The 1997 Guide to Germany: Derivatives

Exchange-traded derivatives

In acknowledgement of the global trend towards using derivatives as a means of portfolio risk management, the German Futures and Options Exchange (Deutsche Terminbörse, DTB) was created in 1990. Since then, the amount of DAX futures, DAX options and stock options has grown steadily.

When compared to the spot market, this increase is impressive. In 1996, DAX futures (worth Dm100 per index point) equating to Dm1.41 billion were turned over. Hence, DAX futures trading volume accounts for 115% of total turnover on the spot market, compared to only 34% in 1992.

Since the beginning of 1996, the number of DTB tradable single stock options has increased from 20 to 41, and now covers almost all active German shares. Introduction of options on Deutsche Telekom shares on the second trading day after the IPO in November 1996 set new standards in providing investors with instruments for managing their equity exposure. The volume in exchange-traded options has increased by 17.5% in 1996 over 1995.

For further refinement in interest rate risk management, new products such as the new two-year future contract (Schatz future), the one and three-month Libor contracts replacing the old Fibor future and a range of exchange-traded yield curve spread contracts were introduced by the DTB. The new products and further extension of trading hours had a dramatic impact on volumes. This resulted in an overall year to year increase of 32% in 1996.

Retail derivatives

Although mostly known for their conservative investment attitude, retail investors in Germany have been the main driving force behind the explosion of certain derivatives market sectors. Factors such as a favourable tax treatment and increased public awareness about the reduced costs and benefits of tracking benchmarks, together with financial innovations, have contributed to the impressive development of this market segment (shares, certificates, warrants and other non-interest bearing instruments are free of capital gains tax after a six-month holding period).

A permanent supply of warrants on both domestic and foreign assets, (currencies, single and basket stocks, indices, bonds, etc) from a number of top tier institutions, contributes to one of the largest and most efficient derivatives markets in the world. Due to investor appetite for novelty and their selectivity, one can find any type of plain vanilla or exotic structure (barriers, corridors, power options, quantos, etc) at a minimal bid/offer spread for almost any size.

Index participation certificates substitute for index funds. The DAX, the MDAX and all of the industry sector participations are extremely effective retail investment products. Clients of Dresdner Kleinwort Benson are offered a comprehensive range of participation notes including eastern European indices and warrants with a unit size of 1/10 of index. With approximately Dm350, one can invest in the DAX with negligible market friction.

Equity derivatives

Insurance companies make extensive use of short-dated derivatives for hedging or enhancing return on equity portfolios. Very long-dated products are used for purposes of asset/liability management. New guidelines are being proposed by supervisory agencies for funds and insurance companies that could result in further increases in volume and in the variety of products used by institutional investors.

Exotic equity derivatives are now widely used in Germany, both as hedging and investment strategies tailored to investors’ market views in the optimal way.

Given the impressive gains in equity markets, long term investors are currently favouring Asian look back call options, expressing their belief of an impending correction and subsequent continuation of the rally in equity markets. The structure gives investors the chance of additional gains from a market setback. A typical structure is a five year call where the strike is set equal to the lowest index level from the inception date in May 1997 until the year end. The final return is based on the average of index levels over the last six months of the option’s life.

Another popular exotic derivative is a rolling strike quanto put option on a basket of indices which has been the most effective risk management strategy for diversified equity portfolios. The investor can lock-in in Deutschmark terms the interim gains over the option life every time a predefined threshold performance is reached by the reference basket. The structure, successfully used by equity funds, is an extremely powerful tool for managing equity and currency exposures of diversified portfolios. The premium amount is reduced due to the various currency and index correlations plus the averaging effects on the basket.

Corporate use of equity derivatives, such as equity-linked financing and leveraged employee share plans, has been an active market sector since last year. From 1996 to date, there has been a revival in the very innovative equity-linked financing market in Germany. Large, liquid convertible bonds, exchangeable bonds and cum warrant bonds in Deutschmark have been issued by banks and corporates. Issuers, benefiting from low interest rates, high stock prices and the scarcity value of these hybrid securities in Deutschmark, have supplied the market with a record amount of plays on blue chip underlying shares. Because of the current trend towards restructuring by refocusing on the core business and of possible changes in the tax law, companies are being convinced of the value of making disposals and unwinding cross shareholdings through synthetic convertibles. Dresdner Kleinwort Benson has lead managed more than Dm1 billion of equity-linked bonds in the first five months of 1997 alone.

Another major development in the German corporate sector is the increased linking of remuneration for top managers and even employees to the company’s stock price performance. Plans for a change in the German Companies Act will make it easier to issue stock options out of conditional equity capital. This approach has already been adopted or planned for compensation of top executives in a number of companies such as Daimler, Henkel, Adidas, BHW, SGL Carbon and Volkswagen. Of particular importance in Germany is the promotion of a shareholder value concept among all levels of employees. As the market leader in designing and hedging employee and executive share ownership plans in Germany, Dresdner Kleinwort Benson has designed and implemented six such programmes for major DAX companies including Lufthansa, Continental, BHW, IVG and Dresdner Bank itself. This enables the employees to leverage on their investment in the share price performance of their companies.

