“We’re not quite back to the heyday of 1993 but the structured asset market is definitely back in a big way.” The period this global head of derivatives is fondly recalling was characterized by highly leveraged bets on falling interest rates that culminated in the debacles at Procter & Gamble, Orange County, and elsewhere. Today the bets are less leveraged but they express views on ever more exotic currencies and assets using an ever more complex combination of non-vanilla products. This increasing fondness for the exotic has already taken its toll this time not only on the buyers of the products but also their suppliers.
Range trades in the foreign exchange markets and recently, to a lesser extent, interest rate markets have been one of the most popular products in the last 18 months. In the most straightforward version, the range binary option, investors receive a payout of several times the premium paid but only if the underlying exchange or interest rate remains within a preset range. More exotic variants are often embedded in bonds. These create products that allow daily accrual of interest on days when the range conditions are satisfied. In some cases, accrual is stopped once the range is broken. In other cases, accrual is restarted after a range breach if the underlying subsequently trades back inside the range.
To give an idea of the scope for leverage in range trades, in mid-1996 products were being structured that gave 8:1, 10:1 and even 15:1 payoffs on a straightforward double knock-out structure. There were more complex versions: Bankers Trust’s Quattro product gave four ranges: if an investor was correct on all four ranges, his payoff was eight times the premium. Even if only one range remained unbroken the Quattro holder received double the premium. Although these instruments are highly leveraged, they limit losses to the premium paid. This differentiates them from more conventional bets on low volatility such as the sale of straddles, which expose the holder of the position to unlimited risk. That said, holders of notes in which these options are embedded can lose significant amounts of their principal if the bonds are not accruing and are sold before maturity. Libor-indexed range floaters cost investors dear two years ago. Recently it’s the dealers who have been hit hardest by range foreign exchange products.
The problem forex deals were struck when volatilities on European cross-rates were close to or at all-time highs. This pushed the price of binary range products down dramatically since it seemed likely the ranges would be broken. Subsequent sharp falls in volatility for example, Deutschmark/lira volatility has fallen from around 15% to nearer 5% have meant that the ranges have not been breached. In addition, the popularity of the product with both institutional investors and corporate hedgers, which used the range option in place of vanilla options to reduce hedging costs, exacerbated dealers’ problems. Prices fell below the levels at which they covered hedging costs as dealers competed for business. Moreover, the scramble to hedge positions once it became clear that the downward trend in volatilities was permanent itself forced down volatility. As a consequence, option holders have made huge profits and underhedged option dealers have taken significant losses. Bank of America, NationsBank and BZW are rumoured to have suffered: these institutions have cut their exotic foreign exchange teams recently. They will not confirm that these moves are linked to losses on exotic options dealing.
However, just as the market recovered quickly from the shocks of 1993, so the range trade debacle is proving merely a momentary stumble on the path to ever increasing acceptance of exotic products throughout the investor and corporate universe.
Investors are still eager for range products despite higher pricing as a result of lower volatilities and the reduction in the number of banks in the market. “Even with present volatility levels there is still enough value to be extracted from range trades for people to be interested,” says Zar Amrolia, head of global risk strategy at Deutsche Morgan Grenfell in London. “That is especially true now that people think that Emu will occur volatility may only be 5% but the currency bands will be 2.5%.”
Volumes have also been driven by demand from corporate treasurers who see range options as a cost-effective hedging instrument. By themselves, range options are not true directional hedges, they hedge volatility. However, in combination with vanilla options or forwards they can be used to create cheap and even self-financing hedges. “It is true that a range binary by itself is not a hedge for a long or short cash exposure,” says one dealer. “However, take a corporate that is long dollars and wants insurance. It can buy a dollar put and a range option on the relevant exchange rate. If volatility falls then the value of the put will fall but the value of the range option will rise. The put may expire worthless but the range may pay out, funding the put premium.”
Rumoured losses
These trades were first seen when volatilities were high and corporates were unwilling to pay the consequently hefty premiums for standard option protection. As usual it was French and Scandinavian companies that led the way in developing the market and one trade, an 18-month range option on the French franc/dollar rate for French state-owned arms manufacturer Aérospatiale, has since become notorious. It is rumoured to have caused substantial losses to the banks which were ultimately left hedging the other side of the position (the original sellers, Credit Suisse Financial Products, sold out early). No parties to the trade returned calls to Euromoney.
