Funds are pouring in, corporate activity is at a peak and the market for Latin American derivatives is back with a bang.

By Margaret Elliott

It isn't 1993 anymore in Latin America. Gone is the unbridled optimism. Gone is the conviction that markets can only go up. Gone is the embrace of exotic derivative structures that could only be termed speculative.

Today, the major three markets-Mexico, Brazil and Argentina-can almost be considered staid. "It's as though the Mexican peso crisis finally forced these governments to take control of their financial and economic futures," says one senior banker. And given the series of economic crises that have rocked the region in the last 20 years, a little stability is long overdue.

The maturing of Latin American markets is drawing investors and corporates back. The attractions, in fact, are still the same. Even during the panic of 1995, no Latin American country defaulted on its sovereign debt. The drastic fiscal restraints enforced in many Latin American countries have pushed down inflation dramatically across the region. And after a year of relative economic stability, growth is returning to the area-real GDP growth could be 3 percent in Brazil and Mexico and 4 percent in Argentina, according to JP Morgan.

But the memories of singed fingers are still fresh, and cautious optimism has inspired even the most bullish investors in the region to use the derivatives markets for products that provide the desired exposures with a degree of risk control.

Banks continue to dominate the playing field in Latin America with customized over-the-counter structures designed to meet specific investor and corporate demands. Yet the proliferation of exchange-traded products in the United States is driving liquidity forward by leaps and bounds. Most of the OTC activity in the past year has centered on equity and fixed-income derivatives. There is rising interest, but still little activity, in credit derivatives. Currency derivatives are lagging behind, hampered by dramatic changes in liquidity.

Latin ranks

The new respectability of the Latin markets makes it easy to forget that they are still classified as emerging. Mexico, Argentina and Brazil are clearly in the top tier, with exceptionally developed domestic markets and substantial domestic players. Brazil boasts one of the largest and most liquid derivatives markets in the world (see box on page 16).

In many cases, investment interest from foreign players has been matched or even exceeded by capital from domestic sources. In Brazil, for example, much of the new money is flight capital that has been reinvested now that stability has returned to the region. Domestic support is also a key reason why the Latin American markets recovered so quickly from the catastrophe of two-and-a-half years ago, according to Silvia Campo, a vice president at Bankers Trust.

Although Latin America has regained access to the international capital markets for financing and has regained investor confidence in its assets, the cost in human terms of reviving this international confidence has been enormous. Mexico endured a bruising recession, with soaring unemployment and a dramatic deterioration of living standards. Brazil's controversial "real" plan has left it with an enormous budget deficit financed with a disturbing amount of short-term international debt. But Brazil has succeeded in reducing inflation and building up a nice reserve nest egg of $60 billion.

Though the news from Latin America is generally good, one indication of the new mood of caution is the reaction to the recent turmoil in the U.S. bond market. Even though these markets do not move in lockstep with the United States at all times, investors in Latin bond markets are keenly aware that any moves by the Federal Reserve Bank will show up in the bond markets from Tijuana to Tiera del Fuego. "In the beginning of the year, investors were buying protection against the downside," says Varun Gosain, head of trading for emerging market derivatives at Banque Paribas. "But since the middle of February, they have been sitting still."

Most complex investment strategies across all asset classes are characterized by a greater need for care and control. It's here, says Robert Hedges, managing director in charge of derivatives trading for ING Barings in the Americas, that "you see investors moving beyond simple, plain vanilla hedging to more sophisticated structures. But the motivation remains hedging, not speculation. Investors are a bit nervous at the moment."

Fixed-income investors seek yield in Latin America. But with the application in the last two years of draconian economic policies by governments across the region, inflation has been tamed, and economic and employment growth curtailed. Yields here simply don't compare to those in, say, Russia.

Because of strong and liquid cash and repo markets in Latin American sovereign debt in the larger markets, OTC derivatives are usually only structured for longer-term international fixed-income fund managers. Demand for these products, which can include structured notes and total return swaps, continues to be high. "These aren't return-enhancement products," stresses Reza Ali, an emerging markets derivatives trader at Bankers Trust. "Investors sell calls against their portfolios or use option spreads to hedge positions by buying puts and selling calls. They aren't looking for leveraged plays."

