U.S. corporates and investors will have to rethink their hedging and risk management strategies in the post-euro era.
Strategies for the New Europe
By Karen Spinner
Until recently, conspiracy theorists on the “X Files” had more credibility in the United States than proponents of European economic and monetary union. The thought of 11 separate governments coming together to form a single currency, yield curve and coinage just seemed...well, bizarre. How could southern Italy and northern Germany possibly operate peacefully under a single set of financial guidelines? And why would they want to?
In the United States, EMU awareness is only now starting to catch on. Indeed, many U.S. firms seem to be in a foggy state of denial. Perhaps they're afraid of the potential economic power of a “United States of Europe” and the euro's likely role as a global reserve currency. Or perhaps they've been distracted by the booming equity markets and year 2000 systems bugs. “We have been trying to educate our clients about the euro, and a surprising number of them do not even know the basics,” says Joseph Bauman, a senior vice president at Bank of America.
When U.S. corporates and investors wake up to the challenge, they'll realize they have quite lot of thinking ahead of them, both in terms of short-range preparation for January 1, 1999, and longer-term strategizing. The first major hurdle is understanding the mechanics of euro conversion and how this will translate into contract modifications, settlements, payments and so forth. But once the technical issues have been resolved, the bigger challenge will be to develop longer-term hedging, profit-taking and risk management strategies appropriate to the post-euro landscape. U.S. firms will have to start looking at Euroland as an increasingly integrated financial entity that will behave like—and compete with—the United States. This process of longer-term strategizing may well go on for quite some time.
Over the past year or so, the currencies and interest rates across the 11 EMU countries have converged toward the Deutsche mark and the Bund. Currency convergence reached its conclusion in May when bilateral European exchange rates were fixed, surprising some economists who initially believed that euro convergence would actually mean movement toward a pan-European average. Since then, the European currency and interest rate markets have been characterized by extremely low volatilities, which have affected European currencies and interest rates considered against the dollar and the yen. “Many people in the markets think that volatility in Europe is low,” says Graham McDevitt, head of global bond strategy for Paribas. “We believe, in fact, that the creation of the euro has shifted volatility to a new lower regime. This is because Europe is becoming an independent investment bloc, decoupling from the United States as investors from Asia and North America increase allocation to the euro zone.”
Since currency rates have been fixed, there are no more “convergence plays” in which investors bet on the rate at which various currencies or interest rates might reach the German standard. Only the Greek drachma and the British pound, which many predict will join EMU in the next several years, remain for those intent on short-term profit-taking. Since interest rates have converged, the yields associated with government-issued fixed-income instruments have been dampened as well. Similarly, corporate debt yields remain low as European corporates take advantage of the current low-yield market environment to reduce the cost of their funds.
|“Many of our U.S. clients are under the impression that EMU is just another version of ERM or the ecu.”|
vice president of global investor marketing in Europe, Chase
“Credit spreads,” which refer to the premium investors receive for taking on additional credit risk vis-à-vis a sovereign standard, are likewise low. Although it is impossible to attribute every characteristic of today's European financial marketplace to the coming euro, it is logical to assume that low volatilities and convergence have had a major effect.
It is not surprising that today's low-volatility, low-yield European markets have plunged U.S. corporates into a somnolent stupor. The movement toward fixed currencies has already proved to be a major benefit to U.S. corporations with extensive European operations. Cross-currency risks and European interest rate risks no longer exist, and cash management in such an environment becomes much simpler. Although payment systems, contract redenomination, account management and other logistical issues will no doubt prove to be troublesome, the benefits in terms of transaction cost savings, lowered earnings volatility and simpler cash management should greatly outweigh the hassle factor.
In the simpler cross-border financial environment facilitated by the euro, U.S. corporates will be less dependent on correspondent banks offering specialized local expertise. Instead, firms will need to choose between global banks and born-again regional banks, which have reoriented their focus over the past couple of years toward the euro. Indeed, many corporates are already jettisoning correspondent banking relationships with European regionals in order to consolidate operations within one or two of the larger pan-European banks.
