Due To Deregulation, Liberalization and Globaliza- tion The Traditional Bank Business Has Changed...

Due To Deregulation, Liberalization and Globaliza- tion The Traditional Bank Business Has Changed Dramatically. Banks can enter a business that had been off limits before Deepening of Capital markets connected corporates directly to the market. Corporate Finance business has suffered from highly specialized securities firms and institutional asset managers. Traditional Sources Of Bank Profits Have Shifted Bank Deposits are decreasing. Liabilities as bank loans are also decreasing on the assets side (Table 1,2). On the other side negotiable liabilities have increased (tradable securities on the asset side) (Table 3,4).

Table 1. Bank Deposits in percent of total bank liabilities In Most G7-Countries Bank Deposits in Percent of Total Liabilities were Decreasing During the Last Twenty Years

Table 2. Bank Loans in percent of total Bank Assets In Some G7-Countries also Bank Loans as in Percent of Total Bank Assets Decreased

Table 3. Negotiable Liabilities in percent of total Bank Liabilities Banks are Using More and More Capital Market Instruments to Refinance Their Businesses

Table 4. Tradable Securities Holding in percent of Total Bank Assets Banks Have Also Entered resp. Enlarged Their Asset Management Businesses

Three Major Changes In The Composition Of Banks Balance Sheets Displacement of lending by other activities. Growth of off-balance-sheet assets in percent of total assets. Displacement of deposit loan-income by other operating income. Changes Are Reflected By Desegementation And Restructuring E xpanding into other markets (Securities) to face competition to the Asset Management Industry. Entering the insurance markets Entering Asset Management business providing investment management services and a wider range of financial services to their customers. All this changes are reflected by heavily increasing M & A activities.

Table 5. Balance Sheet Information of Top 50 Banks in percent as noted Source of Bank Profits Have Shifted From Interest Related Income to Other Income

Traditionally banks intermediate between borrowers and savers by using deposits, securities firms were providing the distribution of new issues of equity and debt to public. On the supply side, Nonbank financial institutions have entered the traditional bank business. Insurance Comp., Investment banks, even telcos and food companies are providing bank-services. On the demand side, households were bypassing banks by investing directly to those investment firms which could cause of theire specializtion more effective handle the savings. As a result from this, the nonbank-sector became larger and larger. (Table 6,7). In the United States the nonbank-sector is managing (1995)11,5 trillion US$ compared to 5 Trillion $ in the banking sector. The Traditional View of Financial Intermediation Has Eroded

Table 6. Assets of Institutional Investors Institutional Investors Were Steadily Growing at High Average Rates

Table 7. Assets of all Institutional Investors in % of GDP Institutional Investors Were Steadily Growing at High Average Rates

Globalization Financial Markets Are Facing Closer Integration Liberalization and Development of Information Technologies prepared the way to globalization and integration Securities Portfolios became far more internationally diversified (Table 8). The growth in gross portfolio flows increased by almost more than 200 times. Cross border transactions in Bonds and Equities reached up to between seven and one times GDP. In the US those transactions between US and foreign investors totaled 17 Trillion US$. (see Table 9) or 213% of the US - GDP. Although investment portfolios are fare away from beeing adequately internationally diversified, i.e. portfolios still do not reflect the the structure of the world market capitalization (USA: 42%, Japan 15%, UK: 9%, other industrial countries: 23%, emerging markets: 11%)

Mirroring this expansion firms also turned to international markets to raise funds (see Table 10). Even the volume of outstanding issues of international debt securities reached to 3,7 Trillion US $, sixfold larger than in 1985. Financial Globalization has been a counterpart to international trade. The foreign exchange market has far outpaced the growth of trade. In 1995 an annual worldwide trade volume of 6,1 Trillion US$ was faced by a daily market turnover of 1,2 Trillion US $. (see T.11.) Nonresidents holdings of public debt also increased substantially (see Table 12) Globalization Financial Markets are Facing Closer Integration

Table 8. Gross and Net Flows of Foreign Direct and Portfolio Investment (G7) Foreign Net and Portfolio Investments (in bn $)

Table 9. Cross Border Transactions in Bonds and Equities Cross Border Transactions of Bonds and Equities

Table 11. Foreign Exchange Trading Foreign Exchange Trading (Turnover in bn $ per day)

Table 12. Nonresidents Holdings of Public Debt (in percent of total public debt) Nonresidents Holdings of Public Debt (in % of Total Debt)

