11

Risk Management Through Bond Risk Management Through Bond Derivatives and Financial InnovationsDerivatives and Financial Innovations

The Korea Stock Exchange Workshop onThe Korea Stock Exchange Workshop onThe Korean Bond MarketThe Korean Bond Market

Yoon-Shik ParkYoon-Shik Park

Professor of International FinanceProfessor of International Finance

George Washington UniversityGeorge Washington University

Seoul, KoreaSeoul, Korea

May 12, 2003May 12, 2003

22

Rapid Growth in the Korean Bond Market Rapid Growth in the Korean Bond Market since the 1997 Financial Crisissince the 1997 Financial Crisis

((Outstanding Volume in Won Billions)Outstanding Volume in Won Billions)

Government Government Corporate Corporate

BondsBonds MSBsMSBs BondsBonds

19961996 25,646 25,030 76,007 25,646 25,030 76,007

19971997 28,643 23,471 90,107 28,643 23,471 90,107

2002(Nov) 96,780 83,869 178,030 2002(Nov) 96,780 83,869 178,030

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Rapid Growth in the Korean Bond Market Rapid Growth in the Korean Bond Market since the 1997 Financial Crisissince the 1997 Financial Crisis

Outstanding Government bonds more than tripled Outstanding Government bonds more than tripled in size from Won 26 trillion in 1996 to Won 97 in size from Won 26 trillion in 1996 to Won 97 trillion in 2002 for financial restructuring and trillion in 2002 for financial restructuring and expansionary fiscal policy to boost the economy.expansionary fiscal policy to boost the economy.

During the same period, corporate bonds rose 2 During the same period, corporate bonds rose 2 and a half times from Won 76 trillion to Won 178 and a half times from Won 76 trillion to Won 178 trillion as companies lessened their reliance on trillion as companies lessened their reliance on bank loans and instead increased direct financing bank loans and instead increased direct financing through the bond market.through the bond market.

The size of MSBs more than tripled as the Bank of The size of MSBs more than tripled as the Bank of Korea tried to offset the expansionary effects of Korea tried to offset the expansionary effects of BOK purchase of KAMCO and KDIC bonds and BOK purchase of KAMCO and KDIC bonds and increased FX reserves.increased FX reserves.

44

Challenges for the Korean Bond MarketChallenges for the Korean Bond Market

In general, the Korean bond market has come a long way since the 1997 financial crisis:

- Doubling in size - Now, the second largest in Asia after JapanHowever, the secondary market needs further

improvement.Market infrastructure is still weak.Repo market is under-utilized. (Trading volume as

of 2001): KTB futures(96%), IRS(3.9%), Repos(0.1%)

Need to deepen and diversify hedging instruments.

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Interest Derivatives in KoreaInterest Derivatives in Korea

91-91-day CD futures (almost no trading)day CD futures (almost no trading) Futures in 3-year Treasury bonds (KTB futures): Futures in 3-year Treasury bonds (KTB futures):

volume rose sharply in terms of the futures to volume rose sharply in terms of the futures to cash market ratio from 56% in early 2000 to cash market ratio from 56% in early 2000 to 233% in late 2001.233% in late 2001.

Interest rate swaps (IRS): daily transaction Interest rate swaps (IRS): daily transaction volume is estimated at Won 300 to 500 billion (or volume is estimated at Won 300 to 500 billion (or Won 100 trillion per year) as of August, 2002.Won 100 trillion per year) as of August, 2002.

Options on KTB futures also introduced in May, Options on KTB futures also introduced in May, 2002, on KOFEX.2002, on KOFEX.

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Measures to Promote Interest DerivativesMeasures to Promote Interest Derivatives

Introduce futures in 1-year MSBs.Introduce futures in 1-year MSBs. Widen the maturity range of KTB futures, by Widen the maturity range of KTB futures, by

introducing 5- and 10-year KTB futures as well.introducing 5- and 10-year KTB futures as well. Futures settlement should be based on physical Futures settlement should be based on physical

delivery as in most developed countries instead delivery as in most developed countries instead of the cash settlement system in order to:of the cash settlement system in order to:

- enhance the linkage between cash and - enhance the linkage between cash and futures markets. futures markets.

- enable market participants to find and - enable market participants to find and deliver CTD (cheapest-to-deliver). deliver CTD (cheapest-to-deliver).