Better debt

The biggest news for fixed-income derivatives in Latin America is the move away from collateralized bonds, although the price has been high. It's been a year since Mexico issued its first global bond issue for the purpose of retiring a portion of its outstanding Brady bonds. The $1.75 billion deal was priced at a stunning 552 basis points over Treasuries, demonstrating that countries that need to raise money do not worry about the niceties of how they do it. "You don't worry about perceptions until you can afford to," says one Latin American derivatives observer. The issue has opened the floodgates for Latin American debt in 1996. Some $60 billion in Latin debt was issued last year; the trend continues this year with some $7.2 billion issued thus far.

All this is important news for derivatives players who watch the Brady bond market. Although no new Brady swaps have been issued yet, it is clear that the yield curves of Bradys and Latin Eurobonds are converging. "The activity in the derivatives market has grown in line, or a bit faster, than that in the cash markets," says Paribas' Gosain. With greater volumes of Eurobonds to balance the Bradys, players have stepped in to arbitrage the two using a variety of OTC and exchange-traded products. "The ability to go long and short is still confined to instrument vs. instrument trades," says Gosain. "Even though yield-curve plays are developing, the majority of the activity is not there."

In some respects, Brady bonds have hampered the activities of derivatives specialists in Latin America. "Bradys are inefficient and have been overpriced," says Rick Beston, vice president for emerging markets debt and derivatives at Societe Generale in New York. "That skews any derivative pricing." As an example, he cites the 620 basis points over U.S. Treasuries of the Brady composite (including non-Latin issues) vs. a comparable BB asset in the United States, which yields about 250 basis points over Treasuries. "As yields fall back into line, relative-value trades and other more sophisticated fixed-income derivatives will be more possible in Latin America," Beston says. Moreover, Brady bonds, which are collateralized by U.S. Treasuries, are expensive for the issuer and don't meet the needs of investors. Mexico netted $600 million when it released the collateral in its Brady swap last year. "Investors want pure-play fixed-income products, not hybrids," says ING's Hedges, who adds that investors are now sufficiently confident about "either the pure sovereign risk of a Mexico or Brazil, or their own ability to manage or hedge that risk."

It is difficult to strip out the U.S. interest rate risk in a Brady bond because of the restrictions on trading the zero-coupon collateral. Repackaging of Bradys as pure plays on the sovereign risk has been done on Brazilian as well as Nigerian and Bulgarian bonds. But a somewhat easier structure to hedge-at least for the issuing investment bank-is the special purpose vehicle, created to hold a single issue and combined with a currency or interest rate swap. "A bond is issued, backed by the floating rate Brady, sold near par, usually with a double-digit coupon and often in a different currency-Swiss francs or Deutsche marks for retail investors-and in smaller denominations than Bradys," explains SocGen's Beston.

Standard Fare

Liquidity in OTC Brady bond options is quite high. Some $200 billion of these instruments traded last year, compared with just $57 billion in 1993. But the issuance of noncollateralized global bonds in Latin America is changing the nature of these instruments. Volatility on Latin Brady bonds dropped dramatically in the last year. In February 1996, 90-day implied volatility was about 25 percent to 35 percent on the most widely traded Latin Bradys; by February of this year it was 10 percent to 17 percent. Of course the drop was not straight line. Spikes occurred in October and January as the markets consolidated.

The shift in volatilities has changed the original reasons for using Brady options. When volatility is low, they do not represent adequate protection for the risk of the bonds being called. But the options can be bargains for investors who worry that the default risk has not receded as far as the option volatility would imply. It's also useful for those who wish to purchase upside exposure in the form of out-of-the-money calls.

Market participants can't quite believe how long the "de-Bradyization" of Latin America is taking. The 20-year tranche of a recent issue of Argentinean Eurobonds was priced at 462 basis points over Treasuries, while its existing Eurobonds trade at 480 basis points because the country's Bradys trade at 400 basis points. But this arbitrage "is not as wide as it seems sometimes," says Dan Sivolella, head of emerging market derivatives at JP Morgan. "The mechanics of getting the pure sovereign risk out of a Brady bond mean that it is more costly." Although they distort the yield curve, Brady bonds won't disappear soon. Peru is still scheduled to issue Bradys as it finishes its economic restructuring. And even as the larger countries start retiring this debt, other smaller countries such as Colombia and Ecuador won't be able to afford to do so for a while.

