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Forward rates are derived from the interest rate swaps curve and represent the cost of borrowing the currency for six months at a future date represented by the maturity on the horizontal axis. Implied vols are derived from cap prices. Data supplied by Chase Manhattan Bank and Chase Securities.

Introduction

European insurance companies and pension funds were last week snapping up multi-callable notes to boost yields in anticipation of a further round of interest rate cuts. Deutsche Bank, J.P. Morgan and Morgan Stanley Dean Witter are heavily involved in structuring and marketing the notes. Multi-callable notes are attractive in a falling interest-rate environment because they pay a juiced-up yield. In return investors run the risk that the issuer will call the bonds. "It will be a frantic year for these products as insurance companies position themselves for a low interest-rate environment," said a derivatives professional at Crédit Agricole Indosuez. An interest-rate derivatives trader at a German bank in Frankfurt estimated that volumes shot up to EUR300 million (USD285 million) in the last week from a third of that at the end of last year.

Iccrea Banca has bought a one-year EUR1.4 million (USD1.3 million) knock-in put on shares of Mediaset to structure a reverse convertible linked to shares in the Italian television company. Banca di Credito Cooperativo bought the reverse convertible. Francesco Polimeni, head of derivatives trading at Iccrea Banca, said the put is struck at EUR14.14, the stock's closing price on Dec. 11, and knocks in at EUR11.31, or 80% of the strike level. The coupon is 10.20%. Polimeni said BCC asked Iccrea Banca to link the reverse convertible to Mediaset. This was probably because BCC wanted exposure to this company and with relatively high one-year volatility on shares in Mediaset, selling puts offered an attractive coupon, according to Polimeni. He added that it may have wanted exposure to the company now because its loans to Mediaset had expired.

Asahi Mutual Life Insurance, one of Japan's largest insurers, plans this year to significantly increase its JPY100 billion (USD872 million) equity derivatives book in order to reduce by more than one third its JPY2 trillion equity holdings over the next couple of years. The insurer expects the Nikkei-225 to trade in a narrow range around 14,000 this year, and so believes it can make money by selling calls struck at the top end of the range and selling puts struck at the lower end, while selling stocks in the cash markets, said Yasuhiko Sato, manager, equity investments department in Tokyo.

Wall Street firms, including Salomon Smith Barney and Banc of America Securities, are recommending customers sell short-dated single-stock implied volatility to take advantage of the Nasdaq Stock Market's roller coaster ride and the Federal Reserve's surprise 50 basis point interest rate cut last week. Leon Gross, managing director and head of global equity derivatives research at Salomon Smith Barney in New York, suggested selling short-dated calls on new economy stocks, such as Cisco Systems and CMGI, and buying longer-dated calls, after short-dated vol spiked dramatically Wednesday. Salomon is pitching the trade mainly to hedge funds in notional sizes of about USD10 million. In a typical trade a customer might sell three-month Cisco options struck at-the-money with implied vol of 80%, and buy one-year options struck at-the-money with implied vol of 62%. The customer wins if the downward slope on term structures flattens in the near term. By changing the ratio of long options to short options, the investor can instead take a view that implied volatility on the longer-dated position will be higher when the short position expires than the forward vol is now. In this particular example, the ratio of the notional sizes of the options could be 1:2.

Several former Exelon Power Team energy derivatives structurers are launching what they believe will be among the first energy derivatives hedge funds. The fund, to be called GingerBread Man Partners, will begin by trading liquid exchange-traded options, such as natural gas and heating oil contracts on the New York Mercantile Exchange. Once it grows to about USD10 million under management, it will be able to trade off-exchange exotics, for example, best-of options and spark spread options, as well as more standardized over-the-counter products, said Tamir Druz, partner and managing director in Philadelphia. A spark spread option would allow the fund to take a view on the price of power versus the heat-rate-adjusted price of fuel. The fund is looking to take advantage of pricing inefficiencies in the energy options markets. For example, the market is struggling with how to model electric power derivatives, said Druz. Prices for power in a power pool can routinely spike in a summer, then revert to a mean level—behavior that many players' models cannot account for or predict. Many players work off the Black 1976 model, or modified versions of it. These models assume power prices move according to geometric Brownian motion, or randomly. The initials in geometric Brownian motion, or GBM, helped inspire the name of the fund, GingerBread Man. The name is also a reference to the elusive children's book character.

Prebon Marshall Yamane has started brokering listed equity derivatives. Nicholas Ruddell, divisional managing director fixed income and securities in London, said the broker wants to offer these products in order to be a one-stop shop. Prebon already brokers over-the-counter transactions, which tend to be longer-dated, but many players use listed derivatives in shorter-dated transactions because they can more easily mark them to market and there is no counterparty risk. Prebon has been trying to broker trades on the London International Financial Futures and Options Exchange since the middle of last year when the bulk of equity products moved to screen trading, according to Ruddell. Screen trading made brokering listed products more attractive to Prebon because less infrastructure was required to start trading on the exchange.

One yard of one-year yen puts/dollar calls went through the London foreign exchange market last week. The options had strikes of JPY135-150 with one-year maturities, according to European-based traders and brokers. Proprietary traders were likely buying the options to hedge against a surprise tumble in the yen against the dollar, according to traders. The yen was trading at approximately JPY115 when these trades went through. David Bloom, foreign exchange strategist at HSBC in London, said if Japan decides to let its currency depreciate against the greenback in order to bring about an export-led economic recovery, then the JPY135 level could be reached. But with the U.S. facing its own growth problems, the U.S. may look to boost its exports and hence resist such a low exchange rate. HSBC's six-month forecast for the dollar is JPY107.

London-based traders bought euro calls/dollar puts with strikes at parity last week. The buying spree was initiated by dollar spot falling against the euro because of lower-than-expected National Association of Purchasing Management manufacturing survey figures published on Tuesday. The options had maturities of one-three months. The notional sizes were between USD20-50 million. One-month implied volatility stayed high amid the rise in spot, rising to 14.7/15% on Wednesday from 13.7%/14.1% the previous Friday. The lower-than-expected data led vol to rise, but traders added that some increase in vol was to be expected anyway. With the new year, players no longer fear time decay from holding options over the holiday season, and there is hence pent-up demand for options, which would lead to vol increasing. Spot rose from USD0.9305 on Friday to USD0.9460 on Wednesday.

London-based traders bought euro calls/dollar puts with strikes at parity last week. The buying spree was initiated by dollar spot falling against the euro because of lower-than-expected National Association of Purchasing Management manufacturing survey figures published on Tuesday. The options had maturities of one-three months. The notional sizes were between USD20-50 million. One-month implied volatility stayed high amid the rise in spot, rising to 14.7/15% on Wednesday from 13.7%/14.1% the previous Friday. The lower-than-expected data led vol to rise, but traders added that some increase in vol was to be expected anyway. With the new year, players no longer fear time decay from holding options over the holiday season, and there is hence pent-up demand for options, which would lead to vol increasing. Spot rose from USD0.9305 on Friday to USD0.9460 on Wednesday.