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  • Risk management is critically important in the management of derivatives – almost every disaster has been caused by a failure to monitor risks and/or blatant disregard for risk procedures in place. Derivatives aren’t bad – people are sometimes bad! Procter and Gamble: The treasurers of Procter & Gamble and of Orange County were making bets—and highly leveraged bets at that—that the general level of interest rates would fall (or, at least, not rise). Barings Bank goes bust. Nick Leeson loses $1.4 billion by gambling that the Nikkei 225 index of leading Japanese company shares would not move materially from its normal trading range. That assumption was shattered by the Kobe earthquake on the 17th January 1995 after which Leeson attempted to conceal his losses. Long Term Credit Management Bailout The hedge fund is rescued at a cost of $3.5 billion because of worries that its collapse would have severe repercussions for the world financial system. 21st Century 2001 Enron goes Bankrupt The 7th largest company in the US and the world's largest energy trader made extensive use of energy and credit derivatives but becomes the biggest firm to go bankrupt in American history after systematically attempting to conceal huge losses. 2002 AIB loses $750 million John Rusnak uses fictitious options contracts to cover loses on spot and forward foreign exchange contracts. 2004 NAB loses A$180 million Four foreign currency dealers at the National Australia Bank are said to have run up the losses in three months of unauthorised trades.
  • Derivatives markets have expanded rapidly in the recent past As more products have been added these have grown in complexity and flexibility Some of these products have obvious applications to pension funds ranging from: Effective and efficient portfolio management to … … adding value through returns not available (at the same cost/risk) in other markets
  • Slides [ppt]

    1. 1. November 2004 Derivatives in Institutional Investment
    2. 2. Agenda <ul><li>Basic definitions </li></ul><ul><li>Size and growth of market </li></ul><ul><li>More detailed examples </li></ul><ul><li>Rationale for institutional use </li></ul><ul><li>Strategic thought process </li></ul><ul><li>Legitimate concerns </li></ul><ul><li>Conclusion </li></ul>
    3. 3. Basic definitions
    4. 4. What is a derivative? <ul><li>A financial instrument whose value … </li></ul><ul><li>… depends on the value of other basic variables </li></ul><ul><li>Including: </li></ul><ul><li>Options </li></ul><ul><li>Futures </li></ul><ul><li>Forwards </li></ul><ul><li>Swaps </li></ul>
    5. 5. Size and growth of market
    6. 6. Size of market Now too big to ignore 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 2,000 1990 to 1997 1998 1999 2000 2001 2002 Interest rate swaps Value of swaps contracts outstanding Credit default swaps Notional outstanding ($bn) Global govt inflation linked bond markets ($308bn) Equity derivatives index options volume 1996 US 47% UK 36% France 9% Canada 4% Sweden 4% Source: Goldman Sachs Source: BIS Source: Goldman Sachs Source: Goldman Sachs 0 40 80 120 160 200 S&P 500 Euro STOXX 50 FTSE DAX Nikkei 225 Volume (in Contract) 2001 2002 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 0 1998 1999 2000 2001 2002 US$ Billions
    7. 7. … even compared with equity/bond markets at end of 2003! <ul><li>Interest rate swaps: </li></ul><ul><li>$110 trillion in notional </li></ul><ul><li>Credit default swaps: </li></ul><ul><li>$3 trillion notional </li></ul><ul><li>World equity markets: </li></ul><ul><li>$20 trillion mkt value </li></ul><ul><li>World bond markets: </li></ul><ul><li>$20 trillion mkt value </li></ul>
    8. 8. More detailed examples
    9. 9. Underlying Derivative Puts Calls Inflation swap Equities Bonds Inflation rates Interest rates Default risk Interest rate swap Credit derivatives
    10. 10. Examples for consideration <ul><li>Derivatives are financial instruments that change the risk/return profile of underlying investment assets, such as equities and bonds </li></ul><ul><li>Derivatives may be used to improve the investment efficiency of investment assets. Uses include </li></ul><ul><ul><li>reducing unwanted/un-necessary financial risk </li></ul></ul><ul><ul><li>efficiently altering the exposure to asset markets </li></ul></ul><ul><li>Interest rate swaps </li></ul><ul><li>Inflation swaps </li></ul><ul><li>Total return swaps </li></ul><ul><li>Equity collars </li></ul><ul><li>Credit default swaps </li></ul><ul><li>Structured credit </li></ul>Examples