Accompanying all this, we can observe extending linkages between international Exchanges (Eurex, CBOT and Eurex) OTC- and Exchange traded markets will merge New Markets for unbundling and trade of risks will emerge Actually the risk market volume is estimated to reach up to a volume of more than 130 Bio US$ /year (notional amount outstanding per end of year). This would be more than the total volume of all traded bonds, equities and bank assets Outlook to new market propositions In future we will face an ongoing increase of methods and products concerning risk markets, also dealing new kinds of risks like: Catastrophe Risks (ART) will change insurance markets Credit Risks will change the business potential of credit business. Private Income Risks

New Trends New Markets New Chances New Risks

New Markets and Products for Unbundling, Pricing, Trading and Managing Risks Example: U.S. bank has given a floating rate Yen denominated loan to a Japanese bank. Risk Exposure of U.S. bank: Foreign Exchange Risk Interest Rate Risk Credit Risk Risk Management Tools: Currency Swap (Y/US$) Interest Rate Swap (V/F) Credit Default Swap Credit-risk loaded floating- rate, Yen-denominated loan Riskless, fixed rate dollar denominated security

How Risk Management Works US Bank Japanese Bank 100 Bio Y at LIBOR LIBOR Payed in Y Payback in Yen LIBOR in Yen Fixed rate in Yen US$ Receiver Yen - Payer Interest Rate Swap Currency Swap Floating Rate Yen Loan Fixed Rate Dollar Loan OTC - Market Credit Default Swap Floating Rate Yen Credit

Growth in Global Security Issues, 1990-2003 Global debt & equity U.S. Issuers worldwide $ Bn

Derivatives - Notional Amount Outstanding per 12/1987 to 12/2005

Markets are Interlinked Example: Spot and Futures Market

Spot Future - Parity Today, one (theoretical) Index-Future is sold at 5,500 (1 per Index-point). Long and Short-positions can be described by a profit and loss diagram: 5,500 Index Profit Loss Long Future = Buyer Short Future = Seller If you are Long-Future, then you may claim for delivery of one index at a price of 5,500 at the maturity of the index- future. That means, if the index at delivery is quoted at more than 5,500, you will win from your futures position. Spot Future Parity Index Arbitrage (Example)

Spot Future - Parity You hold an Index-Portfolio, currently valued at 5,500 (1 Index-point = 1 ). If the annual risk free rate r f is at 3.5 % and the expected dividends on your Index portfolio are at 100 (d = 100/5,500), an Index Future with one year to maturity has a fair price of: To prevent our Index-Portfolio from losses, we could hedge the price risk by taking a short future position (selling a future at 5,592.40). Spot Future Parity Index Arbitrage (Example)

Spot Future - Parity Assets Payoff 1 Payoff 2 Payoff 3 Payoff 4 Payoff 5 Stock Portfolio+4500,00+5000,00+5500,00+6000,00+6500,00 Dividends+100,00 Short Future+1092,40+592,40+92,40-407,60-907,60 Total+5692,40 The total expected payoffs from your portfolio will depend on the future state of the environment (see below payoffs 1-5). A decreasing stock market will be compensated by profits from the short future position, increasing stock prices will be outbalanced by losses due to payment obligations from the future. Loss Profit 5592,40 Index Short Future Spot Future Parity Index Arbitrage (Example)

Spot Future - Parity Assets Payoff 1 Payoff 2 Payoff 3 Payoff 4 Payoff 5 Stock Portfolio+4500,00+5000,00+5500,00+6000,00+6500,00 Dividends+100,00 Short Future+1092,40+592,40+92,40-407,60-907,60 Total+5692,40 Initially you have paid 5,500 for your stock portfolio. Taking the short future position, the final outcome of your portfolio will be 5,692,40 , whatever the stock price will be, i.e. you will earn 192,40 which equals 3.5%. Obviously, this profit is riskless: Spot-Future- Parity Spot Future Parity Index Arbitrage (Example)

