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Innovative swapping

By Zvi Bodie and Joseph Cherian*   
  • Asia
  • Global
Financial swaps can help Asian pension funds to diversify globally, avert domestic capital flight

As volatility in currency markets and rising inflation becomes an increasing threat to economic growth, the more vulnerable and smaller emerging market economies have been looking inwards. Malaysia’s Employees Provident Fund (EPF), for example, announced this year that it intended to allocate more of its investments to local asset classes. In Thailand, a majority of the assets of the Social Security Fund, the country’s biggest pension fund, is already invested locally.

The extent of this so-called home bias can be seen in the chart below, which shows the share of domestic capital market investments of several Asian countries’ pension and sovereign funds against total assets under management.

Except for Singapore, even developed Asian economies like Japan and Hong Kong have almost 60% of their pension-linked asset allocation in local markets. In emerging economies like Thailand, Malaysia and Indonesia, pension and sovereign wealth funds allocate 60%-90% of assets to domestic securities.

Singapore’s mandatory Central Provident Fund (CPF) is unique in this respect. It invests exclusively in special Singapore government bonds. The bond proceeds are managed by GIC, the sovereign wealth fund, which invests the money almost exclusively in overseas assets. By comparison, Singapore state investment company Temasek Holdings invests about 24% domestically. 

Reasons, and the costs

There are several reasons for the home bias of government funds, particularly pension funds in the more vulnerable and smaller emerging market economies, including: 

– To support the local capital market’s stability, growth, and liquidity;
– As a backstop to the flight of domestic capital to safe haven countries during periods of extreme financial market stress;
– To avoid expropriation of their overseas assets by a “rogue” government.

In their defence, the reason for the recent inward-looking slant of some government funds is probably two-fold. They see good investment opportunities once again as the negative effects of Covid-19 on domestic sectors and industries moderate. And they view it as a national duty to assist in stimulating their country’s economic recovery. 

But there are costs involved in having a home bias. The renowned efficient frontier analysis from modern portfolio theory, which can be found in all MBA finance textbooks and programmes, demonstrates that global diversification improves and optimises the risk-reward trade-off in investing. Academic studies over the years have shown that individuals who have portfolios that are internationally diversified have better risk-adjusted returns than those who exhibit a high degree of home bias. 

Swaps as the solution

US economists Zvi Bodie and Robert Merton were the first to point out that government funds could use swaps to achieve the risk-sharing benefits of global diversification and hedging, while avoiding the flight-to-quality of scarce domestic capital to safe haven countries during periods of extreme financial market stress.1

In an article published 20 years ago in the Journal of Pension Economics & Finance, they demonstrated how swaps could be used to lower the risks of expropriation and the transaction costs of investing in other countries.

So, how can swaps be used by government funds for risk management purposes? 

In a simple application of Bodie and Merton’s theory in the context of Asia, we show how the region’s sovereign and national pension funds can achieve the dual objective of attaining global diversification to improve risk-reward trade-offs through global investing, and avoiding capital flight, which can have a detrimental effect on the local currency, economy, and well-being of the nation. 

Swaps can also be applied in the context of hedging, where macro risks like inflation can potentially be hedged on a second best basis even if the local sovereign doesn’t issue inflation-indexed bonds, which we consider the best solution.2 Properly designed and cleared swap contracts can also be executed in a cost-efficient manner and reduce the risk of expropriation. 

A primer on swaps

Financial derivatives for prudent risk management have existed for a long time. Various derivative instruments are used on a daily basis to manage and hedge risks of all types, from currencies and commodities to equity indices and interest rates.3

Swaps are financial agreements between two parties that agree to exchange a set of cash flows based on a pre-agreed benchmark and a notional value. For example, a ten-year US$100 million notional value interest rate swap between party A, who wishes to swap its floating rate exposure for fixed rates every six months, and party B, who wishes to swap its fixed rate exposure for floating rates every six months, implies that on a semi-annual basis, the net difference between the semi-annual floating and fixed rates is calculated on the notional value over the next ten years. That difference, also known as netting, is paid in cash to the party with the beneficial net return over that six-month period. 

In other words, party A has transformed its floating rate exposure to a fixed rate, while party B has transformed its fixed rate exposure to a floating one over the next ten years. While the notional value may sound large, the actual amount exchanged every six months between the two parties is just a fraction of the notional value due to netting. Yet both parties have achieved their risk management objectives on their respective $100 million interest rate exposure over the ten-year tenor of the swap. 

Figures from the Bank for International Settlements show that the notional value of all outstanding derivative contracts, including swaps, was $610 trillion at the end of June 2021. That’s more than six times the $96 trillion global gross domestic product last year. Meanwhile, the gross market value of derivatives, which provides a measure of the contract value actually at risk, was only $12.6 trillion or 2% of the notional value, while gross credit exposure was just $2.7 trillion or 44 basis points. 

The swap can also be quanto’ed, which means if the swap is on interest rates with different currencies, the exchange rate can be fixed ahead of time. Hence neither party faces currency fluctuation risk over the life of the swap contract.

