PTION

'];x;

1,

rln

The scarcity of innovationscooked that counts, but the

has led to product similarity,way it's presented,

so it's not the way it's

DRESSI}IG UP,wlTHouI A l0lLlltc

Players in the swaps andoptions game all agree that theheady days of innovation aregone. What they're less clearabout is how best to adaptwithin what has become alow-margin commoditiesmarket.Simon Brady reports

j ompetition in the derivatives marketis hotting up. Swaps and optionshave become commodities. the pace

i of innovation has slowed dram-aticallv. and the market leaders are tinding itincreasingly difficult ro differentiatethemselves tiom each other. Three strategieshave emerged: concentrate on the high-r'olume. low-mar_qin products and rnakemonev on the bid-otf'er spread: move intoconsultancv: or turn to the retail market. Thecompetition in each area is t'ierce. and domin-atetl bv a handful of institutions. But everyoneagrees that the days when swaps and optionscould be treated separatelv are over.

Pft)iirrcrs are no longci ln issue in the traded

swap and option markets. Mark Tristram.second vice-president at Chase ManhattanBank in London, says: "As far as availableproducts are concerned, there are not manynew ones. All the mathematical explorationhas been done, and there is no more rocket-scientist production of new products. Newproducts centre on the amalgamation of twoor three risk

- forex-cornrnodity and forex-

equiry warrans, anci options on more than onevariable." Banks with thrs view have twochoices: they can either seli the existingproducts more cheaply ihan everyone else(which means having the bcsi systems, thebest internal risk managemenr, and the bestpricing models), or rnarket therr in new ways.Alexander von Ungern Sternberg, managingdirector at Deutsche Bank Capital Markets,summarises the lirst approach: "Whatdifferentiates banks in this rnarket now is notproducts

-

but the abilitv to handle risk sothat you can price an'/ structure, at any size,quickly and competitively.'

Banks that choose the fir:st strategyspecialise in making colr:inuous two-waymarkets in as wide a range of iostruments aspossible and concentrate on h,.isine.ss withother financial instirutions. Giveir thr: itructureof the swap and opticn markets. tlris makessense. Per Sekse, asso.:rate director atManufacturers Hanover, sa_vs: 'lllllese areeducated guesses but I woulo say that leavingaside problems of double counring, about85% of trades [in the swap market] arebetween financial instinrtions, aad. L5Vo arecorporate. Of the total abctrt 25% are inter-bank trades between rrarket-makers

-

arbitrage and positiort-closing .{ big chunkof trading is laying-otf risk irr rhe maiket. and65% are real end-users

-

ba:rks using swapsto hedge their balancr she.:r:r 'or r-(r matchswaps sold to their clients "

A bank with more fixed..rar.: liabilities thanassets can use a swap, irr u,nich it pays floatingand receives fixed, as a Sond or loan sub-stitute. If it has more fixed-rate arssets rhanliabilities it can use a fixed-to-floating swapinstead of issuing a fixai-rate bond. Pre-crash,bank treasuries also used the swap marketextensively to take views on interest rates.According to Sekse. this activiry has dimin-ished, and treasuries prefer the governmentbond markets or futures for their flufters. SaysTristram: "We do not use cur sv/ap books toalter the up- and downside olthe bank's P&L,even though we are authorised to take hugepositions."

Demand lrom non-f,rnancia( institutionsremains thin, despite three years of intensivemarketing. "Corporate demand is irregular,"says Gilles de Chant6rac. second vice-president at Chase Manhanan Bank inLondon. "It does not consist cfa stead',, streamof smaller players but a few largeorganisations with demand frorn smallercompanies dictated by market conditions."The majority of companies are unsuitablecounterparties anyway because of credit.

Says one swaps chief: "I would probablybe killed for.saying that we are not interested

Euromoney April 1990 71

Growth rates of swaps,bonds andequities

750

Total s*"p"O Total aquhiesJrotal bonds

in corporate business -

and ofcourse we caredeeply about our corporate customers

- but

a swaps group cannot survive bv concen-trating on companies." Banks which take theview that the market is now marure and thatdemand patterns are unlikely to change sig-nificantly in the medium-terrn are nowconcentrating on providing a commodiryservice to the financial end-users.

