Slides [ppt]

W W W . W A T S O N W Y A T T . C O MNovember 2004

Derivatives inInstitutional Investment

2Copyright © Watson Wyatt Worldwide. All rights reserved.

Agenda

1. Basic definitions

2. Size and growth of market

3. More detailed examples

4. Rationale for institutional use

5. Strategic thought process

6. Legitimate concerns

7. Conclusion

W W W . W A T S O N W Y A T T . C O MBasic definitions


What is a derivative?

A financial instrument whose value …

… depends on the value of other basic variables

Including:

Options

Futures

Forwards

Swaps

W W W . W A T S O N W Y A T T . C O MSize and growth of market


0200400600800

1,0001,2001,4001,6001,8002,000

1990 to 1997 1998 1999 2000 2001 2002

Size of marketNow too big to ignore

Interest Interest rate rate swaps swaps Value of swaps contracts outstandingValue of swaps contracts outstanding

Credit default swapsCredit default swapsNotional outstanding ($bn)Notional outstanding ($bn)

Global govt inflation linked bond markets ($308bn) Global govt inflation linked bond markets ($308bn) Equity derivatives index options volumeEquity derivatives index options volume

1996

US47%

UK36%

France 9%

Canada 4%Sweden 4%

Source: Goldman Sachs

Source: BIS Source: Goldman Sachs

0

40

80

120

160

200

S&P 500 EuroSTOXX 50

FTSE DAX Nikkei 225

Vo

lum

e (i

n C

on

trac

t)

2001 2002

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

01998 1999 2000 2001 2002

US

$ B

illi

on

s

Source: Goldman Sachs


… even compared with equity/bond markets at end of 2003!

Interest rate swaps:

$110 trillion in notional

Credit default swaps:

$3 trillion notional

World equity markets:

$20 trillion mkt value

World bond markets:

$20 trillion mkt value

W W W . W A T S O N W Y A T T . C O MMore detailed examples


Underlying Derivative

Puts

Calls

Inflation swap

Equities

Bonds

Inflation rates

Interest rates

Default risk

Interest rate swap

Credit derivatives


Examples for consideration Derivatives are financial instruments that change the risk/return profile of underlying

investment assets, such as equities and bonds Derivatives may be used to improve the investment efficiency of investment assets.

Uses include– reducing unwanted/un-necessary financial risk– efficiently altering the exposure to asset markets

Interest rate swapsInflation swapsTotal return swapsEquity collarsCredit default swapsStructured credit

Examples


Agreement to exchange cashflows

Scheme receives fixed payments

Scheme makes payments based on current interest rates

Or vice versa …

Lengthen interest rate exposure

Tailor it to exact duration of liabilities

Tailor it for cashflow matching

Useful tool for active bond management

PensionScheme

Bank

Fixed payments

LIBOR / EURIBOR …

Description Application

Interest rate swap

Floating LIBOR payments


Useful tool to

– Extend duration– Match fixed liabilities

Available for longer and more flexible terms than bonds

Highly liquid and transparent

Requires some specialised trading infrastructure

Swaps are a new area for most clients

Collateral requirements

Pros Cons

Investment banks provide liquidity

Some asset managers can run active positioning

Ideal provider

LIBOR / EURIBOR …Interest rate swap



Scheme receives payments based on inflation

Scheme makes predetermined payments or payments based on current interest rates

Get inflation exposure

Access to appropriate floors and caps (eg LPI)

Tailor cashflows to meet inflation linked liabilities

PensionScheme

Bank

Payments linked to experienced inflation

rate

RPI / LPI / CPI


Inflation swap

Payments rising by fixed inflation rate


Useful tool to match liabilities Available for inflation where

bonds not available – LPI– some European inflation

Can be run as an overlay on existing assets

Limited (but growing) liquidity, especially in longer duration or regional indices

Swaps are a new area for most clients


Pros Cons

Investment bank (large sophisticated clients)

Asset manager (packaged product, inflation management)

Ideal provider

RPI / LPI / CPIInflation swap



Scheme receives payments based on returns on eg S&P500

Scheme makes payments based on eg LIBOR

Or any other permutation …

Obtain exposure to a market without having to directly invest

“Alpha transport”

Transition management

Cashflow matching

Many others …

PensionScheme

Bank

Payments based on returns on S&P500

Equity, bond, LIBOR, …


Total return swap

Payments based on LIBOR


Useful tool for targeting market exposure without direct investment

Separates “alpha” and “beta” investment decisions

Can refine asset cashflows to look like liabilities

Basis risk –may be different to scheme assets/ liabilities

Exact tailoring increases bid/offer spread


Pros Cons

Asset manager (as part of day-to-day portfolio management and/or “alpha transport”)

