Pension Funds and Capital Markets: The Latin American Experience

1. Pension Funds and Capital Markets: The Latin American Experience Nathan Engelhard Director UBS Warburg LLC June 2001

2. Introduction

3. Introduction • Years of creation • Affiliates • Assets under Management & Relationship to GDP • Portfolio Limits • Composition of Assets under Management • Evolution of Assets Under Management • Returns

4. Years of Creation Source: AIOS

5. Introduction System Participants / Total Work Force • As of December 2000 the Work Force was estimated at 81 million Source: AIOS

6. Participants (millions) December 2000 Source: AIOS

7. Assets under Management Assets Under Management (millions of USD) Source: AIOS

8. Assets under Management/GDP Source: AIOS

9. Portfolio Limits Defined by Law • (a) As a percentage of the total value of the fund • (b) Bonds convertible to equity maximum 15% and minimum 10% • (c) Fund type 1. In Chile there are two kinds of funds. Fund type 1 admits any worker; fund 2 admits individuals next to retirement because of old age or disabled individuals. • (d) Fund type 2 • (e) The investment regime in Chile does not talk about derivatives. This regime only mentions instruments necessary to hedge interest and exchange risk; among them figure out credit loans and tradable securities. • (f) The law just considers investments in “SOFOLES”, institutions that give mortgage loans. Source: AIOS

10. Composition of Assets under Management (relative to total value of fund, December 2000, millions of USD ) Source: AIOS

11. Chile 35,000 30,000 Total Assets under Management 25,000 20,000 15,000 10,000 5,000 0 Dec-81 Dec-82 Dec-83 Dec-84 Dec-85 Dec-86 Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Source: SAFP

12. Brazil Source: ABRAPP

13. Mexico Source: SHCP

14. Argentina Source: SAFJP

15. Returns Source: AIOS

16. Derivatives

17. Use of Derivatives In general terms derivatives can be divided into three groups: • Risk Management • Hedging strategies to limit market exposure • Monetization Strategies • Obtaining liquidity against stock positions • Investment Strategies • Risk Diversification • Return Enhancement Structures • Positive Carry Transactions

18. Risk Management • Purchase of Put Options • Sale of Call Options • Equity Collars

19. Purchase of Put Options

20. Sale of Call Option

21. Equity Collar

22. Monetization Strategies • Equity Swaps • Collared Equity Swaps • Forwards • Sale of Stock and Purchase of Calls/Call Spreads

23. Equity Swaps

24. Investment Strategies • Principal Protected Notes • Reverse Convertibles

25. Investment Strategies

26. Investment Strategies

27. Principal Protected Notes (Structuring) • Two main components: • Zero- Coupon Instrument • Option • Principal Protected Note = Zero-Coupon Instrument + Option • Typical Payout at maturity: • Nominal Amount * [ Principal Protection Factor + Participation Factor * (Underlying Performance)] Where, Performance = Max [ 0, (Underl. final - Underl. initial) / Underl. initial ]

28. Principal Protected Notes (Structuring) • Example: Investor interested to invest USD 10.0 million in the Mexican market for 1 year with 100% principal protection. • Step 1: Definition of Zero-Coupon instrument: Suppose issuer bank funds itself at Libor + 1.00%. 1 Year Libor = 4.1679% Discount factor = 1 / [1 + (0.051679 / 360 * 360)] = 0.950860 • Step 2: Definition of Option Characteristics: • 1 Year • Notional USD 10.0 million • Call option (to capture upside potential) • Strike: At-The-Money (100% of Initial Spot Reference) • European Style • Cash Settlement • Option Premium = 13.84% of Notional Amount

29. Principal Protected Notes (Structuring) • Step 3: Capital Protected Note issuer receives USD 10.0 million from Investor and distributes the cash as follows: • Zero Coupon : USD 10.0 million * 0.950860 = USD 9,508,600.00 USD 10.0 Million • Option: USD 10.0 - 9,508,600.00 = USD 491,400.00 • Step 4: Computation of Participation Rate: How many options can you purchase with USD 491,400.00?

30. Principal Protected Notes (Structuring) How many options can you purchase with USD 491,400.00? 1 option (on USD 10 million) is worth USD 10.0 * 13.84% = USD 1,384,000.00 So you can purchase: 491,400.00 = 35.50% (Participation Rate) 1,384,000.00 • Step 5: Payout Formula: USD 10.0 million * [ 100% + 35.50% * Performance] Where, Performance = Max [ 0, (IPC final - IPC initial) / IPC initial ]

31. Principal Protected Notes (Structuring)

32. Derivatives: Benefits & Issues

33. Benefits • The use of derivatives tends to increase liquidity in the local market. • The use of structured notes with guaranteed capital provides diversification over different geographic regions and economic sectors. • Derivatives transfer risk form one entity to another (e.g. Collars transfer downside as well as upside risk). • Use of derivatives would tend to increase the learning curve of the pension fund’s managers as well as that of local banks and other local investors. • Local banks could eventually compete with international banks offering a wide range of derivative products, and thus creating a more sophisticated local capital market.

34. Issues • Use of derivatives may lead to an increase in volatility of the fund’s Net Asset Value. • The size of the derivative market depends on the size/liquidity of the whole market. • Lack of derivatives knowledge could lead to an increase in risk rather than a decrease in risk if instruments not properly managed. • The use of derivatives could impose challenges to the regulators in monitoring the mark-to-market of the funds (especially if complex structures are included).

35. Monitoring the Mark-to-Market • In Latin America the regulators use different benchmarks to monitor the use of derivative products. • In Argentina for example, regulators only allow the use of those derivative instruments that the regulators themselves understand, are capable of pricing and monitoring. • In Mexico, the regulators have assigned the task of monitoring the mark-to-market of pension funds to specialist companies called “Price Vendors”. • Which method is better?

36. The DIVA’s Story • In 1996 the regulators in Argentina allowed the use of DIVA’s and “Fideicomisos”. • DIVA’s and Fideicomisos are zero-coupon instruments (CDs in the case of Divas and Zero-Coupon in the case of Fideicomisos) with embedded options. • The DIVA’s and Fideicomisos were indexed to a series of equity indices and bonds (i.e. the Dow Jones, Nasdaq, Nikkei, Argentina 07, etc.) • The use of these structured notes allowed local banks to obtain inexpensive deposits while pension funds with “low risk” diversification products. • Allowed the pension funds to diversify risk with a 100% investment protection.

37. The DIVA’s Story • DIVA’s and Fideicomisos were improperly valued. • DIVA’s and Fideicomisos became very popular in Argentina during in 1997 that 1998 to take advantage of the valuation methodology in order to boost Net Asset Values. • About USD 2,500 million were outstanding during 1997. • Since the valuation methods were corrected, the use of Diva’s and Fideicomisos has been steadily declining. • Currently, structured notes are used as capital protected investments aimed at diversification.

38. The Diva’s Story