Spot Future - Parity Rising future prices will due to arbitrage trading - induce rising spot prices. For example, a future traded at 6,000 is (relative to a spot market price of 5,500) clearly overpriced, if the stock price remains unchanged at 5,500 . In this case, smart traders will make arbitrage profits of 407,50 per contract and bring back the market to equilibrium: Actiont0t0 t1t1 Borrow money at r F (3,5%)+ 5,500.00- 5,692.50 Buy/Sell Stock Portfolio- 5,500.00+ Stock Sell/Buy Future at 6,0000+ 6,000.00 - Stock Total0+ 307,50 Note, that the arbitrage profit equals the difference between a fair- and mispriced future (6,000 5,592,40) plus Dividends. Higher Future prices will lead to massivly increased demand at spot markets until spot prices and futures are back to equilibrium. Spot Future Parity Index Arbitrage (Example)

Spot Future Parity Financial Market Stability Spot Markets and Future (Forward) Markets are interlinked. Mispriced spot or future market instruments will affect both markets. Future market speculations that drive futures prices will also drive spot market prices due to arbitrage trading (et vice versa). Speculation on futures markets, resulting in higher future prices will induce higher spot market prices due to arbitrage trading. Finally this may result in spot market bubbles that jeopardizes the allocation mechanism of real goods markets. Spot Future Parity Index Arbitrage (Example)

Management of Operational Risks: Weather Derivatives

Weather Derivatives History Weather Derivatives occured in 1997 in the USA after the El Nio effects. (Aquila Energy, Kansas City/Missouri). At the end of 1998 first Weather Derivatives were issued in Germany Since 1998 Weather Futures and Weather - Options are traded at the Chicago Mercantile Exchange. In August 2001 London International Financial Futures Exchange (LIFFE) started trading Weather Futures. Eurex planned to launch weather related derivatives in 2004.

Weather Derivatives German Temperature Index Xelsius

HDD Interval = Max { 0, 18C - Temp } CDD Interval = Max { 0, Temp - 18C } Example: On December, 12th 2001 the average temperature in Berlin has been - 6 C. This day the Index shows 24 HDD. Weather Derivatives German Temperature Index Xelsius

Weather Derivatives In many cases operational income is directly weather related

The annual turnover (Business Unit Heating Energy) of the former Berlin Energy - Supplier BEWAG (now VATTEN- FALL) 1999 / 2000 mounted to 771 Mio DM. The winter season 1999/2000 showed 2.425 HDD. This equals an average turnover per HDD of 320 TDM. If the winter would have been warmer (for example at only 2000 HDD) this would have caused a lower turnover of approx. 425 HDD x 320 TDM = 136 Mio DM. Insofar BEWAGs operational income is directly related to the average temperature in winter season. Weather Derivatives In many cases operational income is directly weather related

Weather Derivatives The Payoff-Profile from Heating Business remembers to the payoff profile of a financial future. Example: If 2500 HDD would represent an average cold winter, then a higher number of HDD would create additional turnovers, whereas a lower number would lead to a smaller turnover.

Weather Derivatives In this example the risk of warmer winters (i.e. < 2500 HDD) could be hedged by weather futures. At a Standard of 100 per HDD, a weather future on the basis of 2500 HDD has a contract value of 2500 x 100 = 250 T. Given a profit-margin of approx. 20% (turnover at 2500 HDD = 2500 x 320 TDM = 800 Mio DM (400 Mio ) i.e. a total average profit of 160 Mio DM or 80 Mio resp. an average profit per HDD of 32 T) BEWAG could hedge the weather risk selling 320 weather futures at an Index of 2500 HDD.

Weather Derivatives If BEWAG takes the short-position this could result in the following scenarios: Operational Income Income from HDD Turnover (Mio ) Profit (Mio ) Short Future (Mio ) Total Profit (Mio ) 2000 320 64 16 80 2100 336 67 12,8 80 2200 352 70 9,6 80 2800 448 90 -9,6 80 2900 464 93 -12,8 80 3000 480 96 -16 80

Weather Derivatives Payoff-profiles of a hedged (operational) business are similiar to the payoff- profiles of a future hedged trade.

Weather Derivatives Options Put - Options Hedging with weather futures means not only to eliminate operational risks but also to eliminate the chance of having a better result than hedged. To avoid this, one could lmake use of weather options (as traded at LIFFE). To minimize option premiums, options frequentlly contain caps or floors. Long Put at a Strike of 2500 HDD 2500 HDD Short Put at a Strike of 2500 HDD Cap at 2300 HDD

Long Call at a Strike of 2500 HDD 2500 HDD Short Call at a Strike of 2500 HDD Floor at 2700 HDD Weather Derivatives Options Call - Options To buy a put at a strike of 2500 HDD leads to compensations when the average number of HDD is below 2500 HDD. To buy a call wouold mean, that the buyer can claim fo compensation-payments if the number of HDD is above 2.500 HDD.