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Interest Derivative Products in U.S. Interest Derivative Products in U.S.

30-30-day Fed funds futuresday Fed funds futures 1-month LIBOR futures1-month LIBOR futures 3-month Eurodollar futures3-month Eurodollar futures 3-month Euro yen LIBOR futures3-month Euro yen LIBOR futures 3-month Treasury bill futures3-month Treasury bill futures 2-year Treasury note futures2-year Treasury note futures 5-year Treasury note futures5-year Treasury note futures 10-year Treasury note futures10-year Treasury note futures Long-term Treasury bond futuresLong-term Treasury bond futures Long-term CMO futuresLong-term CMO futures Municipal bond futuresMunicipal bond futures

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U.S. Exchanges for FuturesU.S. Exchanges for Futures

There are seven exchanges listing and trading There are seven exchanges listing and trading futures in the United State.futures in the United State.

But most interest derivatives are traded on:But most interest derivatives are traded on:

- Chicago Mercantile Exchange (CME)- Chicago Mercantile Exchange (CME)

- Chicago Board of Trade (CBOT)- Chicago Board of Trade (CBOT)

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Types of DerivativesTypes of Derivatives

Credit DerivativesCredit Derivatives

Credit spread forwardsCredit spread forwards

Credit spread optionsCredit spread options

Credit swaps (credit event swaps; default swaps)Credit swaps (credit event swaps; default swaps)

Price DerivativesPrice Derivatives

Commodity derivatives (futures or options in gold, Commodity derivatives (futures or options in gold, silver, etc.)silver, etc.)

Financial derivativesFinancial derivatives

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Types of Financial DerivativesTypes of Financial Derivatives

Forwards – Foreign exchange forwardsForwards – Foreign exchange forwards

Forward rate agreements (FRAs)Forward rate agreements (FRAs)

Futures – Currency futures (1972)Futures – Currency futures (1972)

Interest rate futures (1975)Interest rate futures (1975)

Stock index futures (1982)Stock index futures (1982)

Single stock futures (2002)Single stock futures (2002)

Futures on exchange-traded funds (ETFs) (2002)Futures on exchange-traded funds (ETFs) (2002)

Options – Options on physicals (stock, currency, interest, etc.)Options – Options on physicals (stock, currency, interest, etc.)

Options on futures (currency or interest futures)Options on futures (currency or interest futures)

Options on swaps (swaptions)Options on swaps (swaptions)

Swaps – Currency or interest rate swapsSwaps – Currency or interest rate swaps

Assets or commodity swapsAssets or commodity swaps

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Types of Interest Rate SwapsTypes of Interest Rate Swaps

Fixed to floating rate swap (coupon swap)Fixed to floating rate swap (coupon swap) Floating to floating rate swap (basis swap)Floating to floating rate swap (basis swap) Yield curve swapYield curve swap Zero-coupon swapZero-coupon swap Amortizing vs. non-amortizing (bullet) swapAmortizing vs. non-amortizing (bullet) swap Accreting swapAccreting swap Forward swapForward swap Non-LIBOR swapNon-LIBOR swap Par value swapPar value swap Off-market (non-par) swapOff-market (non-par) swap Extendable swapExtendable swap

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Size of the Global Derivatives MarketSize of the Global Derivatives Market(Notional Principal Amount in $ billions)(Notional Principal Amount in $ billions)

((as of end-2002)as of end-2002)

OTC ExchangesOTC Exchanges Total Total

CurrencyCurrency 18,075 18,075 74 74 18,149 18,149

Interest rateInterest rate 89,995 89,995 21,719 111,714 21,719 111,714

EquityEquity 2,214 2,214 2,089 2,089 4,303 4,303

OthersOthers 17,280 17,280 NA 17,280 NA 17,280

TotalTotal 127,564127,564 23,882 23,882 151,446151,446

Source: Bank for International SettlementsSource: Bank for International Settlements

1313

Global Exchange-Traded DerivativesGlobal Exchange-Traded Derivatives(Notional Principal Amount in $ billions)(Notional Principal Amount in $ billions)

((as of December 2002)as of December 2002)

