Pension Funds and Capital Markets: The Latin American

Experience

Nathan Engelhard Director

UBS Warburg LLC

June 2001

Introduction

3

Introduction Years of creation

Affiliates

Assets under Management & Relationship to GDP

Portfolio Limits

Composition of Assets under Management

Evolution of Assets Under Management

Returns

4

Years of Creation

Country Law YearYear of Operation

Argentina Ley 24241 1993 1994Bolivia Ley 1732 1996 1997Chile Decreto Ley 3500 1980 1981El Salvador Decreto 927 1997 1998Mexico Ley SAR 1996 1997Peru Decreto Ley 25897 1992 1993Uruguay Ley 16713 1995 1996

Source: AIOS

5

Introduction

Country Dec-00Argentina 53.00%Bolivia 20.50%Chile 107.00%El Salvador 33.10%Mexico 42.50%Peru 23.80%Uruguay 38.80%Total 45.60%

System Participants / Total Work Force

Source: AIOS

As of December 2000 the Work Force was estimated at 81 million

6

0

2

4

6

8

10

12

14

16

18

1999 2000

Chile

Argentina

Mexico

Participants(millions) December 2000

Source: AIOS

7

Assets Under Management (millions of USD)

Assets under Management

Source: AIOS

Country Dec. 2000 Dec. 1999 ChangeArgentina 20,381 16,787 21.4%Brazil 66,700 63,993 4.23%Chile 35,886 34,501 4.0%Mexico 17,355 11,430 51.8%Peru 2,978 2,406 23.8%

8

Assets under Management/GDP

Country Dec. 2000 Dec. 1999Argentina 7.1% 5.9%

Brazil 13.22% 12.47%Bolivia 10.8% 7.0%Chile 59.8% 53.3%

El Salvador 3.6% 1.7%Mexico 3.0% 2.3%

Peru 5.4% 4.1%Uruguay 3.9% 2.8%

Source: AIOS

9

Portfolio Limits Defined by Law

(a) As a percentage of the total value of the fund (b) Bonds convertible to equity maximum 15% and minimum 10% (c) Fund type 1. In Chile there are two kinds of funds. Fund type 1 admits any worker; fund 2 admits

individuals next to retirement because of old age or disabled individuals. (d) Fund type 2 (e) The investment regime in Chile does not talk about derivatives. This regime only mentions instruments

necessary to hedge interest and exchange risk; among them figure out credit loans and tradable securities. (f) The law just considers investments in “SOFOLES”, institutions that give mortgage loans.

Country Argentina Chile (c) Chile (d) Mexico Treasury bonds and Central Bank bonds (a) <50 >35

<50 >50 <85

51

Bank deposits and bonds (a) <28 >35 <50

>50 <85

<35

Mortgage bonds guaranteed by banks (a) <28 >35 <45

>45 <75

>.6(f)

Corporate bonds (a) <14 >35 <50(b)

>45 <75

<10

Corporate equity (a) <14 >35 <45

>5 <15

0

Derivatives (futures and options) (a) <2 (e) (e) 0

Source: AIOS

10

 Composition of Assets under Management(relative to total value of fund, December 2000, millions of USD )

Country TotalAssets

GovernmentDebt

FinancialInstitutions

Non-financial

institutions

Equity MutualFunds

Foreignissues

Others

Argentina 20,381 56.0% 15.6% 2.8% 12.3% 8.2% 4.5% 0.6%Chile 35,886 35.7% 35.1% 4.0% 11.6% 2.4% 10.9% 0.3%

Mexico 17,355 92.6% 2.0% 5.4% 0.0% 0.0% 0.0% 0.0%Peru 2,978 9.0% 34.0% 18.6% 29.0% 0.7% 6.7% 2.1%Total 76.600 53.4% 22.5% 4.5% 9.6% 3.3% 6.4% 0.4%