Max. Chance Max. Risk Weather Collar Short Call 2700 HDD and Long Put at 2300 HDD

Weather Collar ( Short Call 2700 HDD and Long Put at 2300 HDD) A Zero Cost Weather Collar (Short Collar) can be designed to restrict the volatility of weather related profits wo to the boundaries of an upper and lower limit.

Management of Operational Risks: Non Performing Loans and Credit Risk Marktes

Topics Covered: NPLs in China and Germany Origin and Dynamics of NPLs Centralized Problem Solving Approaches Decentralized Problem Solving Approaches Outlook

300 Mrd. Germany: At a Total Volume of 3,500 bn. Loans Outstanding approx. 300 bn. are Non Performing (estimated in 2004)

Referring to Fundamental Data (Profits) German Stock Markets Were Overvalued From 1997-2001

Although Investments (Plant, Machinery) Were Decreasing Loans to Enterprises Remained High

After the Bubble Bad Debt and Bad Debt Losses Increased

Solving the Problem Stock Problem Securitisation Workout Smaller Proportions transferred to Bad Banks Write-off 1/3rd of Total Volume will be transferred Tax Deductible, frequently in Combin. With Securit. Flow Problem Enforcement of Controlling Measures New Regulations Issued By Supervisory Authority Due to Measures in Portfolio Management Extended & Improved Approval Procedure Due to Introduction of Rating Systems Credit Restrictions

China: In 2002 Total NPL Amounted to $ 770 bn. Which Corresponded to 61% of GDP or 37% of Total Loans Total Outstanding LoansTotal Non Performing Loans Approx. 2,508 bn $ 168 bn $ 602 bn

Origin and Characteristics of NPL NPL Flow Future loans to debtors, that will not be able to serve the loan Stock Bad loans undertaken in the past Policy directed Policy loans Directed by government to support policy. Before 1986 not lending authority, until 1994/95 obliged to finance budget deficits. Since 1995 by State Dev. Banks Lending to SOEs Loans to SOEs SOE show an accelerated leverage risk due to ex- treme D/E ratios at low profitability. But: 50% of industrial output, 70% of employment, 80% of total capital stock. Financial System Weak Banking Poor risk and portfolio management, high sys- temic risk, no diversifi- cation, no adjustments for approp. Risk premiums possible; AMCs close to SOBs (1:1)

NPL Stock Flow Solve the Stock Problem: Debt-Bond Swaps Securitisation Cash Funding Debt Equity Swaps Amortisation (write-off) Stock and Flow Problems Need Different Approaches Solve the Flow Problem: Credit Ceilings Efficient Legal Framework Operational Restructuring Centralized Bad Bank Hard Budget Constraints

Market for Credit Derivatives Source: British Bankers Association (in Bio. US$)

Basics of Credit Derivatives Asset Swaps Investor Risk Buyer Reference Value (z.B. Bond) pays fixed Swap-rate (Coupon Rate) Receives fixed rate receives LIBOR + var. Premium (spread) The Investor protects his portfolio against credit quality degradations by a simple swap construction: using a interest swap the investor swaps fixed income from his portfolio into variable + premium payments from the risk buyer.

Credit Default Swap (C.D.S.) Risk Seller (Protection buyer) Risk Buyer (Protection seller) Reference value (e.g. Bond) Premium: bps x Notional Value Credit Event ? Yes: Compen- sation No: No Com- pensation

Total Rate of Return Swap (Synthetic Sales or Short Sales of Loans) Total Rate Receiver (Riskbuyer) Total Rate Payer (Riskseller) Reference Value (e.g. Bondes, Indices Asset baskets, Loans) LIBOR +/-Spread Fixed Interest Rates positive Market price changes negative Market price changes

Credit Linked Notes (CLN) Risk Buyer (e.g.Investor) Risk Seller (e.g. Bank) Referencial Assets (e.g. Bonds, Indices, Asset baskets, Loans) Fixed Rate CLN Repayment of C.L.N. possibly minus compensation if Credit Event Notional Value of CLN

Credit Spread Put Construction of strike-spreads Example: 5-y. Corp.Bond: 5,95% 5-y. Swap-rate ( fix against 6-M-EURIBOR) : 5,50% Credit Spread: 0,45% = 45 base points At an agreed strike-spread of 45 bps, the short side will pay a compensation, if the spread increases. Strike Spread: 45 bps 90 bps Spread increases: Loan Devaluation ExecutionForfeiture 25 bps Spread decreases: Improved C. Qual.