The problem with this end of the marketis that there is little value-added. The bankssimply shop around for a price. "In the plaininterest rate markets more and more end-usersare doing their own structures." sighsTristram. Inevitably, margins have eroded.According to Liz Merica, executive directorat Deutsche Bank Capital Markets in London,this has been most noticeable in the US dollar:but spreads have tightened in all currencies.

The primary debt market is also an impor-tant souce of business. Not onll' does itprovide the most opponunities to write bigtickets (Chase quoted on both Sl.5 billionRepublic ofltaly issues). but new issues oftensuit banks'swap books. Says Craig Kersey,director, risk management/technical product's.at Mitsubishi Finance International: "Some-78 Euromoney April 1990

times they are the only way to establish orclose a position. Ifyou tried to close a Ecu200million position in one maturity, you mightmove the market against you, anywhere bet-ween 5 and, on a bad day,20 points. Buyingthe offer rate against a new issue isoften cheaper." This, too. is low-margin sruff."This is a difficult business," says DuncanGoldie-Morrison, head of capital markets andswaps at Westpac Banking Corporation'"Although we will pay more if deals are notput out to bid, a lot are."

Some institutions will not be consoled bya co-lead manager slot for providing the swap."Our senior management is not interested inlines that don't pay, and that means being anti-bonds. I think it is a fact that you don't makemuch on new issues

- it is tough to get large-

size quotes out of the market," says one swaP-per. i3anks which reject punting

-

usually

According to Deutsche Bank's LizMerica, margins have eroded, mostnoticeably in the US dollar.

defined as running positions to alfect thebank's bonom-line eamings

-

get their protltsfrom the bid-otTer spread and a few highlycontrolled net positions which cannot beavoided.

A smaller group of institutions has takena different view. Although they provide acommodity service. they still believe in thevalue-added approach. These houses

- prim-

arily Banque Paribas. Security Pacitlc.Salomon. Citicorp and JP Morgan - otlerclients risk-management consultancy on a no-fee basis. Nick Carter. executive director atSecPac in London. sums up the approach: -lCsnot enough simply to otfer the products anymore: vou have to be creative about selling:you have to advise people when to use whatproduct and so vou need to give people intbr-

mation with which to make that choice anddecision."

For JP Morgan. this has meant providingits clients with a software package which.when programmed with their positions andviews on interest and currencv rates, recom-mends the use of the relevant derivativeproducts.

The other houses like to emphasise theaccompanying problems. "lf you set yourselfup as a software supplier then you have to doeverything that a software supplier does. Youhave to provide education for the users;maintain systems: get rid of bugs tiom theprogrammes. And if you have cliens pushingbunons and being told to buy x. y and z, andthey have done it wrong or they do not under-stand the system. you are going to have adissatisfied customer on your hands," says oneswaps chief.

A popular horror story concems the systemdeveloped by a leading London bank. Recallsone swapper: "They sold just one of theirsystems. Unforrunately they sold it to a ratherdemanding client rather a long way away.Every three weeks or so they have to fly outto explain the results or correct flaults. I'veheard people there saying they wish they'dnever sold it."

Paribas and SecPac have developed a seriesof in-house computer systems on which entiredebt and asset portfolios can be modelled.Rather than sell these packages, they performthe analysis themselves. Using the client'sviews on currency and interest rates, or themarkets' as indicated by forward curves, thebanks produce advice on the ratios of fixedto floating debt/assets and the optimumcurrency combination these views imply. Thisconcept has been refined Ly both instirutionsand both now olfer a range of analyses forwhich they make impressive claims.

"We are changing the way people look attheir existing as well as new issue debt," saysJohn Mussachia. executive director at SecuriryPacific in London. "At the moment chieffinancial officers might do scenario analysis-

looking at what happens when rates go up,stay the same or go down

-

and then theymight choose the alternative with the lowestaverage cost. what we try to do is show thathedging using expected rates can lead topositions that you never would have gotteninto if you had realised the possibiliry, Wedo a probability analysis of all possibleoutcomes so that clients can see what wouldhappen if something outside their expectationsoccurs. This is expressed as a probability

-

so that a client might be told that if he useda swap then there is a l0% chance that hisrates will rise above 11.25%. The client thenhas to decide whether he can accept that risk.-