Source: AIOS

Equity 23.58%Real Estate 8.04%CDs 3.19%Mutual Funds (Fixed Income) 36.70%Mutual Funds (Equities) 11.45%Government 6.60%Debentures 2.04%Other 8.40%

Brazil

11

Chile

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

Dec-81 Dec-82Dec-83 Dec-84Dec-85Dec-86 Dec-87 Dec-88Dec-89 Dec-90Dec-91Dec-92 Dec-93Dec-94 Dec-95Dec-96 Dec-97 Dec-98Dec-99

Total Assets under Management

Source: SAFP

12

Brazil

40,000

50,000

60,000

70,000

80,000

1994 1995 1996 1997 1998 1999 2000

Time

Bill

ion

s o

f U

SD

Total Assets under Management

Source: ABRAPP

13

Mexico

Source: SHCP

-

5,000

10,000

15,000

20,000

25,000

Jun-92 Jun-93 Jun-94 Jun-95 Jun-96 Jun-97 Jun-98 Jun-99 Jun-00

Mil

lio

ns

of

US

D

Total Assets under Management

14

Argentina

0

5,000

10,000

15,000

20,000

25,000

31/12/94 30/06/96 31/12/97 30/06/99 31/12/00

Time

Mil

lio

ns

of

US

D

Total Assets under Management

Source: SAFJP

15

Returns

Country Nominal RealArgentina 12.21% 11.78%Chile 26.82% 11.10%Mexico 29.14% 8.99%Peru 13.91% 5.97%

Historical

Source: AIOS

Derivatives

17

Use of Derivatives

In general terms derivatives can be divided into three groups:

Risk Management Hedging strategies to limit market exposure

Monetization Strategies Obtaining liquidity against stock positions

Investment Strategies Risk Diversification Return Enhancement Structures Positive Carry Transactions

18

Risk Management Purchase of Put Options

Sale of Call Options

Equity Collars

19

Purchase of Put Options B y p u r c h a s in g a p u t o p t io n , a m in im u m v a lu e i s e s t a b l i s h e d f o r t h e u n d e r ly in g s t o c k – t h e a s s e t i s

p r o t e c t e d .

$ 9 5 . 0 0

$ 0 . 0 0

O p t i o n e x p i r e s — n o p a y m e n t i s m a d e

C l i e n t r e c e i v e s s t r i k e l e s s m a r k e t p r i c e

A s s u m e t h e u n d e r ly in g s t o c k i s t r a d in g a t U S $ 1 0 0 . 0 0 p e r s h a r e a n d a p u t o p t io n w it h a s t r ik e o fU S $ 9 5 . 0 0 p e r s h a r e i s p u r c h a s e d . A t m a t u r i t y , i f t h e s t o c k p r ic e i s U S $ 9 0 . 0 0 p e r s h a r e , t h e h o ld e r o ft h e s t o c k w i l l e ff e c t iv e ly r e c e iv e U S $ 9 5 . 0 0 p e r s h a r e , le s s p r e m iu m p a id . T h e a c t u a l s h a r e r e p r e s e n t sU S $ 9 0 . 0 0 a n d t h e p a y o ff o n t h e p u t o p t io n w o u ld b e U S $ 5 . 0 0 (U S $ 9 5 . 0 0 – U S $ 9 0 . 0 0 ) .

20

Sale of Call Option B y s e l l i n g a c a l l o p t i o n , t h e h o ld e r o f t h e u n d e r l y i n g s t o c k s e l l s a w a y a n y u p s id e a b o v e a

c e r t a i n l e v e l , t h e “ s t r i k e ” o f t h e o p t i o n , i n r e t u r n f o r p r e m iu m in c o m e .