CurrencyCurrency InterestInterest EquityEquity TotalTotal

FuturesFutures 47.3 9,958.5 334.5 10,340.4 47.3 9,958.5 334.5 10,340.4

Options Options 26.6 11,759.8 1,753.8 13,540.1 26.6 11,759.8 1,753.8 13,540.1

TotalTotal 73.9 21,718.3 2,088.3 23,880.5 73.9 21,718.3 2,088.3 23,880.5

Source: Bank for International SettlementsSource: Bank for International Settlements

1414

Size of the Global OTC DerivativesSize of the Global OTC Derivatives(Notional Principal Amount in $ billions)(Notional Principal Amount in $ billions)

((as of June 2002)as of June 2002)

Equity &Equity &

CurrencyCurrency InterestInterest CommodityCommodity TotalTotal

Forwards 10,427 9,146 1,163* 20,736 Forwards 10,427 9,146 1,163* 20,736

SwapsSwaps 4,220 68,274 - 4,220 68,274 - 72,494 72,494

Options Options 3,427 12,575 2,036 18,038 3,427 12,575 2,036 18,038

TotalTotal 18,074 89,995 3,19918,074 89,995 3,199 111,268 111,268

*Forwards and swaps are combined.*Forwards and swaps are combined.

Source: Bank for International SettlementsSource: Bank for International Settlements

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Measures to Promote Interest Rate SwapsMeasures to Promote Interest Rate Swaps

Replace the unreliable reference rate (3-month Replace the unreliable reference rate (3-month CD rate) by newly reactivated Treasury bill rate. CD rate) by newly reactivated Treasury bill rate. (This requires replacing the MSBs by new (This requires replacing the MSBs by new Treasury bills, as in the United States and other Treasury bills, as in the United States and other developed countries.)developed countries.)

Amend the existing laws incompatible with the Amend the existing laws incompatible with the netting and novation clauses in interest rate netting and novation clauses in interest rate swaps.swaps.

Amend the relevant ITC laws in conflict with the Amend the relevant ITC laws in conflict with the interest rate swap contracts entered into by ITCs.interest rate swap contracts entered into by ITCs.

1616

Measures to Promote Repo MarketMeasures to Promote Repo Market

Increase the total Treasury issues by consolidating Increase the total Treasury issues by consolidating government bonds and MSBs into Treasuries in order government bonds and MSBs into Treasuries in order to increase the inventory of collateral materials for to increase the inventory of collateral materials for repos.repos.

Encourage position taking in bonds by dealers by Encourage position taking in bonds by dealers by facilitating daylight overdraft facilities.facilitating daylight overdraft facilities.

Since the call market competes with the repo market Since the call market competes with the repo market for short-term financing, enhance the counter-party for short-term financing, enhance the counter-party credit risk perception inherent in call market credit risk perception inherent in call market transaction as compared to repos.transaction as compared to repos.

Reduce the number of PDs and give more weights to Reduce the number of PDs and give more weights to secondary market activities in PD selection.secondary market activities in PD selection.

Repos should be completely open to institutional Repos should be completely open to institutional investors such as ITCs, insurance companies, etc.investors such as ITCs, insurance companies, etc.

1717

The U.S. Repo MarketThe U.S. Repo Market

Terms are short term up to 15 days (60% in Terms are short term up to 15 days (60% in overnight repos) and long term (28 days).overnight repos) and long term (28 days).

Repo collaterals are Treasuries (TBs, TNs, Tbills); Repo collaterals are Treasuries (TBs, TNs, Tbills); Agencies (Fannie Mae, Ginnie Mae, etc.); and Agencies (Fannie Mae, Ginnie Mae, etc.); and MBS’s guaranteed by Agencies.MBS’s guaranteed by Agencies.

The Federal Reserve Banks provide daylight The Federal Reserve Banks provide daylight overdraft facilities to allow dealers to finance overdraft facilities to allow dealers to finance positions.positions.

To control abuse of the daylight overdraft To control abuse of the daylight overdraft privileges, since 1994 the Fed imposes a charge privileges, since 1994 the Fed imposes a charge (now, 36 bps on annualized basis) on average (now, 36 bps on annualized basis) on average daily overdrafts. Banks pass on these charges to daily overdrafts. Banks pass on these charges to their dealer customers.their dealer customers.

1818

Potential Risks in Repo TransactionsPotential Risks in Repo Transactions

$400 $400 million loss suffered by Homestake Savings million loss suffered by Homestake Savings Bank in Ohio due to its failure to properly accept Bank in Ohio due to its failure to properly accept the transfer of the collateral, T-bills.the transfer of the collateral, T-bills.