Currency derivatives

German investors drew lessons from last year’s low volatilities and now make use of a much wider range of forex derivative products. The evolution of the dollar/Deutschmark one-month implied volatility clearly shows this trend. This volatility constantly stayed below 9% during the last three quarters of 1996 and the first quarter of 1997, and then rallied over that level without breaking 11%. As a result, investors looked for more exotic and cheaper structures. Mostly, this explains the big success of the barrier, compound, digital/binary or one-touch options over the past year. Also, exotic currency structures are quite widely traded. Investors clearly demand more refined products such as forward start options, also known as delayed options, partial barrier, quantos or chooser options.

Because of a deeper understanding, investors and speculators tend to use derivatives that are tailored to their specific needs. For instance, a chooser option allows the holder to decide at a future date whether the purchased option is a call or a put at the same exercise price. This option is very similar to a straddle but is considerably cheaper. This option should interest speculators who do not have specific objective levels but expect high volatility at maturity.

Dresdner Kleinwort Benson adapts to investors’ demands and believes in the strong development of the more complex exotic options. Because of this, the bank innovates and creates new products to satisfy its clients. The proprietary option is one such product developed by the bank. After the payment of an upfront premium the option holder has the right to execute a predetermined number of spot trades during a certain period. At maturity, if the buyer makes a loss that exceeds the initial premium, then the bank must bear the cost of this loss. Therefore, the profit profile is unlimited for the buyer, while his loss is limited to his initial investment.

Forward foreign exchange is a hedging instrument for customers with currency exposure, and through foreign exchange swapping customers can finance themselves in currencies of their choice. Forward FX is still very much an integral part of the international money markets. Dresdner Kleinwort Benson quotes customers all currencies up to 10 years in maturity and provides liquidity in the interbank market in major currencies. As well as FX-outrights and swaps, Dresdner Kleinwort Benson provides time options on spot transactions and options on FX-swaps for its clientele.

Interest rate derivatives

The steep German yield curve in combination with historically low long-term interest rates leaves Deutschmark investors with a difficult choice: investing on a long-term basis at rates that are perceived to have almost bottomed out is as unsatisfactory as staying at the short end of the curve and suffering a high negative carry.

Based on the various investor risk appetites, different ‘ steep yield curve’ strategies have appeared in the market, most notably callable step-up bonds and constant maturity structures (such as REX-linked bonds) .

Looking at European spreads, investors find additional opportunities. With the official Emu start date getting closer and the increased likelihood of a broad participation of countries starting in 1999, any remaining (forward) spreads between the respective currencies’ interest rates offer attractive spread trades.

Depending on the investor’s view about the odds of such a broad Emu participation, structured convergence trades can provide interesting yield pick-ups.

Callable step-up bonds

In the past year investors have shown considerable interest in this product as it provides a significantly higher return than current money market levels.

A typical structure of this kind has a maturity of four-and-a-half years with an issuer call option after 6 months. The coupon ­ if the bond is not called after six months ­ steps up for the last four years of the structure.

The embedded issuer call obviously has value, and this is paid out to the investor by giving him a significant pick-up compared to six-month money market rates. This pick-up and the level of the coupon for the remaining four years (if the issue is not called) can be set by the investor. Generally, the higher the remaining coupons are supposed to be, the lower the first coupon, and vice versa. The setting of these coupons is a function of the perceived likelihood of the bond being called.

Most issues seen recently have been structured in such a way that the call option is fairly likely to be exercised, that is, investors see these structures as substitutes for money market investments. Depending on the quality of the issuer, typical pick-ups for the first six-month coupon were 70bp to 100bp, whereas coupon levels for the remaining four years were generally not set below the respective forward swap rate.

The bond’s internal rate of return if the call does not occur is still slightly higher than the market levels for comparable straight issues. Hence the attractiveness for investors.

Constant maturity structures

Typical structures seen in the market are REX-linked Surf bonds with 10-year tenors where the first coupon is set at, for example, 5,50%, whereas all remaining coupons are annually reset at the beginning of each one-year period and pay 81% of the REX 10-year sub-index.

These bonds are less sensitive to parallel yield curve shifts than straight, fixed rate bonds. Their performance depends on the steepness of the yield curve, gaining value with increasing steepness. Investors buying REX-linked issues appreciate the high fixed first coupon, 210bp above the current one year rate, wheras in the following years a pick up of some 130bp is obtained in case of an unchanged steep yield curve.

