By Robert Hunter

The United States may be the birthplace of derivatives, but American fund managers have largely rejected the oft-maligned instruments, proudly advertising “we don’t use derivatives.”

In Europe, the situation is vastly different. Last year, fund managers and other retail players did some $50 billion in derivatives business, ushering in a financial version of the age of enlightenment. The most popular products: equity derivative-linked products in the form of open-ended and closed-end funds, and structured products linked to bonds. The biggest players: the United Kingdom, Switzerland, France and Germany, with Italy and Spain fast on their heels.

Why the boom in business? For starters, the very way Europeans save their money is changing. Defined benefit pension plans, in which the government or an employer pays retirees a fixed amount for the rest of their lives, are quickly falling by the wayside as governments and corporations grapple with the Malthusian demographic reality of one worker for every retiree by 2020.

The heir to the defined benefit system: defined contribution schemes, in which people take responsibility for their own retirement funds by investing pre-tax income during their working lives. “There’s a major transfor-

mation going on in Europe,” says Ian Morley, director and head of quantitative and derivatives Funds at AIB Govett Asset Management. “Germany and France are essentially bust as far as their ability to provide future retirement benefits is concerned. The only way they’re going to be managed is by people privately investing in equities. The growth in this area is going to be massive.”

As people are forced to become their own personal pension fund managers, they’ll want to wring as much return from their investments as they can. But they’ll also look to protect what they’ve accumulated so far. “If somebody retired in the middle of 1974, when the equity market in the United Kingdom was falling by more than 50 percent, their employer was still going to pay their pension at the stated rate under the defined benefit system,” notes Richard Bolchover, a director at Closed Fund Management. “If, however, they had a defined contribution scheme, and all their accrued money had just been halved, they’d be out of luck. They took the investment risk, and they paid the price.”

“There’s a major transformation going on in Europe. The growth in this area is going to be massive.” — Ian Morley

Some advocates of modern portfolio theory believe that diversification can get the risk management job done. But diversification can be problematic. “Diversification doesn’t provide certainty or flexibility,” says Bolchover. “And in a global market crash, all the markets will fall at the same time. Also, the underlying instruments—portfolios of bonds and stocks—are really quite cumbersome and inflexible. You can’t shape the payoff easily.”

Derivatives, by contrast, offer such flexibility—and that’s why they’ve taken off in Europe. Sohail Jaffer, president of the Alternative Investment Management Association, has witnessed a boom in three types of products. The first is one-way rolling guaranteed funds, offering either a full protection of 100 percent of an investor’s capital or, in a low interest rate environment, 90 percent to 95 percent protection of capital, with the balance of the upside linked to various equity indices.

The second group of products is unit-linked insurance instruments, in which, say, a 12-year insurance policy is linked to a payout at maturity of a known capital-guaranteed amount, together with a minimum return and an upside linked to an equity index.

The third type is a bit more exotic and includes such products as the Merrill Lynch Hindsight Bond, which links its payoff to the performance of the best of eight European equity markets since the instrument’s inception date. An investor buys, say, a seven-year bond that pays a certain percentage of the upside of the best performing of the eight markets.

Flavor of the day: vanilla

While European investors and fund managers are starting to embrace derivatives like never before, they’re taking baby steps, steering clear of the truly exotic for now. “Most of what we do is plain vanilla,” says Morley. “Most exotic options are like K-Mart suits at Sachs Fifth Avenue prices. When you disaggregate them, you find that the only people who are truly benefiting are the brokers trying to sell them to you.”

Douglas Shaw, head of derivatives investment at Gartmore Investment Management, agrees. “Ninety-eight percent of the trades I enter into are exhange-traded futures,” he says. “Off-exchange trades can be really sticky. Particularly for the more bespoke trades, you might have to spend three days making the investment bank comfortable with what you want to do.”

Morley’s general strategy is to blend exchange-traded and over-the-counter derivatives. “If you’re running protected structures for open-ended funds,” he says, “you’ll always have exchange-traded products. People are constantly coming in and out, so you need liquidity. But if you’re doing large volume, you also want opaqueness, because you don’t want people knowing what you’re doing. You never want to bid the market up against yourself. In these cases, over-the-counter is the way to go.”

Closing The Gap

Fund managers are proudly declaring that the chasm of sophistication between buy side and the sell side has begun to close. But this may not be trickling down to the end user. “My biggest concern,” says Mamdouh Barakat, president of MB Risk Management, “is that the end purchaser has no idea if he’s getting value or not. Fund sellers have to declare their management fees—they have to say X percent per year. However, when you’re packaging with derivatives, the difference between what you’re paying for the guarantee and how you’re bundling it is a hidden management fee that isn’t actually disclosed anywhere. If I were reading a prospectus for a fund, I would like to know if it has an embedded option, and if so, the value of the embedded option as quoted by three or four brokers. That way, I can figure out if this is really giving me good value or if it would it be cheaper for me to do something else. The fund manager could add value by not hiding that cost.”