Given the relatively low volatilities between EMU currencies and the dollar, now may be a particularly opportune time for U.S. corporates to pick up some cheap protection against dollar-euro volatility. “Currency volatilities between the three major trading blocks—dollar-yen, dollar-Deutsche mark and Deutsche mark-yen—have tended to move together in the past,” notes Sam Ford, head of option structuring and marketing for NatWest Global Financial Markets. “At the moment, however, the yen is the most dominant currency by far, which leaves dollar-Deutsche mark volatility much lower than for the yen pairs. When the euro becomes a reality, it seems probable that dollar-euro volatility will increase. Therefore, the current low volatilities could translate into cheap insurance for corporate hedgers.”
For corporations managing liabilities denominated in euros, it will be important to reconsider the portfolio allocation models used. These models are designed to suggest the most efficient allocation of sectors and geographies in terms of portfolio diversification and maximizing profit, and are based on individual investors' specific risk-return profiles. “European fund managers and pension funds are spending a great deal of time reevaluating their investment allocation models in light of the coming EMU,” says Dominic Huou, vice president of global equity-linked products for Merrill Lynch. “For large U.S. corporates that have allocated portions of their portfolios to various EMU countries, reallocating these funds based on new optimization models will be important.”
|“Many of the so-called disaster scenarios are predicated on the assumption that EMU is primarily about economics. In continental Europe, EMU is really about politics.”|
Creating optimization models designed to maximize both income and diversification benefits under EMU will be important to U.S. corporates and investors. This process will be challenging because many of the historical volatilities and correlations that are used to develop optimization and diversification schemes will be irrelevant once the euro is introduced (see box on page 19). “Euroland will be an entirely new marketplace,” says Merrill's Huou, “and everyone will, to a certain extent, be starting from scratch.”
|The first step toward euro-preparedness is to understand what European economic and monetary union actually means. James Buchanan-Michaelson, vice president of global investor marketing in Europe for Chase, says, “Many of our U.S. clients are under the impression that EMU is just another version of ERM (the Exchange Rate Mechanism) or the ecu. This is a common misconception in U.S.-based firms.” The euro will not be just another, tighter version of ERM—it will be a legitimate currency. There will be euro bills and euro coins, just as there are dollars and pennies. There will be a European Central Bank, which will function much as the U.S. Federal Reserve Board does, regulating interest rates and supporting the currency as necessary.
Already, bilateral European foreign exchange rates have been fixed for the 11 countries that will form the nucleus of the currency union. Before January 1, 1999, the European Central Bank will decide on the percentages of each original currency that will constitute the euro. The final euro basket will necessarily be different from the ecu—an earlier and lightly traded European currency index—because English sterling will not, at least initially, be part of EMU.
On the interest rate side, there will be one pan-European interbank rate, known as “Euribor,” which will be set by the European Banking Federation. Euribor will be quoted using decimals on an actual/360 spot basis for one-, two-, three-, six- and 12-month maturities. Rates will be based on quotes from a panel of reference banks, including numerous banks from EMU countries; up to four banks from non-EMU European countries; and six international banks, which will include one Japanese, two Swiss and three U.S. banks. Rates will be fixed daily at 11 a.m. Central European Time, and the top and bottom 15 percent of quotes will be discounted.
During the coming transition period, from January 1, 1999, to July 2002, local currencies such as the Deutsche mark and franc will function as denominations of the euro. Corporates and investors will have the option to accept payments in euros or local currencies. In theory, between January 2002, when euro bills will be introduced, and July 2002, when local currencies are scheduled to be recalled, someone could walk into a French store, pay for goods with Italian lira and request change in euros. Aside from the logistical headaches, however, the euro will act just like the U.S. dollar, with a single exchange rate and a single yield curve. —K.S.
