Derivatives traders are turning to emerging-markets transactions as a more profitable alternative to common swaps.
Investors and big companies are flocking to banks such as J.P. Morgan & Co., Chase Manhattan Corp., Salomon Brothers, ING Barings, and Deutsche Bank AG to buy such contracts as options on emerging-market bonds, swaps protecting against a plunge in Brazilian reals, and instruments that make it possible to buy hard-to-get Russian treasury bills.
The more complex derivatives, while sold less often, can pay off for banks, with margins that are 10 or 20 times as wide as dollar rate swaps and other more widely used instruments, traders say.
"Any nonstandard option is more profitable," said Gustavo Dominguez, managing director at Chase Manhattan Bank, who's in charge of emerging- markets derivatives.
Mr. Dominguez said he focuses on the simpler and more useful structures clients demand. "Sometimes," he said, "the complications are designed to create the possibility of more profitability."
Most banks charge big companies less than one-hundredth of a percentage point for a dollar rate swap, in which a floating-rate payout is exchanged for fixed-rate payments.
Yet big banks such as ING Barings and Chase Manhattan charge about 20 basis points above the price of their investment for the option to buy Brady bonds at a set price in 30 days.
Deutsche Morgan Grenfell, a unit of Germany's Deutsche Bank, charges as much as 2 percentage points for so-called nondeliverable forwards, which allow an investor to bet on the direction of hard-to-get currencies in the Middle East, Eastern Europe, and Latin America without locking up their money.
"People are willing to pay for access to a market they can't get into otherwise," said Robert Hedges, head of derivatives products in the Americas for ING Barings, which has 10 traders and bankers in New York who focus on emerging-markets derivatives.
Apart from simple puts and calls, there are two basic types of emerging- markets derivatives.
One structure provides access to a developing country stock or bond market otherwise difficult or impossible for foreign investors to buy into, such as Russia's, and often includes a swap back into the buyer's base currency.
The second type lets investors hedge against any combination of a rise in interest rates, a natural disaster, political, or other money-losing event. Hedge funds and some mutual funds have bought complex derivatives and simpler options. Wall Street investors, who hold about 90% of outstanding Brady bonds and are already a primary force in emerging-market debt, use options more frequently, both as hedgers and speculators.
Banks are applying the same kinds of swaps, options, and other derivatives long used in the United States and Europe to Argentina, Poland, and other developing markets.
"It's a market that is growing steadily and building momentum," said Dan Sivolella, head of emerging-markets fixed-income derivatives at J.P. Morgan.
Although exotic bets are the most lucrative, banks do the bulk of their business in simple puts and calls, including on Brady bonds, restructured bank loans named for former Treasury Secretary Nicholas Brady. About $2.8 trillion of Brady bonds changed hands in 1995.
Chase, for example, does the largest portion of its emerging-markets derivatives business in Brazilian foreign exchange and interest rate options. Those were most in demand early this year amid concern that Brazil could devalue its currency.
William Nemerever, portfolio manager at Grantham, Mayo, Van Otterloo & Co.'s Emerging Country Debt Fund, the No. 1 developing market bond fund this year according to research firm Lipper Analytic Services Inc., uses puts and calls on Mexican, Brazilian, and Argentine Brady bonds.
"Sometimes we'll get our exposure through options rather than owning the debt for downside protection; if the market collapses, we're stopped out," Mr. Nemerever said. "We use options on our G-14 portfolios and see it as a natural extension."
This form of insurance costs the portfolio about 1% per year, he said. "Our performance has been reduced somewhat because of the options, but we believe it's the right way to manage," Mr. Nemerever added.
The growth in emerging-markets derivatives is a relief to banks that lost much of their business when companies and big investors all but abandoned using derivatives since interest rates rose.
Emerging-markets investors also soured on derivatives the following year, when many lost millions on the Mexican peso devaluation of December 1994.
Now, however, the derivatives market is coming back.
Overall, the market grew 3% in the first quarter to $17.85 trillion, according to the Office of the Comptroller of the Currency. Emerging-markets derivatives have played their own role in that growth.
ING Barings recently sold $30 million in notes tied to high-yielding ruble-denominated treasury bonds issued by the Russian government, but made available only to a limited number of foreign investors.
Another recent innovation by banks is to use swaps to repackage Latin American Brady bonds into German mark Eurobonds, providing high yields to mark-based investors and lucrative fees to themselves. Morgan Stanley Bank AG, Banque Paribas, and HSBC Trinkaus & Burkhardt recently sold hundreds of millions of marks worth of repackaged Venezuelan and Argentine Brady bonds.
Brady bonds from a Latin American country typically pay higher yields than Eurobonds sold by that same country, because Brady bonds carry a tarnished history of being created from old defaulted loans. (Brady bonds also generally have longer maturities.) Through repackaging, a bank can pass through some of that higher yield to the Eurobond investor.
Bankers say they're prepared to create a derivative to meet almost any investor need, whether it be a bet on Turkish lira treasury bills or speculation on the movement of Lebanese pounds.
"You name it, you can do it," said Nigel Whittaker, head of local- currency fixed-income derivatives at Deutsche Morgan Grenfell in London.