Range options can also be combined with forwards in a similar fashion to create what some banks call the range bonus forward. Instead of buying an outright forward, a treasurer can decide to take some of the forward points and use them to buy a range option. “Say the forward dollar/Deutschmark outright is 1.67 and spot is 1.68. You can take one pfennig of premium to buy a range position that produces say four pfennigs of windfall profit if your view is correct,” says Deutsche Morgan Grenfell’s Amrolia.
It’s not just exotic structures that have become commonplace, exotic currencies and asset classes are also increasingly popular. Dealers report increasing demand for derivative-linked plays in currencies that until recently would have been rare even in cash-market transactions.
Emerging and emerged
“A lot of the currencies still often characterized as being ’emerging markets’ have really emerged,” says one dealer. “We have done structured assets linked to Mexican pesos, the Czech koruna and the Philippine peso the last one of those with a UK investor, which is particularly surprising. The definition of ’emerging’ has moved on.”
This is particularly true of Asia, where volumes in the freely convertible currencies the Malaysian ringgit, Indonesian rupiah and Thai baht have surged. The most common instrument used to take positions in these markets is the non-deliverable forward. This is simply a cash-settled forward and transactions are usually foreign currency against the dollar with the transaction settled in dollars. This type of transaction is better suited to the heavily regulated Asian markets than more complex derivative instruments such as currency swaps which can attract unfavourable tax treatment. Non-deliverable forwards are also the only way for investors to take positions in non-convertible or partly convertible currencies such as the Korean won, Indian rupee, new Taiwanese dollar and Chinese renminbi (itself just announced as a possible candidate for a futures contract on the Chicago Mercantile Exchange).
“We have done a reasonable amount of business in structured notes with embedded non-deliverable forwards,” says the head of a leading bank’s structured asset group. “There has even been business in the Thai baht, which we are not pushing right now because of the political situation. We have seen people who think that over the long term the Thai baht will not depreciate as much as the forward curve suggests and they have bought notes with non-deliverable baht forwards embedded in them.”
It is not just the more adventurous investors who are moving into these markets. Corporate hedging flows are also driving volumes up. “We are seeing a lot of interest in the emerging markets on the back of corporate demand for hedging,” says Sara Sullivan. head of foreign exchange options sales at HSBC in London. “Companies have increased their cross-border investment into these countries and so their need for hedging instruments has increased.” This, coupled with institutional demand for derivatives-linked investment strategies, has created sufficient flows for dealers to be able to offer new products.
The new exotics
So rapidly have end-users moved into once illiquid and little-traded markets that a new class of exotic currencies and assets that not long ago would have been considered untradeable are now attracting derivatives trades. Those dealers who believe that much of Asia, Latin America and eastern Europe has already emerged mention Latvia, Côte d’Ivoire, Nigeria and Bulgaria as interesting new emerging markets, and embryonic derivatives markets on them are being created.
These are extremely risky markets. Thirty-day at-the-money call options on a class of Bulgaria’s Brady bonds known as international arrears bonds were trading at implied volatilities as high as 36% in January and have rarely traded at less than 28%. Despite this, dealers report interest in assets linked to these markets and in currency plays on the Bulgarian lev and other minor eastern European currencies, notably the Latvian lat.
The old exotic currencies are now so far into the mainstream that investors are beginning to apply exotic option strategies to them. Range and barrier trades are the most popular and the favoured currencies are those managed against a basket, such as the Czech koruna (dollar/Deutschmark) and the Asian currencies.
Basket currencies are attractive because they mitigate some of the volatility associated with emerging markets: spot illiquidity feeds through into higher volatility in forward prices. Since options are priced off implied forward curves this means even higher options prices. However, baskets of currencies, as long as the currencies are not significantly correlated, diversify risk and so reduce volatilities. Czech koruna volatilities fall as low as 5%, in line with the most developed markets.
Investors and corporates are combining these low basket currency volatilities with exotic options to bring premiums down to acceptable levels. Call options with down-and-out barriers are another once exotic product now routinely used to take views on currency appreciation the outstrike being set at a point where the call is well out of the money. “These are all basically carry trades,” says one head of exotics. “They are just bets that high yielders won’t depreciate in line with the forward curve.”