Over the longer term, U.S. corporates will need to develop the resources to hedge their exposures to the European yield curve. Obtaining high-level expertise will become critical, particularly as the Euroland over-the-counter interest rate markets come to resemble more closely those of the United States. Indeed, many believe that spreads between U.S. Treasury rates and Euroland rates will become more volatile over time, particularly when compared with Treasury-Bund volatilities, given the ongoing challenges associated with coordinating EMU across 11 separate governments.
Currency volatility between the dollar and the euro will also need to be tracked and hedged carefully. In an increasingly liquid market, however, long-term option protection with barrier options, average-rate options and other instruments will be easier and less costly to obtain. Overall, says David Blatchford, head of capital markets for Bank of America, transaction costs should decline as liquidity increases, thus expanding the possibilities for corporate hedging.
As Euroland's high-yield markets grow, European subsidiaries of U.S. firms may want to consider issuing euro-denominated debt as an alternative to standard bank loans or intracompany funding. Developing greater credit expertise will also be important for corporates that maintain income-generating investment portfolios. This expertise will let firms evaluate corporate and sovereign debt issued in Euroland more effectively.
|“Many people in the markets think that volatility in Europe is low. We believe that the creation of the euro has shifted volatility to a new lower regime.” |
head of global bond strategy, Paribas
Some expertise in credit derivatives, explains Paul Hattori, director of Dresdner Kleinwort Benson's credit derivatives program, could also help U.S. corporates take advantage of burgeoning European credit markets without actually adding European risk to their balance sheets. For example, total return swaps could allow U.S. corporate investors to swap U.S. credit risk for European credit risk.
U.S. investors, meanwhile, have their own set of challenges. One of the biggest will be modifying their European investment benchmarks to reflect Euroland's new identity as a single market. Changes in benchmarks are likely to proceed slowly, however, as U.S. investors come to terms with the reality of EMU. According to a recent survey by Paribas of 98 U.S.-based portfolio managers, 31 percent of these investors plan to change their benchmark indices in response to Euroland, 54 percent said they would not and the rest are undecided. “The survey shows that U.S. fund managers have not yet fully grasped the implications of EMU,” the report concluded.
One early result from the fixing of cross-European foreign exchange rates is the dramatic decline in currency overlay strategies, which have been used in the past to protect against fluctuations in cross rates and volatility. A number of pension funds and mutual funds that rely on European money managers are now reevaluating these managers' ability to compete in the EMU environment. “Most European money managers have developed single-country expertise,” says Mark Kibblewhite, a director at Barclays Capital. “Now they will all be competing within one market. There will be a great deal of consolidation in European money management over the next several years.”
Over the short term, U.S. investors who want to pick up higher yields across the Euroland countries may want to consider structured derivatives designed to protect principal investments while enhancing yields. John Ford, European sales manager for Deutsche Bank's money market and repo products, explains that European structured notes have enjoyed a renaissance as low market-wide volatilities and yields have driven investors to seek out new ways of profit-taking. Likewise, Okan Pekin, a vice president in Citibank's derivatives group, notes that equity-linked derivatives that provide principal protection and a share in equity upside have become an increasingly popular alternative for European investors and others with an interest in the European markets.
|WHERE's THE EURODATA?|
|In the wake of EMU, U.S. corporates and investors will face a major analytical challenge, which some firms are already tackling as they update portfolio optimization models in keeping with the projected Euroland market. On January 1, 1999, corporates and investors will hold portfolios whose variability may depend a great deal on potential movements in the euro and Euribor, but there will be no real historical data reflecting how the euro and Euribor have behaved over time. Historical volatilities and correlations are an important part of value-at-risk analyses and risk-adjusted return on capital measures, and they are essential to developing new valuation models. So far, no one is really sure about the best way to handle this dearth of data.