$1,500 million loss suffered by Orange County in $1,500 million loss suffered by Orange County in California through leveraged repos, wherein the California through leveraged repos, wherein the County used the proceeds of shorter-term County used the proceeds of shorter-term municipal note issues to purchase longer-term municipal note issues to purchase longer-term Treasury bonds, which then were used as Treasury bonds, which then were used as collaterals for repos to borrow short term, and collaterals for repos to borrow short term, and then it used the cash to purchase longer term TBs then it used the cash to purchase longer term TBs for another repos, and so on in order to take for another repos, and so on in order to take advantage of the yield curve spread. The county advantage of the yield curve spread. The county got squeezed when interest rates rose later.got squeezed when interest rates rose later.

1919

Need to Consolidate Government BondsNeed to Consolidate Government Bonds

Currently, there are too many Government or Currently, there are too many Government or Government-guaranteed bonds, reducing the Government-guaranteed bonds, reducing the market liquidity and complicating the issue process.market liquidity and complicating the issue process.

The following instruments should be consolidated The following instruments should be consolidated into Treasuries (Treasury bonds, notes, and bills, into Treasuries (Treasury bonds, notes, and bills, depending upon the issue maturity.)depending upon the issue maturity.)

- Foreign Exchange Stabilization Fund bonds- Foreign Exchange Stabilization Fund bonds

- National Housing bonds- National Housing bonds

- Monetary Stabilization Bonds- Monetary Stabilization Bonds

- FSR (Financial Sector Restructuring) bonds- FSR (Financial Sector Restructuring) bonds

2020

Advantages of Government Bond ConsolidationAdvantages of Government Bond Consolidation

Promotes the benchmark yield curve.Promotes the benchmark yield curve. Increases the secondary market liquidity.Increases the secondary market liquidity. Promotes repos as more Treasuries are available as Promotes repos as more Treasuries are available as

risk-free collaterals.risk-free collaterals. Encourages PDs to post 2-way quotation.Encourages PDs to post 2-way quotation. Encourages inventory position taking by dealers.Encourages inventory position taking by dealers. Promotes IRS such as yield-curve swaps.Promotes IRS such as yield-curve swaps. Promotes screen-based trading as KTB inventory and Promotes screen-based trading as KTB inventory and

liquidity are increased, raising transparency.liquidity are increased, raising transparency. Assists the BOK’s open market operations.Assists the BOK’s open market operations. Treasury bill yield can be used as IRS benchmark rate. Treasury bill yield can be used as IRS benchmark rate. Promotes new products such as STRIPS.Promotes new products such as STRIPS.

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STRIPS (Separate Trading of Registered STRIPS (Separate Trading of Registered Interest and Principal of Securities)Interest and Principal of Securities)

U.S. (1985), France (1991), Belgium (1992), the U.S. (1985), France (1991), Belgium (1992), the Netherlands (1993), U.K. (1995)Netherlands (1993), U.K. (1995)

Financial institutions maintaining a book-entry Financial institutions maintaining a book-entry account at central bank request to have eligible account at central bank request to have eligible Treasury securities into their component parts.Treasury securities into their component parts.

Each of these component parts (various period Each of these component parts (various period interest payments and principal repayments) can be interest payments and principal repayments) can be separately traded as various-maturity zero-coupon separately traded as various-maturity zero-coupon bonds in the form of IOs and POs.bonds in the form of IOs and POs.

In this way, the tradable Treasury securities are vastly In this way, the tradable Treasury securities are vastly increased in the secondary market in the form of increased in the secondary market in the form of Treasury zero-coupon bonds.Treasury zero-coupon bonds.

STRIP is allowed to PDs only in European countries as STRIP is allowed to PDs only in European countries as a reward for their market making.a reward for their market making.

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CATS, TIGRs, M-CATSCATS, TIGRs, M-CATS

Since 1982, Salomon Brothers (now Salomon Since 1982, Salomon Brothers (now Salomon Smith Barney) buys long-term (e.g. 30-year) Smith Barney) buys long-term (e.g. 30-year) normal coupon U.S. Treasury bonds and deposits normal coupon U.S. Treasury bonds and deposits them into an escrow account.them into an escrow account.