As with range products, these carry trades can produce losses as spectacular as the gains if things go wrong. Within Europe, one favoured trade has been to use options to go short Ecu/long Greek drachma. Ranges on this pairing have also been seen. In 1996 the position yielded an interest rate differential of around 6% on an annual basis with a spot depreciation of only 1%. However, realizing these returns was not as easy as it seemed. London-based hedge fund group IFM Asset Management has just closed down its Iliad and Explorer hedge funds after disastrous trades involving short positions against the drachma cost it 20% of one fund’s value. These losses were compounded by further loss-making trades in Japanese derivatives that cost a further 11% of the fund’s capital.
Exotic yes, leverage no
Despite the drive for yield enhancement that is behind the popularity of exotic trades, dealers claim there is little willingness on the part of non-hedge fund players to indulge in the kind of leverage that precipitated the derivatives meltdowns of three years ago. The clearest evidence of this is the move away from structures that increase yields by taking principal risks.
“In the structured asset market principal protection is absolutely crucial,” says DMG’s Amrolia. “Every deal we have done has been 100% principal-guaranteed except one and that was 99%!”
This abstinence from the more dangerous structures is not necessarily a sign that investors have learnt from the mistakes of the past, it may simply be a function of the current yield environment. “Investors are prepared to take on leveraged trades, but not the levels we saw in the past that required sacrifice of principal. But then they don’t need to. In 1992 and 1993 people wanted returns of 20% to 30%. Now, with yields of 3% in Deutschmarks and 1% in yen if you’re lucky, people are content with 10% or less,” explains one dealer.
Going techno
Away from structured assets exotic means technical, and in the vanilla derivatives arena the opportunities presented by convergence and divergence plays continue to drive investors to ever more complex strategies.
“In 1996 activity was one-way, all convergence trades. Now we are seeing a change in sentiment and there are more divergence plays as people start to question whether Emu will go ahead as planned,” says Rob Standing, head of fixed-income derivatives at Chase in London.
The swap and swaption markets are the venues for most these trades. JP Morgan’s neat Emu calculator uses swap spreads to derive the probability given by the market that a country will join Germany in monetary union in 1999. If Emu expectations were 100%, post-1999 swap spreads would be zero. The less confident the market is about a particular country joining Germany the more forward prices for that country will diverge from those for Germany.
According to Standing, it is this type of reasoning that investors are employing to create ever more sophisticated trades in the vanilla markets. “People are modelling European yield curves against Germany and taking views on specific parts of the yield curve.” So investors who believe that Emu will happen model the changes required in the forward curves of the other European markets to make them converge with that of Germany. They then open spread positions using forward swaps, paying one currency and receiving Deutschmarks or vice versa. “There is lots of detailed modelling of the term structures of the European markets and a lot of activity in forward forward swaps 3/7s [a seven-year swap starting in three years’ time], 2/8s and 10/15s to take advantage of forecasted convergence.”
Positions can be coupled to create barbell-like structures to take views on either convergence or divergence. One such trade, recommended by JP Morgan, recently provided a low-cost hedge against Emu failure by capitalizing on the fact that some core European forward swap yields are below the Deutschmark while other markets are above.
The barbell is constructed using two pairs of forward swaps: pay Dutch guilders in a 3/5 forward swap and receive Deutschmarks in the same maturity; simultaneously pay Ecu and receive Deutschmarks under two more five-year swaps starting three years forward. If Emu happens the trade breaks even or makes a small profit; but if Emu does not happen the Ecu will underperform both guilders and Deutschmarks because of its exposure to the higher-yielding European currencies, generating a substantial profit. Again these positions can go wrong fairly quickly: in this case if the Ecu-Deutschmark forward spread converges more quickly than the guilder-Deutschmark spread it will create losses on a mark-to-market basis. Options on forward swaps are also being used in these kinds of structures to provide additional leverage as well as to provide cheap protection against a decline in Emu expectations.
Investors and banks’ swap desks are even taking views on the structural changes that they forecast post-Emu. “You can take a view on the legal structures that will have to be introduced in the market; you can take a view on Ecu/euro convergence; and we have certainly seen trades done that take a view on the details of how domestic reference rate fixing for swaps will relate to euro fixings,” says Chase’s Standing.
This trend towards the complex and exotic is accelerating and dealers expect that to continue. In the words of one asset structurer: “If someone tells you that the exotic business is tailing off then they’re just not seeing the flows.”
