Docstoc

Emerging Derivative Markets

Document Sample
Emerging Derivative Markets Powered By Docstoc
					Emerging Derivative Markets
 market development and risk management issues




         OECD- World Bank
    Annual Bond Market Forum
              3. June 2003


             Oliver Fratzscher
             The World Bank



                                                 Page 1
                      Overview
 500 BC Greece: Thales of Miletus – first option idea
     1859 CBOT: first agricultural derivatives contract

A.   Risk and Rewards of Derivatives
B.   Relative Size of Derivative Markets
C.   Five Driving Factors of Derivatives
D.   Example Korea
E.   Example Brazil
F.   Selected Policy Issues

                                                          Page 2
                      Confusion about D
D are financial weapons of mass destruction (Buffet)
                   D increase financial stability ; the more the better (Greenspan)

D offer high leverage and cheap transaction costs (Financial Policy Forum)
                              Notional values are not meaningful measures (FED)

D make full disclosure even more difficult (World Bank)
                             OTC regulation would stifle market creativity (SEC)

D can avoid prudential safeguards, manipulate accounting, build leverage (IMF)
                Markets, not regulators should focus on risk management (Bankers)

D are hugely profitable ; but each winner finds a dumb looser (Brookings)
                                D are used by only 5% of large banks (Economist)


                                                                                 Page 3
          A. Risk and Rewards of D
 More leverage                Market efficiency
 Less transparency            Risk sharing and transfer
 Dubious accounting           Low transaction costs
 Regulatory arbitrage         Capital intermediation
 Rising CP exposure           Liquidity enhancement
 Hidden systemic risk         Price discovery
 Tail-risk future exposure    Cash market development
 Weak capital requirements    Hedging tools
 Zero-sum transfer tools      Regulatory savings


                                                      Page 4
                      Question

Among the world’s 8 largest derivative exchanges,
     which countries do you think are represented ?

A.    Only G-7 countries
B.    Only OECD countries
C.    G-7 plus Korea and Singapore
D.    G-7 plus Korea, Singapore, Brazil, and Mexico



                                                      Page 5
                                           B. Size of Derivative Exchanges
                                       Top-8 Derivative Exchanges (volume)                                                  Top-8 Equity Index Futures (value)
                                              KSE: 855m (2001) ; 1930m (2002)                            9,000
                         900
                                              Value $1,800 bn (#5)
                         800
                                                                                                         8,000           KSE: market-cap $216 bn (#14 ; 10% Tokyo, 60% Sydney)

                         700
                                                                   BM&F: 101m (2002)                     7,000           Cash trading $593 bn (#12 ; 40% Tokyo, 200% Sydney)
                                                                   Value $3,200 bn (#4)
                                                                                                                         Futures trading $1680 bn (#3 ; 200% Nikkei)
     million contracts




                         600                                                                             6,000




                                                                                           billion US$
                         500                                                                             5,000
                         400                                                                             4,000
                         300                                                                             3,000
                         200                                                                             2,000
                         100                                                                             1,000
                          0                                                                                    0
                               KSE   Eurex Euronext CME    CBOE CBOT AMEX BM&F                                      CME Eurex KSE    CME Eurex Euronext Euronext Osaka
                                                                                                                   S&P500 DAX KOSPI Nasdaq STOXX CAC40 FTSE Nikkei

                                        Top-8 Interest Rate Futures (volume)                                          Top-8 Currency Futures Exchanges (value)
                         180                                                                             900
                         160                    BM&F: DI-futures 44m (2001) ; 71m (2002)                 800                               KOFEX: $75 bn USD futures trading (#7)
                         140                    Value $1,180 bn (DI) + $680 bn (DDI)                     700                               KTB futures trading $1,120 bn (#6) + OTC
million contracts




                         120                    + $850 bn (US$ futures)                                  600                               KTB cash trading $39 bn (Israel, Ireland)
                                                                                           billion US$




                         100                    Brazil: government dom debt $180 bn                      500                               Korea: government dom debt $100 bn
                          80                                                                             400
                          60                                                                             300
                          40                                                                             200
                          20                                                                             100
                           0                                                                               0
                               CME Euronext BM&F Euronext SGX KOFEX Mexder BM&F                                BM&F      CME    CME      CME      CME      CME KOFEX           CME
                               Euro$ Euribor DI-future Sterling Euro$ KTB Interest DDI-$                        US$      Euro   Yen      CHF      CAD      GBP US$             MXP
                                                                                                                                Sources: FIBV (2001) ; KSE, KOFEX, BM&F (2002) Page 6
                       Derivative Products
        OTC Derivative Markets                            Exchange Traded Derivatives
                            $128 trn notional              $29 trn notional
                            $ 5 trn market value           $700 trn turnover                                   US: 35%
                                                                                                               EU: 34%
                                 JP Morgan Chase          Chicago                                28%           Asia: 25%
                                     $ 27 trn             Eurex
           14%                                            Euronext
                                  Non-Financials          SGX
                      70%            $ 20 trn             BM&F
                                                                                  62%
                                                          KSE/KOFEX

