By Andrew Webb

The yen is strong, the euro is moribund and liquidity isn’t too bad after all. the foreign exchange markets have managed to survive quite nicely, thank you.

About this time last year, bank economists were gazing into their crystal balls and making dire prognostications about the foreign exchange markets. European monetary union would annihilate liquidity in foreign exchange derivatives in the coming year, they said. Derivatives activity on exotic currencies would remain negligible. The euro would be strong and the yen would be weak.

Wrong, wrong, wrong, and wrong again.

Despite the predictions at the end of last year, the actual scenario for foreign exchange derivatives in 1999 has been almost benign. “I think the worries at the start of the year about the impact of EMU on the foreign exchange market were overdone,” says Arie Assayag, head of global foreign exchange options at Commerzbank in London. While business obviously vanished in crosses that are now EMU members, in the derivatives market many of those crosses have traditionally been beset by liquidity problems anyway. Traders have either been busy making the most of the new pool of euro liquidity or have been moved to work on increasingly active emerging-market currency derivatives. At the same time, traditional foreign exchange derivative punters such as hedge funds have kept a relatively low profile, while corporates and money managers have stepped in to take their place.

In some respects, changes in the underlying spot market have actually increased liquidity. The premier league now consists of three currencies—yen, dollar and euro. Below that are currencies such as sterling and the other major European currencies that opted not to join the first wave of EMU. Finally, there are the emerging-market currencies, although some of these, such as the South African rand, have been pushing hard for promotion. “The lack of liquidity in the individual underlying pre-EMU spot market currencies, which hitherto tended to hamstring derivatives activity, is no longer an issue,” says Australia-based derivatives consultant Satyajit Das. “The net result is far more foreign exchange derivatives activity than most people had anticipated.”

To the cynical, the fact that so many participants initially called the direction wrongly also helped boost derivatives activity. The collapse in the euro’s much-bruited strength (which lasted all of about 18 hours) forced plenty of people to close trades and then reopen them in the opposite direction. Bingo!—double the derivatives volume than if they’d got it right first time.

“People simply got it wrong,” says Nigel Babbage, global head of foreign exchange derivatives at Paribas in New York. “As a result, the market has been consistently bid for euro calls over euro puts.” According to Babbage, the skew of the risk reversal in favor of calls has persisted all year, with any sign of weakness being greeted by a wave of put selling.

The only exception to this has been in the short dates such as overnight or up to on e week. “Even today with the dollar/euro spot trading at $1.03–$1.04, we still see the 25 delta dollar puts are 0.4 above the 25 delta dollar calls.”

The advent of EMU has seen an increase in both volatility and derivatives activity in certain crosses, especially euro/yen. With 1999 being another strong year for transatlantic merger-and-acquisition activity, particularly as U.S. corporations buy into the United Kingdom and Europe, euro/dollar and sterling/dollar derivatives business has been pretty brisk as well. Probably the only dull derivatives cross in Europe has been euro/Swiss franc, since the Swiss government’s firm pronouncement that it had no intention of joining EMU has crushed volatility.

Most of the liquidity in derivatives is still below one year, with many in the interbank market only prepared to quote within that time frame. An increasing number of clients, however, are now actively dealing out to the five-year mark, with some recent trades going out as far as 10 years. Corporate clients dealing in the longer dates have almost invariably been using exotics, with European digitals and reverse knockouts popular, and there has even been some activity in long-dated basket options between other non-EMU currencies.

Yet not everybody is convinced of the benefits of this brave new world. “I think foreign exchange derivatives really do seem to be a function of people’s spot appetites, and a number of factors have conspired to depress those,” says Adam Kreysar, cohead of foreign exchange derivatives at Warburg Dillon Read in New York. Although Kreysar cites the euro as the major factor, he also points to the e-world, as represented by EBS, as being responsible for the disappearance of the middle-tier players in the interbank market. With only the megabanks and niche players left, volumes have been affected.

Kreysar also points to the relative absence of the macro funds from the marketplace. Leaving aside the hangover from last fall, many of them have (in common with most economists) managed to call both the yen and euro completely wrong this year, which hasn’t done wonders for their capital base. According to Kreysar, it hasn’t done much for their activity level either. “When people are doing well, they will take a flier on options—when pinched, they won’t,” he says.