“For years, Germany spent more money on bananas than on equities. That’s no longer the case.”

Bolchover, however, thinks the institutional sell side is far more predatory than the fund management community. “The duty of the person on the OTC desk is not to his client—it’s to his shareholder. Therefore his duty is to get the highest possible price for the options he’s selling. In other words, he’s in conflict with the client.” Bolchover notes the difference between a structured product that is packaged by an investment bank and sold closed end in five years, and an open-ended retail unit trust. “Unit trusts are highly regulated, and the manager has a regulatory duty to get best the possible execution. Also, his performance is displayed publicly every day, and he knows his reputation depends on the performance of his funds. His duty as a fund manager—and I’m distinguishing between that and the investment bank—is to get the cheapest possible price for that option. And a fund manager in the United Kingdom makes absolutely no money on the options within the funds.”

“My biggest concern is that the end purchaser has no idea if he’s getting value or not.” — Mamdouh Barakat

Even so, there are still some remnants of derivatives distrust both in the regulatory world and the investing public. Moreover, there are pockets of resistance within the fund management community itself—specifically, stock-and-bond portfolio managers who don’t understand derivatives or are afraid the instruments will hasten their obsolescence.

But no one thinks these obstacles will derail the derivatives boom. “Derivatives are going to play a bigger part in retail funds,” says Bolchover. “There are enormous opportunities.” He notes that usage will likely follow a cyclical pattern—when interest rates are low and markets are calm, value products will be popular; when markets get volatile, principle protection will be a top priority.

Either way, the European pension situation has set the stage for explosive growth in derivatives usage. “You’ve got risk-averse investors in Europe coming out of the woodwork in a low interest rate environment,” says a retail derivatives player. “For years, Germany spent more money on bananas than on equities. That’s no longer the case.”

With the stunning proliferation of on-line derivatives auction sites in recent months, it was only a matter of time before the hottest new derivatives market, weather, got in on the action.

Later this month, a new on-line brokerage site called Weathertrade (www.tradeweather.com) will go live, offering trade-matching services in temperature (heating degree days and cooling degree days) and rainfall contracts. The system will provide automated order placement and execution, personalized portfolio tracking, real-time quotes 24 hours a day, as well as modeling and other tools.

“This isn’t anything like the new weather contracts offered at the Chicago Mercantile Exchange,” says Bob Shultz of Weathertrade. “We’re not taking any position on anything, or handling any of the clearing or settlement. We’re just facilitating the transaction.”

Like many of the new on-line brokerages, the entire depth of the market—in this case, weather—will be presented. The system can handle everything from vanilla single-city HDD and CDD puts and calls to baskets and straddles on multiple cities. A user interested in, say, a put on HDDs in Lincoln, Neb., would first go to one of the two modeling facilities the site will offer to determine appropriate pricing levels. Next, he would enter his strike points, the maximum payout and the bid price. Once submitted, the bid would appear live on the site, open to offers. An interested counterparty could present a counteroffer for the end-user to accept or reject. Once the deal is agreed on, the two parties exchange contact and other information, and the deal can be finalized.

Does this represent the end of traditional weather brokers? “Not at all,” says Schultz. “You’ll never eliminate the traditional way of weather trading. There are deals that will always be done directly between traders themselves, and between brokers and traders or end-users. But I think everyone involved in the weather markets will use this site. There aren’t many limitations.”

The site may be useful in another way. With the sophisticated weather forecasts available and the market’s views on the weather for all to see, “it might be a more valuable forecasting tool than the National Weather Service,” says Schultz.

For a free demo of the site before launch, contact Weathertrade at 212-209-1133 or info@tradeweather.com.

The winds of change are blowing through the Chicago Board Options Exchange like never before. Barely a week after the giant exchange announced that it was breaking an old gentlemen’s agreement with the other options exchanges not to cross-list single-stock options, the CBOE announced that it was changing its margin requirements, an action long requested by customers.

Since none of the other options exchanges posed a major competitive threat to the CBOE, it’s clear that the proliferation of Internet-based options trading systems as well as the development of the proprietary screen-based International Securities Exchange were the catalyst for the changes.