                                    (relative size may be misleading)
                                     40% annual growth rates
Interest                                                                                                Interest
FX                                                                                                      G-Debt
Equity                              Key Driving Factors
                                                                                                        Equity-Index
Com                                  Capital flows
                                                                                                        Stocks
Credit                               Leverage
                                                                                                        Com
Other                                Risk Management
                                                                                                        FX
                                     Liquidity
                                     Transaction Costs

                                                                        Sources: BIS (June 2002) ; FIBV (Dec 2001)   Page 7
                    C. Driving factor: capital flows
                                                Cross-border capital flows
                  2001
                  $21 trn                                            2001                                                 2001
      24%         1997                                   23%
            18%                                                15%   1997                                          11% 1997
                  $14 trn
                                                                                                       34%
                              41%                                                                           16%
              All                                              Developing                                     Asia-Pacific
            countries       57%
                                                     21%        countries         54%                          countries
                                                                                                                                        52%
      25%                                                                   64%
                                                                                                                                 73%
                                                    23%

       35%                                                                                                   14%



                                    Loans and deposits          Debt securities         Equity securities         Source: IMF (CPIS, 2002)




   Cross-border flows rise by 50% to $21 trn in 2001
   Capital market flows double to $13 trn ; loans flat
   Trade integration complemented by capital flows
   EM private inflows declined to $120 bn annually
    versus $8,500 bn into G-7 economies in 2001.
                                                                                                                                             Page 8
                      Driving factor: leverage
   Institutional investor assets exceed 100% of GDP
   Investment bank leverage ø 30 times (LTCM 300 times)
   Capital incentives: discounts in Basle Capital Accord
   Enabling regulation: Futures Modernization Act (2000)
    deletion of real demand principle.

                              Institutional Investor Assets

      1998                                                                                           G-7

      1990                                                                                           Japan

      1980
                                                                                                    US
      1970

         0%             50%             100%            150%                           200%
                                  in percent of GDP       Source: Davis and Steil “Institutional Investors” (2001)   Page 9
        Driving factor: risk management
 Seminal research on pricing models
 Immunization of portfolios through derivatives
 Dynamic hedging strategies
 Vehicle to reduce visibility and to smooth earnings
 Derivatives as risk transfer tools: example insurance
  sold $120 bn short credit derivatives (Fitch, 2003)
 Counter-party risk concerns during crises
  shift emphasis towards central counterparty


                                                     Page 10
                       Driving factor: liquidity
   Liquidity premium: ST exchange vs. custom OTC
   Average annual turnover 25 times of underlying
   95% of turnover accounted for by 5 MM futures
   150 * turnover in Asian equity index options (KSE)
   Concentration among large banks, 5% non-financial
     Turnover of exchange-traded derivatives                                      Turnover ratios
            (Quarterly BIS data, in US$ trillion)                               (times outstanding, 2001)
                                                                                  Average            25
                                                                                  Futures            46
                                                                                  Options            11
                                                                                  Interest           25
                                                                                  Equity             25
                                                                                  FX                 30
                                                                                  US                 22
                                                                                  EU                 31
                                                                                  Asia               38
                                                                                  Asia Equity Opt   150
                                    Source: BIS Quarterly Review (March 2003)                               Page 11
                           Driving factor: transaction costs
         Tax exemptions make derivatives cheap instrument
         Technological advances (internet, broadband,real-time)
         Competition of brokers (deep discounts, KOR 5 bp)
         Push by online & program-trading (retail participation)
         Clearing and settlement of standardized products
         Shift from physical to cash delivery
                                                                Korea   1997               1998                  1999                  2000                    2001
                       On-line Trading Share                            Online share:      6%                    25%                    44%                    53%
     %                                                                      Regulatory                                                         IPO, mutual funds
60                                                               Home       approval                 Content
                                                                                                      Tools
                                                                 Trading
                                                                                                                           English version           Program trading
40                                                               System          Service
                                                                                 Launch           Fees
20                                                                                               50 bp            25 bp               15 bp               5 bp
                                                                 Web        Broker
                                                                                                 Online = offline Online fees cut     Competition         Deep
                                                                                                                                                          Discount
0                                                                Trading    deregulation   Common Gateway                    Java / Active-X
                                                                                                                                                          brokers

