GERMANYA EUROMONEY SURVEY – June 1996With the aftermath of the 1994 bond market crash largely digested, the German derivatives market presents itself today in a healthy shape. Owing to impressive growth in volume outstanding in virtually all product areas and the persistent launch of innovative products, it has become increasingly liquid and efficient. Leaving the leveraged adventures behind, the German market participant of today has significantly altered his perception of risk and is aware of the need for sophisticated risk management systems. Based on the undeniable fact that the appropriate application of derivative products adds value, be it in the scope of hedging or yield enhancement, sensible product innovation and improved know-how within the financial community will foster the further deepening and broadening of derivatives markets in Germany.Exchange-Traded ProductsOver the course of the last few months volumes of interest rate-products at the German derivatives exchange DTB increased significantly, fuelled by product innovation and periods of pronounced bond market weakness. Due to an upsurge in hedging activity BOBL futures repeatedly managed to breach the 100,000 contract level for the first time since their launch, with the same high volumes traded in BUND futures. By introducing serial options with maturities of 1, 2 and 3 months on BUND and BOBL futures, DTB successfully responded to the demand and for short-dated volatility positions. Consequently the volume of BOBL options in the first three months of this year has already equalled that of 1995 in its entirety.Meanwhile the DAX option defends its position as the second most liquid equity index product worldwide, with an average daily turnover surpassing 100,000 contracts in 1996 to date. Major contributors to this remarkable volume were professional bank accounts, hedging in this way increased exposure derived from their OTC business. To further broaden the range of liquid equity options in Germany, DTB is scheduling the integration of the traditional options market into its trading system for September 1996. Furthermore an option on the TELEKOM stock will be launched on the issue date of the share. Besides the ongoing talks about a broad based cooperation with the French MATIF, DTB continued its efforts to expand the network of trading screens all over the world. The utilization of DTB-screens in North America could above all add a number of important market participants such as US-registered hedge funds, which today are barred from trading DTB’s products. It remains to be seen whether as a result of these efforts 24 hour trading of DTB-contracts will be achieved around the globe. WarrantsIn 1995 the German warrant market continued to grow at the impressive rate of approximately 40% in terms of issue volume and could hence easily defend its position as one of the largest warrant markets worldwide. Out of approximately 4200 warrants issued last year, over 1000 were each related to foreign exchange, index and equity-underlyings, as well as more than 700 fixed income related warrants. As has previously been the case, private clients induced more than half of the traded volume, followed by banks and market makers. However, with regulation for mutual funds recently been relaxed, activity of institutional investors is likely to gain momentum in the future. Although several newcomers emerged on the issuer side, the German warrant market is still dominated by a mere handful of players in terms of trading volume, which leaves a bulk of new issues highly illiquid. With banks establishing electronic trading systems and on-line price publication, this market nevertheless becomes increasingly efficient and transparent.Equity DerivativesOTC equity derivatives in Germany also experienced an upsurge in volumes, with activity still focused on short maturities in contrast to other European markets. Insurance companies and corporates increasingly implement hedging strategies through long puts and covered call writing on individual shares as well as through the use of Equity Index Collars. Meanwhile Exotic Options such as Knock-Out and Knock-In Options have become widely used. Apparently, market participants comprehend the strengths of these flexible products, enabling option buyers to reduce premium payments or limiting the downside risk for option sellers. For a German investor the added value through the use of exotic options can be exemplified by a DAX Knock-In Put Option. The option can be structured in such a way that premium payment is only due when the $/Dm exchange rate breaches a certain level to the downside. Hence the user, who above all fears the negative impact of a languishing $ on the performance of his DAX portfolio, pays nothing if the option hedge is not necessary, while being hedged in return for the premium outlay if the $ actually weakens.German retail investors gave an enthusiastic reception to Guaranteed Equity Index Funds which through derivative protection strategies offer upside participation in the equity markets without any downside risk. The success of these derivative linked funds may promote the usefulness of derivatives among today’s rather suspicious German public. Another crucial innovation in the German equity market in 1995 has been the launch of a Leveraged Employee Share Ownership Plan (ESOP) for Continental AG. Within this program Continental’s employees purchase shares on a tax exempt basis coupled with an at-the-money put option for each share. Funding is provided via a company loan. Hence employees become shareholders without bearing the downside risk of the share price, while they are leveraged to the upside through the debt financing. One can only hope that such innovative products finally have a positive impact on the equity culture in Germany, which still lags behind other European countries. FX DerivativesThe German market for FX-Derivatives remains dominated by hedging activity. This is namely induced by corporates wanting to reduce their currency exposure out of export