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European I-Rate Mart Dominated By Pension Fund Hedging

European pension funds ramped up their buying of long-dated swaptions and their activity had a profound influence on the euro swaps curve last year, leaving market professionals talking about similar concentrated buying and what impact it may have next year. The buying, especially from pension funds in Denmark, led to an increase in volatility not seen since the 1998 financial crisis, according to Meyrick Chapman, a derivatives strategist at UBS Warburg in London, who added the new levels may be here to stay.

For example, the price of the benchmark five-year option to enter a five-year swap rose as high as 5.20%, compared to a range of 3.80-4.20% during the previous three years. "That is an eye-popping level and there's a fear it might spread to the Netherlands or other countries throughout Europe," said Fred Goodwin, a derivatives strategist at Lehman Brothers. The demand was largely due to buying from Danish pension funds throughout much of the year and activity picked up in the fourth quarter when managers bought swaptions worth billions of euros to hedge their exposure to guaranteed annuities. One such investor, Danica Pension, spent EUR75 million (USD67 million) in premiums to enter a receiver constant-maturity swap in October (DW, 10/22). "The pension fund buying has had a greater effect on the European market than Sept. 11 and any other event, possibly a greater impact than Long-Term Capital Management and Russia," said Neil Cosburn, head of interest-rate options and exotics trading at Royal Bank of Scotland Financial Markets in London.

And it's probably not finished yet. Other market watchers added that pension funds in the Netherlands, which has a much larger asset base than Denmark, may be the next receivers of constant-maturity swaps to hedge their guaranteed liabilities, as rates go down and equity markets continue to falter. They are believed to have waited because they typically offer guaranteed rates of 4%, whereas Danish funds are more generous at 5%.

Another major change from 2000 was the unprecedented interest-rate cutting by the European Central Bank, and by the Bank of England, even if it was not as aggressive as the Federal Reserve. These rate cuts forced dealers to retool some of their pricing models. The issue emerged because traditional Black-Scholes pricing models tend to assume that lower rates will lead to lower volatility, although this year rates went down and vol went up. "Rates have been low in Japan for some time, but this was certainly something new and pressing for the European market," noted one trader. Specifically, models with interest-rate barriers set at zero or below zero are skewed as rates head toward those levels. "When rates are lower, the presence or absence of a barrier becomes very important and differences between different models become much more apparent," said Jessica James, head of strategic risk management at Bank One in London.

The sovereign use of the swap market to manage debt duration was also an ongoing theme. France announced an ambitious plan to lower the average duration of its debt from 6.3 years to 5.5 by the end of this year and began receiving longer-dated swaps. And Spain lined up as well, with intentions to use the swaps market to reduce the 4.3-year average maturity of its liabilities (DW, 11/12).

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