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Money managers have started using credit derivatives to hedge and boost returns for institutional clients and are expected to start using the instruments for retail portfolios this year. Schroder Investment Management is thought to be the first large asset manager to use credit derivatives for retail targeted portfolios, (DW, 12/1) but last year, U.S. asset management giants Western Asset (WAMCO), Fidelity Investments and JPMorgan Fleming Asset Management all staged their entrance into the credit derivatives arena, said credit derivatives sales professionals.

Convertible arbitrage hedge funds are searching out ways of reducing credit risk while avoiding the high premiums associated with the credit-default swap mart, and some think equity derivatives are the answer. One of KBC Alternative Investment Management's convertible arb funds started using deep out-of-the-money equity puts to hedge against bankruptcy risk on convertible bond exposure last year and bankers predict this technique will spread this year.

Investment banks let go staff across the board, but the cuts in derivatives were deepest in Asia as firms moved to eliminate duplication. Next year headhunters and staffers expect to see derivatives houses' centralizing their trading operations to reduce back-office headcount, a trend that started last year. In fact, in 2002 some firms, such as Bank of America, closed down whole operations, while others, such as Goldman Sachs, centralized all their traders in one Asian location.

Invesco Global, the European and Asian arm of Invesco Asset Management, plans to use over-the-counter foreign exchange derivatives in its first long/short equity hedge fund for non-U.S. investors. The fund, which began trading last month, currently uses exchange-traded futures, said Brett Bastin, head of product development for absolute return strategies in London. It has a long/short large cap focus and then uses futures as an overlay to gain exposure to movements in the U.S. bond market and the Standard & Poor's 500. Because it includes non-U.S. investors, currency options will be used for hedging purposes. As the fund grows it will start using OTC options, as well as continuing to use listed options, for currency hedging.

Hybrid structured products across all derivatives asset classes will likely continue to grow in popularity throughout the year, as both institutional and retail investors scour the market for investments that will beat depressed equity investments. Rhomais Ram, director at Deutsche Bank in London, said he is seeing investors become more savvy with using foreign exchange spot and options as investment instruments in themselves, rather than hedging tools, a trend that should make marketing of hybrid products easier.

A tough year with low interest rates and falling equity markets have caused end users to flood into exotic derivatives in an attempt to boost returns for lower premiums, and the landscape is not likely to change this year. "There's definitely been a trend toward more complex all-encompassing derivatives," said Louis Cucciniello, v.p. in global foreign exchange options at JPMorgan in Singapore. "The market has become much more three-dimensional. A few years ago corporates would look at hedging their fx, interest rate and equity risks separately. Now you're seeing structures with fx, interest rate, and perhaps a commodity component or an equity leg," he explained.

Robert Pickel, ceo at theInternational Swaps and Derivatives Association in New York, recounts for DW some of the major events surrounding the over-the-counter derivatives market last year.

Eric Ohayon, head of fx structuring at Lehman Brothers in London, has resigned. Ohayon reported to Mark De Gennaro, global head of fx sales. Jessica Shepherd-Smith, spokeswoman in London, declined to name Ohayon's replacement. Ohayon declined comment and De Gennaro did not return calls.

Vivendi Universal has launched its first earthquake risk catastrophe bond and is believed to be only the second corporation to issue such an instrument. Wayne Cramer, v.p. of global risk management and insurance in New York, said as the financial stability of the insurance and reinsurance sector has continued to deteriorate, the company was looking for another way to offset its risk. "We don't want to be in the business of swapping earthquake risk for credit risk," he said.

Lehman Brothers and Deutsche Bank are recommending foreign exchange trades centered around anticipated changes in levels of implied volatility, but the two firms are focusing on divergent currency pairs. Deutsche Bank is pitching a three-month vol swap to take advantage of cable and euro/dollar having different implied volatilities, while typically they trade at approximately the same level. Lehman Brothers, on the other hand, is pitching a longer-term trade that will pay off if dollar/yen implied volatility rises.

The publication of the 1999 ISDA Credit Derivatives Definitions represented an important step in addressing issues of legal, operational and basis risk in the credit-default swap market. However, since that publication, a series of credit events affecting the relatively limited universe of frequently-traded names has highlighted areas where the 1999 definitions are overly permissive or insufficiently precise. This resulted in the publication by the ISDA Credit Derivatives Market Practice Committee of three supplements, relating to the identification of successors to reference entities, the scope of the insolvency credit event, the treatment of exchangeable and convertible debt securities and, most controversially, the vexed issue of restructuring.