One way of working out this probabiliry isto use the implied forward curves (themarkets' view of where. say three-monthLibor will be in three months' time) and addan expected dispersion by incorporating themarkets' view on how accurate this curve is.This is done by incorporating the impliedvolatility of the relevant interest rate or il>

-Now at Paribas, Jim Durrant says he'simproved on the portfolio models heoriginated at SecPac.

currency derivative.Paribas' approach is very similar. This

comes as no surprise since the same man -Jim Durrant, now head of research at Paribas

Capital iVlarkets in London -

is behind bothsystems. Understandably, Durrant thiirks thathis new package is superior. -Whenever youput together a system, you look back and thinkabout how you would have done it ditferentlvif you had ihe chance ro start again. Well. ihave had the chance to start again, and lveincorporated a number of improvements."

Neither institution charges fbr this analysis,hoping that it will supply any swap oroption products purchased by the clients asa result. "We do not do anything tbr free

-if I said that it would be untrue." says JohnStomber. head of SecPac's origination ettortfor the eastem US. -We expect compensation.If we get within a basis point we expecr robe given the deal. Ifwe kept getting shut ourof deals over half a basis point rhen we wouldbe priced out of the market."

Although clients which make a habit ofgening the analysis done and going elsewherefor the fixes soon find that their queries areanswered more slowly, the banks do seemprepared to run these services as loss-leadersif necessarv. "It is not fbr us to decide whoto do business with and who not to do bus-iness rvith." savs Durrant. -Our clients mavhave relationships with other parts of the bankand this is

.lust pan of an overall service.-The banks do expect that clients will at least

cover their expenses if an analysis turns outto be panicularly long and complicated.SecPac is in the middle of a rhree-monrhbreakdown ol the debt porriblio of a largeItalian state-owned corporation. This kind olservice has to be paid tbr.

The main clients are sovereigns andgovenment entitic-s. major internationalcompanies and some large frnancial insti-tutions. Paribas deals almost exlusively ivirhtriple-A and double-A credits. and itsconsultancv service fiequently advisesborrowers tbr rvhom it has lead-managedEurobond issues such as the Kingdom of80 Eurornonev .\pril 1990

ESWAPS & OPTIONSI

Denmark and SEK. Even corporations within-house finance arms. such as UK oil giantBP, have had analyses done. SecPac reckonsthat as a result of its strategy, 50% of itsbusiness is with end-users. New issue-drivenswaps are now only a minor part of itsactivity, especially since the bank withdrewfrom the primary Eurobond market. Thisemphasis may be detected in SecPac's tradingprofile. Says one trader: *They used to be inthe market all the time. Now we don't seethem so much.'

However, the more complex retail-orien-ted products are growing fastest. Institutionsresponding to the latest Intemational SwapDealers Association survey wrote M67 billionof swap contracts, measured on notionalprincipal amount, in the first six months of1989, compared to the $690 billion in thewhole of 1988. Caps, collars and swap-options contributed another $187 billion

-

swaption notional principal growing by 16370over 1988's semi-annual Erte; c:ps, collars andfloors grew by over 70Vo.

Those houses which concentrate on tradingare sceptical about consultancy. 'We have notset ourselves up as a risk managementadvisory service, and it does not make sensefor a bank to do this. It does not requirecapital, so it is better done by an investmentbank or boutique. Ifyou don't charge, you arenot guaranteed a deal because the user willput the deals out to bid anyway. We wouldrather use our resources on the trading side,"says Westpac's Goldie-Morrison.

The service has a long way to evolve, andsome banks, while remaining trading houses,offer an informal advisory service. "I wouldnot say that we offer consultancy," says Sekse.*We

are a trading house with over l0 currencyswaps books off which we also sell optionsproducts. We sell these products to corporatesand other financial instititions which they thenoffer on to their own retail customers. Oursales approach is to offer a problem-solvingservice to both corporate and financialinstitutions." In the same way, Citicorp andBanMmerica make markets in the full rangeof vanilla derivative products, as well asputting together tailor-made packages on adeal-by-deal basis. These houses. though.have not yet made available the multiplemodels on which entire portfolios can beanalysed.