revenues and raw materials costs. The bulk of the business is executed in maturities under one year, reflecting the need of operational businesses to lock in exchange rates for reliable profit and price calculations. So far, only few corporations apply continuous long-term hedging strategies with maturities of 4 years and longer. In contrast to other FX derivatives markets, German users mainly focus on “plain vanilla” structures such as long calls and puts. In addition, combined strategies such as collars are widely used to avoid net premium payments.Over the last 12 months a number of market participants upgraded their pricing systems aiming to also incorporate exotic option strategies. Consequently the business in Binary and Barrier Options has picked up and is expected to grow further. One popular hedge strategy using exotic options has been the Flexible Forward. The strategy consists of a long at-the-money $ put financed via a short at-the-money $ call. The call is “knocked-in” if the $ reaches a certain trigger point substantially above current market levels. As a result the company is protected against a weakening $ at zero cost while even benefiting of any $ strength up to the trigger level. More speculative accounts use Range Options when they expect the currency to stay in a narrow band for some time. Against an upfront premium they are entitled to receive a payout for every day the currency stays within the predefined range. In conclusion Range Options enable their users to enter a short-volatility position with limited downside risk but significant profit potential. OTC bond optionsIn the field of OTC bond options, Germany consolidated its position as the leading market in Europe over the last year, both in terms of size and importance. This occurred although new legislation significantly limited the ability of certain market participants to trade options. Insurance companies, for example are now only permitted to write puts with the clear objective to purchase the underlying. Additionally, they can be obliged to close their short position when a pre-specified price threshold is breached. Despite these obstacles, the volume in Deutschmark options in 1995 continued to grow at an impressive rate. This is partly due to the significant narrowing of bid/ask spreads over the last few years, rendering transactions in options as attractive as trading the underlying bonds. Furthermore, due to the painful lessons of 1994, the purchase of put options to hedge long positions has become more common today. In addition to demand from domestic accounts a growing number of foreign counterparties also have begun to express their view on the German market by means of OTC bond options.Marching in step with volumes in plain vanilla options, the German market also experienced a rising interest in exotic bond options. Above all, options on cross-market yield spreads, e.g. France vs. Germany, or yield-curve spreads have been in demand. Barrier options have become much more accepted, as have certain types of range options. However, the main constraints to the growth of exotic options in Germany remain the lack of appropriate systems to revalue these derivatives during their life and the low level of market participants’ experience in trading options with discontinuous payoffs. In the foreseeable future, these constraints are likely to gradually fade and exotics should continue to grow at a fairly rapid pace. Swap DerivativesMarket DevelopmentSince the beginning of the 80’s, the swap market has developed into a mature market of remarkable size. From 1990 until the end of 1994, the total size of notional outstanding in the interest rate swap market more than tripled, with the size of the Dm swap market even increasing by a factor of four. While the market for cross currency swaps experienced slower growth, the doubling of volumes in Dm related cross currency swaps reveals the importance of the Deutschmark. Swap bid/ask spreads in the major currencies tightened from 10 basis points in 1990 to around 4 basis points today, which indicates not only the bigger size of the market but also its increased efficiency. In contrast to the mature traditional swap market, volume outstanding in first generation swap derivatives like swaptions, caps, and floors has developed rapidly with caps/floors accounting for the bulk of turnover. At the same time, the market for second generation swap derivatives experienced an impressive growth. Products in this market comprise LIBOR-in-arrear and constant-maturity swaps as well as barrier, average rate, basket, binary, and currency protected swaptions. The size of this market has grown from almost 0 notional outstanding in 1990 to about 10% of the client-related business in first generation swap derivatives today. Strategies Product diversity and complexity in today’s swap derivative markets can be perceived as overwhelming. The following two examples aim to illustrate the cutting edge of swap derivative technology, providing users of customized derivative products with tremendous flexibility. I. Hedging opportunities in view of the steep German yield curve Imagine an investor, who obtained a 10-year Dm asset at a yield of 7.50 % at the beginning of 1995. Originally financing it via a floating-rate liability he enjoyed an improving carry through continuously decreasing short term rates in the past. In the current environment, as interest rates in Germany seem to have bottomed out he considers swapping this liability into fixed using a plain vanilla swap, thus locking in a constant yield spread until maturity. Alternatively, he could enter into a forward starting swap from year 3 until maturity to take advantage of the positive carry for the first three years. However, given the current forward swap rate of 7.90 this would result in locking in a negative spread of 40 bp from year 3 until maturity of the asset. None of these two alternatives are satisfactory since they both limit the potential profit from the investment compared to keeping the liability floating. Given