$ 1 1 5 . 0 0

$ 0 . 0 0

S e l l e r p a y s m a r k e t p r i c e l e s s s t r i k e

O p t i o n e x p i r e s — n o p a y m e n t s

A s s u m e t h e u n d e r l y i n g s t o c k i s t r a d in g a t U S $ 1 0 0 . 0 0 p e r s h a r e a n d a c a l l o p t i o n w i t h as t r i k e o f U S $ 1 1 5 . 0 0 i s s o ld . A t m a t u r i t y , i f t h e s t o c k p r i c e i s U S $ 1 2 5 . 0 0 p e r s h a r e , t h eh o ld e r o f t h e s t o c k w i l l e ff e c t i v e l y s e l l t h e s t o c k a t U S $ 1 1 5 . 0 0 p e r s h a r e . T h e a c t u a ls h a r e r e p r e s e n t s U S $ 1 2 5 . 0 0 a n d t h e p a y m e n t d u e f r o m t h e c a l l o p t i o n w o u ld b eU S $ 1 0 . 0 0 ( U S $ 1 2 5 . 0 0 – U S $ 1 1 5 . 0 0 ) .

T h e s a le o f a c a l l o p t i o n g e n e r a t e s p r e m iu m in c o m e w h i c h d o e s n o t p r o v id e a p u r eh e d g e ; i t m e r e l y c u s h io n s t h e im p a c t o f a d o w n w a r d m o v e . A p r e m iu m a m o u n t o fU S $ 5 . 0 0 w i l l n o t f u l l y c o m p e n s a t e f o r a U S $ 2 0 . 0 0 s h a r e p r i c e d e c l i n e .

21

Equity Collar A n e q u i t y c o l l a r r e d u c e s t h e r i s k o f s t o c k p r i c e d e p r e c i a t i o n w h i l e a l l o w i n g f o r

p a r t i c i p a t i o n i n a d d i t i o n a l s t o c k p r i c e a p p r e c i a t i o n t o a s p e c i fi e d l e v e l .

$ 1 1 5 . 0 0

$ 0 . 0 0

C a l l o p t i o n c a p s u p s i d e

P u t o p t i o n p r o v i d e s d o w n s i d e p r o t e c t i o n$ 9 5 . 0 0

B o t h o p t i o n s e x p i r e

U n d e r l y i n g s t o c k i s t r a d i n g a t U S $ 1 0 0 . 0 0 , t h e c l i e n t s e l l s a c a l l o p t i o n a t a s t r i k e o fU S $ 1 1 5 . 0 0 , a n d b u y s a p u t o p t i o n a t a s t r i k e o f U S $ 9 5 . 0 0 .

I f a t m a t u r i t y t h e p r i c e o f t h e u n d e r l y i n g s t o c k i s U S $ 1 2 5 . 0 0 , t h e c l i e n t p a y s b a n kU S $ 1 0 . 0 0 t o s e t t l e t h e c a l l o p t i o n ( t h e d i ff e r e n c e b e t w e e n U S $ 1 2 5 . 0 0 a n d U S $ 1 1 5 . 0 0 ) ,a n d t h e p u t o p t i o n e x p i r e s w i t h o u t a n y v a l u e .

I f a t m a t u r i t y t h e p r i c e o f t h e u n d e r l y i n g s t o c k i s U S $ 1 0 5 . 0 0 , t h e c o l l a r e x p i r e s w i t h o u ta n y v a l u e .

F i n a l l y , i f a t m a t u r i t y t h e p r i c e o f t h e u n d e r l y i n g s t o c k i s U S $ 8 5 . 0 0 , t h e c a l l o p t i o ne x p i r e s w i t h o u t a n y v a l u e , a n d b a n k p a y s t h e c l i e n t U S $ 1 0 . 0 0 t o s e t t l e t h e p u t o p t i o n( t h e d i ff e r e n c e b e t w e e n U S $ 9 5 . 0 0 a n d U S $ 8 5 . 0 0 ) .

22

Monetization Strategies

Equity Swaps

Collared Equity Swaps

Forwards

Sale of Stock and Purchase of Calls/Call Spreads

23

Equity Swaps A n e q u i t y s w a p i s a n a g r e e m e n t b e t w e e n c l i e n t a n d b a n k t o e x c h a n g e p e r i o d i c e q u i t y -

b a s e d c a s h p a y m e n t s f o r a fi x e d o r fl o a t i n g r a t e o f i n t e r e s t .

