Greater numbers of pension funds are looking to obtain portfolio diversification through greater exposure to emerging markets.

The appeal of returns above those of the majors, over the past 12 months Mexico is up 51% and Brazil 38% against the Dow's 23%, and low correlation with the FTSE, are mitigated by high volatility and unlimited downside, which has been thorough-ly explored in recent times, as well as the many obstacles that remain in the path of direct investment in may of these markets. Although improved in recent years, liquidity and enormous bid/offer spreads take some of the shine off these markets. The need for special dealing accounts, the payment of onerous taxes, as in Chile, with-holding taxes, plus the need to have a high level of understanding of each regulatory environment, create additional barriers to a successful, efficient investment format for pensions.

The use of derivatives can enable investment in emerging markets to be achieved without having to traverse the minefield of risks associated with plain equity investment providing exposure to most of the upside whilst providing shelter from the structural, as well the investment, risks.

By utilising the infra-structure of-fered by the international banking community, it is possible to replicate the plain equity position by using fu-tures, swaps or forwards without any impact from the parochial laws, taxes and regulations with immeasurably increased levels of liquidity. The use of options adds the extra dimension of limited, or total, downside protection.

The recent dramatic rise in level of volatility globally has had a significant impact on pricing plain vanilla options such as puts and calls reducing the absolute investment return achieved. Prices are up an average of 50% across the emerging markets sector compared to the summer. The additional problem of increased inter-market correlation has also had a dramatic impact on the price of more exotic options on baskets of indices.

However, the rise in volatility has little or no impact on the price of many exotic options such as call-spreads that are volatility -neutral and still at the pre-crisis price. Such structures can therefore offer well-costed- exposure to market growth on a protected basis. The use of a blend of exotic/plain-vanilla options such as a 'knock-out with rebate', will provide strong, underpinned pick-up on equity growth for minimal cost.

Exotic options and other derivatives trade for periods of three, six and 12 and up to 24 months generally. Exchange-traded options are available for shorter terms when required for asset re-allocation purposes. It is possible to obtain a price for a term of up to five years a cliquet on an underlying asset such as one of the more liquid telecom stocks.

Approximately 75% of options purchased are on indexes with the balance on single stocks, particularly the large utilities and privatisation stocks, such as the former Russian state-owned oil companies. There is an increasing demand for options on baskets of either indices or shares in a particular sector, following the fashion for such products in Europe.

In addition to the equity investment and infra-structure of investing in emerging markets, currency risk is of particular interest to pension funds with liabilities denominated in sterling, Deutschemark, Guilders or Francs. Given the large interest differential, the cost of buying an option 'quanto'd' into the home currency is generally seen as being prohibitively expensive currently. Most emerging market options are therefore being purchased un-hedged for currency.

As many pension funds gain exposure to emerging markets through investment funds, there has been a flurry of activity recently to offer calls on the more established trusts to provide protected exposure to these vol-atile markets. This is arranged either as a separate option or under recently revised regulations, new fund offering protected exposure to the underlying fund. Key requirements to ach-ieve such structures are well establish-ed with consistent investment policy. It is often that the volatility of the fund is lower than that of the related index, which enables pricing to be keener.

A further asset class of note in respect of emerging markets is the credit derivative. This is becoming a more widely recognised and used tool for providing diversification and yield enhancement separately frommthe international bond market.

The purchaser of a credit derivative is exposed to the relatively inferior credit of a of a counterparty which is predominately an emerging country. An enhanced pick-up yield is paid in compensation for this additional level of risk. Although mostly used for credit diversification, they are increasingly being used for asset/liability management.

John Godden is with the structured products team at Paribas in London

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