Some of the changes taking place as of August 24 include:

• Loan value for long-term listed options. Member firms may now lend up to 25 percent of the current market value of a listed option that has more than nine months until expiration. The initial and maintenance margin is thus 75 percent.
• Reduced maintenance margin requirements for stock positions hedged with options. These include protective puts, conversions, reversals and collars.
• Provisions allowing European-style index spreads in cash accounts.
• Recognition of long and short “butterfly” spreads. Long butterfly spreads will pay in full the net debit incurred (that is, the maximum risk). Short (credit) butterfly spreads will pay the difference between the exercise prices. Net credit received may be applied.
• Recognition of long and short box spreads. The net debit incurred by establishing a long box spread (that is, the maximum risk) must be paid in full. Short boxes pay the difference in the exercise prices (aggregate). Net credit received may be applied.
• Loan value for long box spreads in European-style options. Member firms may lend up to 50 percent of the difference in the aggregate exercise prices on a long box spread if it is composed of European-style options.

These changes represent the first wave of the CBOE’s plan. Beginning sometime around the second quarter of 2000, a portfolio risk-based margin and cross-margin approach will serve as an alternative to strategy-based margin requirements for broad-based index products.

For more information on the changes, see www.cboe.com.

Rating agencies won’t use phrases like “dodged a bullet,” but the general consensus in the wake of Hurricane Floyd was that the storm left catastrophe bonds high and dry.

By the time Floyd pounded into the North Carolina coast, it had already weakened to a low-grade category three storm. More important, it missed Florida entirely, causing many holders of cat bonds to blow a big sigh of relief.

There were two cat bonds that could have been adversely affected by Floyd: USAA’s Residential Reinsurance II, a $200 million issue of floating rate notes due June 1, 2000, and Juno Reinsurance, an $80 million issue of FRNs due June 26, 2003. Standard & Poor’s had rated both bonds BB.

Floyd was not taken lightly, however. In the early days of the storm, there was fear that Floyd, then a category four storm, could veer west and hit Miami, producing up to $75 billion in damages. When Floyd took a turn up the East Coast, modeling agency RMS predicted insured damages of between $4 billion and $10 billion if Floyd hit a regional population center such as Charleston, S.C. Moody’s Investors Service placed Residential Re, which it had rated Ba2, on watch for possible downgrade.

After the storm pulled away, RMS estimated insured losses to be $1.5 billion—much of which was crop and livestock damage. Residential Re and Juno Re covered only property damage. Neither has been downgraded.

Were investors lucky? That’s not the correct way to view the situation, says Isaac Efrat, vice president and senior credit officer in structured finance at Moody’s. “Investors who are gambling may think of it that way, but investors who actually know the risk know that this is precisely the way it’s supposed to be. This is the peak of the storm season—the third week of September is always the worst time. Hurricanes are supposed to happen, and that’s why investors are paid a high coupon.”

Investors searching for investments that are not correlated with conventional stock and bond portfolios have had a rough time lately. Those who have attempted to diversify with plays in Asia, Russia and Latin America have found their assets subject to the unpredictable effects of global economic contagion.

One asset class that seems to have escaped this curse has been commodities. In the last year, monthly open interest on the Chicago Mercantile Exchange’s Goldman Sachs Commodity Index products has skyrocketed 33 percent, from 27,000 at the beginning of the year to 36,000 by early September. While the products have historically been used simply as a play on rising inflation, there are other factors contributing to this year’s boom as well.

Much of the spike, says Richard Redding, vice president of index products marketing at the Merc, is attributable to portfolio managers using the products for diversification. “The GSCI has a negative correlation to stocks and bonds,” he says, “so people are using the products in an overall portfolio context to bring down the risk exposure of their portfolio.”

People are using the products to bring down the risk exposure of their portfolio.

From 1970 to 1996, in fact, the GSCI’s correlations with other assets are as follows: inflation, 0.26; Treasury bills, -0.05; EAFE, -0.24; Treasury bonds, -0.27; and the Standard & Poor’s 500, -0.28.

Another reason for the spike: the index has risen dramatically this year, and some people are using it for direct exposure to rising commodity prices. “Year-to-date, the total return on the GSCI is around 28 percent,” says Redding. “Even considering where stock returns are this year, it’s impressive.”

The GSCI hasn’t always been such a superstar. During the last few years, global commodity prices have flagged as a result of an oil glut and the Asian flu. But this year, oil prices have nearly doubled, and the Asian economic recovery has increased the global demand for commodities. Managers long the GSCI this year have been richly rewarded.

The GSCI is composed of commodities in six sectors—petroleum (39.2 percent), grains and oil seeds (18.6 percent), metals (12.5 percent), livestock (12.1 percent), food and fiber (10.8 percent) and natural gas (6.8 percent). Within these categories are some 26 different commodities.

