Derivatives Surge In Popularity
Plan
sponsors’ use of strategies to manage risk and boost returns fuels explosive growth in the derivatives market.
As institutional investors embrace
the use of derivatives-based strategies for minimizing risk exposures and enhancing performance, they have grown more comfortable
with the contracts and pushed the derivatives market to new heights.
At the end of 2006, the notional
value — or principal amount used to calculate payments on contracts — of outstanding over-the-counter (OTC) derivatives
stood at a tremendous $415 trillion globally, as measured by the Bank for International Settlements (BIS), a Basel, Switzerland-based
clearinghouse for central banks. That represents an increase of 39.5% from the previous year. Another $87.1 trillion worth
of exchange-listed derivatives — $30.4 trillion in futures and $56.7 trillion in options — were outstanding as
of March 2007. In all, between June 1998 and December 2006, global derivatives markets surged at an annualized pace of 21.3%.
Exchange-listed derivatives
such as futures contracts on the S&P 500, are as carefully regulated as any other listed security. OTC derivatives are
private contracts between two parties. One of the most frequently traded OTC derivatives is an interest-rate swap where payments
are made between counterparties based on LIBOR.
The
surge in popularity of derivatives-based strategies is in part due to the increasing need among investors to manage risk.
For example, multinational corporations might be active in currency derivatives to hedge their exposure to exchange-rate volatility,
while many pension funds are drawn to interest-rate swaps because they offset a significant amount of their interest-rate
exposure.
“Interest-rate swaps,
which are contracts where two counterparties exchange one stream of interest for another, help hedge risks relative to pension
plan liabilities,” says Lee R. Freitag, product manager for liability driven investing (LDI) strategies at Northern
Trust. Interest-rate swaps are an effective solution to help match assets to liabilities and lessen surplus volatility, he
says.
For example, a pension plan
with fixed payments to beneficiaries might pay a floating rate of interest in exchange for a fixed-income stream that matches
its benefit obligations. “There are two advantages to this approach. One, you’ve secured a payment stream for
your beneficiaries. At the same time, you’ve hedged your liability value against adverse movements in interest rates,”
Freitag says.
“Interest-rate swaps are an effective solution to match assets to liabilities
and lessen surplus volatility.”
— Lee R. Freitag, product manager for liability driven investing strategies at Northern Trust
To hedge the funding gap,
swaps can be implemented at different points along the yield curve. “Because a pension plan’s future liabilities
are discounted using current interest rates, when rates decline the plan is exposed to a potentially large funding gap,”
says Greg Dennerlein, strategist, alternative solutions group at Northern Trust. “Moreover, there’s a duration
mismatch between a plan’s assets and its liabilities. When rates decline the present value of liabilities grows and
that increase potentially could outpace any increase in asset value.”
Pension plan sponsors need
an instrument that increases in value when rates decline and that is flexible and liquid enough to extend portfolio duration
by 30 years or more, he says. This is exactly what a fixed-rate swap can accomplish, and Dennerlein notes that not many bonds
on the cash market have these long maturities. Interest-rate swaps accounted for 69% of the notional value of all derivatives
outstanding at the end of last year, as measured by BIS.
Credit
default swaps (CDS) — which act as a form of insurance against default on a corporate loan or bond — make up the
fastest growing segment of the derivatives market. Although these contracts comprised only 7% of the total notional value
of derivatives at the end of 2006, the segment has grown at a staggering 112% annual rate during the past two years.
“Investors can use
credit default swaps to reduce the level of credit risk inherent in certain securities,” Freitag says.
Investors also can use credit
default swaps to gain exposure to credits. “Investors can customize their exposure by specifying the terms, such as
notional amount, underlying, maturity and currency. They are very flexible, and protection can be sold to generate additional
portfolio income,” Dennerlein says. “Unlike a cash bond where an investor gets credit and duration exposure, a
CDS is a pure credit play.”
“Investors can customize their
exposure by specifying the terms, such as notional amount, underlying, maturity and currency. [Credit default swaps] are very
flexible, and protection can be sold to generate additional portfolio income.”