Credit Spread Put Mechanism Put Buyer (Long) (Protection buyer) Put Seller (Short) (Protection seller) Option price in base points Right to deliver an Asset-Swap-Pakets at LI +/- Credit Spread Put Buyer (Long) (Protection buyer) Put Seller (Short) (Protection seller) Execution Reference- value Payment par Reference value LI +/- Credit Spread Fixed Rate (Ref. Val.)

What is A Credit Event ? The ideal case would be a reference value (e.g. a bond) that is highly correlated with the secured loan. Down-grading Risk of Convertibility Market Inefficiencies Insolvency Payment Delay Payment Reluctance Cross Default Restructuring

Credit Default Swap / Option Settlement Versions Cash Settlement: CDP = (Par - recovery value) CDP = (Par - Marktpreis nach Credit Event) CDP = (Synthetischer Preis - recovery value) Binary: Zahlung eines kontrahierten Festbetrags Physical Settlement: Lieferung Referenzwert zum Festbetrag bzw. gegen Zahlung von par

Extension of Risk Management by Credit Derivatives Market Risks Risk of Default Insolvency Risk Spread Risk Credit Default Swap Credit Spread Put Total Rate of Return Swap

Alternative I: ABS Transactions (True Sale) Bank (Originator / Seller) S.P.V. (Buyer) Sale of a Credit Pool Price of the Credit Pool Investors Price of Bonds Issuance of ABS Coupon-Payments; Redemption minus Losses on ABS

Market Securitisation of Credit Risks (Europe 2002 in Mrd. $)

Alternative II: Synthetic Sales by Collateralized Debt Obligations (C.D.S.) Bank (Originator) S.P.V. (Buyer) Swap-Prmie Ausfallgarantie per CDS Investoren Bondpreis Emission CLN Kuponzahlung Rckzahlung CLN abzgl. Kreditausflle Sicherheiten Pool Anlage der Emissionserlse

Fazit Die Problemkreditbearbeitung wird zuknftig deutlich strker von risikoprventiven und/oder risikokurativen Managementaufgaben geprgt sein. Im risikoprventiven Bereich erwarte ich einerseits eine intensive Auseinandersetzung mit portfolio-orientierten Risikostrategien, andererseits eine sprbare Zunahme des Transfers von Adressen-risiken Im risikokurativen Bereich erwarte ich eine strkere Akzentuierung eines fundamentalen (Kredit-)Sa- nierungsmanagements auch unter Einbeziehung bankexterner Funktionen

Management of Operational Risks: Capital Markets and Refinancing of Insurance Industry

Alternativer Risiko Transfer (A.R.T.) Katastrophen - Derivate Katastrophen Anleihen (Cat Bonds) Act of God - Bonds

A.lternativer R.isiko T.ransfer Grte versicherte Schden 1989 - 2001

Alternativer Risiko Transfer Versicherbarkeit von Risiken Zuflligkeit Max. Schaden schtzbar Ausr. Anzahl gleichartiger Risiken Risiken Ausfall Olympische Spiele Produkthaftpflicht fr Arzneimittel Attentat mit nuklearen Waffen X X X ? ? nein ?

Klassischer vs. Alternativer Risiko Transfer Versich. nehmer Versich. Untern. Vers. Unt./ Rckvers. Klassischer versicherungstechnischer Risiko- transfer Alternativer versicherungstechnischer Risiko- transfer Versich. nehmer Versich. Untern. Kapital- markt

Produktentwicklung im Risikogeschft Integrative Produkte Tradit. Vers. Produkte Bonding Produkte Multiline Produkte Multiyear Funding Produkte Financial Rein- surance (Finite Risk) Finanz- markt- produkte (Derivate, Securiti- zation) A.R.T.

