Acceleration of OTC derivatives market activity in the first half of 2002
8 November 2002
Data released today by the BIS on positions in the global over-the-counter (OTC) derivatives market at the end of June 2002 point to a further acceleration of activity in the first half of the year.1 The total estimated notional amount of outstanding OTC contracts stood at almost $128 trillion, a 15% increase over end-December 2001.2 This compares with an 11% increase in the previous half-year period. It should be noted, however, that part of this recent acceleration reflected the higher dollar value of contracts denominated in the euro and the yen as those currencies appreciated relative to the US dollar between the two reporting periods. At the same time, gross market values also grew rapidly, with an increase of 18% to $4.5 trillion.3
Market growth continues to be largely driven by interest rate instruments
Market expansion was largely driven by interest rate instruments, the largest of the broad market risk categories covered by the semiannual BIS survey on OTC derivatives markets, with the notional amount of outstanding contracts rising by 16%. Activity was equally robust in all three main groups of interest rate products, namely forward rate agreements (FRAs), interest rate swaps and interest rate options. By contrast, business in foreign exchange contracts, the second largest broad market risk category, was less buoyant, with outstanding contracts rising by 8%. Currency options were the main exception, with a surge of 39%.
Activity in equity-linked contracts, which had been subdued in recent periods, returned to expansion, with an 18% increase in amounts outstanding. The stock of commodity contracts, the smallest of the broad market risk categories, also returned to growth with a 30% increase in the value of outstanding contracts.4
Continued buoyancy of dollar interest rate swaps
Business in interest rate products remained buoyant in the first half of 2002, with a 16% increase in the notional amount of contracts to $90 trillion (see Tables 1 and 3). This buoyancy was evident in all three major market segments but the most significant increase in absolute terms took place in interest rate swaps. With $68 trillion in outstanding contracts, interest rate swaps remain by far the largest single group of products in the OTC derivatives market.
The US dollar-denominated interest rate swap market continued to grow at a rapid pace, with outstanding contracts rising by 14% to slightly less than $22 trillion. Dollar-denominated swaps have grown steadily in recent years on the back of a shift in hedging and trading practices.5 A more active use of swaps and swaptions in the hedging of mortgage prepayment risk by mortgage originators and investors was also reported to have boosted business in recent periods.6
Activity in the other major interest rate swap markets was much less buoyant. The notional amount of euro-denominated swaps expanded by 18% in US dollar terms (the currency of reference of the BIS semiannual survey) to slightly less than $25 trillion but much of that increase resulted from a 13% appreciation of the euro relative to the US dollar between end-December 2001 and end-June 2002. A similar currency effect was at play in the market for yen-denominated swaps. The US dollar value of yen swaps rose by 16% to almost $12 trillion but most of the increase was the result of a 10% appreciation of the yen relative to the dollar over the two reporting periods.
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Surge in currency options
The pace of activity in foreign exchange contracts was somewhat lacklustre relative to that in interest rate instruments (see Table 2), with the stock of contracts rising by 8% to $18 trillion. However, business in currency options was an exception to this overall pattern. The notional value of such contracts rose by 39% to $3.4 trillion, with activity picking up in most currency sectors. Contracts involving the US dollar expanded by 28%, those involving the euro grew by 66%, while those involving the yen increased by 14%. Market sources attributed the market's buoyancy to a rise in the volatility of major currency pairs (the euro/dollar in particular) in the second quarter of the year.
OTC business accelerates relative to that on exchanges
OTC business accelerated relative to that on exchanges in the first half of 2002. The notional amount of OTC contracts expanded by 15% in the first half of the year, while open positions in exchange-traded contracts grew by only 1%.7 In the previous half-year, the stock of OTC contracts had increased by 11%, while that of exchange-traded contracts had increased by 22%.
Rise in gross market values
Estimated gross market values increased by 18% to $4.5 trillion, following a 24% rise in the second half of 2001.8 Much of the increase took place in foreign exchange contracts, reflecting significant movements in the major exchange rates in the first half of 2002 and an upturn in currency volatility in the second quarter.9 The overall ratio of gross market values to notional amounts was stable at 3.5% but, in the case of foreign exchange instruments, the ratio rose appreciably to 5.8% from 4.7%.
It should, however, be noted that data on gross market values tend to overstate the actual credit exposures faced by counterparties because they do not take into account the availability of legally enforceable bilateral netting arrangements and other risk reducing measures. After taking into account such netting arrangements, the derivatives-related gross credit exposures of reporting institutions stood at $1.3 trillion in the most recent half-year.
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2 The notional amount, which is generally used as a reference to calculate cash flows under individual contracts, provides a comparison of market size between related cash and derivatives markets. The numbers are adjusted for double-counting resulting from positions between reporting institutions.
3 The gross market value is defined as the sum of the gross positive market value of all reporters' contracts and the gross negative market value of their contracts with non-reporters (as a proxy for the gross positive market value of non-reporters' positions). It measures the replacement cost of all outstanding contracts had they been closed out on 30 June 2002. The numbers are adjusted for double-counting resulting from positions between reporting institutions.
6 Investors in mortgage-backed securities (MBSs) face significant prepayment (or convexity) risks since the holders of the underlying mortgages enjoy certain prepayment privileges such as the ability to refinance their mortgages on more favourable terms when long-term interest rates decline. Such early repayments in turn lead issuers to call MBSs as the underlying pool of mortgages shrinks. In order to protect themselves from a shortening of their portfolios' duration and from a loss of interest income, holders of MBSs can establish a number of hedges, such as entering into receiver swaps or purchasing receiver (or call) swaptions enabling them to receive fixed rate payments on pre-agreed terms if their securities are called.
7 It should be noted, however, that activity in the two types of markets cannot be directly compared owing to inherent differences in the characteristics and uses of products. In exchange-traded derivatives markets, the reversal of an initial position leads to a decline in open interest because of the offsetting of contracts through a central counterparty. In OTC derivatives markets, such a reversal involves the writing of new positions, which leads to an increase in notional amounts outstanding.
8 While notional amounts provide a reference from which contractual payments are determined in derivatives markets, such amounts are generally not those truly at risk. The amounts at risk in derivatives contracts are a function of the price level and/or volatility of the financial reference index used in the determination of contract payments, the duration and liquidity of contracts and the creditworthiness of counterparties. They are also a function of whether an exchange of notional principal takes place between counterparties. Data on gross market values provide a more accurate measure of the scale of financial risk transfer taking place in derivatives markets.
9 A movement in exchange rates leads to an increase in the value of forward-type contracts for some counterparties and a symmetrical loss for others. In the case of option-type contracts, a change in the implied volatility of exchange rates is accompanied by a corresponding change in the value of contracts.