    11. 11. <ul><li>Agreement to exchange cashflows </li></ul><ul><li>Scheme receives fixed payments </li></ul><ul><li>Scheme makes payments based on current interest rates </li></ul><ul><li>Or vice versa … </li></ul><ul><li>Lengthen interest rate exposure </li></ul><ul><li>Tailor it to exact duration of liabilities </li></ul><ul><li>Tailor it for cashflow matching </li></ul><ul><li>Useful tool for active bond management </li></ul>Pension Scheme Bank Fixed payments LIBOR / EURIBOR … Description Application Interest rate swap Floating LIBOR payments
    12. 12. <ul><li>Useful tool to </li></ul><ul><ul><li>Extend duration </li></ul></ul><ul><ul><li>Match fixed liabilities </li></ul></ul><ul><li>Available for longer and more flexible terms than bonds </li></ul><ul><li>Highly liquid and transparent </li></ul><ul><li>Requires some specialised trading infrastructure </li></ul><ul><li>Swaps are a new area for most clients </li></ul><ul><li>Collateral requirements </li></ul>Pros Cons <ul><li>Investment banks provide liquidity </li></ul><ul><li>Some asset managers can run active positioning </li></ul>Ideal provider LIBOR / EURIBOR … Interest rate swap
    13. 13. <ul><li>Agreement to exchange cashflows </li></ul><ul><li>Scheme receives payments based on inflation </li></ul><ul><li>Scheme makes predetermined payments or payments based on current interest rates </li></ul><ul><li>Get inflation exposure </li></ul><ul><li>Access to appropriate floors and caps (eg LPI) </li></ul><ul><li>Tailor cashflows to meet inflation linked liabilities </li></ul>Pension Scheme Bank Payments linked to experienced inflation rate RPI / LPI / CPI Description Application Inflation swap Payments rising by fixed inflation rate
    14. 14. <ul><li>Useful tool to match liabilities </li></ul><ul><li>Available for inflation where bonds not available </li></ul><ul><ul><li>LPI </li></ul></ul><ul><ul><li>some European inflation </li></ul></ul><ul><li>Can be run as an overlay on existing assets </li></ul><ul><li>Limited (but growing) liquidity, especially in longer duration or regional indices </li></ul><ul><li>Swaps are a new area for most clients </li></ul><ul><li>Collateral requirements </li></ul>Pros Cons <ul><li>Investment bank (large sophisticated clients) </li></ul><ul><li>Asset manager (packaged product, inflation management) </li></ul>Ideal provider RPI / LPI / CPI Inflation swap
    15. 15. <ul><li>Agreement to exchange cashflows </li></ul><ul><li>Scheme receives payments based on returns on eg S&P500 </li></ul><ul><li>Scheme makes payments based on eg LIBOR </li></ul><ul><li>Or any other permutation … </li></ul><ul><li>Obtain exposure to a market without having to directly invest </li></ul><ul><li>“ Alpha transport” </li></ul><ul><li>Transition management </li></ul><ul><li>Cashflow matching </li></ul><ul><li>Many others … </li></ul>Pension Scheme Bank Payments based on returns on S&P500 Equity, bond, LIBOR, … Description Application Total return swap Payments based on LIBOR
    16. 16. <ul><li>Useful tool for targeting market exposure without direct investment </li></ul><ul><li>Separates “alpha” and “beta” investment decisions </li></ul><ul><li>Can refine asset cashflows to look like liabilities </li></ul><ul><li>Basis risk –may be different to scheme assets/ liabilities </li></ul><ul><li>Exact tailoring increases bid/offer spread </li></ul><ul><li>Collateral requirements </li></ul>Pros Cons <ul><li>Asset manager (as part of day-to-day portfolio management and/or “alpha transport”) </li></ul><ul><li>Investment bank (exotic over-the-counter derivative) </li></ul>Ideal provider Equity, bond, LIBOR, … Total return swap
    17. 17. <ul><li>Combination of options </li></ul><ul><li>Sell a call option </li></ul><ul><li>Use the proceeds to purchase a put option </li></ul><ul><li>Payoff curtails downside risk, but restricts equity gains </li></ul><ul><li>Used to protect against downside risks </li></ul><ul><li>Removes “unnecessary” upside </li></ul>Relative Returns Description Application Equity collars Equity returns Funding level
    18. 18. <ul><li>Gets straight to the pensions issue: large equity risk </li></ul><ul><li>Can be manipulated into a scheme specific strategy combined with contribution rules </li></ul><ul><li>Pricing involves selling low skew and buying high skew </li></ul><ul><li>Does not tackle risks arising from a lack of rate exposure </li></ul><ul><li>Collateral requirements </li></ul>Pros Cons <ul><li>Investment bank (large sophisticated clients) </li></ul>Ideal provider Relative Returns Equity collars