Even so, Bradys are a disappearing asset, and thus it is a source of wonder to many observers that the Chicago Mercantile Exchange listed a new quartet of Brady bond options contracts last year. Only the Brazil C bonds have developed any volume to speak of, and the Merc may be wondering why as well (see box). But, says, SocGen's Beston, "expect to see OTC options on globals appearing at an investment bank near you soon."

Corporate access

The range of institutions investing in Latin America is broader than in most emerging markets-and growing. The real difference here is the sophistication and range of local financial institutions. Several factors have pushed the banks to the forefront. Rapidly developing domestic savings rates, strong export-led economies and years of debt restructuring have all contributed to the strength of domestic institutions. So has the development of pension funds as part of some governments' quests for fiscal stability.

While retail demand remains high, particularly in countries like Brazil, the peso crisis forced corporates to reassess their financing and hedging strategies. Necessity became the mother of invention. "Corporates across Latin America used equity derivatives to provide liquidity when conventional sources are costly or not available," says Mary Koveleskie, vice president of global equity derivatives at Deutsche Morgan Grenfell. "That trend continues." It also helped local banks with large stock inventories to access liquidity.

Two types of trades dominate this activity. One is a simple debt-equity swap, whereby a company structures an equity repo, or sale and repurchase of the equity at a cost of LIBOR plus a margin. These trades have become more popular as the economy of the country in question stabilizes. "What drives the pricing on these deals is the exposure to the particular market," says James McNulty, head of equity derivatives at SBC Warburg in New York. "The risk to the bank is whether the stock rises or falls in value, and in most Latin American markets this is determined not by the quality of corporate credit, but the sovereign risk."

The other monetization trade that was popular but has gone somewhat out of favor is a simple put-call strategy. "A company sells its stock to the bank while simultaneously buying both puts and calls on the shares. These short-term trades roll over, keeping the risk exposure for the bank to a minimum," says McNulty. Smaller companies still rely on these types of trades, as do owners of private companies. "In a sense it's horse trading that was used to keep the economies going when liquidity wasn't available," says one emerging markets trader. "But it now provides a real underpinning to economic activity."

The largest corporates in Latin America-Telebras, Telmex and YPF, the bellwether issues-do not need to use so-called monetization trades anymore. That's because the international debt and equity markets have reopened for these credits. Nevertheless, derivatives are usually embedded within these issues to make them more attractive on the international market and to provide affordable funding.

Taking stock

A certain jittery feeling about Latin America is also turning up in the equity markets. In March, Salomon Bros. issued a DECS (debt exchangeable for common stock) security on Telmex, through SBC Communications, which owns a significant stake in the Mexican telecommunications company. It was not a blowout success, though the issue did sell out.

But international equity investors are continuing to use derivatives to gain access to the Latin markets. Many early Latin investors, like the Scudder Latin American fund and the Templeton funds, stayed put when the peso derailed these markets. But the rush of money into international investing since December 1994 has helped develop a new pool of investors that have been in Latin America long enough to have gains to protect.

Since the beginning of the year, equity derivative products designed to protect against downside risk have been selling briskly. "It isn't that we've hit a peak," says Thomas Clark, head of equity derivatives at Morgan Stanley. "It is just that investors have gains in the major markets such as Mexico, Brazil and Argentina on the order 15 percent to 20 percent that they don't want to give up."

Index investing continues to dominate, as it does in other emerging markets. Well-constructed indices from the International Finance Corp. and Morgan Stanley are still the most-used by investment firms seeking to construct passive access to Latin America.

