WHY PFANDBRIEF DERIVATIVES ARE NECESSARY.
The German pfandbrief--morgage bond--market shows a significantly divergent behaviour over the bund or swap market. As it is not as liquid, it tends to react to overall market moves with a time delay. This causes a lower volatility for pfandbriefe in comparison with bunds or swaps and affects the directionality of the bund/pfandbrief spread. The time delay results, in fact, in an outperformance of bunds versus pfandbriefe in a rally and of pfandbriefe versus bunds in a selloff. History has shown that the volatility of pfandbriefe is usually about 20% lower than bunds. Consequently, hedgers normally take about 80% of the short position in a bund future needed for a Bund hedge when hedging a pfandbrief portfolio. However, the volatility difference between pfandbrief and bunds is itself rather unstable and can hardly be foreseen. Hence, hedging pfandbriefe with derivatives on bunds like futures or options leaves a significant spread risk. The mismatch can be up to 10% in the case of another volatility relation between the two markets than assumed when putting on the hedge.
Also, when hedging a pfandbrief with a swap the investor cannot be completely sanguine: asset swap margins of pfandbriefe are subject to significant changes, especially when the assessment of the credit quality of pfandbriefe by the market changes. During the Asian crisis, for example, pfandbriefe swap margins narrowed by up to 15 basis points in less than one week.
Summing up, the pfandbrief market is subject to very specific laws. Therefore genuine derivatives on pfandbriefe itself are needed both for hedging purposes and synthetic long or short positions. Neither derivatives on bunds nor swaps can serve as a full substitute for them. The illiquidity of the repo market together with the related absence of reliable derivatives for pfandbriefe is the main reason why short positions on pfandbriefe can rarely be held.
THE COMING JUMBO FUTURE.
The door for derivatives on pfandbriefe will be opened by the futures on triple A rated jumbos--large and liquid pfandbriefe--with a time to maturity between 3.5-5 years to be introduced probably in the second half of this year. Given the high amount of outstanding pfandbriefe (DEM 1.6 trillion) and the lack of an efficient hedging instrument besides derivatives on pfandbriefe, we expect them to meet significant demand and become a big market. As the futures should be both liquid and have low bid/ask spreads, it is an ideal basis for over-the-counter derivatives like options as well.
As a consequence, it will be possible for the first time to handle easily short positions in pfandbriefe with derivatives. A trader having bought a call could, for example, just sell the necessary amount of jumbo futures to hedge his position. This possibility to manage short positions in pfandbriefe by derivatives will offer a wide range of new trading possibilities for investors. In particular:
* Efficient hedges of pfandbrief positions without a spread risk.
* Expressing views on the credit spread between pfandbriefe and government bonds via the spread between the jumbo and the Bobl future.
* Putting on convergence trades between German pfandbriefe and other European mortgage bonds by buying the latter in the cash market and taking a short position in the Jumbo future or an OTC call on German pfandbriefe, for example. This is particularly attractive now, as the convergence in corporate market has not taken place yet because of different legislation. In the long run, harmonization of European mortgage bond regulations seems possible which could produce a significant convergence pressure.
* Profiting from the relative richness or cheapness of jumbos by basis trades. In case of a high open interest in the jumbo contract meeting a limited liquidity of the cheapeast to deliver it would be attractive to sell the basis of next-to-CTD issues, which would underperform versus the future.
IMPACT ON THE UNDERLYING
Derivatives on pfandbriefe will not only offer new trading possibilities but have a significant impact on the underlying as well. Their introduction will enhance both the efficiency and liquidity of the pfandbrief market. This should attract increasing demand from international investors for pfandbriefe as they trade at significantly higher yields than German government paper and thus improve the liquidity and efficiency of the pfandbrief market even more.
As derivatives on pfandbriefe mainly will depend on the future on jumbos, it is likely that derivatives on pfandbriefe will only be available for jumbos. International demand should thus focus on jumbos and support their outperformance versus other pfandbriefe. This will have the following impact:
* A clear distinction between jumbos which will be more in demand than their illiquid equivalents, classical pfandbriefe.
* Increasing influence on the rating (dominant criterion of internationals) on the pricing.
* Decreasing influence of the coupon (domestic criterion of German investors) on the pricing.