C l i e n t

L I B O R + S p r e a d o n N o t i o n a l A m o u n t o f t h e S t o c k

T o t a l R e t u r n o f S t o c k ( 1 )

B a n k

1 I f s t o c k a p p r e c i a t e s , b a n k m a k e s a p a y m e n t t o t h e c l i e n t . C o n v e r s e l y , i f t h e s t o c kd e p r e c i a t e s , t h e c l i e n t m a k e s a p a y m e n t t o b a n k .

C l i e n t m a i n t a i n s u p s i d e o r d o w n s i d e i n t h e p r i c e o f t h e u n d e r l y i n g s t o c k , w i t h o u to w n i n g t h e s h a r e s .

T h e c l i e n t p a y s L I B O R + a s p r e a d o n t h e n o t i o n a l a m o u n t o f t h e u n d e r l y i n g s t o c k .

24

Investment Strategies

Principal Protected Notes

Reverse Convertibles

25

Investment Strategies Client would like to have exposure to the technology stock sector. Through a capital

protected note Client has a limited downside exposure, and at the same time upsideexposure, to this market.

Note Issue Price 100%

Issuer Bank

Coupon 0%

Minimum Maturity Value 100%

Maximum Maturity Value 100% + (Return on Basket of Technology Stocks) X 1.26

(Up to a maximum of 115%)

Basket of Technology Stocks

Stock Ticker Weight

Intel Corp INTC 10.00%

Microsoft MSFT 10.00%

Texas Instruments TXN 10.00%

Dell Computers DELL 10.00%

Intl. BusinessMachines

IBM 10.00%

Netscape NSCP 10.00%

Motorola MOT 10.00%

Adobe Systems Inc. ADBE 10.00%

Cisco Systems Inc. CSCO 10.00%

Novel Inc. NOVL 10.00%

TOTAL 100.00%

2 Year Principal Protected Note Linked to a Basket of Technology Stocks

26

Investment Strategies F o r e v e r y p e r c e n t a g e p o in t t h a t t h e B a s k e t o f T e c h n o lo g y S t o c k s in c r e a s e s in v a lu e , t h e N o t e p a y s

1 . 2 6 % .

T h e r e t u r n o n t h e N o t e i s c a p p e d a t 1 1 5 % .

T h e C l ie n t h a s n o d o w n s id e e x p o s u r e .

N o t e P a y o u t

R e tu rn o f B a s k e t o f T e c h n o lo g yS to c k s

R e tu rn o f N o te

U n d e r ly in gP r ic e

T im e

1 1 5 %

1 0 0 %

27

Principal Protected Notes (Structuring)

Two main components:

Zero- Coupon Instrument

Option

Principal Protected Note = Zero-Coupon Instrument + Option

Typical Payout at maturity:

Nominal Amount * [ Principal Protection Factor + Participation Factor * (Underlying Performance)]

Where, Performance = Max [ 0, (Underl. final - Underl. initial) / Underl. initial ]

28

Principal Protected Notes (Structuring)

Example: Investor interested to invest USD 10.0 million in the Mexican market for 1 year with 100% principal protection.

Step 1:Definition of Zero-Coupon instrument: Suppose issuer bank funds itself at Libor + 1.00%.1 Year Libor = 4.1679%Discount factor = 1 / [1 + (0.051679 / 360 * 360)] = 0.950860

Step 2:Definition of Option Characteristics:

1 Year Notional USD 10.0 million Call option (to capture upside potential) Strike: At-The-Money (100% of Initial Spot Reference) European Style Cash Settlement Option Premium = 13.84% of Notional Amount

29

Principal Protected Notes (Structuring)

Step 3:Capital Protected Note issuer receives USD 10.0 million from Investor and distributes the cash as follows:

Zero Coupon : USD 10.0 million * 0.950860 = USD 9,508,600.00

USD 10.0 Million

Option: USD 10.0 - 9,508,600.00 = USD 491,400.00

Step 4:Computation of Participation Rate:How many options can you purchase with USD 491,400.00?