A third approach is to avoid the wholesaleswap and options business and to concentrateon developing new products for the retailmarkets. These are the currency. interest rate,commodity and equity-linked warrants thathave been launched as both public issues andprivate placements in the UK, US, Switzer-land, Germany and on the Euromarkets. Sincethe beginning of 1989 there have been over150 such issues and a further 500 issues ofcovered warrants. Investors have been ableto hedge (or gamble on) movements in thestock indices of Germany. France. the UK.the US. Italy. Switzerland and Japan,tluctuations in the yen. Deutschmark, sterlingand Australian dollars against the US dollar:

Advising on risk management doesn'tguarantee deals, says westpac'sDuncan Goldie-Morrison.

and movements in interest rates via warrantson a range of government bonds and bondfurures (French OATs, German Bundes-obligations and Bundesanleihe. and JGBs).

These instruments are the one area ol thederivatives market where domestic insrirutionsstand a fighting chance. They have fbund.irdifficult to make an impression in the swapand option markets because, as commodirymarkets, they are systems and int'rastructure-intensive. The most efficient books are runglobally to maximise the number of possibleoffsening positions, to allow the minor booksto clear through the main book. to make risk-monitoring easier, and to increase the book'sliquidity by allowing bigger limits.

The warrant business offers local insti-tutions one way into the derivatives business.Sociite G6ndrale. Trinkaus und Burkhardt.Commerzbank. VItvl Warburg-Brinckmanand Westdeutsche Landesbank Giroz, rleare all in the top l5 lead-managers of p..,licwarrant issues (excluding covered warrants)since the start of' 1989. il covered warrantsare included. local houses t-eature even moreprominently.

These instruments have been criticised fbrthe excessive premiums charged on thewarrants. and an alleged concentration onshon-term protits at the expense of olientsatisthclion. Says one banker cryptically:*These markets cenainlv oifer banks themargins of products in the early stages ofdevelopment."

Befbre he left the chairman's job ar BankersTrust International. Allen Wheat toldEuromoner- that he saw the warrant marketsswiftlv going the way of the other derivativesmarkets

- becoming low-margin commodiry

markets. His strategy would be to stay in rhemarket until that happened, and then move onto a nerv product ranee. leeving the domestichouses to tight each other tbr the business.

While the banks ponder and pursue theirstrategies. it's clear that the heady days oitrueinnovation are gone. Success in the derivativesmarket will increasingly depend on presenr-ing the same old products in new guises.l ,

Swaps and options gave theEurobond market a new leaseof life in the 1980s. Deriv-ative-driven private placementsand the increasing use ofswaps and options as assetmanagement tools couldundermine the public bond

_markets in the 1990s.y Simon Brady

or the past seven years the swapmarkets have grown on the backof an underlying liquid publicbond market. The primary Euro-

bond market has been transformed first bv theapplication of swaps and then options to newissues. The Ecu market is almost entirelyswap-driven as is the Euro-srerling sectoi.The Euro-yen sector relies on the vieldenhancement provided by embedded Nikkeiput options and the growth ofcallable bondshas been spurred by the development ofa $60billion swaption marker.

As the benefits of using derivatives to tailorproducts to the needs of"individual i^;;;;or investor groups became understood, thestructured private placement began to competewith public markets. In some areas, most'lnificantly Japan. swap- and oprion-driven

_

.lvate placement business has become moreimportant than the public Euromarket.

The major invesrors in Japan are the lifecompanies. Nippon Lifle has over $165 billionof assets; Dai-Ichi Life around $l l5 billionand even tenth-ranked Toho Life has over S25billion. These companies are limited tomaking dividend pay-ours to policy holdersfrom current coupon income, which meansthat they are in the marker for high couponinstruments and are prepared to take on someprincipal risk. The companies' tarqet couponlevel is the Japanese Long-Term Frime d.ate(LTPR). In periods rvhen there has been asubstantial dilfbrence between borrowers'target funding levels and the LTpR. theinsurers have tried ro t'ill the gap bypurchasing bonds in high-coupon currenciessuch as rhe Australian dollar. The rapidappreciation of the yen against thesecurrencies led to heavy loreign exchanselosses on the tbreign bond froldin-gs and tbrcldthe insurers to lo"ok tbr other wavs to meettheir targets. The most tlexible source ofsuitable investments has been the privateplacement market.

