Point of View - Global Investment Solutions from Northern Trust

Voices: Martin Jack

A review of current activity in global financial markets, with an emphasis on U.S. markets.

Today, and over the foreseeable future, a series of events — call them global megatrends — will have a profound impact on the world economy. Each issue of Point of View will share insight into these trends and how the institutional investment community is preparing to address them.

The global derivatives markets grew at a 21.3% annual rate from June 1998 to December 2006. The notional value of global derivatives grew to US$415 trillion as of Dec. 31, 2006, a 39% increase from a year earlier.

Global Derivatives Market: Total OTC Notional Value Outstanding

Note: Data reflect notional value outstanding as of Dec. 31.
Source: Bank for International Settlements

Derivatives are most commonly used in hedging strategies or to generate additional portfolio returns.

Interest Rate Contracts
Primary Uses:

Hedge interest rate risk
Improve cost of funding

Credit Default Swaps
Primary Uses:

Reduce the level of credit risk within a portfolio
Capture premium by selling credit protection

Foreign Exchange Contracts
Primary Uses:

Offset expected foreign currency payment
Hedge currency risk within global portfolios

Equity-linked Contracts
Primary Uses:

Portfolio hedging
Directional position on single stock or index
Creating synthetic equity positions

Commodity Contracts
Primary Uses:

Manufacturers hedging future commodity deliveries
Companies hedging future commodity purchases
Directional position on commodity markets

No other category of derivative comes close to interest rate contracts in terms of notional value outstanding. These instruments accounted for 69%, or $292 trillion, of total OTC derivatives notional value at the end of 2006. Foreign exchange contracts follow as a distant second at 10%, or $40.1 trillion.
Market Composition by Derivative Type (as of Dec. 31, 2006)

Source: Bank for International Settlements

Continued Growth in Derivates Markets
Through December 2006, most derivative types have experienced double-digit annual growth rates in the amount of notional value outstanding. While interest rate swaps dominate the market in terms of volume, credit default swaps have experienced tremendous growth over the past few years.

*Compound annual growth rate is calculated from June 1998 through June 2006, with the exception of credit default swaps, which are calculated from December 2004, the earliest date that data was available.

Source: Bank for International Settlements, Northern Trust

Related Links

International Swaps and Derivatives Association
The trade association represents participants in the privately negotiated derivatives industry.

Bank for International Settlements
The organization fosters international monetary and financial cooperation, and serves as a bank for central banks.

Global Megatrends
“Outsourcing as a Solution to Plan Administration and Investment Challenges,” April 2007

Global Megatrends
“The Move Toward DC Plans,” January 2007

Global Megatrends
“Asset-Mix Shifting in Institutional Portfolios,” October 2006

Past performance is not necessarily a guide to the future. Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Index performance is based upon information provided by the index providers. There are risks involved with investing, including possible loss of principal. There is no guarantee that the investment objectives of any fund or strategy will be met. Risk controls and asset allocation models do not promise any level of performance or guarantee against loss of principal.

Northern Trust Global Investments (NTGI) comprises Northern Trust Investments, N.A., Northern Trust Global Investments Limited, Northern Trust Global Investments Japan, K.K., the investment advisor division of The Northern Trust Company and Northern Trust Global Advisors, Inc., and its subsidiaries.

This material is directed to eligible counterparties and professional clients; it should not be relied upon by retail investors. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy or product described herein. This information is not intended as investment advice and does not take into account an investor’s individual circumstances. Opinions expressed herein are subject to change at any time without notice. Information has been obtained from sources believed to be reliable, but its accuracy and interpretation are not guaranteed.