But the return of direct investing, particularly in larger companies, has been fueled by relatively recent exchange-traded options on single stocks listed in both Chicago and on domestic exchanges. "Telebras may be one of the largest single stock options in the world if you combine its volume on the CBOE and in Brazil," says Hari Hariharan, managing director of Santander Investment. He estimates that of the equity business he conducts in Latin America, some 60 percent to 70 percent involves some derivative product, either to hedge the investment or simply to gain exposure. The missing piece of the equity derivatives matrix is finally being put in place, at least in Mexico and Brazil. Both countries are finally allowing more efficient stock lending processes. Like repo, stock lending allows broker-dealers to maintain continuous two-way trading, thus boosting liquidity. Regulatory impediments have hampered the smooth functioning of domestic Latin American markets, but the lessons of 1994 and 1995 seem to have been learned. One group of products that aren't resurfacing with any speed are the listed warrants that caused such problems. Certain over-the-counter warrants are available on baskets of stocks, sectors and some indices, but there isn't widespread naked exposure to these products. They are used in conjunction with other instruments to provide hedging rather than speculation. Dollar trouble Currency derivatives have proved relatively ineffective in Latin America. Corporates, investors and traders all face a range of problems that can be traced to the quirky relationship between Latin American currencies and the dollar. Unlike many Asian currencies, many Latin currencies are not pegged to the dollar, yet they trade in close relation to the U.S. currency. Devaluation remains the region's bugaboo, and currency risk is such a concern for corporates in Latin America that an estimated 40 percent of funds raised for use in the region are swapped directly into dollars. Beyond the counterparty risks associated with any financial transaction in an emerging market, investors and corporates run the risk that convertibility will be curtailed at the point when an instrument matures or a receivable becomes due. None of these risks are easily hedged with the currency instruments currently available. Even where a dollar peg is in place, as in Argentina, one banker asks, "What happens if that peg crumbles? Nothing will allow you to dynamically hedge that position." The Mexican peso, however, has the most liquid currency instruments. Mexican peso options are well-established and enjoy widespread use in the United States. "The Mexican government and central bank have been very supportive of this activity," says Lawrence Schreiber, an equity derivatives trader at Lehman Bros. in Miami. "It is in their interest to promote as many avenues that give liquidity to the currency as possible." One recent attempt to help the liquidity was the launch last summer of a series of rolling puts on the U.S. dollar, which helped the Mexican central bank beef-up foreign reserves and stabilize the currency. Although the puts have been successful, a new version of the product is due from the central bank later this year.

The Return of the Emerging Market Funds Latin America is no longer full of the world's diciest emerging markets. That honor is now firmly held by Russia and several of its eastern European neighbors. But what Latin America offers investors today is what Santander Investment managing director Hari Hariharan terms "the art of the possible." Emerging market investors have figured out, the Mexican peso crisis notwithstanding, that the markets of Latin America-- particularly Argentina, Brazil and Mexico-offer liquidity, variety and growth. And when derivatives are part of the equation, the level of risk is controllable. Hariharan estimates that some 60 percent of equity investments in Latin America and almost 90 percent of fixed-income trades incorporate some sort of derivative-from a simple currency protector to more complicated exit provisions. For global funds, moving money into Latin America has been a two-stage process. Late 1995 saw most global funds bringing their allocations to the region up slowly, after the sharp cutback at the Mexican meltdown. But in the last six to nine months, some funds, such as those run by Templeton, have been overweighted somewhat in Latin America, particularly at the end of last year. The shift into Latin America was a consequence of worries over the booming Asian markets and Latin countries were seen as safe havens. Since the start of the year, however, the passion for the Latins has been mooted as worries about rises in U.S. interest rates and possible stock market slides have kept investors from raising their exposures. But even though the inflows have dried up a bit, no one expects a rerun of 1994. Says Varun Gosain, head of trading for emerging market derivatives at Banque Paribas, the interesting aspect to the recent jitters about Latin America "is that people are staying put. Volatility has dropped in many of these markets, but there's no exodus of cash." Save for concerns over actions by Alan Greenspan, the mood in Latin America is fairly upbeat. "Because of the success of the economic plans implemented by Argentina, Brazil and Mexico in particular, the economic fundamentals are very good and the markets are much cheaper than they were in 1994. Overall, it's pretty optimistic," says Dan Silvolella, head of emerging markets sales and trading for JP Morgan. It's a different kind of investor today, as well. "The Mexican devaluation discouraged the speculative investor," says Silvia Campo, a vice president of Bankers Trust. "Investments have shifted from longer term to shorter term, especially when they include derivatives and there's much less leverage." Because the recovery in the economies was export and investment led, both locals and foreigners have been able to increase their participation in these markets equally. But the key for all Latin investors remains the same: don't forget 1994. It can happen again. As one trader put it: "We don't sell very out-of-the-money puts anymore."--M.E.