— Greg Dennerlein, strategist, alternative solutions
group at Northern Trust
This
type of derivative instrument is appropriate for investors who want to gain broad market exposure to either a customized basket
or an index, Dennerlein says. “In addition, single-name credit default swaps are quicker to implement and in many cases,
more efficient than trying to find the cash bonds, which may not be available due to limitations of maturity, currency or
size because of supply-demand imbalances.”
For relative-value managers
who want to short a bond, credit default swaps also can serve as a convenient solution. “If an investor wants to go
short in the credit derivatives market, the cost is known and it’s fixed for the life of the contract,” Dennerlein
says. “In the cash market, shorting a bond is often difficult and costly.”
Commodity contracts represent the smallest amount of notional
OTC derivatives outstanding, with just $6.9 trillion as of December 2006. These contracts represent forwards, swaps and options
on metals, grains, livestock and other physical commodities. This derivatives market has grown 39.6% per year, on average,
since June 1998. Investors taking directional positions on the commodity markets, manufacturers hedging future commodity deliveries
and companies hedging future commodity purchases are all users of commodity-based derivatives.
If an investor is seeking
to reduce risk, structured notes linked to a commodities index allow investors to define their downside exposure. “It
can range between zero protection to 100% principal protection,” Dennerlein says. “Although 100% principal-protected
notes might not be efficient for taxable investors, because of the ‘phantom income’ they generate, they work very
well in a tax-exempt portfolio or qualified plan.”
The
growth in the derivatives markets also can be traced to investors searching for ways to capture increasing returns outside
of traditional portfolio management.
The growth in the derivatives markets also can be traced to investors searching for ways to capture increasing returns
outside of traditional portfolio management.
Within the pension plan market,
plan sponsors are considering derivatives as a complement to their existing manager programs. In this case, derivative strategies
can be employed by pension plans seeking to enhance returns as they strive to fully fund their plans in the face of new accounting
and pension regulations. Portable alpha strategies, where derivatives are used to selectively choose sources of portfolio
alpha and beta, have grown in popularity.
Hedge funds commonly utilize
derivatives to capitalize on movements in all asset classes, including currencies, interest rates and credit markets.
Hedge funds are prominent players in the credit default swap market,
accounting for about 25% of the credit default swap volume.1 Often, leverage is used in the portfolio construction
process, which means funds can obtain much more market exposure with less capital. This market exposure is obtained through
the use of derivatives since the full notional amount invested does not need to be paid at contract initiation. The use of
leverage in this case must be carefully monitored, as adverse market movements coupled with leverage can exaggerate losses.
Another use of derivatives
is structured products, which seek to enhance returns through the use of stock options. Products in this space use options
to provide investors with multiples of index returns. A common structured product can be designed to deliver expected returns
of three times the S&P 500 return on the upside with one times the downside exposure.
Skilled experts should evaluate every contract’s potential
risks, which largely involve the creditworthiness of each party in the transaction. The International Swaps and Derivatives
Association (ISDA), a New York-based trade organization, has standardized the template for use in counterparty negotiation
and set up the “Credit Support Annex” to spell out guidelines for both sides to post collateral, typically cash.
ISDA does not, however, actively manage or monitor collateral. The counter-parties are responsible for that process.
In the United States, the
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 also has helped bring derivatives out of the shadows. The
legislation mandates immediate resolution of financial contracts — including derivatives — if either party files
for bankruptcy or is otherwise unable to meet its obligations.
The U.S. Pension
Protection Act of 2006 (PPA), which requires full funding of corporate defined benefit plans by 2013, is expected to further
increase the demand among institutional investors for strategies such as LDI.
“We have about seven
years before U.S. corporate pension plans are required to be 100% funded. This deadline is driving a good deal of the interest
among plan sponsors to consider derivatives-based strategies in order to meet this requirement,” Freitag says.
The PPA followed similar
legislation in the United Kingdom and the Netherlands that sparked the greater use of derivatives by pension funds in those
countries.
Institutional investors’
desire to hedge various risks and to identify opportunities for higher investment returns will be the driving force behind
the increased acceptance of, and comfort with, sophisticated derivatives-based investment strategies and should ensure the
continued growth of the derivatives market.
1 Brad Bailey; Wall Street & Technology “Trading
Credit Derivatives: The New Frontier”
© 2007 Northern Trust Corporation
