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ISDA teams up with Reuters and Intercapital Brokers to make the world’s swap markets a little more transparent.

End-users of over-the-counter derivatives have always fought an uphill battle when it comes to pricing deals. The only surefire way for them to get a truly accurate snapshot of the market has been to pick up the phone and call 10 or more dealers for quotes. This is a tedious task, considering the multitude of deals some big players make every week, but a necessary one—acting based on incomplete or inaccurate information can be dangerous.

The International Swaps and Derivatives Association, Reuters and Intercapital Brokers believe they’ve changed all that. In April, the trio launched a new par-rate screen service to provide mid-market swap rates and dollar spreads to users and dealers.

The service offers a par swap curve for cash-settled swap options quoted by a total of 23 top market-makers (see chart) as of 11:00 a.m. local time in New York and London, and 10:00 a.m. and 3:00 p.m. in Japan. Reuters and Intercapital collect reference bank rates from 10 quoting dealers for each currency in Europe, the United States and Japan, and the rates are displayed a half-hour later on the Reuters ISDAFIX pages. Reuters also offers secondary screens showing the rates and spreads reported by each quoting dealer, and ISDA archives these data for future reference.

The service will initially cover mid-market swap rates for four currencies—French francs, Deutsche marks, Japanese yen and U.S. dollars—in maturities of one to 10 years, and for transactions in dollars, swap spreads and rates will be listed in maturities of two, three, five, seven and 10 years.

According to ISDA, the new service is designed “to establish authoritative values against which exercised swap options can be settled, as well as to serve other valuation needs”—such as the cash settling of interest rate swaps. In order to ensure that the information is accurate, ISDA says, “the rates and spreads provided by each dealer are the mean of what an acknowledged dealer of good credit standing in the market would itself offer and bid a swap in the relevant maturity for a notional equivalent of $50 million or other amount deemed to be market size in that currency for that tenor.” In addition, for U.S. dollar spreads, quoting dealers are required to indicate the U.S. Treasury issue against which the quoted spread is benchmarked.

Who can you trust? The new Reuters screen service calls on some of the world’s biggest dealers for quote information:
Currency Quoting Firms    
Deutsche mark Chase Manhattan
Commerz Financial Products
Credit Suisse Financial Products
Deutsche Morgan Grenfell
Dresdner Kleinwort Benson
JP Morgan
SBC Warburg
Societe Generale
Union Bank of Switzerland
French franc Credit Agricole Indosuez
Banque Paribas
Banque National de Paris
Credit Commercial de France
Credit Suise Financial Products
Citibank, N.A.
Deutsche Morgan Grenfell
JP Morgan
Goldman Sachs
Societe Generale
U.S. dollar Bankers Trust
Chase Manhattan
Citibank, N.A.
Credit Suisse Financial Products
Fuji Bank Capital Markets
Goldman Sachs
JP Morgan
Merrill Lynch
Morgan Stanley
SBC Warburg
Japanese yen Bank of Tokyo-Mitsubishi
Chase Manhattan
Citibank, N.A.
Credit Suisse Financial Products
Industrial Bank of Japan
Fuji Bank Capital Markets
JP Morgan
Merrill Lunch
Sanwa Bank
Societe Generale

TMA Publishes Derivatives Guide

Four years ago, as the first wave of derivatives debacles splashed throughout the financial press, the Treasury Management Association released a rudimentary document identifying some voluntary principles and practices, which it mailed to 1,100 of its 12,000 members. Then in March of this year, the TMA published a revised and expanded treatise on the state of the art in the derivatives world entitled “Principles and Practices for the Oversight and Management of financial Risk.”

At 32 pages, the guide doesn’t break any new ground, but it does offer many important rules of thumb for corporate treasurers and others who may be unfamiliar with the intricacies of the business. “This document continues our approach of trying to educate and advise our members, to increase their understanding and provide guidelines they can refer to in their particular operations,” says Pat Montgomery, chairman of the TMA. “We’ve tried to develop voluntary practices and principles that corporate treasurers could follow in order to improve their internal controls, infrastructure and overall strength.”

The guide identifies the main responsibilities for the risk management process as exposure forecasting, collection and consolidation of financial exposure data, exposure analysis, hedge strategy development, strategy implementation, hedge transaction accounting and control, and performance measurement and measurement reporting. Of particular use to corporate treasuries is the report’s explanation of the Securities and Exchange Commission’s 1997 market risk disclosure requirements and the Federal Accounting Standards Board’s proposed standard for accounting for derivatives and hedging activities. The report also includes sections on the role of senior management in risk management, policy and control guidelines, organizational roles and responsibilities, credit risk management and enterprise-wide risk management.

A copy of the report is available at www.tma-net.org.

A Board-Level Checklist For Risk Measurement
  • Do you have a written risk management policy which includes a clearly defined and detailed implementation strategy approved by the proper levels of management?
  • Does the policy clearly define the underlying business rationale for the company’s derivative use or does it leave open the possibility of speculative transactions?
  • Is your hedge orientation toward a “market view” or a defined strategy? If a “market view” orientation is chosen, have the entry and exit criteria for trading positions been formalized by proper levels of management?
  • Does the policy include approval levels for various dollar levels of transactions? If any of those transactions are complex or leveraged instruments, does the approval level cover their risk profile or just their simple face value?
  • Is there an oversight function to ensure that policies and procedures are being implemented properly, and is this function headed by someone other than those involved in the derivative instrument selection and execution (such as internal audit)?
  • Does the study of the derivative execution group’s performance measures find that they could encourage speculative or undesired behavior to improve performance?
  • Is there clear reporting to senior management of the potential market and credit risk due to derivatives activities, and do these risk measures also separately indicate the underlying business risks being managed?
  • Is the risk measurement methodology (that is, sensitivity analysis or value-at-risk) appropriate for the company’s risk tolerance and exposure complexity levels?
  • Do proper expertise and systems reside in-house to identify and quantify risk, as well as to price and evaluate derivative positions?
  • If the expertise does not exist within the organization, has it been secured outside the company from knowledgeable and objective sources?
  • Is there an effective reporting system in place to inform proper levels of management of position gains and losses? Are management reports on program status and performance measures reviewed by senior management at least one level (if not two levels) higher than the level required to approve transactions?
  • Does the board periodically review the program’s performance to ensure it is consistent with the risk profile of the company?