For more information on the GSCI products at the Merc, see www.cme.com/market/gsci.

Another web site has emerged in the increasingly competitive on-line derivatives business: CFOWeb (www.cfoweb.com), a derivatives trading portal for CFOs, corporate treasurers and fund managers. At the time of its launch later this month, the site will feature interest rate and currency derivatives, foreign exchange, loans and deposits, and the pricing and modeling of fixed-income instruments, taking another swipe at the already reeling derivatives brokerage industry.

Like retail trading portals, CFOWeb.com is a free service, available in its base form at no cost to end-users of financial products. (Members can choose to subscribe to premium services for a fee.) Participation in the CFOWeb.com providers’ network is open to all institutions whose products and services have been certified for use and who have agreed to the site’s fee structures and general operating guidelines.

The site’s goals are ambitious. Instrument coverage includes interest rate swaps, currency swaps, interest rate caps and floors, forward rate agreements, spot and forward foreign exchange, foreign exchange options, loans and deposits, government bonds and various cash instruments.

In addition to brokering trades electronically, the site will offer a number of other services, such as presenting real-time market data; generating zero curves and implied volatility surfaces; saving trades to a portfolio; managing trading work flow; transmitting trades to interested counterparties for pricing, trading, confirmation and settlement; performing portfolio analysis; marking to market; cash management; risk management, including value-at-risk, scenario analysis and market-rate sensitivity analysis; and back-office functions, including settlements, confirmations, payments and rate resetting.

“For some time, we have been executing the strategy of reinventing the investment bank on the web,’” says Al-Noor Ramji, global CIO of Dresdner Kleinwort Benson’s investment banking division. “CFOWeb.com pushes the idea to other areas of financial services and allows institutions to play a key role in delivering on the promise of effective e-commerce for capital markets.”

CFOWeb is novel in that it’s not an independent company but rather an array of products and services delivered by vendors. The site uses Palo-Alto, Calif.-based Integral’s Integral Platform, which is based on Enterprise JavaBeans and the extensible mark-up language. Other contributors include Algorithmics, which is offering its Mark-to-Future framework, and the Moneyline Network, which will provide real-time financial data.

Most economic pundits are predicting that the financial markets in the final days of the year will gyrate more than Ricky Martin. Investors and financial institutions around the world are expected to scale back their equity and fixed-income positions until it’s clear that the markets—and the world’s technological infrastructure—are safe.

While this cautiousness is understandable, it may be precisely the wrong approach, says a September Goldman Sachs research report titled “The Y2K Liquidity Risk Trap: Hedging Strategies and Lessons From the 1999 Transition to the Euro.” Rather than pulling back, says the report, fund managers should stay the course. And if things get too rocky, there are some derivatives strategies that can help.

The benefits of keeping investment portfolios intact are threefold. First, there’s a low probability that year 2000 disruptions will have much of an economic impact, given the level of preparedness in potentially vulnerable countries. Second, the typical investment horizon for fund managers is longer than one year, and is often several years, while the small disruptions attending Y2K will be short-lived. Moreover, price falls that accompany Y2K disruptions will only present opportunities to add to positions at attractive prices. Third, central banks and large commercial banks have taken it upon themselves to make sure sufficient liquidity will be available to companies and consumers should market disruptions occur.

Nonetheless, some cautious fund managers will inevitably decide to reduce their positions and carry more cash in the run-up to Y2K, or at the very least wait until things calm down in 2000 before adding positions. Goldman warns that “lowering a fund’s risk profile by carrying excess cash equivalents or by delaying equity investments and speeding up sales may pose a risk of missing rapid upward moves in stocks as investors rush to restore their target equity allocations early in 2000.”

The real Y2K problem

Market liquidity usually decreases over the turn of the year, as financial institutions and brokerages, wary of trades that settle during this period, effectively shrink their balance sheets. If tracking the turn has been a headache in years past, it will be a nightmare this year because investors will avoid year-end settlements like the plague, preferring the safety of cash.

The result: investors exiting the capital markets to hold larger cash balances will likely drive down prices, while net buying to rebalance portfolios won’t occur until early 2000.

Some cautious fund managers will inevitably decide to reduce their positions and carry more cash in the run-up to Y2K.

The flight to cash won’t come without problems, however. According to the report, year-end financing pressures are already creating a premium in financing costs over the turn of the year. From July through September 17, for instance, the spread on eurodollar future yields between December 1999 and September 1999 was 40 basis points to 60 basis points, vs. 20 basis points in normal years. This relative tightening of monetary conditions, says the report, “will negatively impact stock and bond prices for a short period, until the pressures from this perceived risk subside.”