A.R.T. - Produkte Finanztitel originr derivativ Bonds Principal Coupon Options Futures Underlying Verknpfung mit versicherungstechnischem Risiko GCCI, PCS (Property Claims Services) - Indices Principal und / oder Coupon at Risk

A.R.T. - Produkte Struktur eines CAT - Bonds mit S.P.V. Versicherungs- nehmer Versicherer Special Purpose Vehicle Investoren Kapitalmrkte Refinanzierung des Schadenausgleichs Tilgung, Zinsen Kapital Tilgung Zinsen Wert- papiere Prmien Schadens- ausgleich

A.R.T. - Produkte Ausstattungsmerkmale Cat-Bonds Pionierprodukt war der Cat-Bond (Hagelbond) der Winterthur Versicherung (WinCat). Der erste WinCat Bond enthielt folgende Formulierung: Die Zahlungen auf den Zinscoupon entfallen, wenn die Winterthur whrend der Beobachtungs-periode, die jeweils vom 1. November bis zum 31. Oktober des Folgejahres dauert, als Folge min-destens eines groen Hagel- oder Sturmereignisses fr mehr als 6,000 Motorfahrzeuge ihrer Motorfahrzeug-Kasko- versicherung Leistungen erbringt. Dabei werden Schden, die innerhalb eines Kalendertages auftre- ten, dem gleichen Schadensereignis zugeordnet.

A.R.T. - Produkte Beispiel Cat-Bonds 1997 plazierte ein SPV (United Services Automobile Association und Residential Reiunsurance Limited) einen Cat- Bond ber 477 Mio USD in zwei Tranchen mit jeweils einjhriger Laufzeit: Die erste Tranche war nominalwert- geschtzt (Class A-1, LIBOR + 273 bps) und umfate 164 Mio USD, die zweite Tranche (Class A-2, LIBOR + 576 bps) ber 333 Mio USD unterlag Tilgungsrisiken. Die Zahlungsstrme der Tranchen waren auf Hurricane Katastrophenschden bedingt, soweit diese in ausgewhlten Regionen einen Gesamtbetrag von 1 Mrd. USD bersteigen. Erreichen die Hurricane - Schden ein Volumen von 1,5 Mrd. USD, verlieren die Class-A-2 Investoren ihr gesamtes Kapital.

A.R.T. - Produkte Optionsprodukte/ Beispiel An der Chicago Board of Trade werden seit 1992 indexbasierte Optionsprodukte, Puts und Calls, gehandelt. Der zugrunde-liegende Index ist der PCS - Property Claims Services - Schadensindex. Jeder Indexpunkt reprsentiert einen Marktschaden von 10 Mio USD. Beispiel: Ein Erstversicherer mchte sein Sturmrisiko / Florida reduzieren. Er nutzt hierzu den an der CBOT gehandelten Florida PCS - Call Spread 100 / 150, d.h. er kauft Call Optionen auf einen PCS - Indexstand 100 und verkauft gleichzeitig Call Optionen auf einen PCS - Indexstand von 150.

A.R.T. - Produkte Wirkung eines 100/150 Call Spreads auf den PCS-Index

A.R.T. - Produkte Optionsprodukte/ Beispiel Szenario A: Liegt der PCS -Index aufgrund der in Florida aggregierten Marktschden bei weniger als 1 Mrd. USD, verfallen beide Optionen. Per saldo sind Prmien von 5 Mio USD verloren. Szenario B: Marktschden bersteigen 1 Mrd. USD, bleiben jedoch niedriger als 1,4 Mrd. USD: Die Long Call Position bei einem Strike-Index von 100 gert ins Geld, die Short-Position verfllt wertlos. Schadensausgleich wird im Idealfall kompensiert durch A.R.T. Gewinne. Szenario C: Die Marktschden liegen bei mehr als 1,4 Mrd. USD. Der Wertzuwachs der Long-Position wird kompensiert durch Verluste aus der 140er Short-Position.

Alternativer Risiko Transfer A.R.T. - Refinanzierung der Versicherer / Rckversicherer ber die Kapitalmrkte erffnet Chancen zur Kapazittser- weiterung und Versicherung bislang unversicherbarer Risiken. A.R.T. bietet Instrumente, die aufgrund ihrer Kovarianzpro- file gut in viele Anlageportfolios passen wrden. A.R.T. bieten sich an zur kapitalschonenden Risikodiver- sifkation der Versicherer bzw. zur Ergnzung von klassischen Investor - Portfolios aus traditionellen Finanzmarktprodukten. A.R.T. Produkte sind schwierig zu bewerten. Es exisitiert kein allgemein anerkanntes Preisbildungsmodell, Investoren verhalten sich deshalb abwartend. A.R.T. Markt ist klein und entwickelt sich zgerlich.