Three basic swap- and option-driven struc-

HOW IO TAI1OR YOUR ASSTTS

With over $ 160 billion of assetsplacement market illustrates the

to invest, Nippon Life's use of the privatepopularity of derivative-driven instruments.

tures have been popular: callable yen bonds:dual-currency instruments; and Nikkei-linkcdinstruments. The straight )'en placement issimply a loan with bullet repayntent onmaturitv. The cash flolvs can be swapped toprovide competitive funding in anothercurrencv.

Callable ven bonds are typicallyr purchasedby insurance companres. Thev van' in rnat-urity but a common structure is ibr theinsurance companv to extend the loan tbr tenyears at a trxed ven rate rvith an option tbrthe borrorver to cancel any tinte atier threeyears. The borrorver. usuaiiv an AA- orAAA-rated Europeen bank. s,'vaps the trxed-rate ven into the currency t>i its choice at asub-Libor level. The swap counterpany hastherefbre entered an ottmarket srvap in r""hichit pavs out the highcr-than-rnarket-rate uoupondemanded bv the insurance companv. rnd rec-eives a sub-Libor tlow in return. To make upfbr this discreoancy the borrorver ,.v't ites Icallable swap {an option to cance'l the srvap)in lvhich the srvap counterpartv has the rightto cancel the swap alter three vears. Il venrates fall. the srvap is called and rhe borrorvercancels the Ioan. The srvap counterpan\'sclisthis option dorvn and uses the prentiunt to sub-sidise the oft'-market swap.

Dual-currencl- structrlres involreinstrumenls whose principal is paid and repaid

in yen. but rvhose coupons are in a high-coupon currencv. Loans are made b.u- the ins-urance companv either direct. or rhrouqh aleasing companr, intermediary. This choice rsdictated bv the rvpe of borrower as the leasinecompanies are eiiorved to lend to a rviderrange of credits. The ieasins companiestypically lend on a subordinated basis toborrowers oi BBB or berter credit-rarins.The.v- take r spread ol 15--10 basis points i5racting as an intermediarv but are stiil able toprovide competitivelr-priced funds taroundLibor less l0) because oi their relarionshipsrvith the insurance comoanres. The end-userrrreiv

"vants 1en rundine. and so the principal

is su,apped into tloarinc-rate US doilars.This market has slow'ed recentl.,, because

rhe .upplv ot iherp runds trom rhe lire com-panies has dried up as rher., reach rheir lrmitson exposure ro leasing companies. This sque-ezc has meanl that the Ielsing corrpanies'costof ftrnds has risen irom around Libor less i0to Libor ilat or even hieher. A recent issuebv rhe Banco di \apoli resulted ln a cost oftunds to rhe end borrow'er oi Libor plus 55.

The third srrucrurL-. Nikkei-linkcd deals.started in rhe private placentenrs sector but isnow'comtron in the public ntarkers. Like cal-Iable bonds. the borro*'er pavs an above-nrarket coupon tnd reccives :ub-Lrbor fund-ins in the currencv rri its choice. The swao

I:trrrrnrorter j,Orrl 1q9() 3.1

SWAPS &

FixedRate

7%

Creating synthetic "bear assets"

@Libor

For examole, take an investment portfolio of DM 10m with a5-year avirage life, To take advan'tage of a projmrcd 0 5ooriie in S-yeai rates, the portfolio manager iuts on a DM20m,S-year swap: this works as follows:

Ircss on bonds: Price at 7 .1Vo rates -

Price at 7qo rat'es =DM10m x (97.977

- 100)/100 = -DM202,294.

Gain on swap: Present value (PV\ of 0.54o on DM2Om over5 yeaE at 7.3% =Pv 15,7.57o, DM100,000) = DM404,588.50.(Libor is assumed to have remained constant)Net gain on bear position: DM202,294.50

Source: SecuritY Pacific Hoare Go\

Source: Security Pacific Hoare Govett

Hedging against adverse interest rate movements

wFixed

rate10%

SecPac's Chris Botsford advocatesswaps, not bond switches, as thelogical way to modify exposure.

is subsidised by the sale of Nikkei put optionsby the investor to the arranging bank. Theseare then sold on to the OTC market and thepremium received is factored into the swaprates.

