Derivatives (THỊ TRƯỜNG PHÁI SINH SLIDE)

DERIVATIVES From An End-user’s Perspective (personal reflections) Dan Svensson - Dragon Capital DỰ ÁN VIE/026 HỖ TRỢ KỸ THUẬT PHÁT TRIỂN THỊ TRƯỜNG VỐN PROJECT VIE/026 DEVELOPMENT OF THE CAPITAL MARKETS Outline: Example on end-users and how and why they use derivatives Emphasis OTC interest rate and currency derivatives Evolution of a derivative market Vietnam today and in the coming years 1 Example on end-users_ interest rate and currency derivatives Different institutions- all with different profiles, risks and needs – – – – – – – – Real estate/property companies Industrials/manufacturing companies Municipalities Pension funds/mutual funds/hedge funds Infra structure developers Housing loan institutions Banks’ treasury and lending operations Banks market making desks Example on end-users_ interest rate and currency derivatives Real estate/property companies Characteristics – Large amounts of debt – Usually bank loans with floating rate reference, e.g Libor Note that this leaves with exposure to rising rates Use of derivatives to manage the liabilities – Hedges with mainly interest rate swaps (IRS) are often static – no strict liquidity requirements – Buy interest rate caps (although their nature make them expensive) • 5% cap means if Libor>5% pay 5% else pay Libor • If the company has many loans with different reset dates it may consider Asian style caps which instead have a pay-off against the average Libor during a defined period Asian style options are cheaper than normal options – Some sell volatility or sell options and receive premium to reduce interest costs – however the risk increases at the same time Here banks offer more exotic options to make it possible for the company to choose level and type of risk Very important that the company understands the product, and also that the bank has a sense of responsibility 1 Example on end-users_ interest rate and currency derivatives Industrials/manufacturing companies Characteristics – – – – Export flows Mix of bonds and bank loans Large companies often have prop trading desks Historic scandals like Procter and Gamble and Gibson which made huge losses on products they didn’t understand Use of derivatives for hedging balance sheet – – – – FX-forwards and currency swaps to hedge export flows FX-options to hedge uncertain deals IRS to hedge liabilities/revenue and expenditure flows Small companies often use structured products to solve specific problems Use of derivatives in prop trading – Mostly the most liquid instruments like IRS and FRA’s (forward rate agreements) to take positions Often in packages to take a view on the slope of the yield curve and interest rate differential – FX-options Example on end-users_ interest rate and currency derivatives Large/small municipalities Characteristics – Liabilities to bridge mismatch between tax revenues and expenditures – Cash management is extremely important – Large cities issue bonds Small ones use banks or a legal structure where many small cities guarantee each other – Large media exposure Strict internal/external control – Scandals in the past in many countries with rouge traders causing gigantic losses Use of derivatives for hedging balance sheet – Plain vanilla like IRS as static hedges – Not keen on exotic products – Currency swaps to convert foreign currency debt to local currency 1 Example on end-users_ interest rate and currency derivatives Mutual funds Characteristics – – – – Big difference in policies and technical skills Generally limited leverage Constrained by mark-to market requirements Generally measured against bond index Use of derivatives for hedging balance sheet – Prefer liquid instruments, exchange traded futures, FRA’s and IRS – Both exchange traded bond futures and money market futures – Avoid illiquid exotic products and structures – Credit derivatives like Credit Default Swaps (CDS) to get credit exposure CDS may be more liquid than corporate bonds Complexity of these products can be daunting and at times potentially dangerous 2 Evolution of a derivative market FRA’s and money market futures: assume a well functioning interbank market with money market indices FRA’s are very often the first market to develop since money market generally have best liquidity Interest rate swaps can exist on its own but in developed markets Market makers normally use bond futures and money market futures, FRA’s, and swaps to hedge a swap portfolio, bond lending/borrowing Without these swap market unlikely to grow Currency derivatives, forwards as well as options, assume a well functioning money market, a friction less spot currency market Credit derivatives, useful but potentially dangerous Natural hedges in banks loan books Options hedging would require that both short and long positions of the underlying are possible In theory buyers and sellers taking outright positions not worrying about hedging could meet directly, but it is unlikely that the market would get any depth Exotic options are often hedged with plain vanilla options Thus a true exotic options market is unlikely to be material with the points above 3 Vietnam today and in the coming years Where is Vietnam today? – Young market yrs old while Indonesia, Philippines which are >15 years still not have very developed markets – Virtually no derivatives – No FRA’s, no money market futures, no bond futures – IRS have been done but in reality there is no market since hedging is close to impossible – Exotic products? Maybe it has been done but very rare – Currency swaps have been done Also currency options Challenges: – Narrow investor basis – The money market has decent volumes but has no reference interbank indices The equivalent of Libor is needed – Government bond market is illiquid and short selling is not possible – Currency very limited convertibility – Regulatory framework for derivatives undeveloped – Financial risk culture still in its infancy – No central clearing house which can handle derivatives including exchange traded futures 3 Vietnam today and in the coming years How can Vietnam develop? Develop a robust interbank index, equivalent of Libor Make legal framework clearer for offshore as well as onshore market actors Tax status? Establish standardized documentation, ISDA equivalent Set up one central clearing house which can handle all products including OTC and exchange traded derivatives Unique chance for Vietnam to something which all countries need but very few have before the market takes off Make short selling of government bonds possible How to find the bond which was sold? Improve repo market Sufficient government bond sizes Legal status Encourage and stimulate development of mutual funds and pension saving 3 Vietnam today and in the coming years Instruments FRA’s or forward rate agreements Within 18 months? – Money market by far the most liquid one – Easy to understand instrument Simple mechanics – Easier to take a view over the near future than 10 years ahead – FRA’s out to 18 months achievable – Initially physical delivery since reference index is missing Interest rate swaps (IRS) Already exists but in infant stage – Useful and relatively harmless Companies can convert floating rate debt to fixed rate without issuing bonds – Quite easy to understand – Support from FRA market in the shorter maturities – Once more clarity with documentation and legal swap market can slowly develop without supporting instruments Credit derivatives Already exists but in infant stage – Useful for financial institutions/funds to manage credit risk – Natural hedges exist in loan portfolios etcetera – Bad reputation and potentially very complicated and dangerous Caps and floors 2-3 years from now stage – Useful for companies to manage liability – Although the money market is the most liquid one functioning interbank rate index must be developed Exotics Patience – Not all exotics are necessarily dangerous – Tend to be illiquid Exit potentially very expensive – Really need plain vanilla markets to develop Final words – Derivatives have quite rightly gained pretty bad reputation over the years But used sensibly they can be used to reduce risk – Firm’s management must be aware of the mechanics and risks of a trade Not only the trader – Firms need to assure that they have the systems and knowledge to assess risks and prices – Incidents/scandals in the past very often caused by lack of (or no) understanding of the financial instrument  ... use derivatives Emphasis OTC interest rate and currency derivatives Evolution of a derivative market Vietnam today and in the coming years 1 Example on end-users_ interest rate and currency derivatives. .. market unlikely to grow Currency derivatives, forwards as well as options, assume a well functioning money market, a friction less spot currency market Credit derivatives, useful but potentially... convertibility – Regulatory framework for derivatives undeveloped – Financial risk culture still in its infancy – No central clearing house which can handle derivatives including exchange traded