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Yoon-Shik Park Professor of International Finance George Washington University Seoul, Korea

Risk Management Through Bond Derivatives and Financial Innovations The Korea Stock Exchange Workshop on The Korean Bond Market. Yoon-Shik Park Professor of International Finance George Washington University Seoul, Korea May 12, 2003.

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Yoon-Shik Park Professor of International Finance George Washington University Seoul, Korea

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  1. Risk Management Through Bond Derivatives and Financial InnovationsThe Korea Stock Exchange Workshop onThe Korean Bond Market Yoon-Shik Park Professor of International Finance George Washington University Seoul, Korea May 12, 2003

  2. Rapid Growth in the Korean Bond Market since the 1997 Financial Crisis (Outstanding Volume in Won Billions) Government Corporate BondsMSBsBonds 1996 25,646 25,030 76,007 1997 28,643 23,471 90,107 2002(Nov) 96,780 83,869 178,030

  3. Rapid Growth in the Korean Bond Market since the 1997 Financial Crisis • Outstanding Government bonds more than tripled in size from Won 26 trillion in 1996 to Won 97 trillion in 2002 for financial restructuring and expansionary fiscal policy to boost the economy. • During the same period, corporate bonds rose 2 and a half times from Won 76 trillion to Won 178 trillion as companies lessened their reliance on bank loans and instead increased direct financing through the bond market. • The size of MSBs more than tripled as the Bank of Korea tried to offset the expansionary effects of BOK purchase of KAMCO and KDIC bonds and increased FX reserves.

  4. Challenges 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 Japan However, 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.

  5. Interest Derivatives in Korea • 91-day CD futures (almost no trading) • Futures in 3-year Treasury bonds (KTB futures): volume rose sharply in terms of the futures to cash market ratio from 56% in early 2000 to 233% in late 2001. • Interest rate swaps (IRS): daily transaction volume is estimated at Won 300 to 500 billion (or Won 100 trillion per year) as of August, 2002. • Options on KTB futures also introduced in May, 2002, on KOFEX.

  6. Measures to Promote Interest Derivatives • Introduce futures in 1-year MSBs. • Widen the maturity range of KTB futures, by introducing 5- and 10-year KTB futures as well. • Futures settlement should be based on physical delivery as in most developed countries instead of the cash settlement system in order to: - enhance the linkage between cash and futures markets. - enable market participants to find and deliver CTD (cheapest-to-deliver).

  7. Interest Derivative Products in U.S. • 30-day Fed funds futures • 1-month LIBOR futures • 3-month Eurodollar futures • 3-month Euro yen LIBOR futures • 3-month Treasury bill futures • 2-year Treasury note futures • 5-year Treasury note futures • 10-year Treasury note futures • Long-term Treasury bond futures • Long-term CMO futures • Municipal bond futures

  8. U.S. Exchanges for Futures • There are seven exchanges listing and trading futures in the United State. • But most interest derivatives are traded on: - Chicago Mercantile Exchange (CME) - Chicago Board of Trade (CBOT)

  9. Types of Derivatives Credit Derivatives Credit spread forwards Credit spread options Credit swaps (credit event swaps; default swaps) Price Derivatives Commodity derivatives (futures or options in gold, silver, etc.) Financial derivatives

  10. Types of Financial Derivatives Forwards – Foreign exchange forwards Forward rate agreements (FRAs) Futures – Currency futures (1972) Interest rate futures (1975) Stock index futures (1982) Single stock futures (2002) Futures on exchange-traded funds (ETFs) (2002) Options – Options on physicals (stock, currency, interest, etc.) Options on futures (currency or interest futures) Options on swaps (swaptions) Swaps – Currency or interest rate swaps Assets or commodity swaps

  11. Types of Interest Rate Swaps • Fixed to floating rate swap (coupon swap) • Floating to floating rate swap (basis swap) • Yield curve swap • Zero-coupon swap • Amortizing vs. non-amortizing (bullet) swap • Accreting swap • Forward swap • Non-LIBOR swap • Par value swap • Off-market (non-par) swap • Extendable swap

  12. Size of the Global Derivatives Market(Notional Principal Amount in $ billions) (as of end-2002) OTC Exchanges Total Currency 18,075 74 18,149 Interest rate 89,995 21,719 111,714 Equity 2,214 2,089 4,303 Others 17,280 NA 17,280 Total 127,564 23,882 151,446 Source: Bank for International Settlements

  13. Global Exchange-Traded Derivatives(Notional Principal Amount in $ billions) (as of December 2002) CurrencyInterestEquityTotal Futures 47.3 9,958.5 334.5 10,340.4 Options 26.6 11,759.8 1,753.8 13,540.1 Total 73.9 21,718.3 2,088.3 23,880.5 Source: Bank for International Settlements

  14. Size of the Global OTC Derivatives(Notional Principal Amount in $ billions) (as of June 2002) Equity & CurrencyInterestCommodityTotal Forwards 10,427 9,146 1,163* 20,736 Swaps 4,220 68,274 - 72,494 Options 3,427 12,575 2,036 18,038 Total 18,074 89,995 3,199 111,268 *Forwards and swaps are combined. Source: Bank for International Settlements

  15. Measures to Promote Interest Rate Swaps • Replace the unreliable reference rate (3-month CD rate) by newly reactivated Treasury bill rate. (This requires replacing the MSBs by new Treasury bills, as in the United States and other developed countries.) • Amend the existing laws incompatible with the netting and novation clauses in interest rate swaps. • Amend the relevant ITC laws in conflict with the interest rate swap contracts entered into by ITCs.

