Learning Curve

There is always demand in the foreign exchange market to determine market positioning as a guide to the near term pressures on a currency. This is because if the short term speculative market is long in a particular currency, then there is an increased risk these positions will be reversed and there will be a sharp move lower. The data on international money markets (IMM) positioning will give some indication on the speculative stance of the market, but it only represents a small part of the marketplace. In addition, it only provides information on Friday for market positioning up to the previous Tuesday. By Monday morning, when the figures are widely known, the data are nearly a week out of date.

The Basel Committee on Banking Supervision has issued two working papers on securitizations, including synthetic securitizations, and has proposed minimum capital requirements for securitizations contained in Technical Guidance under the committee's "Quantitative Impact Study" ("QIS") 3. The second working paper ("WP2") and QIS 3 were released in October, and on Nov. 21, the committee issued a series of Frequently Asked Questions and responses regarding the revised capital standards for banks it proposed in January.

The Securities and Futures Ordinance was enacted in March 2002 and is widely expected to come into force by April. The SFO is a major piece of legislation, consolidating and superseding 10 primary pieces of current legislation relating to securities and futures.

During September European equity indices rallied by between 5%, (the FTSE 100) and 14%, (the Dow Jones Euro STOXX) and over the same period three-month at-the-money index implied volatility fell by around 9% to 10%.

The phenomenal growth of the CDO market has lead to new structures, with investors moving away from the initial black box CDOs toward transparent ones, initially static and most recently dynamic, with substitution or a manager. This article addresses some of the more recent developments in the sector and the analytical challenges they present. Although we are aware there are a lot more issues that need to be reviewed by investors in every individual situation, space restraints have meant we have focused on the most important areas.

The use of credit-default swaps as a hedge for all or a portion of the credit risk embedded in a convertible bond has increased dramatically over the past few years. One reason is that convertible arbitrage funds attempt to profit by buying embedded equity options cheaper through a convertible bond than is possible by purchasing the option separately in the equity derivatives market. Thus, although arbitrage funds are typically focused on isolating the equity option's value, the repackaging of the equity option in the convertible bond gives rise to other risks inherent in bonds--such as interest rate and credit risk--that are frequently hedged.

A synthetic arbitrage collateralized debt obligation is originated by collateral managers wanting to exploit differences in yield between the underlying assets and that payable on the CDO. The generic structure is as follows: a specially-created special-purpose vehicle enters into a total-return swap with the originating bank or financial institution, referencing the bank's underlying portfolio. The portfolio is actively managed and is funded on the balance sheet by the originating bank. The spv receives the total return from the portfolio and in return it pays LIBOR plus a spread to the originating bank. The spv also issues notes that are sold to CDO investors.

The models used to create a time-series of survival probability rates for a default swap can be quite complex, but we can simplify the main points in the process:

An investor with a long or short position in an existing credit-default swap can monetise a change in the default swap premium, and realize profit and loss, in three ways:

Collateralized fund obligations (CFOs) represent the latest application of securitization technology to a new asset class--hedge funds--and offer investors debt and equity classes backed by a diversified portfolio of funds managed by a fund-of-hedge-funds manager. Financing investments in hedge funds is nothing new. Banks have financed hedge funds for many years. But financing the investment using securitization technology and tapping institutional investors is new, with the first two publicly rated deals having closed this past summer, and a growing pipeline at dealers and rating agencies. Relative to the collateral backing conventional CDOs, a CFO's underlying hedge fund collateral is much more diversified, having high risk-adjusted returns and very low correlation to traditional equity and fixed income asset classes. These features, together with low historic return volatility and relatively low absolute losses, even in distressed markets, make hedge funds both an attractive addition to an investment portfolio and an attractive asset class to securitize. Investment in a CFO provides equity investors with efficient, non-recourse leverage, and offers debt investors with an opportunity to lend against an asset class less correlated with credit markets. The universe of hedge funds includes as many as 5,000 hedge funds managing in excess of USD550 billion in assets. Hedge fund investment strategies may be grouped broadly into 12 to 15 different styles, such as merger arbitrage and distressed situations. Fund of funds managers strive to assemble a portfolio of hedge funds that is resistant to event risk by employing multiple managers having diverse investment strategies, with the goal of achieving "equity-like returns with bond-like volatility." CFOs offer portfolio managers with another way to increase assets under management and diversify funding sources, as well as provide longer term financing than bank lines.

Risks in long-dated foreign exchange derivatives are driven by three factors: spot and the yield curves of the home and foreign currency. These products are in general quite complex and difficult to manage. This article uses typical power reverse dual currency (PRDC) swaps to illustrate the embedded FX optionality and the associated risks.

September is the six-month anniversary of the introduction of the new Australian laws for financial services. The law is now much wider than before and covers all aspects of financial services and markets. While the new laws impact all over-the-counter markets, the hardest hit products are the global financial transactions, such as foreign exchange derivatives, where the rules were previously supra national.