The issue is listed in Luxembourg.

The same competitive forces have and will continue to affect individual stocks, too. In September 1995 the listing of Telebrás ADRs in New York had a devastating impact of Bovespa volume-since Telebrás, the state-run telephone conglomerate, accounts for about half the exchange's volume.

Long-term it is hard to see how the Latins can win this fight against such powerful offshore opponents.

To invest in Latin American equity-related derivatives, the best place to head is the U.S. Although Brazil has an established derivatives exchange, for pricing and flexibility the U.S. exchanges are still the best bet for foreign investors and, increasingly, local investors.

On the American Stock Exchange, two ADR options are continuously among the top 10 most active: Telecomuncicacoes Brasileiras S.A. (Telebrás) and Teléfonos de Mexico (Telmex).They typically follow closely behind such U.S. bellwethers as Intel and Motorola. For all of 1995 Telmex finished as the ninth most active option on the exchange, trading almost ten million contracts. Telebrás options are a more recent listing, but in the first four months of the year they finished in 18th place, with almost a quarter of a million contracts exchanged. This popularity is also reflected on the Chicago Board Options Exchange (CBOE) where, in the first quarter alone, Telmex traded almost a half a million contracts and Telebrás was well over the 100,000 level and growing significantly.

Telmex interest is declining though, say brokers, who claim that devaluation of the peso has been fully played out. And activity in Telmex options has never returned to the volumes seen in pre­peso crisis days. Some brokers claim the total option market is only 20 percent of previous volumes.

But that trend may be about to change. "That this market has hit bottom in terms of volume and there have been some surprising upticks recently that signal a coming resurgence," says Scott Kilrea, a primary market maker on the CBOE. This sentiment is echoed by Kieran Duffy, an Amex floor specialist: "Individuals and speculators are beginning to come back into the market, especially rich Latin Americans who are tired of seeing their money erode and who have a better feel for individual stocks then we do here." Kilrea says that as much as 80 percent of the interest on the exchanges is being generated south of the U.S. border. "They want to play in their own country with U.S. currency in order to avoid devaluation," he says.

Of course arbitrage remains a key driver in the market. Thomas Wales, a floor specialist on the American Stock Exchange, says: "Local investors can buy in Latin America and sell here for a profit." Thomas Frankel of Frankel Option Brokerage, which represents several Latin brokerages, sums up the reason Latins come here: "Big-time arb plays and the exciting possibilities."

A more prosaic reason for Latin Americans to come to the U.S. is tax avoidance. "A lot of big Latin banks and institutions are here because of a need to diversify efficiently and as part of carefully crafted tax avoidance plans," says Duffy. Many brokers report a surge in option transactions on specific taxes that coincides with dividend dates.

For the Latin American derivatives market to return to the volumes of yesteryear, foreign investors will need to join the locals. This requires a commitment by the large U.S. and European institutions, which have so far shunned individual stocks in favor of indices and other specifically created baskets. Brokers and Latin market watchers are hoping that recent economic reforms and the stabilization of some of currencies in the area will begin to draw the investors back.

Opportunities nevertheless abound for the strong of heart. "Investors will do well to keep an eye on Brazil," says Duffy. "Telebrás will replace Telmex as the most-watched option and will bury it in volume terms in the next couple of years." Kilrea completely disagrees: "Telmex will always be the biggest-traded option on the exchange and nothing will rival it soon. As Mexico continues to recover that is where money will be made."

By John Thackray

Mention currency risk to most emerging equity market investors in Latin America and you'll likely get a shrug of the shoulders. There are several reasons for this widespread disinterest. One is their common belief in a correlation of equity and currency movements that offer a buffer to currency swings. Two, many reason that potential equity returns are fat enough to absorb any likely currency devaluation. Three, even when an investor feels a strong rationale for hedging-scared by some manifestation of the area's fabled instability-he will likely find that there is a paucity, sometimes a total void, of cost-effective emerging market FX hedges.

This third objection, however, has somewhat evaporated thanks to the recent popularity of offshore nondeliverable forwards among both direct and indirect investors in emerging markets. Nondeliverable forwards can be had in a variety of currencies, from Chinese renminbi to Hungarian forints, but they are most populous in Latin American currencies which have become more commonly used by asset managers and speculators in Brazil, Mexico and to a lesser degree Colombia.

Easy shopping

The nondeliverable forward, which began life about five years ago as a trade hedging product, has lately become a standard offering of most big international banks and FX dealers. (Some of the more prominent players in the field are rumored to be ING, First Boston, Bankers Trust, Standard Charter and Citibank.) To be sure, they're not always delighted to get into these transactions, but most of the time they do it because clients want one-stop shopping.