Others are disappointed that the extra pool of spot liquidity in the market hasn’t pushed up activity in exotic currency trades as much as some anticipated. “There has been some increase, but not as pronounced as some people thought,” says Das. “Exotics such as barriers and digitals have become commoditized in the worst sense of the word—that is, no margin in them—so there hasn’t been much incentive to increase participation in the interbank market.”

Convergence, Part II

One aspect of EMU that has caused a flurry of related digitals has been the next wave of convergence trades, especially on Greece, where trades that produce a fixed payoff if drachma volatility falls below a preset level have been popular. Similar popular EMU convergence derivative trades have focused on sterling, and, more recently, there has been an increasing interest in Sweden and Norway as well. Trading volatility rather than absolute price levels has been the typical convergence strategy, with the sale of two-year volatility one year forward being especially popular in sterling—particularly during the first three months of the year.

New business on the buy-Side

Hedge funds and other leveraged players who made wrong calls on the euro and yen early this year may be sitting on the sidelines licking their wounds. But other participants have been taking their place. “An important factor in the broadening range of participants in exotics on European currencies has been improving liquidity,” says Satyajit Das, an Australia-based derivatives consultant. “In those circumstances, people feel more comfortable with the marketplace.” The introduction of the euro has meant that quite a few of those who used to punt foreign exchange spot have found their traditional playing field curtailed. As a result, they have moved into foreign exchange exotics as a means of extracting more bang from the reduced number of trading opportunities available. Conventional “real money” fund managers have assumed a higher profile in foreign exchange exotics during the year, with many using basket options to play currency correlation games. Since many currency markets have recently been following a pattern in which they stay in narrow ranges for long periods and then suddenly lurch out in one direction or another, these managers have also been active in digitals. Some aren’t so convinced about the scale of the conventional fund managers’ foray into exotics. “While it’s certainly true that the real activity has been coming from the real money managers, rather than the hedge funds, from what we’ve seen recently they’ve mostly been using vanilla products,” says Adam Kreysar, cohead of foreign exchange derivatives at Warburg Dillon Read in New York. That’s not entirely surprising when you consider that perhaps 90 percent of all foreign exchange exotic trades involve barriers, and that many of these have already been knocked out this year by a yen/U.S. dollar range of 103 to 126, and a U.S. Arie Assayag, head of global foreign exchange options at Commerzbank in London, hasn’t seen much sign of fund manager activity in the market so far, and cites the obstacles to entry. “Using exotic foreign exchange derivatives involves a considerable outlay in terms of IT and expertise, and while fund managers are more sophisticated than corporates, and some may even have made the leap already, they certainly aren’t in the majority,” he says. Nigel Babbage, global head of foreign exchange derivatives at Paribas in New York, also doesn’t see conventional funds hedging currency as regular business yet. “The yen has been pretty much the only area where there has been a lot of activity, and most of that has been fairly straightforward, such as using call spreads as protection—typically selling two calls for each put purchased,” he says. Frances Cowell, European sales director at Quantec, a fund adviser in London, is more upbeat. “In the past, U.K. fund managers haven’t worried too much about currency risks, which in view of the United Kingdom’s role as a center of international finance has put a cap on the volume going through the market,” she says. “However, they’ve had to endure two years of a strong pound and, as a result, have discovered OTC foreign exchange derivatives in a big way.” Particularly in emerging markets, the potential for further fund manager involvement in foreign exchange derivatives is enormous. Cowell estimates that to date probably no more than the most sophisticated 25 percent of managers are active in foreign exchange derivatives, which could presage a flood of activity as the other 75 percent start to appreciate the sort of currency risks they are inadvertently running via their equity holdings. Another huge and largely untapped source of participants is the U.S. fund market—especially the pension funds. Traditionally, the U.S. funds have had relatively low overseas exposure, especially when compared with their U.K. counterparts. Ten years ago, the average offshore equity exposure for an American pension fund was about 3 percent to 4 percent. That has now risen to around 10 percent to 12 percent, still low when compared with the United Kingdom, where it has been 20 percent for years. The exposure is quite likely to rise further, since many U.S. fund consultants currently recommend 20 percent exposure. If that comes to fruition, the impact on foreign exchange derivatives activity (subject to overcoming the funds’ traditional conservatism) could be considerable, to say the least. There are also signs of increased corporate activity in the market—and, on the distant horizon, the prospect of retail participation as well. “I think corporates are definitely getting more involved in the market,” says Vincent Craignou, assistant director and head of derivatives in local markets at ING Barings. Given the growing proportion of most multinationals’ revenues that is generated in developing countries, and also given the impact of last autumn on many corporate profit-and-loss accounts, that seems plausible. “They are also the people likely to do the most sophisticated trades,” he adds. —A.W.