Most experts, however, advocate shortening time horizons used for VAR and similar analyses. Once, say, 30 days of history has been accumulated, it will be possible to run short-term analysis based on real, legitimate data. For longer-term analysis, one possibility is to reconstruct the euro by tracking its constituent parts.
But Kenrick Ramlochan, a vice president in Bank of America's foreign exchange risk analysis group, cautions clients against placing too much faith in reconstructed data. “Yes, it is possible to build a historical euro based on past exchange rates, but these rates incorporate Eurloand cross-currency volatility that will no longer exist under EMU.”
It may also be possible to apply certain experiences from the energy markets. Alex Tsigutkin, president of Axiom Software, points out that certain instruments in the energy markets that have rich price-data histories can be factored into the expected price and risk behavior of new instruments until they develop a better price history.
According to Mary Pieterse-Bloem, a lead analyst in Paribas' bond strategy group, developing “historical” volatilities to feed VAR, optimization and valuation models will be particularly difficult. “We believe that volatility during recent months has been artificially depressed, as European banks and investors have spent more time and energy preparing for the euro than trading aggressively for short-term profits,” she says. “We are likely to see an increase in volatility after January 1, 1999.” Researching this volatility problem will be a major task for Paribas and other large banks.
Perhaps the silver lining in EMU-spawned analytic confusion is that everyone will be in the same boat. If the lack of historical data will affect everyone, then it isn't likely to present a competitive liability. U.S. corporates and investors can take comfort in the fact that no one is completely sure how EMU will play out. That, of course, does not absolve them from the need to start strategizing now. —K.S.
In the long term, U.S. investors will need to accept fully that Euroland is on its way to becoming a financial market that rivals the United States. As Euroland financial markets increasingly resemble U.S. markets, investors may want to increase their euro-denominated holdings to obtain greater credit diversification. According to Paribas' recent survey, credit diversification is the principal reason why the average U.S. fixed-income investor allocations to Euroland holdings will increase from 15 percent (as of June 1998) to 19 percent by January 1999.
Changes in U.S. investor behavior, however, are likely to proceed slowly, as fund managers choose to wait and see. The rise of a predominant European equity index and the development of real European credit expertise should serve to increase U.S. investor interest in Euroland. Indeed, many U.S. funds have been deterred from investing in European equities and corporate bonds because the majority of European corporates are not rated by the major credit-reporting agencies. As this begins to change, U.S. investors are likely to participate more aggressively in both European equity and corporate debt markets.
Tim Pettit, a managing director at Greenwich NatWest, adds that the growth of a European market for high-yield debt could appeal strongly to U.S. and European investors looking for enhanced yields. Experts still debate, however, how long it will take for robust high-yield markets to develop on a pan-European basis.
And, as U.S. investors develop greater insights into European credit markets, it is likely that currency plays, which have provided quick profit-taking opportunities in the past, may be replaced by relative-credit plays, in which derivative structures may be used to help investors take bets on the relative creditworthiness of two or more European corporates (see box on page 23). Some profit-making opportunities may also arise in the form of spreads among debt issued by the 11 EMU countries.
Over the longer term, as European equity markets become larger and more liquid, there will be more complex and more liquid interest rate products available to investors and corporate risk managers, and dollar-euro currency volatility is likely to be analogous to dollar-yen currency volatility.
European investors' behavior has already begun to resemble that of U.S.-based investors. Historically, continental investors have tended to favor domestic fixed-income products over equities. In recent years, however, continental funds have gradually moved toward various European equity markets, and most experts believe this trend will continue. In 1995, German equity holdings rose to 12 percent of institutional portfolios, and Dresdner Klienwort Benson is predicting that this figure will reach 16 percent by 2000.
