FINANCIAL DERIVATIVE INSTRUMENTS

Exchange-traded instruments The aggregate turnover of financial contracts expanded further in 1998 (by 9%, to $388 trillion). Interest rate products, which remained by far the most actively traded, experienced a sustained increase in activity and reached to $350 trillion. Uncertainty over the course of monetary polity in Europe and North America supported trading in short-term interest rate contracts for much of the 1998, while the flight towards highly rated and liquid government paper boosted activity along most of the yield curve in the second half of 1998. There was, however, a decline in turnover towards the end of 1998 owing to the calming effect of lower official rates, the withdrawal of leveraged investors and the paring-down of positions ahead of EMU. Contracts on equity indices continued to record much faster growth than interest rate products (=16%, to $34 trillion) as new indices were introduced and bouts of downward market pressure and volatility prompted investors to seek protection. In contrast, the wide fluctuations seen in the major 2 currency pairs were not accompanied by an overall upturn of activity in currency related contracts (-17%, to $3.5 trillion). Aside from the continuing dominance of OTC business in the management of currency risk, observers attributed this subdued activity on exchanges to the stability of European cross rates and investors reluctance to take positions in emerging market currencies. The CBOT remained the largest exchange in the world (with a 16% increase in the number of contracts traded, to 281 million), owing to the sharp rise in the turnover of US Treasury contracts and the growth of new equity index products. The CME and the CBOE, the next largest US exchanges, also reported an increase in activity (by13% and 11% respectively, to 227 million and 207 million contracts). In Europe, Eurex Germany (formerly the DTB) posted a new record (+87%, to 210 million) and overtook LIFFE as the third busiest marketplace in the world. The flight t quality in the second half of 1998 propelled its bund futures contract into third position in the interest rate category after US Treasury bond and Eurodollar contracts. However, the squeeze which occurred in German government bonds at the time of the turmoil created concerns that the underlying market might not be sufficiently large to support futures trading in periods of stress. Meanwhile, overall activity on LIFFE declined (by 7% to 194 million), as increases in the area of short tern interest rate products and in some equity-related products were more than offset by a contraction in government bond instruments. In particular, the exchange‘s bund contract dried up as trading migrated to Eurex‘s cheaper electronic system. Despite strong advances in technology; trading on MATIF fell sharply 9 –31%, to 52 million contracts in a context of reduced relative movements between continental European interest rates. The anticipated consolidation in European interest rate instruments spurred the introduction of plethora of euro-compatible contracts, creating concerns that, in the drive to innovate, liquidity might suffer. Another notable development in Europe was the significant increase in the trading of equity-related products, which benefited from attempts to introduce a variety of new pay-European equity indices and contracts, as well as the reduction in the unit value of certain options. Activity in the Pacific rim was generally subdued, particularly in Japan, where; despite some trading opportunities provided by the ―Japan premium‖, the record low level of interest rate (except for a short period at year-end) reduced the demand for interest rate hedging. There was a tentative recovery in other Asian markets due t more active trading of equity-related contracts. Nevertheless, activity in Asian and other emerging markets remains a fraction of that in industrial countries in values terms. 3 The battle for European market share took a dramatic new turn as exchanges that had been based primarily on open outcry, such as LIFFE and MATIF, surrendered to the relentless expansion of screen-based trading. The agreement between the Deutsche Borse (DB) and the London Stock Exchange in July, 1998 while focusing on the cash trading of securities, also accentuated pressures for consolidation and for new regional links. US exchanges, for their part, entered into a number of joint ventures with wholesale market brokers and specialized IT firms to introduce electronic facilities for the joint trading of government securities and related derivative. With the rapid development of trading technology, the battle for supremacy is gradually shifting from the listing of new contracts to the technological arena, to the benefit of a small number of cost-efficient hubs. In this respect, it is worth noting that the proprietary systems of core electronic exchanges are already being challenged by ―new generation‖ trading systems that permit the interconnection of different exchange-traded and OTC facilities (in particular, via the internet). The growing importance of screen-based facilities cutting across product and market segments is creating new challenges for regulators wishing to ensure the soundness and transparency of such systems. Over-the-counter instruments Following a pause in 1997, expansion resumed in OTC instruments in 1998. Although the rise in notional amounts of positions outstanding (76%) was inflated by the increases in the number of dealers, the adjusted rate of growth remained significantly higher than the rise in open interest on exchanges (35% and 9% respectively). In particular, the unwinding of leveraged positions which took place in the second half of 1998 led to an upsurge in the volume outstanding (since, in contrast to futures markets, existing positions are not extinguished by the writing of opposite contracts). However, concerns about credit risk led to a sharp cutback in credit line to weaker counter parties towards the end of 1998 thus acting as a damper on overall market expansion. The activity in interest rate products was the main driving force. Faced with heavy losses, proprietary traders and leveraged funds unwound their positions, inter alia through asset swapsand structured securities. In addition, the unusual revolution of Japanese interbank rates and bond yields towards the end of 1998 generated some trading. As Japanese banks faced new upward pressures on their interbank liabilities, western-based banks began to offer negative rates on yen-dominated deposits, prompting a reversal of outstanding yen swaps and some activity in interest rate floors. 4 In the area of cross-currency derivatives the fairly steady appreciation of the dollar against the yen until August, 1998 fuelled activity in related options, offsetting somewhat the decline in intra-European business and emerging market currencies. Thereafter, the massive deliver aging of positions in dollar-denominated securities was associated with a parallel unwinding of short yen positions, leading to record volatility in the major exchange rates and a drying-up of activity. There was, however, some improvement in non-Japanese Asian business, as the appreciation of local currencies and the recovery of stock markets allowed a gradual relaxation of monetary policy and a partial resumption of trading in forward contracts. In the market for credit derivatives, the crisis in Asia had already focused the attention of market participants on the issue of credit risk, but its global extension in the second half of 1998 subjected the market to conflicting influences. On the one hand, concerns about banks‘ exposure to highly leveraged institutions and emerging market countries created broad interest in instruments offering protection against counterparty risk. On the other hand, the pronounced widening of credit spreads for emerging market names led intermediaries to exhibit caution in providing hedges to lower-rated entities. Moreover, market sources reported that liquidity suffered from doubts about the adequacy of loan documentation, as highlighted by legal disputes between counterparties over hedges arranged on credit exposure to Russia. Buyers of protection faced difficulties in enforcing payment owing to disagreements over the definition of a credit event, the pricing of reference credits and the settlement of contracts.

CIFA Revision - Derivative Analysis

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