         Korea    US       Canada     France   Sweden   Japan    System                    Interface trading                 based trading
                                                                                           Delayed price quotes             Real-time price quotes
     Sources: KSDA, Samsung Research (2001)                                                                                                                 Page 12
           D. Market overview for Korea
D $630 bn = 130% of GDP ; tripled in two years
KTB-futures: $5 bn daily; contract $87,000; OI $7 bn; 90% OTC
KOSPI-futures: $7 bn daily; contract $38,000; OI $4 bn
KOSPI-options: $0.5 bn daily; contract $50; OI $0.3 bn
Exchange volumes top-1 ; equity volatility top-2 in world
OTC Gross market value 3% [1%] ; FX swaps 13% [5%]
Public banks very active in D ; 85% unrelated to loans
15% institutional investors ; tax incentives for D trading
Questions on legal and counterparty risk ; 14% ø netting
Questions on exchange margins ; trading collars ; cushions
                                                           Page 13
                                             Korean market growth
                                    OTC Derivatives Growth                                                          Commercial Banks' Leverage
                 800                                                                                          400
                                 Swaps (value outstanding)
                                                                                                                     Loans (outstanding)
                 700                                                                                          350
                                 OTC (value outstanding)                                                             Derivatives (notional)
                 600                                                                                          300    Regulatory Capital
  KRW trillion




                                                                                         KRW trillion
                 500                                                                                          250
                 400                                                                                          200
                 300
                                                                                                              150
                 200
                                                                                                              100
                 100
                                                                                                              50
                  0
                             2000              2001               2002-Sep                                     0
                                                                                                       1999           2000            2001             2002-Sep
    Source             : FSS response to questionnaire (December 2002)                     Source : FSS monthly statistics (table 13)


                               Securities Firms Revenues                                                              Equity Derivatives Trading
                                                                                                              12
                  12
                                                             Derivatives (trading rev)                              Derivatives (daily average)
                                                                                                              10
                  10
                                                           Commission (revenues)                                    Cash (daily average)
                                                                                                               8
KRW trillion




                   8
                                                                                               KRW trillion         Open Interest (mill contracts)

                   6                                                                                           6

                   4                                                                                           4

                   2
                                                                                                               2

                   0
                          1998        1999      2000          2001    2002-Sep                                 0
                                                                                                              1998       1999         2000       2001      2002Oct
                                                                      annualized
  Source : FSS monthly statistics (table 25)                                                        Source : KSE monthly statistics KOSPI200 futures & options

                                                                                                                                                                     Page 14
                                                                              for illustration only

                     Korean market assessment
 Notional size outstanding           lower risk       higher risk
   (% market cap, % GDP)                                             130% of GDP [250%BIS]
 Growth of leverage
   (OBS/assets, open interest)                                     200% growth in 24 months
 Gross market value
   (% notional)                                                Ø   3% value [1%US; 1.4%JAP]
 Netting of credit exposure
   (%, legal issues, collateral)                                     Ø 14%   [70%BIS, 52%JAP]
 Concentration of credit risk
   (% top 5, credit quality)                                             82% for top-5 banks
 Product characteristics
   (FX, equity, credit, duration)                              38% FX prod [14% BIS&JAP]
 Exchange infrastructure
   (margins, cushions, insurance)                                                Weak cushions
 Private sector risk mgmt
   (staff, systems, disclosure)                                              Strong investment
 Supervision effectiveness
   (analysis, frequency, arbitrage)                                    Remaining challenges
 Risk-based capital charges
   (level, consistency, profits)                                                      Low ratios
      USA            JAP       BIS      1     2    3    4     5                            Page 15
                            Korea: volatility and liquidity
                     Equity Market Volatility                                                     Regressions and Statistics
60%
                                                   50% Online                KOR
                                                                                                           n              4             n

       Futures Asian                                 Futures                 HKG           Rt     jRt  j   iDi   jt  j  Ut .
                                                                             AUS
50%                                                                                                     j 1             i 1           j 1
      launched crisis                                                        SAF
                                                                                                    n              4              m            n
                                                                                           t     jUt  j   iDi   jAk   jt  j  et
                                                                             POL