An illustration

It’s instructive to provide an example with respect to global diversification in order to fix ideas in the current context. Let’s assume pension fund A in the US has $20 billion passively invested in US equities, say the Russell 3000, and pension fund B in Malaysia has invested the same amount in local currency – around 88 billion ringgit – in Malaysian equities in the FTSE Malaysia Index. 

The funds can enter into an equity total return swap (TRS), which agrees to exchange the total returns of the Russell 3000 for the FTSE Malaysia returns on a notional value of, say, $5 billion on a quarterly basis for the next five years at the dollar/ringgit exchange rate on the date of the agreement (i.e., quanto’ed).

Multilateral banks and financial institution such as the World Bank, the International Monetary Fund, the Asian Development Bank and the Asian Infrastructure Investment Bank can also serve as the counterparty to the vulnerable economy’s national pension fund; in our hypothetical example, that’s pension fund B.

The beauty of this form of agreement is that netting ensures if the Russell 3000 returns 4% in the current quarter, and the FTSE Malaysia returns 5% over the same period, only the net return of 1% on $5 billion, or $50 million, flows from pension fund A to pension fund B this quarter. Yet both pension funds have achieved an international diversification level of 25% of total portfolio value without any substantial capital flight from the local economy to the overseas country, at least in terms of the S$20 billion of assets invested. Rather, just $50 million was exchanged between the two pension funds in the current quarter, with the money flowing from the US to Malaysia in this period. 

Swap arrangements can also be conducted in a cost-efficient manner and under the watchful eye of the International Swaps and Derivatives Association (ISDA), which develops master agreements and related materials to ensure their internationally standardised contracts, payments, collateral, and the risk of expropriation are well-managed, fulfilled, and enforced. 

Time for Asian pension swap shops?

Despite the efficiency of swaps in achieving cost-efficient international diversification for the institutional fund and mitigating capital flight, pension and government funds, particularly those in Asia, hardly use this risk management product in the manner described above. Here are the ways they can do so:

  • Global diversification: In Malaysia, pension funds would like to invest more of their capital in the local market to support the economy and reduce capital flight. But they appreciate the benefits of international diversification and efficient frontier analysis. They could enter into equity returns swaps with various pension counterparties around the world, exchanging Malaysian equity returns for foreign ones. 
    In Thailand, the Government Pension Fund is overweight on local equities and bonds and would like to diversify its portfolio into international asset classes. Here, both total return (equity) and interest rate (fixed income) swaps could come in handy.
  • Hedging: If Malaysian pension funds want to index their members’ pre-retirement earnings or post-retirement payouts to inflation in some form, and no inflation-indexed bonds exist in Malaysia, they could exchange their sovereign sukuk or Islamic bond rates for US TIPS inflation-indexed rates via interest rate swaps.
  • Supporting domestic markets without sacrificing diversification: The GIC would like to continue its constitutional mandate to invest its assets outside of Singapore. However, the sovereign wealth fund and its sole client, the Ministry of Finance, realise the tremendous benefits of domestic institutional fund management activity with respect to stimulating the local financial market, liquidity, price discovery, jobs, and the economy. So the GIC could redeploy part of its overseas assets in Singapore’s financial markets to fulfil its domestic responsibilities while entering total returns swaps to achieve its international investment and diversification mandate. This is a case of killing two birds with one stone.

A small economy, particularly those in Asia, need not sacrifice its comparative advantage, be it in manufacturing, drilling, agriculture, financial services, biotech, etc., in order to achieve the benefits of portfolio diversification across industries and internationally at the government fund level. 

Financial swaps done via the proper Asian sovereign channels, ISDA’s standardised agreements, and perhaps even with collateral management and marking-to-market through established clearing houses, allow for the benefits of diversification and hedging at the national level, i.e., risk re-allocation, in a cost-effective manner. This can be done without having to disrupt the local real economy while mitigating the risk of (nationalistic) expropriation.

* Zvi Bodie is professor emeritus at Boston University and has served on the finance faculty at the Harvard Business School and MIT Sloan School of Management. Joseph Cherian is practice professor of finance at the Asia School of Business and Cornell University (visiting). 


“International Pension Swaps”, Zvi Bodie and Robert C. Merton, Journal of Pension Economics & Finance, Volume 1, Issue 1, March 2002 (Cambridge University Press).

“Worry-free Inflation-Indexing for Sovereigns: How Governments Can Effectively Deliver Inflation-Indexed Returns to Their Citizens and Retirees,” Zvi Bodie, Joseph Cherian and WK Chua, in Lifecycle Investing: Financial Education and Consumer Protection (CFA Institute), The Research Foundation of the Chartered Financial Analysts (CFA) Institute Publications Series, November 2012.

The US Federal Reserve regularly enters bilateral and multilateral central bank liquidity and currency swap agreements with a number of foreign central banks, including those in Asia. These swaps provide much needed U. dollar lines of credit to the counterparty central bank(s) during periods of extreme financial economic stress.