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Opalesque Futures Intelligence

Insider Talk: A line-up of industry people with derivatives experience talk about trends in options and futures markets.

Tuesday, June 02, 2009


Derivatives Trends

As much as futures markets developed over the years, the pace of change has not slackened. Government actions in response to the credit crisis and climate change will probably result in new types of listed derivatives that some traders will doubtless take advantage of. Hedge funds and commodity trading advisors look for opportunities in local markets and new instruments.

While there can be no certainty as to what will emerge, we asked several market veterans for insight as to recent developments. Our lineup starts with Jay Kim, global head of futures brokerage and head of the prime service group at Woori Investment & Securities. Woori is the top index futures and options brokerage in the Korean institutional market.

Many macro funds and CTAs trade in Asian markets. As of November 2008, the US Commodity Futures Trading Commission allowed US residents to trade Kospi 200 futures contracts. The Kospi is an index that covers all common shares on the Korean Stock Exchanges, while the Kospi 200 consists of the largest 200 companies that together account for over 70% of the Kospi market value.

Opalesque Futures Intelligence: How active is the Korean futures market?

Jay Kim: Kospi 200 options and futures are very liquid. The market contracted in the past 12 months but now it is growing fast again. There are many global market makers and foreigners are a growing presence. From April 2008 to April 2009, foreign participation in Kospi 200 futures has been quite stable at 25%. However, during that period there has been a great deal of increased activity in options by foreign investors, from 23.7% to 33.5% in terms of the number of contracts and from 36% to 46.4% in terms of the value of trading volume.

OFI: Who trades in this market?

JK: One reason there is liquidity is that there are different kinds of investors. Some use computer-driven systems, others are manual traders. Some traders bet on countries, for instance selling futures in Korea and buying futures in Japan. Traders compete with each other, so the speed of execution is very important, especially in options. Also, Korean retail investors remain a large part of the futures market, accounting for 37% of the trading. We think that is why Kospi options attract big global traders.

OFI: What is it that attracts big traders like hedge funds?

JK: Korean retail investors are sophisticated, but still they bet on direction and don’t worry about fair value. So there is more mispricing than you see in markets dominated by professionals and market makers have a good chance to make money. That said, we’ve known individuals who traded futures with their own automated system and made high returns year after year. Other retail investors hear about that and decide to trade futures themselves.

A big change is happening in over-the-counter derivatives. Regulators want centralized clearing and standardization. The IntercontinentalExchange Inc. began clearing credit default swap index contracts in March and the Chicago Mercantile Exchange teamed up with hedge fund firm Citadel to launch CDS clearing. The next step is to move standardized OTF derivatives to exchanges.

That would continue a trend of increasing diversity in listed derivatives instruments. Stock index, currency and interest rate futures, now commonplace, were once novelties. Over the years, managers in sectors such as discretionary macro, trend-following and quantitative trading developed programs to take advantage of the wider range of instruments. Extrapolating from that experience, we can expect new traded derivatives to lead to new strategies.

Tim Youssef and Nimit Savani, managing directors and co- heads of derivatives at Lighthouse Financial, and Rob Weinstein, senior managing director at the firm, tell us what they see happening. Lighthouse Financial covers all areas of derivatives.

Opalesque Futures Intelligence: Will credit default swaps become traded like futures contracts?

Tim Youssef: We don’t yet know what CDS trading on an exchange will look like, but it is a foregone conclusion that credit derivatives will become centrally traded and more transparent. As these markets become more transparent, we’ll see debt and equity derivatives come together. There’ll be a lot of spillover between equity derivatives and credit derivatives in the coming years. Instruments that have been separate will increasingly be intertwined.

OFI: What products are in demand?

Rob Weinstein: As the market changes, the need for derivatives changes too. For instance, trades that used to be done with single stocks are now being executed through exchange-traded funds. As single-stock trading dried up, ETF trading ramped up. Many large hedge funds use ETFs as the vehicle of choice to take directional views.

Nimit Savani: Many single securities are highly correlated with an index, so an ETF can be used to make the trade instead of the single name. For example, an individual security in an emerging market like China may not have much liquidity; the ETF is more liquid. As a wide variety of ETFs came to be traded, options on these became available.

OFI: How common are these derivatives?

NS: You see market makers writing options on ETFs for Asia, Latin America and other emerging markets. Listed options are more liquid than you would think, because there is interest in making markets. That creates more trading opportunity, which in turn encourages market making.

OFI: Are the options actively traded?

NS: There has been an explosion in ETF derivative trading in the past couple of years, from plain vanilla listed options to total return swaps. People use them to take positions in some of the less liquid international ETFs. Long/short traders use ETFs to make country and sector bets. Increasingly those trades are moving into derivatives, using options on ETFs.

For an alternative view, we turned to Hans Hufschmid, chief executive officer of GlobeOp, a provider of services to hedge funds and other financial players. The company processes complex over-the-counter derivatives, among other services. It administered $91 billion in assets as of May.

Mr. Hufschmid is a true hedge fund veteran. He was a principal at Long-Term Capital Management and co-head of that firm’s London office for five years, where he supervised traders, researchers and other personnel. LTCM nearly collapsed in 1998 and was liquidated by a consortium of banks. In 2000, Mr. Hufschmid became one of GlobeOp’s founding partners.

He takes a long term perspective on OTC derivatives while discussing the current state of markets and prospects for global macro strategy.

Opalesque Futures Intelligence: Will credit default swaps become traded like futures contracts?

Hans Hufschmid: There’s been talk for some 15 years about moving over-the-counter derivatives to exchanges, so I’m not sure whether it will happen this time either. If it does, it would make our life a little easier. Standardized contracts are always easier to process, though it doesn't take away the need for valuation, pricing and collateral management work.

OFI: How active are derivatives markets?

HH: What we’ve seen in the past 12 to 18 months is a clear contraction in OTC market volumes, both open contracts and average daily volumes. Although markets have somewhat recovered from the shock of 2008, you do still see liquidity problems.

OFI: Which markets look promising?

HH: There’s a lot of interest in all kinds of debt trading. Also, there are great opportunities for global macro, whether in indexes, currencies or other assets. To make money, this strategy needs dislocations in markets and shifts in economic fundamentals. That’s what’s happening now.



 
This article was published in Opalesque Futures Intelligence.
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