Switzerland: Foreign Exchange

SWITZERLAND

A EUROMONEY SURVEY - MARCH 1996

BACKGROUND

From 1994 to 1995 the Swiss economy reached positive year-on-year growth rates despite the tough competition brought about by the sharp appreciation in the Swiss franc's value. The Swiss franc is one of the key parameters driving the Swiss economy. The Swiss franc is expected to stay strong and there is a good chance that the Swiss National Bank will become more expansionist in order to stimulate the desired effects on the exchange rate.

MARKET CHARACTERISTICS

The Swiss franc

In the most recent in-depth survey of foreign exchange market transactions by the Bank for International Settlements (BIS), Swiss franc spot transactions were ranked sixth both by value and turnover in currency trading worldwide. The Swiss franc was involved in 14% of all transactions carried out. Its average trading volume was $87 billion per day.

The Swiss franc's reputation as a safe haven remains unshaken. But political developments and economic conditions stimulated spot market trading among other major currencies. On the one hand, dramatically increasing volatilities among European currencies over the three years to 1995 prompted a considerably higher trading volume in the dollar, Deutschmark, yen, pound and French franc. And the approaching deadline for European monetary union raised speculation that induced hedge trades in the above currencies. On the other hand there has been a shift away from pure interbank trading towards more customer-oriented trading during the last three years.

The share of customer trading in the whole foreign exchange market increased from 19% to 22% in the three years to April 1995. The Swiss franc, with its low volatility, continues to be sought after as a safe haven currency. As the Swiss franc traditionally is more a vehicle for preserving value than for active trading, its importance is declining as the share of the interbank market in overall volume declines.

The Swiss foreign exchange market

The BIS survey indicates the important role Switzerland plays as a marketplace within the international foreign exchange market. It currently ranks as the sixth most important currency marketplace in the world. Switzerland continues to stand ahead of Germany and all other European countries except the UK. This position underlines the traditional dominance of Zurich, after London, as the second most important forex trading centre in Europe. In Switzerland, spot trading in foreign exchange still accounted for 51.1% of all transactions, while the volume of forward transactions is on the rise. The dollar is still the most traded currency. Dollar/Deutschmark and dollar/Swiss franc trades make up 50% of all deals settled on Swiss territory.

The Swiss derivatives market

At the end of March 1995 a notional $1,546 billion (2.7% of the world market) in international derivatives contracts was outstanding in Switzerland. Over-the-counter (OTC) business made up 94% of the total. The market value of the total contracts outstanding was $86.5 billion, which was up 32% from 1992. Of the outstanding contracts, 68% were ascribable to currencies, followed by interest rates, equities and commodities.

As Switzerland is a small open economy it is naturally very export-oriented and faces, as a result, significant currency risks. The currency fluctuations in recent years, partly caused by the chaotic movements in the European currency system, have grown to an unacceptable level for some companies. This has triggered tremendous growth in currency derivatives, most notably in OTC currency options, as they ensure unique flexibility with respect to hedging characteristics, hedging levels, terms, amounts and currencies. Nowadays market participants are also increasingly making use of exotic options in order to cope with companies' specific risk profiles and to keep their hedging costs as low as possible. Today's Swiss treasurers are increasingly using the entire range of products to hedge the various forex risks. It is therefore not surprising that Switzerland is home to some of the most sophisticated currency risk managers.

Hedging strategies

One of the frequently-applied hedging instruments is called the basket option, which is used as a tool to hedge multiple currency cash flows. A basket option provides the right to exchange two or more currencies for a base currency at expiration. For example, a company expects to receive income from exports to various countries. A put on the basket option consisting of these currencies gives the company the right to exchange the currencies for Swiss francs at expiration. The option is cash settled and the main advantage of this product is its low cost. The option is generally 15% to 20% cheaper than a strip of standard options. In some cases savings of up to 30% can be achieved. The lower the correlation between the currencies, the cheaper the basket. Basket options are also very flexible and can be tailored to exactly match a particular set of multiple currency cash flows. In addition, basket options are easier to administer, eliminating the need separately to monitor, revalue and exercise a strip of options.

Asset managers in Switzerland have also had to become very sophisticated, because the current low interest rate environment in Switzerland is not very encouraging to investors. Many market players have therefore been looking for opportunities to improve the return on their Swiss franc investments by taking advantage of specific events in other financial markets, while having the principal amount and a minimum rate of return guaranteed. A very popular strategy in this respect is the GRIP (guaranteed return on investment product). Investors who do not expect a significant movement in the $/Swfr exchange rate purchase a GRIP. The GRIP guarantees a minimal interest rate and offers a better return on investment, provided the $/Swfr exchange rate stays within a given range and strike levels are never touched during the lifetime of the product. For example, with the $/Swfr at 1.1650, the investor receives 0.50% pa guaranteed. If the $/Swfr rate stays within the range of 1.1100-1.3100 during the next six months, the investor receives 4.50% pa. This compares favourably with a six-month money market deposit, which would only yield 1.60% pa.
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