Based on the expected cash flows generated into Based on the expected cash flows generated into the escrow account for the coming years, the escrow account for the coming years, Salomon issues a series of synthetic zero-coupon Salomon issues a series of synthetic zero-coupon Treasury bonds, named CATS (Certificates of Treasury bonds, named CATS (Certificates of Accrual on Treasury Securities), thus profiting Accrual on Treasury Securities), thus profiting from the yield curve spread.from the yield curve spread.

Merrill Lynch’s TIGRs (Treasury Investment Merrill Lynch’s TIGRs (Treasury Investment Growth Receipts), Salomon’s M-CATS (municipal Growth Receipts), Salomon’s M-CATS (municipal bond CATS), etc.bond CATS), etc.

2323

Need to Develop KIBORNeed to Develop KIBOR

LIBOR (London inter-bank offered rate), SIBOR (in LIBOR (London inter-bank offered rate), SIBOR (in Singapore), TIBOR (in Tokyo), etc., have been Singapore), TIBOR (in Tokyo), etc., have been used as the benchmark rate for financial used as the benchmark rate for financial transactions and for interest rate swap contracts.transactions and for interest rate swap contracts.

Along with the introduction of new Korean Along with the introduction of new Korean Treasury bills, both KIBOR and T-bill rates can be Treasury bills, both KIBOR and T-bill rates can be used as the benchmark rates for interest rate used as the benchmark rates for interest rate swap contracts.swap contracts.

In turn, the fixed rate counterparts in IRS can be In turn, the fixed rate counterparts in IRS can be also used as the fixed rate benchmarks. (Both also used as the fixed rate benchmarks. (Both U.S. dollar and Euro swap rates are widely used U.S. dollar and Euro swap rates are widely used as fixed rate benchmarks.)as fixed rate benchmarks.)

2424

Structured Debt InstrumentsStructured Debt Instruments

Structured notes (SNs or structured debt Structured notes (SNs or structured debt instruments) are hybrid securities combining a instruments) are hybrid securities combining a regular debt instrument with a series of derivative regular debt instrument with a series of derivative components.components.

As a result, the bond’s coupon, average life, As a result, the bond’s coupon, average life, and/or redemption value can become exposed to and/or redemption value can become exposed to FX rate, commodity, equity prices, etc.FX rate, commodity, equity prices, etc.

They are also known as “derivative-embedded They are also known as “derivative-embedded securities.”securities.”

SNs are used for risk management, lower funding SNs are used for risk management, lower funding cost, and regulatory arbitrage.cost, and regulatory arbitrage.

Active SNs can deepen the Korean bond market, Active SNs can deepen the Korean bond market, moving it forward to a higher level.moving it forward to a higher level.

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Some Examples of SNsSome Examples of SNs

Credit-linked notes/bondsCredit-linked notes/bonds Currency-linked notesCurrency-linked notes Commodity-linked notesCommodity-linked notes Equity-linked notesEquity-linked notes Interest rate-linked notesInterest rate-linked notes Yield curve-linked notesYield curve-linked notes

2626

Need to Develop Foreign Bonds in KoreaNeed to Develop Foreign Bonds in Korea

Foreign bonds, Eurobonds, and global bondsForeign bonds, Eurobonds, and global bonds Arirang bondsArirang bonds (Korean foreign bonds) are (Korean foreign bonds) are similar to other foreign bonds such as Yankee, Samurai, similar to other foreign bonds such as Yankee, Samurai,

Shogun, Bulldog, Marathon, Kiwi, Kangaroo, Matador, Shogun, Bulldog, Marathon, Kiwi, Kangaroo, Matador, Navigator, Rembrandt, Alpine and Dragon bonds.Navigator, Rembrandt, Alpine and Dragon bonds.

Promotion of Arirang bonds can also attract foreign Promotion of Arirang bonds can also attract foreign investors to the Korean bond market.investors to the Korean bond market.

Unlike Korean equities, our bond market attracts few Unlike Korean equities, our bond market attracts few foreign investors.foreign investors.

Foreign investor participation in local bond markets (as Foreign investor participation in local bond markets (as of December 2000):of December 2000):

Korea (1.1%), US (40%), UK (18%), France (29%), Korea (1.1%), US (40%), UK (18%), France (29%), Canada (22%).Canada (22%).

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Thank You!Thank You!

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