the weak overall state of the German economy and with inflation being subdued, the investor regards future short-term rates implied in today’s term structure as too high in general and in particular believes that short-term rates above 9.50% are highly improbable within the next 10 years. Thus, he decides to maintain his floating rate financing and to additionally purchase a cap with a strike of 6.75% as protection against unexpected increases in interest rates. Unfortunately, the high level of implied forward rates and their implied volatilities makes this a very expensive protection strategy with a cap price of 640 bp upfront. Hence the investor should take advantage of his positive interest rate forecast by buying a cap with a knock-out feature at 9.50% which reduces the upfront premium outlay to 220 bp. The considerable cheapening in comparison with the standard cap can be traced back to the extreme steepness of the current term structure in Germany, implying a high probability of the back dated cap payments being knocked out. Additionally the investor can capitalize on his view that current forward rates are too high in general by entering into a Libor-in-arrears swap. In such a swap he will receive on each payment date the 6-month Libor rate fixed at the beginning of the period allowing him to service the floating rate liability. Against this he agrees to pay the Libor rate fixed at the end of the respective payment period, i.e. fixed “in-arrears”. Hence, a Libor-in-arrears Swap basically equals the exchange of the low current 6-month Libor rate against the much higher discounted 6-month implied forward rate for the last payment date. This relative advantage to the Libor-in-arrears receiver results in a compensating upfront payment to the investor. The combination of Libor-in-arrears swap and knock-out cap leads to a strategy which is consistent with the view that today’s Deutschmark implied forward rates overestimate the level of interest rates in the future. In the current environment the premium to be paid for the knock-out cap is exactly matched by the premium received for the Libor-in-arrears swap, thus resulting in a zero-cost hedge strategy. The investor profits by the attractive carry of the fixed-rate asset versus the floating-rate liability at the same time as being protected against variable rates rising above 6.75%. This desired result will prevail as long as the respective 6-month Libor-rate fixings do not breach the 9.50%-threshold over the next 9 years. As this example reveals, the application of modern swap derivative technology allows to capture value in the German yield curve that would otherwise have been lost. II. Using swap derivatives in asset management The traditional approach to gaining exposure to international bond markets consists in buying a selection of bonds which induces costs and challenges, such as bid/offer-spreads, custody, liquidity constraints and the re-investment of coupons. A cheaper way to gain this exposure is the utilization of bond index swaps. In such a swap the investor agrees to exchange the return of the chosen index such as the J.P. Morgan Government Bond Index or its subindices against Libor in the index swap reporting currency plus or minus a spread. This spread embodies all the costs of replicating the index including bid/offer spreads, rebalancing costs and tracking error. The usage of bond index swaps greatly reduces the burden on the asset manager as he no longer has to set up custody accounts for different countries and can easily bring the portfolio performance to a guaranteed level in proportion to the benchmark. Besides their application as an efficient tool to pursue a passive investment strategy they can also be used to provide guaranteed index returns to retail investors. In addition, bond index swaps enable fund managers who out-perform a particular market to transfer their excess return to global fixed income clients. Overnight Indexed SwapsA key development in the German money markets in 1996 will be the introduction of Deutschmark overnight indexed swaps (OIS). An OIS can be considered as the exchange of a fixed rate against the total return on call money over a certain period, i.e. interest accrued through compounding the floating rate index, based on the agreed notional amount. Both the fixed and the floating leg coupon payments are due at the maturity of the swap and are legally netted. The floating leg payment in Deutschmark-OIS is currently pegged to the Frankfurt Interbank Overnight Average (FIONA), which is published on Reuters page RMIG, but an official daily FIBOR Overnight fixing is scheduled to be introduced soon. Maturities of OIS range from 1 to 12 months, with non-standard maturities as well as forward starting swaps also to be accommodated by market makers. OIS, which can be secured by the standard ISDA master agreement, represent a major innovation in German money markets being a cheap, off-balance sheet instrument to replicate the interest rate sensitivity of short term cash instruments. As settlement at maturity takes place on a net basis and without the exchange of principals the inherent credit risk is very low. Given the popularity of OIS in French Franc, Lira, Peseta and ECU one must expect the OIS market in Deutschmark also to strongly develop.The main users of Deutschmark-OIS will likely be banks, money market funds and corporates. OIS provide a hedge against funding risk for users, whose cost of funding is based on the overnight rate. This is usually the case for banks’ bond portfolios and for corporates, that fund their subsidiaries on a daily basis. Hedging is of particular value in the Dm where call money rates can be quite volatile at times for technical, e.g. the end of a reserve period, or for fundamental reasons. Investors, in the meantime, can create synthetic assets indexed on the overnight rate by entering into an OIS. A mutual fund for example can swap a commercial paper into a synthetic overnight-indexed asset, thus locking in the call money return plus