The infrastructure to support pan-European equity markets is already under construction. German, British and French exchanges are already working together on various strategies to promote Europe-wide equity trading in both large-cap and small-cap stocks. Over the next several years, many predict that coalitions among various European exchanges will result in markets that behave like the New York Stock Exchange and NASDAQ in the United States.
|COMING OUT OF DENIAL|
|There has been no shortage of popular “disaster scenarios” in which the euro goes up in flames. One of the most popular such scenarios is known as the “breakaway” scenario. According to Lars Norup, head of derivatives marketing for northern Europe at Greenwich NatWest, the “breakaway” scenario involves one or more EMU countries experiencing extreme domestic turmoil as increased cross-border transparency and competition results in production imbalances and pockets of severe unemployment. Because the European Community has limited taxation powers, currently capped at 1.27 percent of gross national product in each of the countries in question, it would not be possible to pay for a bailout of any of the bigger countries falling on tough times in terms of higher unemployment or diminished competitiveness.
Although Norup believes the breakaway scenario is not a high probability event, he points out that it does have underpinnings in reasonable economic theory and remains a possibility. The real long-term risk to the EMU would be a scenario in which there existed a strong euro but not the necessary political will to push through reforms necessary to solve the structural problems in continental Europe. Based on the bank's own analysis, there is a 45 percent risk that this scenario will take place. The ultimate outcome of this scenario would be the loss of competitiveness and a politically unacceptable rate of unemployment in specific European regions or countries. This is all the more crucial because the European union has so far not managed to harmonize tax legislation, legal systems and a number of other crucial issues associated with moving toward a single common market. Another, more remote possibility that has been widely discussed is whether or not an economic disaster affecting Eastern Europe and Russia could delay the implementation of EMU. According to Eric Bommensath, a managing director at Barclays Capital, Germany derives a great deal of its income from trade with the former Eastern Block countries. Should Germany, one of the primary “anchors” of EMU, suffer a major economic downturn, it is logical to assume that Germany's crisis could have an impact on the timing of EMU.
From the perspective of U.S. corporates and investors, however, the dwindling likelihood of various “disaster scenarios” is beside the point. Although there are no guarantees that EMU will thrive and endure for the foreseeable future, the consensus in the global banking community is that EMU is going to proceed on schedule and is going to succeed. “Many of the so-called disaster scenarios are predicated on the assumption that EMU is primarily about economics,” says Deutsche Bank's David Knott. “In continental Europe, EMU is really about politics. It is a move toward creating a federalist political entity, rather than an end unto itself.”
In short, endless speculation about the likelihood of various EMU outcomes does not eliminate the need for U.S.-based firms to prepare for the euro, both in terms of short-term mechanical issues and longer-term strategic ones. —K.S.
Dow Jones is already attempting to cash in on the need for pan-European equity indices. In February, Dow Jones teamed up with German, Swiss and French stock exchanges to release the Stoxx European indices, which include two broad indices and two narrow indices designed to benchmark European fund managers' performance in the same way that U.S. investors might be measured against the Standard & Poor's 500. The Dow Jones indices will coexist with other, competing European equity indices, each based on different sector and country weightings.
Likewise, many bankers are predicting the growth of European high-yield markets. This is closely connected to the development of the European credit markets. Like municipal debt in the United States, euro-denominated debt issued by European sovereigns will be evaluated primarily according to the creditworthiness of the issuing governments rather than the likelihood of relative currency or interest rate fluctuations. Standard & Poor's, for example, plans to provide credit ratings for Euroland governments following EMU.
Other experts believe, however, that there will not be significant credit spreads among European sovereigns. “We disagree that EMU materially reduces the creditworthiness of European sovereign issuers,” reads a recent report issued by Deutsche Bank. “Sovereign spreads are unlikely to be wide at the start of EMU, and sovereign debt should asset-swap below Libor.”
The market for European corporate debt, however, will almost certainly become more credit-driven and more liquid. This process will take place slowly, as ratings agencies begin to provide more reliable data on a wider range of European corporates. And high-yield European corporate debt will become more appealing to investors as credit spreads between European sovereigns decrease.
