Emerging markets derivatives: Swings and roundabahts
Emerging markets derivatives: Latins learn virtue of credit swaps
The images often associated with Vienna – waltzing couples, horse-drawn carriages and Gothic cathedrals – are far removed from the aggressive world of the trading floors of New York, London or Chicago. Yet over the past year the Austrian capital has become the centre of a booming trade in east European equity derivatives. Last month, the Austrian Futures and Options Exchange (Ötob) launched a futures contract on a Polish equity index. This is the third equity market it trades, following the launch of the Czech traded index (CTX) on May 20 and its Hungarian counterpart in March. Already, it looks as though exchange-traded equity derivatives may end up as the hottest new product of 1997 in central and eastern European capital markets.
Exchanges throughout Europe, including Moscow, St Petersburg and Prague, have tried to set up credible, liquid, derivative contracts. So far, only Ötob has succeeded – although the BUX futures contract traded in Budapest has kept its head above water. Before the introduction of the Ötob products, east European equity portfolios were a nightmare to hedge. High volatility, a lack of securities lending, unresolved regulatory issues and a near absence of over-the-counter (OTC) instruments meant that most equity funds didn’t hedge at all.
The first, and so far most successful, of Ötob’s products is the Hungarian traded index (HTX). The futures and options contracts on all three indices have maturities of one, two or three months, with a contract value of $5 per point. Trades are cleared by Cedel in dollars via a market-making system comprising three banks: Creditanstalt, Bawag and Bank Austria. Ötob itself devised the three indices and is responsible for calculating them on a real-time basis. With the addition early next year of a Slovak traded index (STX), Ötob will meets its goal of offering investors the chance to trade five countries in dollars from one screen (Austrian equities being the fifth). A Russian index will probably follow.
Ötob, which operates on behalf of the Vienna Stock Exchange, comprises 14 member banks, all either German or Austrian. The solid backing these banks represent is crucial in meeting competition from other exchanges that are becoming increasingly active in the market, notably the Chicago Mercantile Exchange and the combined Budapest Stock Exchange and Budapest Commodity Exchange. But Ötob’s dominance of the eastern European derivatives market may be short-lived – the London International Financial Futures & Options Exchange (Liffe) and Paris-based Matif have expressed interest in east European equity products.
The HTX comprises 11 blue-chip shares, which represent more than 90% of the Budapest Stock Exchange’s market capitalization and trading volume. Daily volume in the HTX averages 2,000 contracts with a notional value of $30 million, in comparison to a physical market that averages only $15 million a day. The 11 shares are Primagaz, Graboplast, Pannoplast, Pick Szeged, Danubius, Egis, OTP, Borsod Chem, TVK, MOL and Gideon Richter. Gideon Richter is the largest component, accounting for 20.4% of the index. Ötob picked Hungary as the first market on which to trade derivatives because of the relatively high levels of volatility and ease of access for share purchase. In mid-July the HTX was trading at 1995, up from 1295 at the end of December 1996. Although the HTX is different from the better-known BUX index, the two are closely correlated. Brokers working with the more volatile BUX have started investigating the possibility of arbitraging between the two indices.
According to Marcus Klug, responsible for research and index management at Creditanstalt: “The biggest participants so far have been emerging market fund managers looking to hedge their portfolios, proprietary traders and hedge funds.” It is not surprising that hedging against downside risk is a priority for buyers of Hungarian-linked products. The Budapest Stock Exchange was one of the world’s best performers last year, appreciating 125% in value. Investors cite the robust domestic economy, transparency of financial information, regular reporting of accounts and a large domestic share-owning base as significant factors behind the appeal of Hungarian equity.
Klug adds: “I think trading volumes, already greater in notional terms than the cash market in Budapest, will steadily increase. There just needs to be more time for investors to familiarize themselves with the market and open accounts.” Although the current market-makers and the central computer are all based in Vienna, Klug sees no reason why other institutions, in London or elsewhere, could not become market-makers as well.
By contrast, enthusiasm for the CTX product has been limited by poor investor relations in the Czech Republic and the bitter taste left by recent trading scandals in that country. The notional value of CTX contracts traded has averaged only about $5 million a day. The CTX, like the HTX, is capitalization-weighted and well correlated to the broader PX50 equity index. The CTX stood at 994 at the start of the year, and has steadily fallen to the present level of 751, making it the worst performer in the region. The 10 blue-chip Czech shares that make up the CTX are: SPT Telecom, CEZ, Komercni Banka, Chemopetrol, Ceska Sporitelna, Skoda Plzen, Vodni Stavby, Elektr Opatovice, IPS Praha, and Biocel Paskov. These account for 59% of market capitalization and 47% of trading volume of all first-tier Czech stocks.
