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Thursday, 19 October 2017

Derivatives 2006

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The derivatives markets continue their sharp growth trajectory, led by a credit derivatives sector that has brushed off the dual threats of rock bottom spreads and processing strains.

As trading margins erode in the bond-based credit derivatives market, dealers are increasingly looking to asset-backed credit default swaps and loan-based default swaps for future profit growth.

Both markets have seen an increase in liquidity this year, but there is still debate between different constituencies over contract terms, and some target users remain unwilling to use the new instruments. We look at the issues that have to be ironed out before the CDS of ABS and loan-based CDS markets can come of age.

Equity derivatives provide an example of how an apparently mature market can continue to provide profit growth opportunities for dealers who can give end users product options they did not know they needed. We look at how markets such as dispersion swaps have evolved this year, despite losses for some hedge funds and dealers when volatility spiked in May.

The commodities markets – in both cash and derivative form – have provided a roller-coaster ride this year. The high-profile failure of hedge fund Amaranth after it racked up US$6bn of energy derivatives losses in a matter of days may help dealers to push end investors into use of structured products that offer commodities exposure within defined risk parameters.

The spectacular blow-up gave dealers one more issue to explain to potential new market participants, however.

The nascent market for Islamic derivatives is another sector where there is clear pent-up demand for hedging and risk-taking tools, but a need for extensive educational work by dealers. We look at progress on the development of Shariah-compliant derivatives markets.

We also chart the development through the year of the Chinese derivatives markets. China is having a second crack of the whip here. Ten years ago China had what appeared to be functioning derivatives markets, before they were effectively closed amid corruption scandals during the Asian financial crisis of the late 1990s. Legal certainty is accordingly at the forefront of dealers’ minds as the Chinese derivatives markets re-open, but no major bank wants to miss out on the hedging and structured investment opportunities in the fastest growing major economy in the world.

The listed futures and options market are in rude health, but the planned US$8bn merger of the CME and the CBOT has intensified pressure on all exchange managers to maintain their growth rates. We look at the prospects for development via further exchange consolidation and the viability of new markets for listed property and credit futures. Many attempts to convert OTC derivatives markets into successful listed contracts have failed in the past, but hope springs eternal and any exchanges that crack a move into property and credit futures will see an increase in market profile, as well as higher direct trading revenue.

The market for derivatives-based hedging of asset and liability management needs is much debated, with some consultants claiming that it barely exists. Dealers disagree, contending that surveys by consultants can miss the flurries of long end swap and option trades that accompany ALM hedging programmes.

Hedge funds seem to side with dealers on this question. A number of funds have looked to take advantage of temporary dislocations in swap and option prices due to ALM hedging programmes.

This provides yet another example of how a legitimate hedging need can breathe life into a derivatives market by providing a trading outlet for nimble financial risk takers.

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