The key to the succcss of these deals hasbeen the swap and option books of the arran-ging banks. The avaiiabiliw of rhe appropnatederivatives dissociates investor pret'erencefiom that ol the borrower. Investors get thecash tlorvs thev rcquire. borro,'vers get cheapt'inancing. The lvailabilitv oi ln increlsingnumber ol liquid and sophisticated derivativeshas altered the balance of power between thepublic and private markets. More and moreissuance. which r.vould have been donepublicly two years ago. is being done pri-vatelv. Large numbers of ostensibly publicdeals have been targeted and pre-sold. Ofthe60-plus Eurobond issues by Bankers Trust iastyear. less than ten rvere straightibrward debtissues. The rest lvere highly structured andhad been discussed and refined rvith the largetinstitutions tbr tlays il not weeks belbre issue.

However. the private placement markethas. until norv. been hampered by its oneover-riding disadvantage: illiquiditv. This hasalrvrvs overshadorvcd the manv udvantages otthd rnarket. rvhich include a kxver cost olfunds bccuuse r)l rltvrolIS on printing. ilgcncv.legal und undenvritins expenses: flexibility olstructurc because oniv a small number ofinvestors have to be satistled: speed ofarrangement bccause no svndiclte has to bearranged: no public disckrsure: lnd thebuilding rrf close rciationships

'.vith rnajorinstitutionul in'u'estors.Thc traditionul ri*v rvas that institutional

invcstors such ls pcnsion funds -

tvhich hold

For example, for a US$10m 10-yeu bond with a 10-yeuswap and a 0.5% increase in lGyear yields to 10.5%,the hedge works as follows:

Loss on bond: Price at L0.57o rats -

Price at 107o rates =$10m x (96.993 - 100y100 = -$300,700.Gain on swap: Present value (PV) of0.57o on $10m over10 years at 10.5% = PV ( 10, 10.57o, $50,000) = 3300,738.(Libor is assumed to have remained constant)

longer-term assets than liabilities to obtain ahigher yield iiom a positively sloping yieldcurve

-

are sensitive to interest rate changes.and so unwilling to commit to a hold-to-maturity philosophy. They theretbre avoidheavy investment in illiquid bonds because.should their currencv or interest rate viewschange. the-v- want to be able to alter the pro-portions of lixed- and floating-rateinvestments and the currency mix of theirporttblios bv switching bonds. To do this'they need a liquid bond market. The swapsand derivatives markets challenge thisorthodoxy.

The argunrcnt runs like this: institutionalinvestors' appetite tbr private placements hasproved that tariured products overcome theirliquidiw rvorries. By buying such instruments,the institutions have got to grips with thecomplexities trl derivative-linked products. Itis a shon step ti()m here to recognising thatthe same derir.atives can be applied to anexisting rsset porttolio to alter itscharacteristics regardless oi the liquidity ofthe instrumcnts it contains: so there is lessneed tbr a iiquid public bond market.

The illiquidity of manv government andEurobond markets relative to their corres-ponding swap markets only strengthens theargument for using swaps. rather than bondswitching, lor porttblio management. Try tomove f25 million of gilts or S20 million ofa Sl00 million AAA-rated Eurodollar bondissue and see what happens to the price," saysCraig Kersey, director of risk manage-ment/technical products at Mitsubishi FinanceInternational. "But you can easily do similar-sized tickets in the swap markets withoutmoving the price." There is now over 52trillion outstanding in the swap markets. andthe business is still growing.

-The Tokyo market offered solutions for theinsurance companies in response to foreignexchange regulations and the insurance com-pany code." says Kersey. "The next area ofgrowth will be European pension funds. Thederegulation of 1992 will benefit Europeaninsurance companies: their problem will bewhere to get enough flxed-rate assets in eachcurrency. The answer is the swap market

-

the largest and most liquid tixed-rate marketin Europe: so liquid that in currencies like the

I

i>Euromoney Aprrl i990 85

Ecu. which lack a good spread of maturitiesand issues. the swap rate is already being usedas a benchmark of value."