Investment bank (exotic over-the-counter derivative)

Ideal provider

Equity, bond, LIBOR, …Total return swap


Combination of options Sell a call option Use the proceeds to purchase a

put option Payoff curtails downside risk, but

restricts equity gains

Used to protect against downside risks

Removes “unnecessary” upside

Relative Returns


Equity collars

Equity returnsEquity returns

Funding levelFunding level


Gets straight to the pensions issue: large equity risk

Can be manipulated into a scheme specific strategy combined with contribution rules

Pricing involves selling low skew and buying high skew

Does not tackle risks arising from a lack of rate exposure


Pros Cons


Ideal provider

Relative ReturnsEquity collars


Protection (or insurance) type of agreement

Scheme receives a payment if a corporate bond issuer defaults

Scheme pays a regular premium for this protection

Or vice versa …

Manage credit exposure without having to buy/ sell bonds

Protection against sponsor default

PensionScheme

Bank

Payment of (100-R) if corporate defaults

Corporate bond


Credit default swap

Fixed CDS premium

R is the bond value in default (recovery value)


Can take positive and negative positions in credit

Potentially more liquid than cash market in some names

Can be used to protect against sponsor default (in some cases)

Manager requires more sophisticated infrastructure

Some legal/ definition issues

Potential liquidity issues


Pros Cons

Asset manager (corporate bond portfolio management, credit overlay)

Investment bank (single name CDS for sponsor protection)

Ideal provider

Corporate bondCredit default swap


Cash invested into a SPV that buys a large pool of credit

SPV is structured into debt tranches which have different levels of seniority

Losses are absorbed by the tranche with the lowest seniority which has capital remaining

Managed credit exposure without having to buy/ sell bonds

Protection against pre-agreed level of initial losses

Credit Assets


Structured Credit

Coupon and principal

Super Senior

Tranche

‘A’ Rated Tranche

Equity Tranche

PensionScheme

Initial investment

Losses above subordination


Exposure to a pool of credits in a single investment

Potentially provides higher yields for a given level of risk

Can tailor: – Level of credit risk – Inflation linkage– Liability matching

Complex to understand Difficult to ascertain pricing

attractiveness Risk of losing all capital

(depending on what tranche you invest in)

Pros Cons

Ideal provider

Credit assetsStructured credit


Asset managers with a strong track record in CDO arena

W W W . W A T S O N W Y A T T . C O MRationale for institutional use


Pragmatism

Matching liabilities (duration, inflation)

– For example, vanilla or inflation swaps

Lower transaction costs

– Bid/offers tight in forwards

Changes in portfolio composition

– Overlay and transition strategies

Tax implications

– Awareness of Inland Revenue rules


Other considerations

Non-linear payoffs

– Matching the non-linearity inherent in liabilities

Better Liquidity

– Deeper, more liquid markets– Better able to cope with large

trades– OTC market can provide

confidentiality

An example is a swaption contract

– Put/call on interest rates– Useful for life assurers and

pension schemes

Payoff

Interest rate

W W W . W A T S O N W Y A T T . C O MStrategic thought process


Strategic thought process

Derivatives must make sense in the decision life cycle

Core objectives

Current asset mix

Contract types

Overlay analysis

Technical aspects

Counter- party

Execution of

strategy

Reporting and

management

W W W . W A T S O N W Y A T T . C O MLegitimate concerns


When genius fails.…

BaringsBarings(1995)(1995)

LTCMLTCM(1998)(1998)

EnronEnron(2001)(2001)

Risk monitoring and management are key

AIBAIB(2002)(2002)

The next eventThe next event(200?)(200?)

W W W . W A T S O N W Y A T T . C O MConclusion


Development of derivative markets

1980’s 1990’s 2000’s

Co

mp

lexi

ty

FX forwards and futures

Single stock options

Index futures and options

Interest rate swaps

Currency swaps

Caps/Floors

Swaptions

Index swaps

Credit derivatives

Portfolio insurance

Inflation swaps

Cross asset derivatives

Credit default swaps


Future prospects

Derivatives increasingly used by sponsors

Risk management continues moving to the fore

Scheme specific risks to come

Recognition of MTM risks?

Pensions to follow the life assurance market?

Authoritative, independent advice will be critical

Slides [ppt]

Documents

Transcript of Slides [ppt]