Financial Markets Imbalances are Accompanied By Increasing Size and Activity of Alternative Investments

Berlin KlippakademieBerlin School of Economics84 Alternative Investment Strategies And Financial Market Stability Southwestern University of Finance and Economics Chengdu September 2006 The only hope to produce a superior record is to do something different. If you buy the same securities as other people, you will have the same results as other people John Templeton Prof. Dr. Rainer Stachuletz Berlin School of Economics

Contents oBusiness models of hedge fund investors and their current role in financial markets oTypical designs, mechanisms and conditions of hedge funds investment strategies oDo alternative investments jeopardize the stability of financial markets oSummary / Conclusions / What to do ?

The Universe of Alternative Investments Real Estate and Natural Resources Private Real Estate REITs Commodities / Energy Private Equity Strategies Venture Capital Buyouts Distressed Debt Mezzanine Public Market Strategies Hedge Funds Multy-Strategy Funds Arbitrage Managed Futures

General Characteristics of Alternative Investment Strategies Features of Trad. Investments (e.g. Investmentfonds) Benchmark oriented High correlation with equity- and/or bond markets Must always be invested Transparent, regulated markets No investments in own funds No levered investments Striktly limited use of derivatives Features of Altern. Investments (e.g. Hedge Fonds) Absolute Return Low or no correlation with other markets Short sales possible Unregulated markets, offshore Investments in own funds High levered investments Usage of derivatives

Hedge Funds Business Model Mostly unregulated, offshore residing eclectic investment pools with aggressively managed short term portfolios. Hedge Funds employ investment techniques like short selling, leverage, and are allowed to create a variety of synthetic positions by unlimited usage of derivatives. Often hedge funds are set up as private partnerships, open to a limited number of investors and require a very large initial minimum investment. Typically hedge Funds are illiquid as they often require investors keep their money in the fund for a minimum number of years. Hedge funds managers typically charge a management fee (1-2% of asset value) and a performance fee of about 20% of the capital gains and capital appreciation.

Development of Hedge Funds Number and Portfolio (in Bio US$)

Risk and Return Hedge Funds Investment Strategies Relative Value ( Arbitrage ) Equity Market Neutral Convertible Arbitrage Fixed Income Arbitrage Global Macro Managed Futures Dedicated Short Bias Long/Short Equity Directional Event Driven Merger Arbitrage Distressed Securities

PROFIT LOSS P/E - Ratio 23,9 Short Lowes at 23,9 Expected Market 16,7 Long Home at 16,7 Expected Market Relative Value Strategy Long / Short Equity Hedge

Enter spread position Relative Value Strategy Long / Short Equity Hedge

Directional Strategies Non Hedge Long-/Short Directional Strategies represent unhedged, directional speculations on growing (long) or declining (short selling) markets. By additional usage of debt (leverage) respectively completing short or long-positions synthetically, the total risk and return positions can be amplified. Exp. Market Leverage Expect. Market Short Call Long Put

Event Driven Strategies (Merger Arbitrage) Merger Declaration 1 3 End of Purchase Ad hoc News at 28. April 2000 Hypovereinsbank Bank Austria 2

Event Driven Strategies LongShortEquity and Merger Arbitrage -20 -10 0 10 20 30 40 50 455055606570758085 Expected Share Price HVB Expected Share Price Bank Austria Long Bank Austria Short HVB

Event Driven Strategies (Merger Arbitrage) 9,80+ EUR 58,60-EUR 48,801 BankAustria Verkauf 28. Dezember 2000 Differenz Kauf 28. April 2000 Aktien Anzahl + 9,80 9,80+ EUR 58,60-EUR 48,801 BankAustria Sale 28. Dezember 2000 Profit / Loss Purchase 28. April 2000 Shares Number + 9,80 Traditional Investment Fund Trade: Due to the short selling, the Hedge Fund gains an approx. 100% higher profit than the trad. Fund.

Three Popular Arguments on Hedge Fund Investments and Financial Market Stability ? 1.Hedge Funds operate high leveraged portfolios of mostly risky assets. As a result, market processes tend to be more volatile and more uncertain. Thus syestemic market risk will increase ! 2.Hedge Fund investments tend because of their sheer size to manipulate asset prices. This will directly compromise the pricing mechanism and thus lead to inefficient factor allocations ! 3.As Hedge Funds often do not have to follow any regulations that are used to be applied to onshore financial institutions (transparancy of investment styles, accounting, disclosure and auditing, taxes etc.) investors are not sufficiently protected.

monthly S&P 500 Volatility CSFB/Tremont Hedge Fund Index Returns Source: Bloomberg 1. Do Hedge Funds Increase Market Volatility ?