In other words, asset managers will useswaps, not trading, to adjust their portfoliosto changing interest rate and currency views.'The logical way of modifying exposures inthese areas is swaps," says Chris Botsford. atSecurity Pacitlc Hoare Govett in London."and if vou use swaps. you need not investin liquid bonds. So you might as well get theadditional benefits of cheaper funds and tailor-made structures of the private placementmarket." The time will come, according to thistheory. when the only bond markets will beefficient government bond markets and thederivative-driven private markets.

The popularity of active debt managementusing derivatives makes asset-swap supponersoptimistic. From a deal-by-deal use of swapsand options to manage their debt, institutionsare steadily moving towards active debt port-fblio management. With the help of banks'consultancy departments. sovereigns, sup-ranationals and government entities are usingswaps to alter ratios of fixed to floating debt,and also currency mixes. They are using capsand floors to control their rate exposures. Andcentral banks are using the swap markets toalter their positions rather than bond and forexmarkets. One head of risk management says:"If a government was seen to be moving outof its own currency, it could cause instabiliry.For reasons of anonymiry they are now usingthe swap markets."

As a result, the advantages ofusing deriv-atives are becoming obvious on the asset side:the swap markets allow the investment man-ager to "buy" or "sell" a yield without anunderlying principal credit risk. By de-coupling market-rate decisions from creditdecisions. swaps increase an investmentmanager's tlexibility, opening up a muchwider range of investment opponunities tomeet an investor's particular requirements.And swaps enable accurate comparison ofasset values in different currencies withdifferent structures.

Asset managers have already started to useswaps in this way via the synthetic securitiesmarket. With a synthetic securiry. an arrangerbuys an underlying bond and is principal toa swap which creates the investors' requiredcash flow (for example bunds swapped intosterling to create a synthetic gil0. The investorpurchases only the bond principal and thetailored cash flow. The arranger takes careofthe original coupon on the underlying bond.deals with the swap cash flows and pays theinvestor the requisite coupon. The syntheticscan be tailored on a one-ofTbasis, or a specialpurpose vehicle can be created which buys theunderlying bonds. modifies their currency andinterest rate characteristics and issues newpaper against them. These synthetics. likeprivate placements. would tbrm the illiquidbasis tbr a swap-managed pontblio. Thesimilarity of synthetics to asset swaps isdemonstrating the benet'its of active swapmanagement to the investors.86 Euromoney April 1990

Creating synthetic fixed rate assets

Fixed rate,G + 1.0%

SterlingLibor

+0.5% Floating Asset Yield. Libor + 0.5%Investment Mansger pays on swap: (Libor)I.M. reeives on swap: gilts + 1.07oYield on repackaged bonds: gilts + 1.5%

Source: S*urity Pacific Hoare Govett

Per Sekse of Manufacturers Hanover:asset managers will start to useswaps in the next three years.

But the lcap to full_,--tled-sed asset swappineis large. In an asset swap. the investor is thecentral tlgure: he buvs rr suitable bond andthen goes to the swap market to moditycoupon and currency. Even if an alTangeradvises the investor on the instruments to beused. the inve:tor is still responsible tbrmanaging and accountrng lbr the cash tlowsof the transaction. He owns the underlyingbond. and he is u principal to the swap.

The disadvantages of the approach are theadministrati"'e costs ol handling these cashtlows. and in particular the need to value theswap tbr accounting purposes. Asset swapsupponers believe that large institutionalinvestors lre elreadv clpable of pertbrmingboth these tasks. lnd that scveral large USinstitutions are alreadv actively managingswaps porttblios. Suys Nlark Tristram. second

vice-president at Chase Manhattan in [,ondon:*It goes without saying that people are lookingat these instruments for active managemenl.Profits are taken, swaps are unwound." Thepopulariry of yield-curve swaps which exploitspread and yield-curve anomalies shows thatinvestors will use complex derivatives to lockin profits.

The illiquidity of both private placementsand synthetic securities becomes an issue onlyif the fund manager has to move quickly intocash. In this case the investor has rwo choices.Sell the instnrment back to the arranger, orsell it on in the market. It would be up to theinvestor to make sure that the first alternativeremained possible until maturityt the secondalternative will become easier as a formalsecondary market for private placements isdeveloped. In the US, a private placementsmarket designed for ofiering, trading, clearingand settling these securities will come onstream when Rule l44a is approved. CalledPORTAL. it is run by NASDAQ and will bethe first trading market for privately placedsecurities.