40%                                                                                                 j 1          i 1           k 1          j 1


                                                                                           Rt = daily return ; Di = dummy variable ; t-j= volatility
30%
                                                                                           Ut = unexpected return ; Ak= volume activity (OI)

20%
                                                                                            Trading            Equity           Futures            Open-Int    Open-Int
                                                                                           (2002, %)           (value)           (value)             (short)      (long)
10%
                                                                                         Foreign               13.0%              5.0%               20.3%       22.0%
       Jan-97




       Jan-98




       Jan-99




       Jan-00




       Jan-01




       Jan-02
      Sep-96




      Sep-97




      Sep-98




      Sep-99




      Sep-00




      Sep-01




      Sep-02
      May-96




      May-97




      May-98




      May-99




      May-00




      May-01




      May-02
      Nov-96




      Nov-97




      Nov-98




      Nov-99




      Nov-00




      Nov-01
      Mar-96




      Mar-97




      Mar-98




      Mar-99




      Mar-00




      Mar-01




      Mar-02
       Jul-96




       Jul-97




       Jul-98




       Jul-99




       Jul-00




       Jul-01




       Jul-02
      Jan-96




                                                                                         Institution           16.0%              9.0%               11.9%        4.6%
0%                                                                                       Securities             4.0%             38.0%               31.8%       10.5%
Note: volatility is defined as 52-week standard deviation of weekly returns times √52.   Retail                67.0%             48.0%               32.2%       61.2%
Vol(KOSPI) = 1.22*Vol (HKG) + 0.22*Vol (DOW) for entire period with R2 = 85%.


     Derivative markets have increased equity volatility
     Foreigners led the exit in late-1997 (40% of market)
     Securities firms are main contributor (90% D, 10% OI)
     Retail, online, program trading enhanced volatility
                                                                                                                                                                Page 16
           E. Market overview for Brazil
D $160 bn at BM&F ; top-5, central clearing & counterparty
DI-futures: $6bn daily; contract $27,000; OI $24bn (12m active)
DDI-futures (local $-interest): $4bn daily; $47,000; OI $32 bn
US$-futures: $3bn daily; contract $50,000; OI $20bn
80% of debt indexed to FX or I ; trading D parts separately
Repo and D market liquidity is far larger than cash markets
ON and D may be substitute for IB and cash bond markets
Credit derivatives growing fast ; equity derivatives negligible
BM&F established 3 guarantee funds ; seeks int’l insurance
Strong margin systems ; but 90% collateral as Govt bonds
Distortionary taxes: huge reserve requ , CPMF, D exempt
BCB issuing FX swaps to meet bank & corp sector demand
                                                             Page 17
                                                                                                                                          Brazil’s debt indexation
                                                                                   Absolute Levels (1994-2002)                                                                                                                                                                                                                                                  Relative Shares (1996-2002)
         700                                                                                                                                                                                                                                                                                                         100%
                                                                                                                                                                                                                                                                                                                      90%
         600
                                                                                                                                                                                                                                                                                                                      80%
                                                                                                                                                                                                                                                                                                                      70%
100 bn BRL




         500
                                                                                                                                                                                                                                                                                                                      60%
         400
                                                                                                                                                                                                                                                                                                                      50%
         300                                                                                                                                                                                                                                                                                                          40%
                                                                                                                                                                                                                                                                                                                      30%
         200
                                                                                                                                                                                                                                                                                                                      20%                                                                                             SELIC              NOMINAL                             FX-LINK                    INFLATION

         100                                                                                                                                                                                                                                                                                                          10%
                                                                                                                                                                                                                                                                                                                       0%




                                                                                                                                                                                                                                                                                                                                                                                           Sep-98




                                                                                                                                                                                                                                                                                                                                                                                                                                Sep-99




                                                                                                                                                                                                                                                                                                                                                                                                                                                                    Sep-00




                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        Sep-01
                                                                                                                                                                                                                                                                                                                                                       Sep-97
                                                                                                                                                                                                                                                                                                                                              Jun-97




                                                                                                                                                                                                                                                                                                                                                                                  Jun-98




                                                                                                                                                                                                                                                                                                                                                                                                                       Jun-99




                                                                                                                                                                                                                                                                                                                                                                                                                                                           Jun-00




                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               Jun-01




                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   Jun-02
             0




                                                                                                                                                                                                                                                                                                                            Dec-96




                                                                                                                                                                                                                                                                                                                                                                Dec-97




                                                                                                                                                                                                                                                                                                                                                                                                    Dec-98




                                                                                                                                                                                                                                                                                                                                                                                                                                         Dec-99




                                                                                                                                                                                                                                                                                                                                                                                                                                                                             Dec-00




                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 Dec-01
                                                                                                                                                                                                                                                                                                                                                                         Mar-98




