| Using derivatives to bypass the asset-liability tools bottleneck |
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| 03/04/2005 | |
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The use of derivatives among pension funds throughout Europe could be ripe for rapid growth as pension schemes increase their focus on asset-liability matching -- one of the main issues at the NAPF's last conference -- but the supply of well-adapted instruments such as long-dated indexed bonds remains limited. Even with the recent issuances of 50-year bonds by France and Telecom Italia and the announcement of more to come by the UK government, pension funds still face a small supply of ultra-long maturity bonds, that are themselves exposed to the interest and inflation risks. Yet there is no such shortage on the derivatives market, which has been rapidly expanding over the recent years. According to the International Swaps and Derivatives Association (ISDA), the notional amount of credit derivatives grew by 123% in 2004 and now stands at $8.42 trillion. Equity derivatives grew by 21% on the same year. Eurex, the world's largest futures and options exchange, had its strongest growth ever in 2004 with over one billion contracts traded for the second time, despite the fact that volatility was at historically low levels. "In Europe we are currently seeing two major trends – continued convergence of the OTC and exchange traded markets and a further sophistication and increased maturity of the risk management industry as a whole. These two trends further drive growth in fixed income and equity derivatives", explains Candice Adam, a communication manager at Eurex. Risk matching Derivatives, which pension funds have traditionally been reluctant to use given the need for specific sophisticated back-office capabilities and risk monitoring, may offer part of the answer to the pensions' asset-liability conundrum. Pension schemes can directly enter derivative contracts on OTC markets such as swaps or trades options and futures, or eventually buy structured products. Derivatives and structured products can be used for a wide range of purposes such as hedging a portfolio value, cash management, tactical asset allocation and duration adjustment. In this spirit, AP2, the Swedish buffer fund, has been said to be considering the use of options as a mean of hedging risks after having invested about 5% of its portfolio in futures. "It is possible to even out the results of a strategy through time so as to match the cashflow requirements of a pension fund", confirms Gildas de Nercy at Exane, a broker that trades in derivatives. Pension funds can keep a close tab on the matching of their asset and liability duration by entering fixed income swaps that will modify their cashflows so as to match their liability needs. Pension funds willing to invest in stretched index-linked corporate bonds market can bypass the problem by investing in synthetic instruments found on the derivatives market. The fund just has to buy the conventional bond on the market while entering an inflation swap, which will result in a product similar to a pre-packaged index-linked bond. The same can be done for enlarging the pool of long-dated bonds beyond borders. Structured products such as a currency swap combined to an international long-dated bond, which will provide a hedge against currency risk by synthesising a domestic bond, will have the same effect. Beware But derivatives and other structured products are no free lunch. If derivatives can mitigate the risks in a portfolio – and even props up returns if all the conditions are present - they can also have a downward leverage effect and reduce the returns of a portfolio at a time when pension funds. All this at a time when pension funds, whose combined deficits of the 300 largest in Europe stands at €214 billion, are hungry for supplementary returns. For instance, a pension fund that has interest rate swap agreement with a bank might be protected against a fall in the interest rate, but will also miss out on a rise. "It is important to remind that structured products have to be selected on the basis of the liability constraints of the investor", reminds Gildas de Nercy. While exchange-traded derivative products such as futures can be bought at a low cost on public exchange, more sophisticated structured products and swaps, that trade on OTC market, usually comes at a higher cost. The lack of experience of many pension schemes on OTC market might also put off some of them to invest in this kind of products. According to Barclays Capital, pension managers still feel somewhat uncomfortable with swaps, which explains their reluctance to enter those contracts. In many countries, accounting and regulatory issues still prevent pension funds from using derivatives. Julien Laplante |
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