From being instruments used primarily for speculative or hedging purposes, they have now become important for investors as tools for optimizing use of capital (within the constraints of their investment mandates).
The rapid growth of the OTC derivatives market (interest rate, currency, equities and, more recently, credit) has meant that investors can now assume risks with which they are comfortable, but which instruments in the cash market cannot provide.
It is appropriate to begin with the investors, since their objectives, and the constraints they face in meeting those objectives, are the starting point in structuring a suitable derivative instrument for the investors. They fall in three broad categories: portfolio managers, hedge funds and retail investors.
The most general of these three categories is the first, and needs to be subdivided further, since the investment objectives of the various portfolio managers vary significantly. Insurance companies, pension funds, asset management companies and banks (excluding the bank dealing desks) fall into this category. The differences in the investment objectives are driven by the nature of the liabilities for all these groups.
Insurance companies (particularly life insurance companies) and pension funds, for example, have long-term liabilities, and their major challenge is to achieve returns greater than the yields that they are obliged to give to policyholders or pensioners. They also have to actively manage the duration of their portfolio so that the assets match the liabilities.
In most jurisdictions, insurance companies are also heavily regulated, and that regulation defines, to a large extent, the products they are allowed to invest in, and sometimes also fixes their liabilities (e.g. in the case of fixed returns to policy holders which is set by the regulators). Most companies will also have internal credit limits governing their investments. This exposes them to significant risks if the duration of their assets and liabilities are not matched, especially if there is a long term decline in interest rates which makes it increasingly difficult for them to meet their yield requirements within the credit constraint.
This is precisely what has happened since the beginning of the 1980s. Long term rates have declined, and insurance companies and pension funds have found themselves unable to generate the kind of yields that would be required to meet their liabilities (e.g., in the UK). The response has been to buy structured products that help them to achieve their target yields.
Banks generally look for floating rate assets to meet their floating rate liabilities, optimal utilization of credit lines, and investment opportunities in the currency of their liabilities. Sometimes there are regulatory restrictions on the kinds of assets banks can invest in (e.g. in Taiwan, banks can only invest in bonds if they are rated 'A' or above). As explained later in this article, these problems are sometimes best solved by the use of structured products.
Asset management companies include indexed funds and funds that specialize in a particular market (e.g. emerging market funds). Index funds, for example, would have the objective of beating the index. The constitution of their portfolio would also mimic the index. The primary goal for asset managers is yield enhancement in their portfolios.
The defining characteristics of hedge funds are leverage and very specific views on the market. There are two types of hedge funds - macro (directional) funds and arbitrage (relative value) funds.
The arbitrage funds look for 'relative value' in the markets - analyzing the relative richness or cheapness of a particular asset versus another, and taking offsetting positions. The macro funds take directional bets on interest rates, currencies and equities, depending on the underlying economic fundamentals.
The importance of derivatives as a structuring tool to meet the needs of the above investors arises from their very nature. The classical definition of a derivative - "an instrument whose value depends on the price of an underlying security" - is a useful guide. By changing the underlying security, derivatives can be used to enhance yield, provide market access, enable the assumption of very specific risk, provide leverage, enable transformation and/or isolation of a particular risk from a security, and to manage the duration of a portfolio.
Yield Enhancement
Yield enhancement strategies involve the investor selling optionality of one kind or the other (interest rate, currency or credit) and picking up the premium as higher return. It is possible to structure a product which expresses a view/risk with which the investor is comfortable, and enhance yield on the asset at the same time.
Callable zero coupon notes (high yield for duration risk), credit linked note (high yield for credit risk), capped floating rate notes (limiting upside potential) are all examples of yield enhancement strategies.
Market Access
Derivative products can be structured to provide access to a market where no cash instruments are available. The best example of this is in the credit derivatives market. Credit default swaps, credit linked notes, total return swaps, repackaged notes are all being used to allow investors access to markets previously closed to them.
For example, investors might want to buy local currency assets in an emerging market, but find it uneconomical to do so due to some reason (e.g. the requirement to have a booking entity onshore). The investor can do so economically by investing in total return swaps or deposits which have the effect of passing on the returns from those assets. (See Illustration 1).
Transforming the nature of the instrument, while retaining the economics also provides access to markets. For example, the Taiwanese banks that cannot buy bonds rated below 'A', have no such restrictions on loans. The problem - there are no loans for the credits that they want. The solution is to repackage the bond they want to buy into a loan through an SPV. This transformation of the nature of the instrument to meet investor requirements is useful in allowing investors to take risks they want to, but normally cannot due to documentation, form, regulatory, accounting or settlement reasons.
Expression of specific views
Derivatives allow the investor to express very specific views on the market. For sophisticated investors, they offer a chance to play on shapes of yield curves, volatility curves, correlation between assets etc. Hedge funds, for example, widely use derivative instruments to express such views. This, combined with the leverage that derivatives provide, makes them an ideal tool for leveraged accounts to make their investments.
Risk isolation and transformation
Most evident in credit derivatives, this use of derivatives has enabled structured solutions to several investor problems. Asset swaps are widely used by banks as synthetic floating rate assets, since the most widely available fixed income instruments in the market are fixed rate bonds.
Asset swaps also provide investors an opportunity to buy the cheapest available security (for a particular credit) in any currency and swap it into their currency of choice.
An interesting product is the stripped convertible bond asset swap, where fixed income investors buy the credit aspect of the bond only, and the equity option is stripped away. This isolation of credit risk and equity risk from the bonds allows the two to be traded separately. Credit investors do not manage equity risk, and this product fits their investment profile. (See Illustration 2)
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Duration Management
The development of assets which have coupons linked to long term rates (e.g. Constant Maturity Swap linked floating rate notes) has made it easier for insurance companies and the like to manage their duration risk. They can now buy assets that more closely replicate their liabilities than they were able to do in the fixed income securities market.
Derivative instruments allow great flexibility in deciding which investment to make, regardless of whether a cash market for the product exists or not. Default swaps, cross currency swaps, non deliverable forwards, total return swaps, repackaging vehicles, interest rate swaps, currency options, swaptions, caps and floors are some of the tools that can be used in conjunction with a standard investment vehicle (e.g. bonds, deposits, loans etc) to produce a wide variety of products and meet investor needs.
They are being used increasingly as an investment vehicle. The structured products market is already large in Japan, Europe and the USA, and it is now growing in Asia as well, as governments liberalize, and local currency capital markets develop.
