US economic data helps drive derivatives volumes – BIS

Currency hedging markets were notably active in the first quarter of the year, with turnover rising to $2.7 trillion, up 15% from the previous quarter. The BIS said the hedging was not a precaution to expected increases in uncertainty – implied volatility in fact dropped significantly over the quarter – but could instead represent a growing belief that the dollar is set to hold its value or even appreciate against the euro after years of decline. This would require hedge buyers to adjust their positions.

The strengthening economy in the US also provoked a shift in commodity hedging towards non-precious metals and agricultural commodities, which saw trading rise 21% and 32% respectively, while trading in precious metals fell 31% in terms of number of contracts during the first quarter of 2005. Precious metals are normally preferred during downturns, while non-precious metals prices tend to anticipate recoveries. However, overall commodities hedge trading was flat during the period.

Trading in longer-term interest rate contracts - those with maturities of more than a year - also continued to rise in the first quarter of 2005, up 20% to $43 trillion in turnover terms. This increased trading activity could represent an anticipated divergence between US and euro-area interest rates, the BIS said.

As the BIS revealed in its semi-annual OTC report in May, credit default swaps (CDS) are still a comparatively small sector of the derivatives market – with a notional outstanding total of $6.4 trillion compared with $187 trillion for interest rate products at the end of last year – but the CDS market grew at an exceptional rate of 568% in the period June 2001-June 2004, compared with 121% overall growth for over-the-counter derivatives. The BIS expects this rapid growth to continue or even accelerate following the introduction in March of a weekly credit derivatives fixing service by US broker Creditex and UK data provider Markit.

The CDS market saw dramatic movement after a General Motors earnings warning on 16 March, with the US car manufacturer’s CDS spreads widening 90 basis points immediately and another 400bp over the following month. Spreads also widened on AIG debt protection after the US insurer warned of accounting problems. And the situation was similar with CDS on Danish facility services company, ISS, after a leveraged buyout left its bondholders effectively subordinated.

Although CDS spreads started to narrow again in May following better economic news, the BIS warned it is still unclear whether the sell-off has run its course.

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