Interest-rate derivatives market makers expect a surge in demand from Danish pension funds looking to receive fixed in derivatives to hedge fixed-rate guaranteed annuity liabilities as regulators force funds to examine the issue. They also predict the trend will spread across Europe. One estimated there is still EUR30-40 billion (USD27-36 billion) of business to execute, with approximately EUR10 billion executed since July.
Danish financial institutions are more advanced in the risk management of these products than their counterparts in other European countries, according to interest-rate marketers and traders. Danish institutions Pensionskassernes Administration (PKA), AP Pension andDanica Pension have all started hedging their exposure since July andCodan is expected to start soon, according to bankers and pension fund officials.
PKA, Denmark's largest pension fund, was one of the first Danish pension funds to hedge interest-rate exposure on its annuities when it bought a floor on a constant maturity swap in July. Peter Melchior, executive director and actuary at PKA in Copenhagen, said it purchased the derivative because it expected other institutions across Europe to start buying these products, which combined with a rate cut, would drive up prices. Pension fund regulators are increasingly asking funds to stress test their portfolios, that is, examine their hypothetical performance under various market conditions, he continued, and this is one of the driving factors behind insurance companies and pension funds looking at these products.
In the floor PKA paid an up-front premium of 2.1% of the EUR5.5 billion notional, and in return receives a minimum of 5% per year. J.P. Morgan and BNP Paribas are the swap counterparties. Officials at BNP Paribas confirmed the trade. Officials at J.P. Morgan did not return calls.
Vibeke Thinggaard, assistant chief actuary at The Danish Financial Supervisory Authority in Copenhagen, attributes the increasing demand for interest-rate hedging to discussions the regulator and the Ministry of Economic Affairs have had with pension funds and insurance companies.