Unexpected cash demands would tend toaffect unit trusts and. in exceptional circum-stances. insurance companies. Mainstream lilecompanies and pension funds

- the major

inveslors -

predicr their cash flows years inadvance and should not be worried aboutilliquidity.

It will still take time to overcome the innareconservatism ol institutional investors, andin some countries, including the UK. theregulators need tinre to catch up with thet'inancial engineers. The proponents ofderivative-based asset management admit thatit will be a slow process. Says one swapper:"l have devoted a lot of my time. (though notmy stafls because this does not make muchmoney) into showing fund managers assetswaps. I say: 'lf you had invested in bundsand swapped them into sterling last year youwould have got 80 basis points over gilts.'andthey do not buy it. You ask yourself how toget these things t-unher up their list ofpriorities. and you realise that pension tund

(-,'ilililtr\l,\t l\t\t ilg

APS & OPTIONS

Anilnu&l /itilil pugc tJ6managers are actuaries and that someone likeme going in and showing them a lancy swapdoes not impress them very much."

"That's why we just recruited an actuary,"retorts Willy Simon, at Citicorp. "We figuredif you can't beat them, join them." SecPacemploys fwo actuaries, but even in the US theprocess is only just beginning. Says JohnStomber, head of SecPac's origination effortfor the eastern US: 'Because the US has beensuch a dollar market we are only just beg-inning to see the mutual funds and pensionfunds doing this. Even swap-driven privateplacements are still a relatively small part ofthe total private placement market here. Wehope to be a leading institution in helpingmurual funds, pension funds and insurancecompanies create assets in any currency andwe are gearing up our operations to do this."

Manufacturers Hanover's Sekse believes thatthe process will take off in the next threeyears: *Swaps took eight years because theywere a new product. Now they are not new-

the hurdle is just a new application."Of course, investors will still need under-

lying bonds in which to invest, but these willbe the synthetics and structured private place-ments. As the public markets shrink, so thismarket will grow. And it will not just be theEuropean market that follows Tokyo's lead.Approval is imminent for Securities & Ex-change Commission Rule l44a which prov-

ides exemption ior the registrationrequirements of the 1933 Securities Act forre-sales of restricted securities to *qualifiedinstitutional buyers". Approval will allowforeign issuers to sell debt or equiry private

CSFB's reputed $5 million lureto Allen Wheat emphasises the

importance.it places onderivatives

placements in the US without having to gothrough the cumbersome process of SEC reg-istration; without having to comply with USaccounting regulations; and without the two-to three year holding period that applies atpresent to unregistered securities. This willmake the US market attractive to companiesfrom countries such as Germany and Switz-erland which had previously been unwillingto make the necessary disclosures. Smallercompanies from European countries withsimilar disclosure requirements to the US,such as the UK, have already found the USprivate placement market a cheaper and moreconvenient source of fu4ds than the publicmarkets, according to IanPeacock, at Klein-wort Benson in London.

The etfects on the banks are difficult topredict. Few houses make significant profitsfrom primary public Eurobond issuance. Theerosion of this market will not hurt them. andthey are already making money from privateplacements anywav. Fixed-income tradingoperations are being scaled back or closed inmany institutions now, and a reduction in thesupply of new benchmark issues will simplvaccelerate this process. And those banks withthe largest swaps and options capabilities, thebig commercial banks, will be better pos-itioned to take advantage of this process thanthe investment banks which have traditionallydominated the primary bond markets.

The strategic necessiry of derivatives washighlighted recently by the evident delight ofCSFB's Hans-Joerg Rudloff in having luredAllen Wheat and some of his most accom-plished lieutenants to head up a new s ;and derivatives company within CSFB.

-,efact that CSFB was prepared to pay a reputed$5 million for Wheat and a further 51 millioneach.for selected other staff emphasises theimportance one leading house puts uponderivatives in the bond markets in the i990s.At the time Rudloff commented: *CSFB hasnever taken swaps positions. . . We are fillinga hole that CSFB had. The market has dev-eloped to the point where you have to be ableto ofler clients not only your services but yourbalance sheet as well." T

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