The real costs of carrying more cash relative to stocks and bonds during the turn will be even higher than these wide spreads indicate, since returns on short-term cash are usually far lower than either stocks or bonds. Moreover, funds converting longer-term assets to cash and then back into stocks and bonds will rack up hefty trading costs.

Even more troubling, says the report, “the price gap risk from the timing of the reinvestment of those funds back into stocks and bonds can be delayed. Investors can risk missing significant gains in stocks or bonds as investors move aggressively after the year to push to more fully invested positions.” Normally, the first few months of the year see heavy flows into mutual funds and other investment vehicles. This year things could be even more hectic, because of bigger-than-normal December pullbacks.

The report cites the example of euro conversion as a historical precedent. There is an obvious parallel between the euro conversion and Y2K: the euro conversion required a massive IT effort. Even though there were relatively few problems during conversion, there was a general reduction in liquidity in European equity markets until it was clear that things were under control. In the last few days of December 1998, trading volumes for the 50 stocks that constitute the Euro Stoxx 50 index decreased sharply, before increasing sharply on January 4 after conversion proved largely successful.

The solution(s)

Goldman offers three specific derivative strategies to take advantage of Y2K jitters. The first is to remain fully invested and simply purchase put options for protection, thus avoiding the risk of being underinvested and the opportunity costs and transaction costs involved in temporarily shifting toward cash. “If a fund manager is considering delaying equity purchases until after Y2K,” the report notes, “they could purchase the stocks this fall, but employ a hedge for perceived Y2K risk. Option-based index hedges can be structured to expire in mid-January and could be closed out or offset earlier than that if indexes fall dramatically in the first week of January.”

The report advocates the 5 percent/20 percent strategy, which provides protection from 5 percent to 20 percent downside moves and is less costly than full downside protection. As of September 17, these hedges, expiring January 21, 2000, were priced at the levels indicated in Table 1 for three broad market indices.

Because of the U.S. Federal Reserve’s aggressiveness in containing Y2K risks, the report notes, investors have priced in a greater Y2K impact on the European and Japanese markets. For investors bearish about the first few days of 2000, the report recommends using zero-premium collars—selling calls to finance the purchase of puts.

The second strategy is to hedge with put options contingent on interest rate falls. The Federal Reserve has already put in place mechanisms to provide additional liquidity in 2000, much as it did in the aftermath of the Russian default in 1998. “A put option that is activated only when interest rate cuts occur may achieve the same desired end as a standard ‘plain vanilla’ put option,” the report notes, “but for a lower cost.” The pricing for such a strategy, as of September 17, is indicated in Table 2.

The third strategy is to hold call options against increased cash balances. “If investors believe that the buildup in fund liquidity is inevitable, but that there is some possibility of strong performance in the early weeks of 2000,” the report notes, “then buying call options against cash holdings may be advisable.” Managers can also use this strategy if they have been restricted from trading for some reason.

Where’s the risk?

Despite the expected exodus from the capital markets in the run-up to 2000, options prices, at least as of September 17, had not reflected a great amount of perceived risk. “The impact has been surprisingly small given the premium in financing rates that has emerged over this time period,” notes the report.

As of September 17, the typical spread of longer-term to shorter-term options was “only a little higher than normal.” For the Standard & Poor’s 500, the spreads were at the levels indicated in Table 3.

While implied volatility increased from July to September, it was still only a little higher than normal. Elsewhere, the report notes that “the consensus expectation of turbulence in markets as reflected in current S&P 500 option premium is an event that is 1.4 standard deviations above median volatility levels.”

The moral of the story: stay the course.
For a copy of the report, contact Joanne Hill at 212-902-2908.

Table 1

	Standard & Poor’s 500	Euro Stoxx 50	Nikkei 225
At-the-money put	5.2%	6.25%	5.75%
5% out-of-the-money put	3.65	4.5	3.6
10% OTM put	2.55	3.4	2.1
5%/20% put spread	2.55	3.2	3.05

Table 2

	S&P 500 Euro	Stoxx 50
10% OTM put	2.55%	3.4%
10% OTM put, contingent on three-month dollar Libor falling below 5 percent	1.5	1.9

Table 3

Implied volatility spread	As of 9/13/99	As of 7/13/99	Five-month average
Jan. 00–Dec. 99	1.18%	0.99%	0.9%
Mar. 00–Dec. 99	2.23	2.01	1.59
Normal spread between	1.85	1.6	1.37
6-month and 3-month options

Was this information valuable? Subscribe to Derivatives Strategy by clicking here!