    19. 19. <ul><li>Protection (or insurance) type of agreement </li></ul><ul><li>Scheme receives a payment if a corporate bond issuer defaults </li></ul><ul><li>Scheme pays a regular premium for this protection </li></ul><ul><li>Or vice versa … </li></ul><ul><li>Manage credit exposure without having to buy/ sell bonds </li></ul><ul><li>Protection against sponsor default </li></ul>Pension Scheme Bank Payment of (100-R) if corporate defaults Corporate bond Description Application Credit default swap Fixed CDS premium R is the bond value in default (recovery value)
    20. 20. <ul><li>Can take positive and negative positions in credit </li></ul><ul><li>Potentially more liquid than cash market in some names </li></ul><ul><li>Can be used to protect against sponsor default (in some cases) </li></ul><ul><li>Manager requires more sophisticated infrastructure </li></ul><ul><li>Some legal/ definition issues </li></ul><ul><li>Potential liquidity issues </li></ul><ul><li>Collateral requirements </li></ul>Pros Cons <ul><li>Asset manager (corporate bond portfolio management, credit overlay) </li></ul><ul><li>Investment bank (single name CDS for sponsor protection) </li></ul>Ideal provider Corporate bond Credit default swap
    21. 21. <ul><li>Cash invested into a SPV that buys a large pool of credit </li></ul><ul><li>SPV is structured into debt tranches which have different levels of seniority </li></ul><ul><li>Losses are absorbed by the tranche with the lowest seniority which has capital remaining </li></ul><ul><li>Managed credit exposure without having to buy/ sell bonds </li></ul><ul><li>Protection against pre-agreed level of initial losses </li></ul>Credit Assets Description Application Structured Credit Pension Scheme Coupon and principal Super Senior Tranche ‘ A’ Rated Tranche Equity Tranche Initial investment Losses above subordination
    22. 22. <ul><li>Exposure to a pool of credits in a single investment </li></ul><ul><li>Potentially provides higher yields for a given level of risk </li></ul><ul><li>Can tailor: </li></ul><ul><ul><li>Level of credit risk </li></ul></ul><ul><ul><li>Inflation linkage </li></ul></ul><ul><ul><li>Liability matching </li></ul></ul><ul><li>Complex to understand </li></ul><ul><li>Difficult to ascertain pricing attractiveness </li></ul><ul><li>Risk of losing all capital (depending on what tranche you invest in) </li></ul>Pros Cons Ideal provider Credit assets Structured credit <ul><li>Investment bank (large sophisticated clients) </li></ul><ul><li>Asset managers with a strong track record in CDO arena </li></ul>
    23. 23. Rationale for institutional use
    24. 24. Pragmatism <ul><li>Matching liabilities (duration, inflation) </li></ul><ul><ul><li>For example, vanilla or inflation swaps </li></ul></ul><ul><li>Lower transaction costs </li></ul><ul><ul><li>Bid/offers tight in forwards </li></ul></ul><ul><li>Changes in portfolio composition </li></ul><ul><ul><li>Overlay and transition strategies </li></ul></ul><ul><li>Tax implications </li></ul><ul><ul><li>Awareness of Inland Revenue rules </li></ul></ul>
    25. 25. Other considerations <ul><li>Non-linear payoffs </li></ul><ul><ul><li>Matching the non-linearity inherent in liabilities </li></ul></ul><ul><li>Better Liquidity </li></ul><ul><ul><li>Deeper, more liquid markets </li></ul></ul><ul><ul><li>Better able to cope with large trades </li></ul></ul><ul><ul><li>OTC market can provide confidentiality </li></ul></ul><ul><li>An example is a swaption contract </li></ul><ul><ul><li>Put/call on interest rates </li></ul></ul><ul><ul><li>Useful for life assurers and pension schemes </li></ul></ul>Payoff Interest rate
    26. 26. Strategic thought process
    27. 27. Strategic thought process Derivatives must make sense in the decision life cycle Core objectives Current asset mix Contract types Overlay analysis Technical aspects Counter- party Execution of strategy Reporting and management
    28. 28. Legitimate concerns
    29. 29. When genius fails.… Barings (1995) LTCM (1998) Enron (2001) Risk monitoring and management are key AIB (2002) The next event (200?)
    30. 30. Conclusion
    31. 31. Development of derivative markets 1980’s 1990’s 2000’s Complexity FX forwards and futures Single stock options Index futures and options Interest rate swaps Currency swaps Caps/Floors Swaptions Index swaps Credit derivatives Portfolio insurance Inflation swaps Cross asset derivatives Credit default swaps
    32. 32. Future prospects <ul><li>Derivatives increasingly used by sponsors </li></ul><ul><li>Risk management continues moving to the fore </li></ul><ul><li>Scheme specific risks to come </li></ul><ul><li>Recognition of MTM risks? </li></ul><ul><li>Pensions to follow the life assurance market? </li></ul>Authoritative, independent advice will be critical