Although the view of Euroland from this side of the Atlantic may appear hazy, new strategies that take advantage of opportunities in this new economic behemoth will become clearer. By next year, a new generation of liquid and sophisticated interest rate and equity derivatives are likely to be available at a dealer near you.
|Trading EMU Credit Spreads|
|European economic and monetary union is about to drag the European bond markets kicking and screaming into a new era. On January 4, 1999, EMU will enter its third stage, with the euro introduced as the new currency. All government debt is expected to be redenominated quickly in euros, and governments will simultaneously relinquish control of monetary policy to the European Central Bank (ECB).
In the pre-EMU climate, sovereign debt is considered to carry no default risk, since governments have many tools at their disposal to avoid default. Debt can be monetized by being sold to the central bank, or the currency can be devalued to stimulate export tax revenues.
After the introduction of the euro, however, these tools will no longer be available. The ECB will be prohibited from buying local government debt, and currency control will be out of the hands of individual member states. As a result, governments will now find that their bond issues carry a sovereign credit risk.
“Until now, people have watched the market and taken advantage of differences in, say, lira vs. Deutsche marks,” says Jeff Larsen, an independent risk management consultant. “This kind of activity will all disappear. Instead, people will be trading the bonds of an Italian municipality against that of a German municipality. If this trading is happening in the same currency, you have to ask what the difference between them will be. The answer is the credit spread. A lot more people will be looking at credit, and not just of municipalities, but of corporates in different member states as well.”
Sovereign credit analysis will also have to adapt to these changes. Ratings agencies such as Moody's and Standard & Poor's are planning to merge external and domestic ratings for EMU countries in recognition of the adoption of common monetary policy. Credit risk analysis will need to focus on the fiscal issues.
According to Matt King of JP Morgan's fixed-income research division, the key drivers behind relative credit valuation are tax levels, particularly the prospect of rising tax rates; a government's ability to raise capital; a government's social benefit liability; and its long-term pension fund structure.
A number of indicators will figure prominently in determining a country's ability to meet its future debts. Nondiscretionary interest rate liabilities will be an important factor, as will the ratio of debt to gross domestic product and projected gross domestic product growth.
The impact on credit differentials of social benefit payments and pension liabilities can be estimated using indicators such as the projected growth in elderly dependency and the level of current pension payments as a proportion of GDP. Political changes within the union must also be taken into account, since it will take time for the landscape to take shape.
“Many of these future expenditures can be controlled by governments through changes in legislation,” says David Theobald, managing director and head of European fixed-income research at JP Morgan. “Governments can adjust their levels of taxation, but it is worth considering how much room each has to do this. Also of concern might be the potential for political events arising from devolution within a sovereign state as powers to tax and legislate move away from central government.”
International investors, such as those managing a portfolio against a global bond index, already treat EMU countries as, effectively, a single market and asset class. Yield curves within the European union have collapsed into each other. Only the short ends of the curves in Italy and Spain show a significant yield differential. The behavior of these international investors, who increasingly focus on Bunds for their European positions, indicates the likely structure of the EMU credit market.
“The trend toward trading credit spreads will emerge over the next few years, and it is everyone's opinion that a market will evolve with Bunds as the base,” says consultant Satyajit Das. “It is not often that you get to see a new market develop in this way. There will be more rating activity, and credit derivatives will be much more important. European fund management will change too. Most managed money in Europe is pension fund money, which is managed quite conservatively. Fund management in Europe will become more like that in the United States, which is more dynamic.”
At the moment, spread trades are mainly focused on the divergent ends of the yield curves and on the next wave of EMU entrants—primarily the emergent economies of Eastern Europe. “Two or three years ago it was Spain and Portugal,” says a source at Dresdner Kleinwort Benson. “Now it is the Czech Republic, Hungary, Poland and Greece. The spreads are still wide.”
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