Financial Derivatives

EUROBONDS

A Eurobond is a corporate or government bond denominated in a currency other than the national currency of the issuer. These bonds are ordinarily issued in bearer form by international syndicates of commercial banks and investment banks that bid on securities offered for sale through a panel. Eurobonds may be issued in a single currency, in multicurrency form, or a unit of account, such as the European Currency Unit (ECU) . An important capital source for multinational companies, Eurobonds are cleared and settled through Euroclear and Cedel, two bank-owned clearing houses. Borrowing in the Eurobond market often makes it possible to obtain financing at lower interest rates. A Eurobond is a debt contract, which records the borrower's obligation to pay interest at a given rate and the principal amount of the bond on specified dates. The issue has a specific structure and is defined in the EU Prospectus Directive (89/298) as transferable securities.

The euro bond market developed quite well since 2001. The growing importance of the euro as an international investment currency has made the market for euro-denominated issues more attractive for both investors and issuers. A key element behind these developments of the European bond market in this period was the impetus for a better integrated and more liquid market and the increasing diversity of innovative products, such as index-linked bonds, real-time bond indices; fixed income exchange traded funds, credit derivatives and structured products. At the beginning of European monetary union, corporate bonds had a share of only 9% in the stock of outstanding bonds. This share went up to 14% towards the end of 2003 as access was gained to a larger potential pool of investors than existed before the introduction of the euro.

Improved access to financial markets within the EU allows investors to diversify their portfolios and to invest more easily in markets of countries other than their own. Since many investors prefer assets denominated in local currency, the introduction of the euro has reduced the home bias of euro area investors and further promoted the diversification of investments within the euro area. Furthermore, the development of a relatively broad and homogenous financial market in the euro area attracts international investors. Efforts to reduce information asymmetry and to improve transparency (as enforced by the FSA Plan) together with increased liquidity and declining transaction costs further foster the attractiveness of European bond markets for European and international investors. In recent years the more intense competition, also due to the introduction of the euro, has accelerated the process of reshaping market infrastructure and has involved trading, clearing and settlement stages. The different components of the financial marketplaces have developed new services and slimmer ownership structures. Strong synergies, the need to lower costs and the drive to strengthen the position of the main management companies have spurred integration between the trading circuits and the settlement systems.

The euro covered bond market, an example for on-balance sheet securitization, has witnessed interesting developments over recent years. While the issuance of covered bonds declined until 2001, mainly due to the sharp reduction in issuance of German Pfandbriefe, a recovery started in 2001. However, apart from the rising volumes since 2001 and continuous product innovation, the interesting feature in this market segment is the growing share of issuance from European countries other than Germany, whose covered bonds nonetheless still dominate the market to a large extent. While issuance has increased in the existing covered bond markets, new markets have also developed or are about to be born. This is an outcome of the modernization of existing covered bonds legislation in several countries, while other countries have already adopted covered bonds legislation or will soon do so. These developments show the current dynamism in the covered bond market in a pan-European context. Considering the performance of the European bond markets, spreads of corporate bond yields over government bond yields were at exceptionally low levels by the end of 2003 after having peaked in the autumn 2001 and in 2002. Quantitative assessment of this phenomenon suggests that much of corporate spread depression is due to historically low interest rate levels, encouraging investors to search for yield. In addition, spreads, taken as premia for default risk, have been depressed by declining corporate leverage, a possible indicator of companies' solvency.

Finally, the increasing market liquidity associated with the maturing corporate bond market has squeezed liquidity premia. The current broadening and deepening of the European corporate bond market is expected to continue in the future. This gives reason to believe that the dampening impact of lower liquidity premia on spread movements will continue. Another segment of European credit markets which has expanded rapidly in recent years is the credit derivatives market. Credit derivatives, which allow the transfer of credit risk to other sectors that lack direct origination capabilities, are on the way to becoming one of the most successful financial innovations in recent history. The remarkable development of credit derivatives markets especially in Europe and the ongoing integration of European credit markets is contributing to the evolution of liquid markets, thus facilitating the efficient pricing and trading of credit risks.

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One of the most recent innovations in the European bond market was the development of exchange-traded funds (ETFs), which allow a diversified portfolio to be bought or sold more cost efficiently through one single transaction than is currently possible with traditional funds. Another means by which innovation could help would be through the development of futures contracts based on portfolios of corporate bonds, with delivery taking place through either cash or through ETFs. A prerequisite for the development of the former (cash-settled futures contracts based on corporate bond portfolios) is, however, the development of indices whose integrity is beyond doubt and whose computation and publication is effected in real time.

INTEREST RATES

Ð'* Interest: annual payments (360/360 day basis); deferred coupon bondÐ'--delay in payment for first period; with accrued amounts paid in later period;

Ð'* Redemption: one time repayment of principal (bullet maturity);

Ð'* FRN: interest paid at end of periods (3, 6mos., with interest then adjusted for next periodÐ'--avoids risk of continued and material depreciation