Polish attractions
The Polish instrument may attract more interest than the Hungarian one. Steeply declining interest rates and inflation, as well as strong prospects for a rapidly growing economy have led many emerging market analysts to rank Polish equity as a strong buy – especially after the run-up in prices in Moscow and Budapest. But so far, the index has lagged, starting the year at 991 and falling to 953 in July. The PTX, correlated with the WIG20, consists of 14 Polish blue chips: Elektrim, Bank Slaski, BRE, BPH, Debica, Stomil Olsztyn, Zywiec, Agros, WBK, Mostostal Export, Polifarb Cieszyn, Staleexport, Exbud and Gorazdze.
Trading in contracts on the CECE Composite – the central European clearing house and exchange index – is expected to begin next year. The index, which is already being continuously calculated, covers 41 shares in the Czech Republic, Hungary, Poland and Slovakia and accounts for over 70% of the market capitalization and over 60% of the trading volume of all listed stocks in these markets. An extension into other central and east European markets, such as Romania, Croatia and Russia, is expected some time next year.
Ötob next aims to launch a Russian product. Russia is by far the largest equity market in eastern Europe, but notoriously opaque share-price information, compounded by the fact that a huge amount of equity trading takes place in London and New York, has left many observers sceptical about the viability of any Ötob-sponsored index product tracking Russian stocks. Creditanstalt’s Klug is nonetheless upbeat: “We think launching a Russian product this year or next is entirely realistic. Of course, the main problem to resolve is ensuring accurate pricing information.”
An increasing volume on Ötob originates in OTC structured-products. Big banks, notably Dresdner Kleinwort Benson and Deutsche Morgan Grenfell, have started to use Ötob to hedge index-linked notes. According to Gunther Schiendl, Ötob head of research and development: “The German banks are very active in developing east European equity participation notes and have even generated sales among German retail investors. These notes can be very effectively hedged through traded futures and options and without going to the cash market at all. Thus, as the OTC structured-product trade develops, so, we expect, will liquidity on Ötob.”
The exchange-traded products may come to look even more attractive as the equity markets lose their excitement. Last year, against the backdrop of a bull market and high volatility, investors could achieve short-term speculative gains of over 50% just by buying shares. As volatility flattens out and the markets starts to lose steam, hot money speculators may lose interest in holding shares directly and instead look at trading in the underlying futures and options to meet their targets.
The increasing number of equity products on offer, as well as the possibility of several different exchanges offering similar products, may mean that in the long run transaction costs on a synthetic equity position will be squeezed to the minimum. Transaction costs involved in trading eastern European equities are among the highest in the world. After taking into account bid-ask spreads, custodial fees, two-way broker commissions, and sporadic liquidity problems, a fund manager buying into, for example, a $10 million position, may be down as much as 10% by the time he hangs up the phone.
Awash with choice
Liquidity problems alone make for interesting effects as well as lucrative opportunities for local brokers. “There are days when so many buy orders come flooding in from the US that, given the limited availability of blocks of shares even on a good day, brokers can just pick and choose who they want to sell to,” observes a London-based east European fund manager. “Rather than just adding X amount of basis points to their price as a commission on the shares they can obtain – the usual practice in London or New York – a broker can actually auction off the block to the most desperate buyer, who often just wants to lock in a position in the country and cares about little else.” At the other extreme, on days when the market is falling, unloading a block of shares can be a nerve-racking task with many brokers simply not answering the telephone. Pick the wrong day to buy or sell and you pay the price.
Given the possibility of smaller transaction costs using equity derivatives, holding a position in the cash market and facing liquidity, custodial and execution issues looks the less attractive option. Investors in emerging markets typically buy into a country or an industry rather than selecting individual stocks on the merits of the company. Buying broadly based equity indices provides a rough substitute for individual portfolio selection. The virtual portfolio, where a fund guarantees to provide an equity market-linked return without ever buying any shares in the market, could be the wave of the future.
Virtual foreign-exchange products, such as non-deliverable forwards (NDFs), have become a growing niche product in emerging market currency trading. With an NDF, counterparties deal in east European currency positions without owning a single Czech koruna, Romanian lei, Polish zloty or Hungarian forint. Many south-east Asian funds, notably those targeting Korea and Taiwan, have routinely been based exclusively on swaps and futures written out of Hong Kong. This is because ownership restrictions prevent substantial foreign purchase of shares in these two markets.
Ötob’s Schiendl, however, argues that there will be a constant development of the cash market. “I think, even with the increasingly efficient equity derivatives market we expect, a virtual portfolio of east European equity will probably not be necessary. More and more of the trading in first-tier or blue-chip shares is moving out of eastern Europe and into western financial centres like Frankfurt, New York and London. The derivatives market may develop much faster than the local cash market, but the local market will always remain the main trading area for second-tier stocks.”