These instruments have documentation similar to and behave much like a forward rate agreement, where two parties cash-settle their opposing bets on currency movements. For instance, an investor in Mexico who is suddenly nervous about the peso short-term will call up a London or New York money center bank and buy dollars forward and arrange for the bank to guarantee, say, a 790 forward rate. If at settlement time the spot is 800, the bank will pay ten pesos in dollar equivalent. The transaction would trade pretty close to interest rate differentials, with a small premium charged by the bank for the fact that they settle in dollars. Except for the dollar settlement, their structure is not very different from the local cobertura market.

Brazilian real forwards are available locally, but not every equity player is willing to assume the necessary counterparty risk with a Brazilian bank. Another alternative, putting on real hedges at São Paulo's Bolsa de Mercadorias e Futuros, has the disadvantage of high costs, due in part to high local interest rates compared to New York. There is a further possible drawback for some users: an inadequate maturity structure. "Basically the liquidity is generated by the São Paulo contracts," explains one banker. "Most deals are done upstairs and then washed through the floor. But there are only two contracts, so the maximum you can have is six months. Beyond six months it really disappears and, depending on where the maturity is, it could disappear after three or three and a half months."

Most dealers warn clients not to expect much in the way of liquidity. Mexico's is adequate most of the time, especially compared to Brazil's. Coming up a long way behind either are the markets in Argentinian pesos, Chilean reals and Colombian pesos. Most trade on news, generally bad news, that causes customers to bid up the forwards. Then when the negative rumors subside the market could be dead in the water for weeks at a time.

As with so many hedging products, availability is sometimes inversely correlated with user need. "You'll find periods when, say, you can get Colombian peso nondeliverable forwards easily, by which I mean five million for two months. And this can go on for months and months," says a banker, who adds: "Then suddenly there is a rumor of a devaluation, or some horrible change in the government threatens, or some new law, and suddenly everyone is the same way. So you get 50 to 60 end-users inquiring of the four or five banks involved, begging them to be counterparties to what is effectively a sale of the peso. Just when you need it most, the market dries up."

The nondeliverable forward market got a real shot in the arm in 1994, when Prebon Yamane initiated an interbank market. Prebon started with a focus in Mexico, trading nondeliverable options, which are traded to this day. However, forwards proved to attract the biggest volume. In the early days there were fewer than half a dozen banks in the game. But others were soon attracted by the fact that they didn't always have to do these forwards and keep them on the books till maturity when, instead, they could lay off their risks in the interbank market. This market was probably helped by the fact that some banks anticipated the eventual Mexican devaluation. Says Prebon Yamane's Ross Pearlstone: "A few months before the Mexican peso crisis hit, one or two banks anticipated the devaluation and wanted the help of a broker who could assess the flow of the market to help them grow a position. Building off our existing involvement in Mexican markets, Prebon was able to step right in and provide that service, and I think the interbank market really took off from there."

One of its benefits has been to enlarge the size of transactions. According to an options salesman at a money center bank, "You can get size done, though usually not all at once. In the interbank market $20 million in one hit would be a reasonably large amount, for example. Four lots of $5 million would be much more manageable. We'd be able to do it in days."

Shaky status

Nondeliverable forwards have a dubious legal status, at least from the perspective of some Latin American central banks. That's why they're sometimes called a grey market. "Some central banks tolerate them. The Bank of Mexico knows these things exist," says one banker, who like many others declined to speak on the record, because, he continues, "Other countries look severely at them and don't take them lightly. They have a more Machiavellian view and think that banks are aiding and abetting portfolio speculation without regard to central bank guidelines." Some dealers recall that several years ago Venezuela's central bank had a real snit about nondeliverable forwards and made a number of threats to impair the local banking operations of any perpetrator. So, notes one banker, "Some of the deals are done principal-to-principal offshore."

Estimates of total market size for any currency are impossible to come by. Yamane claims to do about 80 percent of the brokered business in nondeliverable Mexican forwards, but that is far from a stable flow. While on many days they'll trade between $30 and $50 million, there are plenty of times that the market surges or withers. "Emerging markets can grow nervous very quickly," says Pearlstone. "When the peso is active and interest rates are moving around, we'll see a lot of hedging transactions. There have been days when we've seen as much as $100 million go through. But on a quiet day, we might see very little activity."

Under such conditions the costs of any nondeliverable forward are bound to yo-yo up and down. "In any currency that doesn't have a mature forward market, or even allow one to exist for that matter, or which lacks a well-developed local paper market, you'll see the interbank players willing to step in and take the wide bid and asked spreads," notes J.D. Cronin, vice president at the First Chicago National Bank. In Brazil local tax regulations make these deals particularly costly. A 7 percent withholding tax on "on any spot position makes it incredibly expensive," according to Cronin.

Dollar-to-local currency interest rate differentials also drive the price of nondeliverable forwards. "Recently you've seen them come up in the Venezuelan bolivar. Because interest rate differentials are between 40 and 50 percent it "invites speculators to go in and take a chance on the currency depreciation not turning out to be as steep as is expected in the buy price," says Cronin.