An economy in trouble is good news for derivatives dealers.

By Margaret Elliott

Bad news and good news are equally welcome to derivatives dealers, who thrive on uncertainty. And there's plenty of uncertainty to go around in Germany these days. As it becomes clear that Germany will be unable to meet the economic criteria for entrance into the proposed European Monetary Union on January 1, 1999, the country's debt and equity markets are on edge.

The Germans, you'll recall, are the prime movers for EMU in Europe. So its no small black mark that the country's litany of distressing economic statistics just keeps on growing: unemployment at 12 percent and growing; growth stuck at just 2 percent; a potential budget shortfall of 2.9 percent; and a certainty that Germany won't be able to meet the EMU benchmark of debt at 60 percent of GDP.

With these woes it is no surprise that derivatives dealers in Frankfurt are doing a brisk business in warrant products on the DAX, the German stock market index. The most popular version today, according to equity derivatives trader Bogdan Oprisan at Dresdner Bank, are rolling strike puts, which help investors to lock in profits. The DAX briefly hit 3,500 earlier in the year, he notes, and German fund managers are now seeking to protect the money made in last year's huge run-up. "Everybody in this market has cold feet. They want to stay invested, but they want insurance."

Stock strikes

Traditionally, German corporate, institutional and retail investors have steered clear of complicated structured derivatives products, particularly on the DAX. The country does not have a history of domestic equity investment, though that is changing, as the successful flotation of Deutsche Telekom last year proved.

Nevertheless, last year saw a number of innovative OTC equity derivative products and a greater use of listed options on the Deutsche Terminborse. "Interest began to pick up at the turn of the year, but since the middle of February, as the market has moved up and volatility increased, there has been even more interest," says Laurent Bouyoux, an equity derivatives trader at Commerzbank Financial Products. "Technically, the smile is very sharp on the downside and that is very unusual in Germany."

An example of a recent structured product would be a rolling strike put on the DAX 30 to the end of the year. "If it is structured at 5 percent out of the money, then if the market goes up, it resets and the strike goes up 5 percent as well," explains Oprisan. "This is issued as a private placement with a zero-coupon guaranteed portion and the warrant is attached." A relatively short-term product like this would be attractive to German mutual fund managers, as it is neither too complicated nor too expensive.

Another short-term trade popular today is the compound option. Here a manager buys a three-month call on the DAX 30 (or DAX 70, or a particular sector or basket of stocks or indices), and at maturity, the manager has the option to exercise the call for a put out six months in the future. The attractive feature of this type of structure is it can provide rolling protection.

The cost of the protection depends on how you choose the strike price. "If the strike is higher, the call costs more, but the put is lower. If you don't spend much on the call, then if the market crashes, you've bought an expensive put. It depends on how you view the risk," says Oprisan.

Interest in locking in gains for longer periods is also attractive to German insurance fund managers, who do not typically use derivatives products. That means they use longer-term equity linked notes, a zero-coupon bond with a linked call/put structure. Unfortunately, when the yield curve is flat, as it is today, at-the-money options make these products too expensive for most investors.

The success of equity derivatives in Germany can be traced more directly to the use of such products for exposure into some of the closer emerging markets in eastern Europe. Now that volatility and uncertainty are coming closer to home, domestic investors are looking to receive the same type of insurance in the home market.