Learning Curve

Over the last few years, credit-default swaps have helped transform credit investment from a long-only game to a global market in which wholesale credit risk can be transferred, managed and assumed pro-actively. For all its merits, the default swap is not hugely adaptable for tailoring returns around specific views or return requirements.

Asian markets have been awash with a variety of vanilla equity-linked notes and capital guaranteed structures in the last three years in an attempt to meet investor demand for yield in a low interest rate environment. However as stock and index volatilities have declined and equity markets have rallied, equity-linked products have evolved that allow coupons to be accrued or stock accumulated over the life of the note.

While interpreting violent market movements can potentially be illuminating, many experienced finance practitioners shy away from this exercise, having recognized the difficulty of the task. At the same time, the majority of them appear to have accepted the premise that supply-and-demand dislocations have emerged as increasingly influential forces driving the fixed income markets. Their impact on interest rates, credit spreads, and implied as well as realized volatilities rivals that of geopolitical events, economic fundamentals, and credit crises. Paradoxically, the adoption of similar risk management practices by a large proportion of the financial system has become an extremely potent technical factor that may exacerbate market volatility and result in financial losses. One cannot help but wonder whether the creation of the field of risk management, directed toward protecting institutions from financial losses and decreasing the overall volatility, has at times become a self-defeating prophesy. Obviously, the realization of risk management's potential to affect market behavior, particularly as it applies to dynamic hedging strategies, is not new.

As part of its focus on special purpose entities, the Financial Accounting Standards Board (FASB) has undertaken several projects which re-define which party, if any, must consolidate the assets and debt of SPEs with which it is involved. FIN 461, released in January, applies to all actively managed financing structures including many commercial paper conduits. Proposed changes to FAS 1402, would apply to "passive" financial asset securitizations, including many mortgage and asset-backed transactions structured as qualifying SPEs (QSPEs).

To aid market participants in the adoption of the 2002 International Swaps and Derivatives Association equity derivatives definitions as the standard for documenting equity derivative transactions, ISDA recently published a User's Guide.

In recent years the financial industry has evolved significantly with the creation of new products, formulation of trading strategies, development of theoretical tools and growing sophistication of customers. Accordingly control functions such as internal audit have evolved to keep pace. One of the outcomes is the emergence of a new function of risk analysts within internal audit.

The economy and financial markets have a large impact on the performance of insurance companies. In the long-term, rising per capita income and property values have an impact on demand for insurance, increasing premium growth. In the short-term, however, the economy and markets primarily affect insurance companies through the valuation of assets and liabilities. On the liabilities side, lower inflation reduces the cost of future property/casualty insurance claims. For life insurers, low inflation generally lowers interest rates so insurers with interest rate guarantees in their life/savings policies may suffer financial stress if rates decline sufficiently. On the asset side, insurance companies hold mostly bonds and equities to pay future claims. These assets rise and fall along with interest rates, credit spreads, corporate default rates, equity markets and--if the company owns foreign assets--exchange rates. In managing these risks, insurers may shift asset allocations, alter their allocation of risk capital, change the terms and conditions on their policies and hedge their interest, market and exchange rate risks with derivatives. Stress Test

Hong Kong Exchanges and Clearing (HKEx) recently announced that a new type of product, Capital Protected Instruments (CPIs), is eligible for listing on The Stock Exchange of Hong Kong (SEHK). The CPIs provide a certain level of guaranteed return for investors and are regarded as structured products for the purpose of the Listing Rules of the SEHK. In order to list CPIs on the SEHK, issuers will need to comply with the listing requirements set out in Chapter 15A of the Listing Rules of the SEHK.

The International Accounting Standards Board made several concessions at its Board meetings in late July and continues to listen to intellectual and practical arguments on IAS 39 from the European banks. This article is the first half of a summary of the July update published by the IASB. It remains the IASB's intention to issue a final standard by the end of the first quarter. A further exposure draft on macro hedging was issued last week.

Many derivatives professionals will immediately call a forward contract a delta one trade. That's because they believe that a forward sale position can always be perfectly hedged by buying the same amount of the underlying asset at the spot price and vice versa. This is also known as a static hedge because once it is executed it does not have to be altered for the duration of the contract.

Passive hedging of currency exposure of non-domestic equity portfolios can be problematic because of fluctuations in the net asset value of the portfolio itself. The purpose of electing a passive hedging strategy is to eliminate currency risk. However, the portfolio volatility will continuously create a mismatch with the forward contracts that the manager has put in place to hedge portfolio currency risk. In practice, the impact from this can be significant. For example a sterling-based client investing into MSCI Europe and adjusting currency hedges quarterly could have lost a total of 8% in performance since 1988.

Typically the payout of an option at maturity is linear with respect to spot. However, non-linear payouts can offer either enhanced leverage, or a better hedge for a non-linear underlying exposure. Pricing of such structures can be done by: * Monte Carlo simulation