Nevertheless, the Mexican peso and the Brazilian real do enjoy certain status in Chicago, thanks to the Merc. According to Phil Ruffat, vice president for Latin America at Sakura Dellsher, "Liquidity is great on the Mexican peso in Chicago; most days it's bigger than the Canadian dollar. But all the activity is in the futures. For Brazil, the activity is in the options and it's all puts in Chicago. That's because no one in the United States wants to sell country risk. There's no open interest in the calls. All that is provided by the Brazilians." Ruffat thinks that it is unlikely that the Merc will list an Argentinean peso contract, but suggests that a Chilean peso would be welcome, though that is not probable because of the size of the economy.

Mexican banks are happy to use Chicago for currency hedging. And that is what keeps the market hot, says Jim Tomitz, head of sales to Latin America for Commerz Futures. "There's limited counterparty credit within Mexico, so it makes sence for these banks to come to Chicago where they may pay a bit more and incur a bit more commission, but do not run up against counterparty limits," Tomitz says.

Credit derivatives hold lots of promise in all emerging market countries, and the Latins are no exception. "Corporates that have had experience with credit derivatives in the United States are very interested in using them to strip out all or parts of sovereign risk that they are uncomfortable holding," says Ignacio Sosa, head of credit derivatives at the Bank of Boston. "But the first line of users we expect to see are international hedge fund investors with interest in receiving the yield of certain smaller Latin countries, but who don't want the sovereign credit risk." As yet, though the potential structures are myriad, there are few takers for credit derivatives in Latin America.

It may take another breathtaking dislocation to hammer home the advantages of credit derivatives. And even though the Latin markets have matured, the structural problems of high and unsustainable debt levels, possible domestic unrest and ties to the possibly fickle U.S. dollar remain. The threat of high volatilities and the risk of sovereign default is always just around the corner. But for now, anyway, Latin America is enjoying its new respectability in the world financial markets.