For example, “If you wanted to be short 2001 sterling volatility—the possible EMU entry date for the currency—you needed to buy one-year volatility and sell two- or three-year volatility in sterling/euro,” says Commerzbank’s Assayag. “However, during the year, in addition to a general drop in sterling volatility levels, the price of long-dated sterling volatility became discounted compared with the one-year volatility because of the popularity of that trade.” Nonetheless, on the back of a surprise interest rate rise from the Bank of England, the volatility situation has more recently returned to more typical levels—so any further excitement from City traders could see this trade quickly swing back into fashion.

This type of trade was also popular in February and March of this year in euro/Czech koruna. Initially the selling of volatility was simply down to the high level it had reached during the turmoil in emerging and G-7 markets between August and October 1998. But by February of this year, after a portfolio liquidation by investors and two rate cuts by the Federal Reserve, the general environment was much improved and therefore volatility was due for a fall.

“After that, the continuing soft trend in euro/Czech koruna volatility on heavy selling of back-end volatility—using straddles—could reasonably be regarded as an extremely premature convergence trade,” says Vincent Craignou, assistant director and head of derivatives in local markets at ING Barings. “The most optimistic bet is that the Czech koruna will join in 2007. But people already seem to have started to focus on it—and, to a lesser extent, the Polish zloty.”

“When people are doing well, they will take a flier on options— when pinched, they won’t.” —Adam Kreysar Warburg Dillon Read

The Russian crisis of last year meant that those who did get into this trade on the ground floor should have squeezed plenty of juice out of it. Back-end euro/Czech volatility was running at about 16 percent toward the end of last year and was still trading at 14.5 percent to 15 percent at the beginning of this year. The substantial move in Czech/euro spot last January saw the cross go from 34.50 koruna to 38.50 koruna and then stop moving, while implied volatility remained high. The market sold heavily into this and volatility levels across the board have fallen sharply—for example, one-year volatility is now down to around 8 percent. With the road to EMU for the Czech koruna and other East European currencies likely to be bumpy, there will undoubtedly be future periods of instability marked by rising implied volatilities. Unless these are driven by a serious crisis, investors and banks are likely to sell back-end volatilities again, taking advantage of the higher levels to enter convergence trades.

“U.K. fund managers had to endure two years of a strong pound and have discovered OTC foreign exchange derivatives in a big way.” —Frances Cowell Quantec

When it comes to emerging markets more generally, there has been an increased level of activity in both currency and product. “Turnover is definitely on the up in emerging-market foreign exchange derivatives,” says Craignou, who singles out the U.S. dollar and crosses with the South African rand, Polish zloty and Czech koruna as being particularly active. While conceding a slow start to 1999, he notes that derivative volumes have been picking up strongly since April. Although it still isn’t earth-shattering, daily turnover is now respectable and it is possible to transact most vanilla trades in decent size. “This reflects the less-volatile atmosphere—it doesn’t always mean that clients are doing much more, but the banks are certainly more comfortable in this environment,” he says.

The net result of this brisk activity has been that the economists’ dire predictions haven’t really fed through to the bottom line in terms of employment. It appears that the much-bruited collapse in activity as a result of EMU was so well-flagged that many banks dexterously shuffled their deck of derivative dealers to cover other markets. Some even attribute the steady resurgence of business in emerging currencies to this atypical redeployment of surplus traders, as opposed to the customary practice of depositing them on the sidewalk.

While certain areas such as Deutsche mark/French franc options have obviously disappeared, these would typically only have occupied one or two traders anyway. By contrast, many players weren’t previously active in derivatives on currencies such as the South African rand—so, for example, instead of having two traders working the EMU crosses, those traders now focus on the rand. “On the spot desk, EMU has had an impact,” says Commerzbank’s Assayag. “But in foreign exchange derivatives, it’s been OK—the prospects are certainly much brighter than a year ago.”