1. Are Hedge Fund Strategies Risky Investments ?

1. Do Hedge Funds Increase Systematic Risk ? 100% HF/ 0% TF 45 % HF / 55 % TP 0 % HF / 100% TP (Theoretical Portfolios of Traditional Assets (MSCI 50%, JP Morgan Global 50%) and the CSFB-Hedge Fund Index based on monthly figures between 1994-2004)

2. Hedge Funds and Market Manipulation Hedge Funds do not rely on momentum investments and often take contrary positions. Thus, their engagement will support the pricing mechanism while providing liquidity and keeping the market process running. By this, Hedge Funds help substantially to rebalance the markets and smooth volatility. Hedge Funds, that operate in smaller markets generally have the potential of market manipulation. In the case of arbitrage trading or related relative value strategies, hedge funds activities target directly to change market prices. A manipulation of prices back to the equilibrium is desired. This may be seen different concerning other investment strategies.

2. Hedge Funds and Market Manipulation In fact, only 20% of the total investment is arbitrage trading. The rest is more or less directional. The major part of directional investments is represented by directional equity-investments (long-/short-only).

The Hedge Funds market is dominated by well experienced, well informed and educated powerful investors (average entry investment at 630 T$ !) like banks, pension funds, endowments and wealthy individuals (HNI). As they are strong enough to take care of their specific information needs, no regulation is required. 3. Need Investors to be Protected ?

Investor protection seems to be a week argument, if it is focused on the typical hedge fund investor as shown above. As hedge funds have started to copy the profitable investment model of private equity funds in a short term version, there are not the hedge fund investors that need to be protected, but those long term investors, who are affected by short term hedge fund investment activities. Therefore, to focus investor protection on the hedge fund investor is misleading. Investors should be protected against hedge fund investors. 3. Need Investors to be Protected ?

Summary and Conclusions 1.Currently Hedge Funds control an investment volume of about 1.2 Trillion USD, which means a proportion of 12% of the total global fund investments. 2.Although they are powerful, Hedge Funds are widely unregulated, e.g. they do not report their acitivities like other financial institutions, mostly they dont have to fol-low minimum capital requirements, minimum disclosure standards or minimum audit standards. In a strong sense they do not contribute to rational decision making. 3.Due to their characteristics non regulated offshore residents, excessive leverage, short sales and unlimited incorporation of derivatives (synthetic assets) their investment styles and their sheer size, hedge funds affect or have the potential to affect market processes.

Summary and Conclusions 4.The total business model including investors who provide equity, hedge fund corporations that select investments and investment styles and investment banks which provide the loan is highly concentrated and interlinked. That high integrated and concentrated business modell increases the probability of extensively widespread cascading effects in case of a failure (see the LTCM Case in 1998). 5.As Hedge Funds have started to copy typically Private-Equity-Engagements even those parts of the real economy that have not been direktly linked to capital markets, have become the target of short term financial investments and will be exposed to intensified leverage risks.

Does The Market Need Hedge Fonds ? Hedge Funds are in general non transparent, offshore located and tax avoiding investment strategies beyond any national jurisdiction. With the today known market strategies that includes desireable arbitrage trading only to a proportion of approxi- mately 20% and the observable move to directional strategies concerning long equity positions Hedge Funds need to be regulated to support long term oriented micro- and macro-policy approaches. Hedge Funds have not only the potential but also strong incentives to manipulate market processes e.g. to generate price movements that enhance the profitability of their underlying positions.

Private Equity Investments and Regulatory (Tax) Arbitrage Private Equity means to invest in non-listed, frequently undervalued corporations and any other (undervalued) assets. Mostly returns result simply from tax arbitrage. Withdraw E. and replace by D. Assets 1.000 E500 D500 (r D : 4%) Assets 1.000 D (1) 500 (r D : 4%) D (2) 500 (r D 8%) Exp.: 60 Int. : 20 Tax:5 Profit:15 Sales 100 Exp.: 60 Int.: 60 Tax:0 Sales 100 Loss 20 Offshore Int. 40Tax 0 Profit 40

Due To Deregulation, Liberalization and Globaliza- tion The Traditional Bank Business Has Changed...

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