Hybrid Derivatives Help Investors
On Lookout for Correlated Trends
By KATIE MARTIN
DOW JONES NEWSWIRES
August11,2004;PageC4
LONDON -- Open any currency strategy report at the moment and the focus is likely to be on one thing: oil.
The recent surge of crude prices to 21-year highs has obvious implications for foreign-exchange markets. September crude-oil futures on the New York Mercantile Exchange hit a record yesterday before slipping to $44.52 at the end of trading.
A 10% rise in oil prices has historically generated a 6.1% increase in the U.S. dollar against the yen, for example.
Traditionally, companies looking to simultaneously manage their exposure risk from movements in currencies and commodities -- and investors hoping to benefit from them -- have had to enter a series of separate derivative contracts.
Now, a new generation of structured instruments is making it easier to deal with the interrelation between apparently separate markets. And investors skilled at identifying correlated trends could make big gains.
"The reason this is a hot topic is that more and more people on the investor side and on the corporate side have caught on to the fact that it is more efficient," said Lutfey Siddiqi, global head of foreign-exchange structuring at Barclays Capital.
The theory behind correlated products is fairly simple. A company that needs to buy oil at a certain date can lock in the price it pays through a futures contract. That's normal market practice.
But if that company reports its earnings in euros and buys oil in U.S. dollars, it has a simultaneous foreign-currency risk. So it can either enter a further derivative contract to lock in the currency-exchange rate, or it can choose a correlated product. That product could be an option to buy dollars in the future, where the notional amount that the company can buy is linked to the oil price. The higher the oil price, the more dollars it can buy.
The range of products that can be combined into a single correlated instrument is limited only by the imagination. A United Kingdom investor with a portfolio of U.S. stocks may know that he has to sell those stocks on a date in the future and bring the money back to the U.K. It can buy a U.S. dollar "put" option with the dollar amount linked to the Standard & Poor's 500-stock index. A put gives the holder an option to sell a security at a specific price during a set period.
Other products linking foreign exchange with interest rates or credit instruments also are becoming more popular.
Not surprisingly, banks insist they aren't simply packaging basic instruments together so they can add a margin. "Whether there is more of a margin is a moot point if the product is a better fit and is cheaper than the vanilla alternative," said Mr. Siddiqi.
Companies that wish to limit their risk exposure make up one group of clients. But bankers say investors seeking to make a profit form a more exciting potential market.
"We have seen a really tremendous amount of growth on the asset side," said Kevin Rodgers, managing director in commodities and energy trading in London for Deutsche Bank AG.
These investors are taking a view on more than one market at a time, using the relatively small cost of taking out an option to reap potentially large returns.
"Investors are looking for ways to cheapen up the cost of options by using hybrids, where two or more market views may be combined together," said Robert Heathcote, a managing director in credit correlation at Goldman Sachs Group Inc.
If only one factor from the client's predictions materializes, the client gains nothing. But if all of the predictions are accurate, the client stands to make big gains.
While the rapid development of correlation products gives banks a new area of focus, it also creates risk-management headaches. Historical prices clearly show that if the Nikkei Stock Average drops, so does the yen, making it hard to find takers for the other side of a related trade.
For the moment, banks are breaking down the multifactor products and hedging the component parts. "We have just got to take the risk and hold on to it," said Mr. Rodgers at Deutsche Bank.
Write to Katie Martin at