a fixed spread. Trading orientated accounts meanwhile can take a view on the very short end of the yield curve by using the credit-cheap and liquid OIS. Credit and Insurance DerivativesAs other derivatives serve to hedge market risk exposure without direct balance sheet impact, credit derivatives can transfer credit risk without moving the underlying asset. Increasingly, German market participants regard credit as a distinct asset class. In addition they comprehend the advantages of using credit derivatives as a dynamic risk management tool. Risk conscious credit managers are enabled to continuously adjust the exposure of their portfolios in diverse credit brackets without bearing the disadvantages of balance sheet transactions. They preserve total confidentiality, circumvent the illiquidity in the underlying market, avoid adverse marking-to-market, and do not upset the balance of the interest rate or FX position induced by the assets concerned. On the other side banks and corporations seek diversification by taking exposure to credits which are difficult to find in their traditional home markets. Those with spare balance sheet may enter into the position through a credit-linked note while others with funding restrictions can benefit by assuming the exposure off balance sheet through a credit default swap.A typical situation inducing the use of credit derivatives is given for a bank which sees the credit amount given to a regular client exceed the maximum exposure it is willing to take. Instead of discontinuing business or risking negative client reaction by selling existing positions, the bank can free up credit lines and valuable economic capital by buying credit protection through a credit default swap. On the opposite side of the swap investors who lack a relationship with the credit concerned and cannot find such securitized issues are ready to bear this particular exposure for diversification or yield enhancement purposes. Also regarded as products with huge potential by many, insurance derivatives are still in an early stage of development in Germany. Insurers and reinsurers especially show growing interest in hedging their insurance risks through the use of derivatives, with a significant potential above all inherent in the area of contingent capital and catastrophe bonds. Insurance companies seeking to protect their capital base have to compare the cost of traditional reinsurance with the right to raise capital at cheaper rates while maintaining their solvency margin. Thus they should be increasingly attracted to insurance derivatives as their margins come under pressure and reinsurance prices tighten. With German insurance and reinsurance companies being active on a global scale, they can offer diversified pools of insurance risks to investors who seek to diversify their portfolios by means of this “new” asset class. While some private transactions in the area of insurance derivatives have already taken place, the first public deal is expected to hit the screens in the foreseeable future. The Art of Risk ManagementAs widely publicized disasters in the recent past have proven, the management of market risk is a pivotal issue in today’s financial markets. In addition to the need for sophisticated risk management systems, the perception of risk within the financial community will substantially alter in the future. Having dedicated enormous resources to the issues of risk management in the past, J.P. Morgan today possesses an outstanding position in the fields of sophisticated risk management advice and innovative derivative products. With the publication of RiskMetricstm the firm not only demonstrated the willingness to share its information advantage and expertise with the market but also promoted greater transparency in the field of risk management. RiskMetricstm today is an established benchmark for market risk measurement, making sound advice available to clients. Based upon this extensive database J.P. Morgan recently launched the FourFifteentm analytical tool. The software provides clients with an easy to use PC-based tool for evaluating, exploring and reporting exposure to market risks inherent in cash positions as well as in derivative products.J.P. Morgan in GermanyJ.P. Morgan is one of the few preeminent firms in the financial industry which integrates investment, commercial, and merchant banking on a truly global scale, aiming to provide its clients with the best service and analytical competence possible. Having been established in Germany for over thirty years, J.P. Morgan’s Frankfurt office is today staffed with over 250 employees to offer a broad array of sophisticated financial services to the government, corporations, financial institutions and wealthy individuals. In its location across from the Frankfurt Stock Exchange, the firm operates one of the most advanced technological platforms, enabling its services to be linked even closer to all major international marketplaces.J.P. Morgan is deeply committed to its clients and holds great promise for the future of the Finanzplatz Deutschland. Founded upon its active participation in the Bund Consortium, the bank recently had the honour of being chosen as one of the few members of the Innenausschuss. Based on the primary dealership in all G7 government bond markets and given the outstanding strength in the field of derivatives, J.P. Morgan is considered as a leading multicurrency fixed income house in Europe. Its capabilities are backed by sound analytical and macroeconomic research conducted in both developed countries and emerging markets. Hence, J.P. Morgan is uniquely positioned to advise its German clients on the best execution and to give them access to financial markets worldwide. DTB options on BOBL & BUND futures Swaptions, caps and floors notional outstanding Source: ISDA (latest available statistics) J.P. Morgan GmbH, Frankfurt Tel. (49) 69 7124-0 Head of Markets Peter Schwicht (-1497) Trading Martin Korbmacher (-1482) Sales Jochen Friedrich (-1353) Risk Management Robert Bierich (-1331) |