  16. Measures to Promote Repo Market • Increase the total Treasury issues by consolidating government bonds and MSBs into Treasuries in order to increase the inventory of collateral materials for repos. • Encourage position taking in bonds by dealers by facilitating daylight overdraft facilities. • Since the call market competes with the repo market for short-term financing, enhance the counter-party credit risk perception inherent in call market transaction as compared to repos. • Reduce the number of PDs and give more weights to secondary market activities in PD selection. • Repos should be completely open to institutional investors such as ITCs, insurance companies, etc.

  17. The U.S. Repo Market • Terms are short term up to 15 days (60% in overnight repos) and long term (28 days). • Repo collaterals are Treasuries (TBs, TNs, Tbills); Agencies (Fannie Mae, Ginnie Mae, etc.); and MBS’s guaranteed by Agencies. • The Federal Reserve Banks provide daylight overdraft facilities to allow dealers to finance positions. • To control abuse of the daylight overdraft privileges, since 1994 the Fed imposes a charge (now, 36 bps on annualized basis) on average daily overdrafts. Banks pass on these charges to their dealer customers.

  18. Potential Risks in Repo Transactions • $400 million loss suffered by Homestake Savings Bank in Ohio due to its failure to properly accept the transfer of the collateral, T-bills. • $1,500 million loss suffered by Orange County in California through leveraged repos, wherein the County used the proceeds of shorter-term municipal note issues to purchase longer-term Treasury bonds, which then were used as collaterals for repos to borrow short term, and then it used the cash to purchase longer term TBs for another repos, and so on in order to take advantage of the yield curve spread. The county got squeezed when interest rates rose later.

  19. Need to Consolidate Government Bonds • Currently, there are too many Government or Government-guaranteed bonds, reducing the market liquidity and complicating the issue process. • The following instruments should be consolidated into Treasuries (Treasury bonds, notes, and bills, depending upon the issue maturity.) - Foreign Exchange Stabilization Fund bonds - National Housing bonds - Monetary Stabilization Bonds - FSR (Financial Sector Restructuring) bonds

  20. Advantages of Government Bond Consolidation • Promotes the benchmark yield curve. • Increases the secondary market liquidity. • Promotes repos as more Treasuries are available as risk-free collaterals. • Encourages PDs to post 2-way quotation. • Encourages inventory position taking by dealers. • Promotes IRS such as yield-curve swaps. • Promotes screen-based trading as KTB inventory and liquidity are increased, raising transparency. • Assists the BOK’s open market operations. • Treasury bill yield can be used as IRS benchmark rate. • Promotes new products such as STRIPS.

  21. STRIPS (Separate Trading of Registered Interest and Principal of Securities) • U.S. (1985), France (1991), Belgium (1992), the Netherlands (1993), U.K. (1995) • Financial institutions maintaining a book-entry account at central bank request to have eligible Treasury securities into their component parts. • Each of these component parts (various period interest payments and principal repayments) can be separately traded as various-maturity zero-coupon bonds in the form of IOs and POs. • In this way, the tradable Treasury securities are vastly increased in the secondary market in the form of Treasury zero-coupon bonds. • STRIP is allowed to PDs only in European countries as a reward for their market making.

  22. CATS, TIGRs, M-CATS • Since 1982, Salomon Brothers (now Salomon Smith Barney) buys long-term (e.g. 30-year) normal coupon U.S. Treasury bonds and deposits them into an escrow account. • Based on the expected cash flows generated into the escrow account for the coming years, Salomon issues a series of synthetic zero-coupon Treasury bonds, named CATS (Certificates of Accrual on Treasury Securities), thus profiting from the yield curve spread. • Merrill Lynch’s TIGRs (Treasury Investment Growth Receipts), Salomon’s M-CATS (municipal bond CATS), etc.

  23. Need to Develop KIBOR • LIBOR (London inter-bank offered rate), SIBOR (in Singapore), TIBOR (in Tokyo), etc., have been used as the benchmark rate for financial transactions and for interest rate swap contracts. • Along with the introduction of new Korean Treasury bills, both KIBOR and T-bill rates can be used as the benchmark rates for interest rate swap contracts. • In turn, the fixed rate counterparts in IRS can be also used as the fixed rate benchmarks. (Both U.S. dollar and Euro swap rates are widely used as fixed rate benchmarks.)

  24. Structured Debt Instruments • Structured notes (SNs or structured debt instruments) are hybrid securities combining a regular debt instrument with a series of derivative components. • As a result, the bond’s coupon, average life, and/or redemption value can become exposed to FX rate, commodity, equity prices, etc. • They are also known as “derivative-embedded securities.” • SNs are used for risk management, lower funding cost, and regulatory arbitrage. • Active SNs can deepen the Korean bond market, moving it forward to a higher level.

  25. Some Examples of SNs • Credit-linked notes/bonds • Currency-linked notes • Commodity-linked notes • Equity-linked notes • Interest rate-linked notes • Yield curve-linked notes

  26. Need to Develop Foreign Bonds in Korea • Foreign bonds, Eurobonds, and global bonds • Arirang bonds (Korean foreign bonds) are similar to other foreign bonds such as Yankee, Samurai, Shogun, Bulldog, Marathon, Kiwi, Kangaroo, Matador, Navigator, Rembrandt, Alpine and Dragon bonds. • Promotion of Arirang bonds can also attract foreign investors to the Korean bond market. • Unlike Korean equities, our bond market attracts few foreign investors. • Foreign investor participation in local bond markets (as of December 2000): Korea (1.1%), US (40%), UK (18%), France (29%), Canada (22%).

  27. Thank You! 감사 합니다!

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