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Derivatives

Alternative Investments Benefit From Increased Demand

Whether it was making a first foray into weather derivatives, launching a hedge fund, issuing catastrophe bonds, or setting up a fund-of-funds the alternative investment sector skyrocketed in 2001. With the equity market in the gutter firms and wealthy individual investors began exploring other avenues for capturing high returns. "Investors are coming up against a challenging market that's having a massive impact on their portfolio construction. We've seen a sustained period of shrinking equity premiums that's had a real impact on traditional asset allocation. We realize that high-quality alternative investments can improve portfolio returns, while at the same time reduce overall volatility," said Bill Santos, managing director of Montgomery Asset Management, a San Francisco-based investment firm with more than USD7 billion in assets.

In 2001 there were approximately USD500 billion in new convertible bond issues. This triggered the launch of a series of convertible bond arbitrage funds, from both institutions, such as Montgomery and individuals. One of the most notable individuals was J. David Rogers, the former head of Goldman Sachs' equities division (DW, 11/19). Rogers said the fund, called JD Capital Management, would raise USD350-400 million and use relative-value and arbitrage strategies that incorporate interest-rate and credit derivatives. "We're definitely going to use credit derivatives as a way to hedge credit risk in our convertible portfolio," Rogers noted. Market professionals said hedge funds are increasing their focus on convertible arbitrage strategies because it has become a means of achieving competitive portfolio returns with lower risk and is an asset class that has performed extremely well over a long period of time.

The year also saw a resurgence in catastrophe bond issuance, as re-insurance and insurance companies began looking toward the capital markets as a way to remove risk from their balance sheets at lower costs. Debt market professionals predicted that more than USD3 billion in CAT bonds will be issued this quarter as insurance companies look to increase their capacity for covering disasters in the wake of the Sept. 11 terrorist attacks (DW, 11/19). "Insurance companies are against taking on any more risk after Sept. 11. The industry has already lost more than USD70 billion because of the attacks," said James Doona, a CAT bond analyst at Standard & Poor's in New York. In November, Swiss Re took the lead in the market and began preparing a USD150-400 million CAT bond deal (DW, 11/19). Goldman Sachs soon followed, structuring a USD150 million deal for Paris-based reinsurance company SCOR Group to securitize Californian and Japanese earthquake risk and European windstorm risk (DW, 12/3).

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