Range accrual swap strategy

Asset managers who prefer to invest their excess liquidity in short-dated deposits have shown a lot of interest in a structure that allows them yield enhancement based on the idea that future Deutschmark money market rates will remain low and relatively unchanged.

With the 12-month Deutschmark accrual swap the client receives Libor plus 110 bp for every day that Deutschmark three-month Libor stays below 3.50% and above 3.00%. If the Deutschmark three-month Libor is fixed above or below these boundaries, the client receives no interest for that particular day. The accrued interest is paid at maturity. The client pays Deutschmark three-month Libor.

Through this swap the client has an advantage over a straight deposit if three-month Libor is fixed more than 74% of the time within the range. This structure has worked in other currencies as well. Similar accrual swaps have been transacted in French francs and Italian lire.

Convergence strategy

The Deutschmark and French franc yield curves have offered attractive spread plays in the past year. The chart opposite shows the development of the Deutschmark versus the French franc spread differential for a two-year swap rate starting two years forward. Given the widespread view that both France and Germany will be among the countries participating in the first round, this spread should ­ assuming that the market expectation becomes true ­ tighten and eventually disappear in the run-up to Emu.

Deutschmark structured bonds as described below have been placed in Germany in the past year, based on exactly this expectation. The forward spread is leveraged up in order to generate a high potential yield pick-up above Deutschmark 10-year interest rates:

* Maturity: 10 years

* Coupon 1st and 2nd year: 7.25% (Ann.30/360)

* Coupon 3rd to 10th year: 7.25% minus 15 times the Spread

* Spread: Two-year Deutschmark swap rate minus two-year French franc swap rate at the fixing

* Fixing: rate fixed once after the first two years for the remaining 8 years

* Issue price/redemption:par

* All cash flows in Deutschmark

If Emu goes ahead as planned, the structure offers up to 7.25% for the full 10 years, which represents a yield pickup above the current 10-year swap rate of roughly 125bp. The risk of the structure is a positive spread at the fixing date, which would lower the rate for the remaining 8 years. If the spread exceeds 48bp, the coupon for the remaining 8 years turns to zero. Given that Emu without France or Germany is very unlikely and the political will exists to start on time in 1999, the risk of the structure has proved acceptable to many investors.

Liability management

Given the still weak state of the German economy with low inflation, most liability managers regard today’s Deutschmark forward rates as too high and therefore find it unattractive to do straight swaps into fixed rate or to buy plain vanilla caps. Instead, many have sought to reduce the cost of their long-term hedges by selling different options against the yield curve.

Switch strike caps

This structure is based on the above-mentioned market view that today’s implied forward rates are exaggerated. A switch-strike cap is a middle way between a straight interest rate cap and a ‘up-and out’ knock-out cap. It is a compromise of the two that provides the purchaser with two different strike levels. Therefore, it is cheaper than a plain vanilla cap, but more expensive than the knock-out cap.

For example, a straight 6.00% five-year cap can be bought for some 208bp. The switch-strike alternative cap has the same 6.00 % strike, however, any Libor setting in excess of 9.00% “switches” the strike to a second level of 9.00%. As a result, for that specific six-month period the effective rate is 9.00%. If Libor subsequently falls below 9.00%, then the lower strike level of 6.00% again applies.

The switch strike cap premium of 145bp allows the liability manager a 63bp saving compared to the 208bp premium of the standard cap.

Credit derivatives

One of the buzz words of the last 12 months has been without doubt credit derivatives. These instruments have been through a considerable development from an experimental stage to a strong growth stage. It is not so long ago that the Bank of England and the Federal Reserve Bank published guidelines and discussion papers regarding the regulatory treatment of these new instruments. Estimates for the size of the market by the year 2000 vary widely. A survey conducted in the London market found that market participants on average expect the volume to increase from estimated $20 billion in 1996 to about $100 billion in the year 2000.

The management of market risk with derivatives is a well established and mature sector. The major appeal of credit derivatives lies in their promise to extend similar techniques to the large area of credit risk and make it more flexible and efficiently manageable. Credit derivatives can reduce credit risk, off balance sheet, without touching the underlying exposure and thus without possible negative implications for the client relationship. Financial institutions which have a relative funding disadvantage can on the other side assume off balance sheet credit exposure. The decision to assume credit risk will be based on risk and reward and not only on concentration of risk. Hence, Credit derivatives can help to overcome the so called credit paradox by separating the relationship management from the credit decision.

Moreover, credit derivatives offer an attractive investment opportunity in the current low interest environment. In the search for enhanced yield, investors can enter into credit derivatives structures which offer an exposure that is not available in the underlying market. Notes linked to a basket of emerging market credits, especially eastern European credits, have experienced increased interest. Because of their potential, it is almost certain that credit derivatives will remain one of the hottest issues for the rest of 1997.