30

Principal Protected Notes (Structuring)

How many options can you purchase with USD 491,400.00?

1 option (on USD 10 million) is worth USD 10.0 * 13.84% = USD 1,384,000.00

So you can purchase: 491,400.00 = 35.50% (Participation Rate) 1,384,000.00

Step 5: Payout Formula: USD 10.0 million * [ 100% + 35.50% * Performance]

Where, Performance = Max [ 0, (IPC final - IPC initial) / IPC initial ]

31

Principal Protected Notes (Structuring)

Comparison of P&L: Capital Protected Note vs Long IPC Position

At Expiration

$(4,000,000)

$(3,000,000)

$(2,000,000)

$(1,000,000)

$-

$1,000,000

$2,000,000

$3,000,000

$4,000,000

70 73 76 79 82 85 88 91 94 97 100

103

106

109

112

115

118

121

124

127

130

Final Spot at Expiration

Pay

ou

t in

US

D

Note Payout

Long IPC Position

Derivatives: Benefits & Issues

33

Benefits

The use of derivatives tends to increase liquidity in the local market.

The use of structured notes with guaranteed capital provides diversification over different geographic regions and economic sectors.

Derivatives transfer risk form one entity to another (e.g. Collars transfer downside as well as upside risk).

Use of derivatives would tend to increase the learning curve of the pension fund’s managers as well as that of local banks and other local investors.

Local banks could eventually compete with international banks offering a wide range of derivative products, and thus creating a more sophisticated local capital market.

34

Issues

Use of derivatives may lead to an increase in volatility of the fund’s Net Asset Value.

The size of the derivative market depends on the size/liquidity of the whole market.

Lack of derivatives knowledge could lead to an increase in risk rather than a decrease in risk if instruments not properly managed.

The use of derivatives could impose challenges to the regulators in monitoring the mark-to-market of the funds (especially if complex structures are included).

35

Monitoring the Mark-to-Market

In Latin America the regulators use different benchmarks to monitor the use of derivative products.

In Argentina for example, regulators only allow the use of those derivative instruments that the regulators themselves understand, are capable of pricing and monitoring.

In Mexico, the regulators have assigned the task of monitoring the mark-to-market of pension funds to specialist companies called “Price Vendors”.

Which method is better?

36

The DIVA’s Story

In 1996 the regulators in Argentina allowed the use of DIVA’s and “Fideicomisos”.

DIVA’s and Fideicomisos are zero-coupon instruments (CDs in the case of Divas and Zero-Coupon in the case of Fideicomisos) with embedded options.

The DIVA’s and Fideicomisos were indexed to a series of equity indices and bonds (i.e. the Dow Jones, Nasdaq, Nikkei, Argentina 07, etc.)

The use of these structured notes allowed local banks to obtain inexpensive deposits while pension funds with “low risk” diversification products.

Allowed the pension funds to diversify risk with a 100% investment protection.

37

The DIVA’s Story

DIVA’s and Fideicomisos were improperly valued.

DIVA’s and Fideicomisos became very popular in Argentina during in 1997 that 1998 to take advantage of the valuation methodology in order to boost Net Asset Values.

About USD 2,500 million were outstanding during 1997.

Since the valuation methods were corrected, the use of Diva’s and Fideicomisos has been steadily declining.

Currently, structured notes are used as capital protected investments aimed at diversification.

38

The Diva’s Story

-

500

1,000

1,500

2,000

2,500

3,000

Dec

-96

Sep

-97

Jun-

98

Mar

-99

Dec

-99

Time

US

D (

mil

lio

ns)

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

45.00%

50.00%

% o

f T

ota

l A

sset

s

Divas in USD

CDs in USD

Divas % of Total

CD % of Total