BEN MATTLIN
POINT OF VIEW, October 2007
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Northern Trust's POINT OF VIEW magazine
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FEATURES

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.

 

A Hedge Against Volatility
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.

 

Efficient Credit Exposure
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.”

 

Commodities
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 Search for Increasing Returns
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.

 

Safeguards
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.

 

A Growing Wave
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

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