8. Exchange Traded Interest Rate Derivatives in Asset Management

Exchange Traded Interest Rate Derivatives in Asset Management


The necessity of managing risk and ensuring sufficient coverage of positions has been highlighted by the considerable underperformance due to the lack of hedging by most mainstream managers throughout the last bear market in global equity markets. Funds with as much as 60 percent exposure to equities could have managed the last few years better if they had hedged their exposures. Decreasing market returns and increasing market volatility have reinforced the pressing need for adequate and active risk management strategies. Many managers are now turning to financial futures, and they are discovering that the cost of a futures trade (in terms of market impact, bid-offer spread and commissions) can be significantly lower given the concentration of liquidity in standardized contracts such as Eurex derivatives. In a risk averse and volatile environment, futures and options offer the investor several hedging and trading opportunities, such as moving out of equity-based positions and into bond positions quickly and efficiently. Eurex fixed income and equity index futures can be used to execute this tactical asset allocation strategy effectively.


Managing the Move to Fixed Income

The European market has seen a sizeable shift from equity into debt. European pension funds and insurance companies have continually raised their bond allocation over the last three years. WM has reported continued net inflows into government bonds during the third quarter 2003. Fixed income products in general have seen significant price rises and concomitant growth in trading volumes. According to a 2002 Greenwich Associates study, global bond volume reached $25,320 billion, with global trading volumes rising by some 20 percent on average. There has also been a focus on high-quality government bonds, boosted by persisting geopolitical uncertainty. However, the fragmentation in the Europe-wide bond market, a result of each country issuing its own sovereign bonds, has increased demand for a benchmark. With their unrivalled liquidity, German government bonds have clearly won the competition to be the European benchmark yield curve. Reflecting this, fixed income futures and options continue to contribute the majority of the volume at Eurex. Figures at the end of 2003 (table one) show year-on-year growth in fixed income futures and options of 23 percent and 57 percent, respectively.

View Graph of Growth in Eurex Euro Fixed Income Futures

Given their current cash bond holdings, fund managers now face leaving their bond portfolios as they are, or putting together a program to manage their portfolio risks. Using futures and options, managers can cover themselves against the kind of swings seen in the market.


By selling Euro Bund Futures contracts, an investor could easily protect a large bond portfolio from adverse market movements given the depth of liquidity in this contract. Once the portfolio manager has readjusted the underlying portfolio or the perceived market risk has been reduced, the futures position could be closed out. Any potential loss that might occur in the cash bond portfolio would be offset by the profit on the short futures position which could be bought back at a lower price.


This kind of activity demonstrates a key benefit of futures over cash. Because they are not buying or selling actual securities, investors can use futures to move quickly between different securities, even in large volumes. An investor using futures can move out of a certain position without creating a large market impact - a huge benefit for larger investment funds or investors. It is also possible to carry out asset (re)allocation in the cash market over a period of time and still be invested in a particular security using futures or options.


In addition, an investor could transform the duration of a bond portfolio without selling any positions in the portfolio. If an investor is holding 10-year European government bonds but had decided they would get a better pick-up in yield if they switched to five-year bonds, the traditional solution would be to sell the 10-year bonds and buy five-year bonds to replace them. This can be both costly and time-consuming in the cash market. Instead, the investor could leave the portfolio untouched, sell 10-year Euro Bund Futures and buy five-year Euro Bobl Futures.


Moreover futures and options represent a viable way of investing without ever making a cash trade. Of course, there may be reasons why investors would seek physical ownership of the underlying bonds, e.g. coupon flow. However, with the lower costs, the risk management capabilities and the agility that skilled users of futures can provide, the case for using fixed income futures and options for portfolio replication is stronger than ever.


For more information on Eurex interest rate derivatives, please visit
http://www.eurexchange.com/products/overview/INT.html<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

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