Adapting RiskMetrics to the Euro

By Ted Kim

How do you calculate correlation and volatility for a currency that doesn’t exist? That’s the problem JP Morgan is tackling now as it prepares for the introduction of the euro next year. The standard RiskMetrics data sets use historical market prices to calculate one-day and one-month forecasts of volatility and correlation. But in January there will be no historical market prices to work from. How will RiskMetrics calculate the volatility and correlation of the euro, as well as euro rates, against other world currency and interest rates?

Although Morgan hasn’t reached a final decision, it has announced it will use some kind of “proxy” data. An example of a proxy would be to use the historical rate of the European currency unit (ECU). The ECU is a type of imaginary currency that acts as the EU’s official unit of account—somewhat similar to the IMF’s special drawing right. EU budgets are not laid out in Deutsche marks or French francs, but rather ECUs. The value of the ECU is determined by calculating the value of a basket of 12 EU member currencies.

Using the ECU as a proxy for forecasting euro values has a lot going for it. Not only is there a great deal of readily accessible statistics on ECU values against non-European currencies as well as ECU interest rates, but also the euro will be set to equal exactly 1 ECU from next January’s start date. This is no mere coincidence—by choosing the ECU rate as the starting level for the new euro, the architects behind this massive EMU plan are encouraging ECU usage in advance of next January. If the ECU is chosen as a “proxy,” RiskMetrics will then use historical data on the ECU-U.S. dollar rate in order to calculate a dollar-euro one-day and one-month volatility and correlation estimate. The first day of market trading in the euro will be January 4, 1999—the day when a euro-dollar volatility estimate will be highly useful.

Morgan, however, is not committed to the ECU proxy and is considering at least three others: dollar-mark; a weighted basket comprising the mark, franc and ITL, all major components of the new euro; or a weighted basket comprising the above as well as the dollar.

After having run an analysis of the volatility and correlation of dozens of different baskets, RiskMetrics says it will probably end up using a proxy measurement that consists solely of the participant currencies—that is, only those exact currencies that will be replaced by the euro. (The British pound accounts for about 17 percent of the value of the ECU, making the ECU unsuitable as a proxy.) Since the markets have already assumed that monetary union will occur, the first wave of participating currencies are currently trading in a tightly correlated range. Thus, it may prove that one currency alone, such as the mark, will prove to be the ideal proxy.

In any event, the decision as to defining an exact proxy series for both interest rate and currency calculations need not be taken until the end of this year. Once that decision is made, a five-month database of historical market statistics can be quickly assembled.

Although the euro may cause major headaches in the financial world, it will have at least one positive effect: By eliminating the individual analysis of the participating currencies, RiskMetrics will reduce the total number of volatility estimates it generates by 100 and the total number of correlation estimates by 30,000.

Derivatives Policy: The Game

For years, companies have shoved policies and procedures down the throats of hapless and uninterested employees like so much creamed spinach. Now BT believes it is at the forefront of a revolution in training: corporate gameware. The mind-numbing policy manuals, training videos and classroom lectures of yesterday are slowly being replaced at BT with video games designed to teach the same old material in a lively—and at times, even fun—format.

“The idea was simple,” says Mark Prensky, vice president and founder of the corporate game unit at BT. “Business has all the content but no engagement, and video games have all the engagement but no content. What we’ve developed here is a combination of the two.”

Straight Shooter is the first such product to hit BT employees’ desks, and it has been greeted with open arms by the under-thirties just starting out in the derivatives business. “The younger generation grew up with a whole lot of different technology,” says Prensky. “They’re a different group of people in terms of their learning patterns, and games are second nature to them. Straight Shooter is designed to suit their cognitive styles.”

The game can be played in two ways. In question mode, players simply answer questions relating to BT derivatives policies. When they answer correctly, they move on. When they answer incorrectly, the screen bounces to the policy in question, and players are given the opportunity to change their answer until they get it right.

In game mode, players must navigate through several labyrinthine settings, greeting as many potential clients as possible and defeating “problems” with the “ideas” they accumulate along the way. Potential clients ask the player a derivatives question, and a correct answer persuades the client to come aboard—and scores the player points. To make things more interesting, players can wager points, ŕ la Jeopardy, and there are million-point suitcases in every location. Again, wrong answers bounce the player to the policy, and players are given the opportunity to change their answers until they get the question right.

While racking up points is fun for the competitive game player—and has inspired several at BT to form leagues to compete with one another—it is irrelevant to the training process. A central server is notified only when an employee has answered all 200 questions in the training program, regardless of how many attempts the employee made or whether the employee worked in question mode, game mode or a combination of the two. “What we’ve tried to do,” says Prensky, “is engage the people who think in a certain way, and still give the opportunity to all people to learn in an effective and detailed manner about these policies. We couldn’t have done this by any other means.”

Perhaps more important for BT, the content of the game can be updated in minutes to accommodate the ever-changing markets. And since Straight Shooter is merely a video template for corporate content, BT is marketing it to other companies as a training tool. Before long, new employees at different companies could be competing with each other and betting huge sums of points to increase their score—great practice for the business they’re entering.

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