Exotic Currencies: Back From the Dead

Judging by the mayhem in exotic—especially Asian—currencies last fall, you could be forgiven for assuming that the foreign exchange derivatives landscape in those currencies would now be little more than a wasteland. The reality, happily, is rather different, with more than the odd green shoot peeping through. Although trying to put on exotic derivative trades in exotic currencies still isn’t a rewarding task, the recovery in more vanilla products is tangible. “Asian emerging markets have been quite active,” says Satyajit Das, an Australian-based derivatives consultant. “Nothing too fancy, but cash-settled non-deliverable forwards, for example, have become an important market in Asia.” Some see the situation continuing to improve, however. “We’ve certainly noticed a greater interest in exotic trades in Asia,” says the head of one major interbank dealing desk. “For instance, we were recently asked to price a Thai baht knockout, although I don’t think activity is as yet back to the levels of early last year. The main problem is that although there is more liquidity, it is extremely fickle and disappears quickly with any scare.” Elsewhere, certain currencies that were previously considered emerging, such as the South African rand, are now exhibiting trading behavior more akin to a G-7 currency. “Emerging markets generally have recovered a lot, with the rand very much in the forefront as its volatility has declined,” says Adam Kreysar, cohead of foreign exchange options at Warburg Dillon Read. “The sort of derivatives activity and underlying currency behavior we have seen in other currencies such as the Greek drachma mean that you could plausibly argue that they were no longer emerging, but had already emerged.” By the end of the third quarter of this year most exotic currencies were much less volatile, with Poland possibly being the only notable exception—a good backdrop for a recovery in derivatives activity. “In those conditions, traders feel more comfortable trading larger size,” says Vincent Craignou, assistant director and head of derivatives in local markets at ING Barings. “For example, a year ago the standard size in U.S. dollar/rand options was $10 million–$15 million, and today it’s more like $20 million–$30 million. And if you want to do $50 million, it’s relatively easy to do so.” One foreign exchange derivatives trade that went through the market between April and June has been perceived as something of a watershed in terms of rebuilding confidence. During that period, one major player in the interbank foreign exchange derivatives market (believed to be UBS) bought in excess of $1 billion of six-month U.S. dollar/rand at-the-money forward straddles—a colossal amount by the standards of the market, and certainly a record. The exact reasons for the trade are unknown, but the lack of any attendant activity in the U.S. dollar/rand spot market makes it more than possible that it represented a straight volatility position either by the bank itself or a client. The buying started about six weeks before the South African general election and could therefore easily have been a bet on rising volatility over the elections. The bank started buying the straddles at 12.25 percent volatility, eventually pushing it up to a peak of 14.5 percent. (It has since fallen back to 9.5 percent.) Although the trade went through on several tickets, individual lot sizes were still significant, which made the rest of the market’s appetite for taking the other side of the deals particularly encouraging. One popular U.S. dollar/rand trade this year has been in risk reversals. These trades, which are typically put on by traders expecting a move to develop over time, involve buying out-of-the-money calls and selling OTM puts for a similar maturity—usually equidistant from the spot rate. Their raison d’être is to capture the foreign exchange move without running the risk of being shaken out by the short-term volatility that a position in the spot market would incur. Activity has mostly been concentrated in long U.S. dollar trades with participants taking the view that the rand will depreciate again, probably in the second quarter of next year when current-account pressure starts to build up again. Despite the general improvement in derivatives liquidity, however, the marketplace is still shy of making prices in, or trading, longer-dated products. In the more exotic currencies, there is still little derivatives activity beyond one year—with only the occasional 18-month or two-year trade—usually in U.S. dollar/rand. ING Barings’ Craignou nevertheless takes the view that the situation will improve. “We’ve seen customers asking for four-year options in Czech koruna, and although it’s obviously difficult to make an aggressive quote on that, the situation is definitely improving,” he says. He sees the interest rate markets as a harbinger of this trend, and points to the fact that the Czech interest rate swap market has good liquidity up to 10 years, with a similar situation prevailing in the rand. He also feels that the gradual emergence of swaptions, caps and floors in the rand and Czech koruna will help to manage risks linked to long-dated foreign exchange options and will therefore enable more competitive pricing. “As a result, I don’t think it will be too long before we start seeing see longer-term foreign exchange options in currencies such as the Czech koruna,” he says. In Latin America most of the foreign exchange derivative activity has been focused on Argentina, Brazil and Mexico, with currencies such as the Chilean peso rarely putting in an interbank appearance. When it comes to exotics, however, most of the action is in the Mexican peso, with double no-touches (also known as ranges or corridors) being especially popular with the buy-side community. Most players are using them to express the view that the peso won’t be affected by the economic contagion afflicting of the rest of Latin America and will therefore remain stuck in a trading range. —A.W.

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