Looking for Paydirt in Mexican Cetes In the great quest for economic stability, many Latin American countries are pinning their hopes on developing derivatives exchanges. From Mexico to Argentina, new exchanges are due to come on line this year. But the real activity in Latin American contracts is north of the border. In Chicago to be exact. The Chicago Mercantile Exchange is due to launch contracts on the 91-day Mexican Cetes and the 28-day TIIE (Mexican equilibrium interbank interest rate, or domestic interbank rate). It hopes that these contracts will follow the lead of the peso futures and options contracts that have been the fastest-growing contracts ever at the Merc, since launch in April 1995. All four contracts are denominated in Mexican pesos and are used by corporates to hedge peso exposure back into dollars. Effectively, the addition of the Cetes contract would be the equivalent of a Eurodollar contract. But for derivatives traders, the attraction of the new contract would be the arbitrage between Cetes and the peso futures and options. "The key to the success of this contract is whether the Mexicans figure out how to use it." says Phil Ruffat, vice president for Latin America at Sakura Dellsher. "There's a huge problem with mortgages in Mexico-interest rates are too high, people are defaulting and then the government has to absorb the loss. What this contract could do for Mexican banks is to provide cheap funding-which they can't get onshore because there are no interest rate swaps-and help to restructure the mortgage overhang." Nevertheless, Ruffat doesn't think the Cetes contract will fly out the door immediately. He expects volume to build slowly and the bid/offer spread to narrow gradually. The Cetes contract is eagerly awaited by U.S. traders. "The future should be a great success," predicts Robert Hedges of ING Barings. "What would compound that success would be the introduction of interest rate swaps. The only problem I see with the Cetes contract is that by launching it ahead of Mexican regulatory and legal approval, the Merc may be a tad ahead of itself." Though another gold strike is possible with Cetes, the launch has been held up by two potential structural problems. "We're still awaiting approval from the Mexican government to allow Mexican broker/dealers to trade the new contracts in Chicago," says Michael Gorham, vice president of international product development at the Merc. The exchange launched the Mexican stock index (IPC) contract without waiting for this approval, causing hiccups at the outset and eventually causing volume to dry up. It isn't going to make the same mistake twice. (And the exchange is considering moving the IPC up to the second floor, where it would trade with the interest rate and currency products for Latin America.) But of more possible concern are the plans of Mexico to launch its own domestic derivatives exchange with a Cetes contract of its own. "If the Mexicans think that the Merc is going to steal the volume, they aren't going to approve Mexican broker-dealers trading in Chicago," says one observer. It's a bit of stalemate at the moment, with each side waiting for the other one to move. The problem with a Mexican Cetes contract onshore in Mexico is the credibility issue. U.S. corporates and dealers are simply more comfortable trading in Chicago, in part because of the systems and margining support. The Merc's successful peso contract, however, has been the exception that proves the rule. The United States didn't prove to be the right home for the ill-fated Brady bond contracts. "It was a chicken-and-egg situation," says Banque Paribas trader Varun Gosain. "They didn't have the liquidity so they didn't have the volume, and they died." And four U.S. exchanges-the Chicago Board of Trade, the Merc, FINEX and the derivatives division of the New York Cotton Exchange-all tried to launch futures and options contracts on Brady bonds. FINEX was the first to try and fail, in November 1995. Its options and futures on an index of Brady bonds never traded 200 contracts. The CBOT also tried unsuccessfully in March 1996 with futures and options on a range of indices on Mexican, Argentinian and Brazilian Bradys. The Merc had a more promising launch of the futures and options launched on four individual Brady bonds last spring. "We thought that a lot of banks in New York that make markets in Brady bonds might need to lay off this risk with an exchange-traded product," says the Merc's Gorham. Unfortunately for the Merc, the New York banks did not flock to these contracts. In the first three days, the Brazilian C contract traded 1,900 contracts a day-a good start by any measure. But the interest was coming from Brazilian investors. Sao Paulo's derivatives exchange, Bolsa de Mercadorias & Futuros (BM&F), was also watching carefully, and on the fourth day of trading, the BM&F launched a competing product. The volume on the Chicago contract headed south, leaving the Merc contract trading a forlorn several hundred a day. The Merc has returned to the drawing board. Gorham says the exchange isn't giving up the fight, but hopes to redo the contracts to make them a bit more acceptable to traders. One proposed change would be to make the contracts deliverable. Now there's no need to deliver bonds at expiration and therefore no need to make good the bet. "The best thing the Merc could do is to make the Bradys deliverable," says Sakura Dellsher's Ruffat. "Even better would be if they made them deliverable with any of the four Bradys. That would make a real market." The Merc's Gorham says all of the above are under consideration. It's clear that the exchange wants a piece of the very healthy OTC volume in hedging the Brady bonds, at least for the time they continue to be around. Local Brazilian activity in the Brady bond contracts is driven by a regulation that prohibits residents from holding Bradys in physical form. Luis Forbes, marketing representative for the BM&F in the United States, says, "The real customers for hedging Brady bond exposure are in Latin America, not the United States. That's what the U.S. exchanges failed to understand." The BM&F is a formidable rival for any American exchange hoping to get a piece of the market for Brazilian exchange-traded products. It is creative and forward-thinking. And with the recent purchase of the Rio exchange, it may be the second-largest exchange in the world by volume (although lot sizes are smaller than in the Chicago exchanges). The depth and liquidity of the Brazilian market, moreover, is enviable. Because the BM&F and the other Brazilian exchanges prohibit foreigners from trading, many foreign banks have set up domestic broker/dealers to get a piece of the action. "It is important to have a local presence in Latin American markets," says Mary Koveleskie of Deutsche Morgan Grenfell. With the emergence of other derivatives exchanges in Latin America, the opportunities for these locals can only increase. Meanwhile, in the United States, the exchanges will continue to seek ways to gain a piece of what is fast becoming a huge market for exchange-traded derivatives.--M.E.