                                                                                                                                                                                                                                                                                                                                                                                                             Mar-99




                                                                                                                                                                                                                                                                                                                                                                                                                                                  Mar-00




                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      Mar-01




                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          Mar-02
                                                                                                                                                                                                                                                                                                                                     Mar-97
                                              Apr-95




                                                                                   Apr-96




                                                                                                                        Apr-97




                                                                                                                                                            Apr-98




                                                                                                                                                                                                  Apr-99




                                                                                                                                                                                                                                      Apr-00




                                                                                                                                                                                                                                                                                          Apr-01
                                     Jan-95




                                                                          Jan-96




                                                                                                               Jan-97




                                                                                                                                                   Jan-98




                                                                                                                                                                                       Jan-99




                                                                                                                                                                                                                             Jan-00




                                                                                                                                                                                                                                                                                 Jan-01
                                                       Jul-95




                                                                                            Jul-96




                                                                                                                                 Jul-97




                                                                                                                                                                     Jul-98




                                                                                                                                                                                                           Jul-99




                                                                                                                                                                                                                                               Jul-00




                                                                                                                                                                                                                                                                                                   Jul-01
                                                                Oct-95




                                                                                                      Oct-96




                                                                                                                                          Oct-97




                                                                                                                                                                              Oct-98




                                                                                                                                                                                                                    Oct-99




                                                                                                                                                                                                                                                                        Oct-00




                                                                                                                                                                                                                                                                                                            Oct-01
                 Jul-94

                           Oct-94




                                    US$-Linked                           Nominal                     Zero-Duration                        Price-Level-Linked                                    Others                 Duration                          Average remaining Life                                                 Sources: Garcia (2002) ; Brazil STN (2002) ; Deutsche Bank (2002).


                                                                  10
                                                                                                                                                                                                                                               Real Interest Rate (%)
                              Brazil                                                       Brazil             Turkey
                          Turkey                                    9
                                   Fiscal Deficit (% of GDP)           Public Debt Stock (% of GDP)
                                                                    8
                                                                    7
                Poland
                                                                    6                   Poland           Philippines
                     Hong Kong Philippines                            Hong Kong
                            Israel                        Russia 5                           Russia               Israel
              India                Indonesia                                     South
                  Colombia                          South Africa 4               Africa    Colombia
                                                                                            Malaysia             Indonesia
                    Malaysia                                        3                              India
                                      Mexico                                      Mexico
                                                           Korea    2 Chile              Korea
                                              China           Chile 1          China
                                      Hungary                                 Hungary                        Singapore
                                                         Singapore
             % -6     -5       -4       -3         -2      -1        0        20      40       60       80       100     120 %
                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 Page 18
              Risk management issues
EM lessons (Mexico, Thailand, Russia): FX and Credit D may
 not be compatible with fixed FX and credit policies
OTC risk concentration: Public banks’ transparency,
 weak best practices, trend to central counterparties
Disclosure (IAS39) essential for insurance solvency,
 distinction between hedging and proprietary book
Exchanges need better cushions (margins, insurance)
Basle Capital Accord has fueled explosive D growth
D may enhance volatility, may substitute cash market

                                                        Page 19
                        F. Future challenges
1. Official regulation of rapidly expanding OTC derivative markets may need to be
     aligned across institutions to limit arbitrage and enhance transparency.
2. Prudential supervision of off-balance sheet exposure may need to be strengthened
     with reporting requirements and systemic risk analysis.
3. Derivatives exposure data may need to be considered in order to accurately assess
     BOP and reserve positions.
4. Proper valuation and full disclosure (strong IAS39) may reveal solvency issues of
     financial institutions.
5. Capital requirements for derivatives may need to be enhanced to limit regulatory
     arbitrage and leverage.
6. Derivatives as zero-sum risk-transfer tools may create conflict with managed FX
     and credit policies.
7. Derivatives driven by distortionary taxation and weak underlying issues may
     substitute for cash markets.
8. Management of counter-party risk may need to be enhanced (ISDA master, central
     clearing and counterparty).
9. Margin systems could be tightened for leveraged members (dynamic, insurance).
                                                                                 Page 20
   Thank you !
www.worldbank.org/finance




                            Page 21